Chance of defaulting on debts increases in absence of socialising some of losses

Fri, Apr 1, 2011, 01:00

ANALYSIS:The fastest way to stop Ireland being a problem for euro area as a whole is to provide a European backstop for the Irish banking system, writes DAN O'BRIEN,Economics Editor

EXACTLY SIX months ago, on the last day of September, a line was drawn in the sand. The final cost of the banking crisis was known, the then Government claimed. Even after yesterday’s announcements we still do not know that figure, because it is unknowable at this juncture.

The cost of the banking fiasco will depend on many things, including the pace of economic growth, property prices and the costs of servicing debt over the years ahead. The full and final cost will not be known until the economy has recovered and the State’s stake in the banking system has been sold off.

But getting from here to there is the problem. Indeed it has already proved so problematic that the State can no longer borrow in the normal way and has been bailed out by the international community.

Yesterday’s news that another €24 billion is to be pumped into the banks – €14 billion more than envisaged just four months ago when the terms of the EU-IMF bailout were set down – means even more debt on the State’s back, barring measures to place upon others, bondholders or European taxpayers,the losses generated by the banks.

At a briefing yesterday, Department of Finance officials euphemistically described efforts to achieve this as “mitigating actions which the Government are considering”. That there was no announcement yesterday from Brussels or Frankfurt on that issue demonstrates that there has been no agreement on how to deal with the running sore of the euro area’s banking system that is located in Ireland. This is disappointing but not surprising.

Euro area governments remain behind the curve on dealing with the Europe-wide crisis that threatens the existence of the currency. The failure last week to reach a “grand bargain” on the future of the euro, as leaders had previously committed to achieving, means much remains at play. Changes to the terms of Ireland’s bailout, including on how bank losses are distributed, will take place in that context. Nothing is agreed until everything is agreed.

But it should be clear that the fastest way to stop Ireland being problematic for the euro area as a whole is to provide a European backstop for the Irish banking system. Given the operational consensus that burning bondholders is too risky for everyone, the only was to do this is socialise some of the losses, or losses above a certain point, on a euro-wide basis.

In the absence of such action, the chances of beginning the long process of rebuilding the banking system will be impossibly difficult. It will also increase the chances of the State defaulting on its debts.

With considerable doubt about whether sovereign default could be avoided before yesterday, the situation is clearly more precarious now.

The reaction of the bond market this morning will tell a tale, but the risk premium on the Irish Government may not rise as the €24 billion figure will surprise nobody. Not only had leaks flagged to the markets the sort of figure to expect, but the European Commission and the IMF had signalled months ago that they believed much more than €10 billion would be needed.

In January and December respectively, these institutions published forecasts based on assumptions of €25 billion and €35 billion being shovelled into the banks.

By contrast, the previous government took a minimalist approach. In its budget forecasts, drawn up in December, it assumed recapitalisation would be kept to the €10 billion set out under the terms of the bailout.

As a result of yesterday’s announcement, the new Government has revised the official forecast for the size of the debt.

But, as the table shows, the new Government’s expectations of public indebtedness remain below the forecasts of the commission and the IMF. This is because of differences in what they believe will happen to GDP.

And therein lies the greatest unknowable – how much growth there is in the Irish economy in the coming years. Without growth, all bets are off.

What is known for sure after yesterday is the Irish banking fiasco will be one of the worst ever.

The most costly banking crisis to date took place in South Korea more than a decade ago. It ended up costing Koreans more than half their annual GDP. With yesterday’s announcement, Ireland is going to give Korea a run for its money when it comes to winning the booby prize for the biggest-ever banking bust.