Strongest argument against a State default has disappeared

Fri, Nov 26, 2010, 00:00

ANALYSIS:If Ireland is forced to default, better that it happens after restabilisation, writes DAN O'BRIEN

MANY SERIOUS people, in Ireland and elsewhere, have reached the conclusion that the Irish State cannot support the debt burden it has taken on.

Flowing from this conclusion comes the view that a portion of that debt must be defaulted on. The most obvious and frequently mentioned portion of that debt that advocates of default point to are monies lent to Irish banks, including senior bonds.

There are very powerful arguments to support the default view, and the strongest argument against it, from Ireland’s perspective, evaporated last week – that argument was that any default on bank bonds would cause lenders to stop giving money to the Government to fund its deficit. That has now happened anyway.

It is no longer in Ireland’s narrow national interest to prevent senior bondholders from suffering the consequences of their own bad judgement.

But this is very unlikely to happen, in the short term at any rate. That is so because a consensus exists among European policymakers regarding the extremely weak and fragile state of the Continent’s financial system.

It has been based on a view that the system might not survive the direct and indirect effects of a default shock – the direct effect would be tens of billions of losses distributed across the system and the indirect effect would be panic as other bondholders realised that their government-backed protection had been removed.

This consensus is also informed by how, in hindsight, the US authorities grossly underestimated the effects of allowing Lehman Brothers to default 26 months ago; by how Europe’s financial system continues to function owing only to massive government support; and by the fear that there may not be enough additional government resources to keep the system standing in the event of another shock.

This view underpins the policy of preventing both banks and countries in the euro zone from defaulting on their debts since the crisis erupted.

It must be stressed that nobody can know for sure if this consensus is correct in general, and in particular what would happen in the event of a default on Irish senior bank debt.

But they are real risks, and policymakers are very much in the risk-management business now. They must consider the probability of an event happening and the impact it would have if it did happen. As the risk associated with large-scale default is high and the impact potentially massive, Europe is taking a cautious, if very costly, approach.

What does this mean for Ireland and its bailout?

In a nutshell, and as is the case with Greece, the bailout terms are likely to be stringent enough to ensure bailout is never the preferred option for any county, but not so penal as to make the repayment schedule obviously impossible to meet.

If repayment does become impossible, then more will be done to prevent default until the financial system can withstand the hit.

The bailout money to cover the Government’s budget deficit in the medium term (expected to be three years) is likely to be lent on terms similar to those given to Greece in April, with an interest rate in the region of 5-6 per cent, which is well below market rates. On that basis, this part of the problem could yet be overcome.

The real difficulty comes with the banks. Currently, they survive on the very cheap, short-term borrowings that the European Central Bank (ECB) has been providing all banks in the euro area as an emergency measure since Lehman Brothers crashed.

As the Irish banks rest fully on this buttress, the ECB’s freedom of manoeuvre has been curtailed. The desire to regain that freedom was one of the reasons the ECB triggered the EU-IMF bailout mechanism two weeks ago.

But the consequences of weaning Ireland’s banks off cheap ECB money simply transfers the problem. Support for the banks will have to come from the bailout fund, which, in theory, will offer cash at a much higher rate of interest. If a large part of the ECB funding were to be refinanced at a much higher interest rate, the State’s total debt burden (Government and banks) would become unmanageable.

It is truly difficult to see how the circle can be squared, but it must be, and with resources and creativity it can be, at least temporarily.

Dealing with the problem in this way is often described, unusually pejoratively, as “kicking the can down the road”. It may well be. But forbearance can work. It certainly buys time.

If Ireland (and Greece) are forced to default, better that it happens after the financial system has been restabilised, reformed and restructured so that it can absorb the losses without the risk of meltdown.

The avoidance of such a meltdown must be the over-riding interest of both Ireland and Europe now.

Dan O’Brien is Economics Editor

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