Merkel hit below belt but Ireland was already on ropes

Fri, Nov 19, 2010, 00:00

SERIOUS MONEY:JOE FRAZIER ranks among the most talented prizefighters ever to grace a professional boxing ring. Smokin’ Joe won the heavyweight title in 1970, though he will always be remembered for his epic encounters with Muhammad Ali.

The pair first traded punches in New York during the spring of 1971 after Frazier successfully petitioned President Nixon to restore Ali’s licence to box – which had been revoked following his refusal to join the armed forces when drafted during the Vietnam War. Smokin’ Joe took the honours in the so-called “Fight of the Century”, but lost the rematch in the same city three years later.

The boxers met for the last time in Manila’s sweltering heat 35 years ago. Frazier returned to his corner battered, bruised and barely able to see through his swollen eyes at the end of the 14th round. His trainer, Eddie Futch, signalled to the referee to end the bout, and though the boxer protested, Futch told him, “It’s all over. No one will forget what you did here today.”

The Irish sovereign is engaged in a Fight of the Century, but is currently losing on points, as the yields available on Government debt securities have soared across the entire maturity spectrum.

The yield on 10-year bonds has increased by 135 basis points since the start of the month and is 235 basis points higher than the recent low registered in mid-October.

Meanwhile, the spread versus German bunds has widened by two percentage points during the past month to 5.7 per cent. The spread on two-year notes has also soared, as investors deem a negative debt event to be ever more likely in the immediate future.

The renewed turbulence began on October 19th when Taoiseach Brian Cowen revealed the State would need to increase its planned budgetary consolidation significantly over the next four years.

Matters escalated following Angela Merkel’s proposal for a permanent rescue mechanism as of 2013 that would entail debt restructuring with losses for private holders of sovereign bonds. The German chancellor stated: “We must keep in mind the feelings of our people, who have a justified desire to see that private investors are also on the hook, and not just taxpayers.”

Merkel’s statement of intent threw petrol on the fires that were already burning in the euro zone’s periphery, and the subsequent mayhem forced the finance ministers of Germany, France, Italy, Spain and Britain to issue a communiqué at the G20 summit in Seoul. This stated that consideration for private sector participation, “does not apply to any outstanding debt and any programme under current instruments. Any new mechanisms would only come into effect after mid-2013 with no impact whatsoever on current arrangements.”

The statement has not undone the damage inflicted by Merkel’s below-the-belt blow and has only served to focus investor attention on the periphery’s future financing needs. Needless to say, the Irish sovereign received a standing count and is being asked to accept help via the European Financial Stability Facility.

Being offered assistance to minimise contagion is a far cry from requesting help, and the Irish should acquiesce, though not before using its leverage to negotiate the best possible terms.

The status quo simply cannot be sustained indefinitely, and though the Government may be fully funded through to the middle of next year, the banking sector’s increasing dependence on the European Central Bank, combined with reduced credit availability and higher borrowing costs, is almost certain to precipitate a further downturn in private sector demand.

The removal of uncertainty should bring interest rates down and enable the powers that be to get on with the important business of fiscal consolidation. In this respect, recent turbulence overshadowed the Government’s announcement the overall fiscal consolidation required to reduce the deficit to 3 per cent of gross domestic product (GDP) by 2014 is estimated to be in the region €15 billion, with €6 billion of the total budgetary adjustment to occur in 2011.

The growth assumptions accompanying the release look far too optimistic, however; household consumption is sure to decline next year in the face of tax increases and lower levels of employment. Application of more reasonable assumptions across-the-board leads to the conclusion that real GDP will grow by no more than 1 per cent next year, while the general government deficit relative to GDP could well be north of 12 per cent.

The disappointing outcome then raises the issue of whether a debt restructuring is likely. Conservative growth numbers suggest gross debt would exceed 125 per cent of GDP by 2014, while the deficit would still be unacceptably high at about 5 per cent. The calculations indicate the levels of debt are unlikely to stabilise by the end of the forecast horizon, which means more consolidation and more pain. The probability of default is thus unacceptably high. It may soon be time to accept the fight is over.