Klaus Regling: “I hope Ireland realises that a lot of help has been provided”
“We know from experience that structural reforms combined with fiscal adjustment, over time leads to higher growth”
The is the full text of The Irish Times interview with European Stability Mechanism (ESM) managing director Klaus Regling on July 22nd, 2013.
PRECAUTIONARY CREDIT LINE FOR IRELAND
Suzanne Lynch, European Corespondent [SL]: Ireland is entering the final phase of the programme - it had its eleventh troika review last week - and intends to exit its bailout programme and return to private market funding by the end of the year. Do you think it needs the support of a precautionary credit line?
Klaus Regling [KR]: It’s hard to say. The first thing to say is that Ireland has made very good progress. The objective of every support programme is to return to the market. Ireland has been able to return to the market already, even with a 10 year government bond issue, there was one in March , and there were shorter maturities and all were at reasonable rates. 10 year government bonds for Ireland now have a yield in the secondary market of below four per cent. That’s a very reasonable rate and in that sense Ireland is already a success story and very close to normal market conditions . I know there is a debate out there about what should happen after the end of this programme, but I cannot add very much to that because we are now in July and the programme ends in December. I am very happy to see the 11th review was concluded successfully like all the reviews before, so let’s see in a few months time where the country stands. Concerning your question on a precautionary credit line I can only say that in principle the instrument is available.
SL: Yes, so what possibilities are there from the ESM’s perspective?
KR: The ESM has a precautionary programme, like the IMF offers such a programme. It has never been used so far at the ESM. It does require a request from the government of the beneficiary country to the group of euro finance ministers, the euro group, which is our board of governors. It would require, in five or six member states, approval by their parliaments.
SL: What kind of conditions would it require?
KR: That is really impossible to say. That would depend very much on the assessment at the time.
SL: As you say the bond yields have come right down below 4 per cent. There’s been a huge drop.
KR: By more than two thirds. Very impressive!
SL: But how important is it - Ireland has a budget coming in October - that Ireland implements this cut of €3.1 billion in terms of it exiting the bailout and keeping those bond-levels down?
KR: I think that is certainly one of the elements markets are looking at. They want to know how the budgetary developments are. Ireland comes from a particularly high fiscal deficit. We know why, it is the result of recapitalising banks. Ireland had in that context the highest deficit of any country in Europe, or maybe the world, so Ireland has made good progress. But it is important to continue that. All our member states agreed on the revised stability and growth pact which requires to move first to a deficit below 3 per cent of GDP and then towards a balanced budget. It is important to make progress in that direction. I think that at the end of the 11th review, it was very clear that another €3.1 billion fiscal adjustment as foreseen under current rules and as previously agreed with the authorities is the important next step.
SL: You mentioned there that any decision on a precautionary credit line would need the support of the euro group...
KR: Oh absolutely, there the rules are very clear. We can only engage into a new programme, whether it’s a full scale macroadjustment programme or a precautionary programme, if the euro group takes an unanimous decision.
SL: So do you think that Ireland needs to stick to its target in October in order to get the support of the euro group?
KR: I don’t know what the conditions would be, but if the agreed target were not reached I’m sure that would not be well-received.
SL: Ok, to move on, to the direct bank recapitalization instrument. This was a real priority for Ireland in terms of the retroactivity element, and it was seen as a victory for Ireland and Portugal last month when the euro group agreed to look at this on a case by case basis. Irish people have been told, or believe, that this will be open to Ireland. Do you think this is realistic?
KR: Firstly the agreement to create the instrument of direct bank recapitalisation once the ECB plays its role as a single supervisor is a very important step for Ireland, but also for the entire euro area. The reason is that it is one of several elements of the banking union that we are trying to achieve and I think that’s very important for the euro area as a whole, including Ireland. The question of retroactivity is controversial. The euro group agreed to consider it on a case by case basis and to decide on it by mutual consent, that’s what the communiqué said. So it’s impossible for me to judge today under which circumstances it might be approved.
SL: Is it not the case that the whole ambition of direct recap has been scaled back slightly? There’s a belief out there that it might never happen. Now it is dependent on the Bank Recovery and Resolution Directive being passed by the European Parliament. Is direct bank recap ever going to happen?
KR: The euro group, the 17 finance ministers of the euro area, agreed on the main features of the instrument, so here at the ESM we are preparing ourselves to be ready in case a formal decision is taken later to create this new instrument. We received the mandate to prepare ourselves and I assume we would not have been asked to do that unless ministers wanted to use it once the circumstances are in place under which they want to use this instrument. When you say there is a general feeling it has been scaled back, I don’t know whether you refer to the media, or to analysts. There is a bit of fluctuations in these feelings. Two weeks before the main features of the direct bank recapitalisation instrument were agreed there was a general feeling in many newspapers that it would never happen, that there would be no agreement. But there was agreement. And I think that was positive for the euro area as a whole.
Of course one has to look at the overall context. The ESM has an overall lending capacity of €500 billion. We have many instruments available. We know that direct bank recapitalisation takes a lot of our capital, up to three times more than for a normal macro-economic adjustment programme. That’s why the overall amount that is potentially available for direct bank recap was capped at €60 billion. The reason for this cap is that everyone agrees that enough money should be left for the other instruments that the ESM has at its disposal, in particular the macroeconomic adjustment lending . That will remain the main focus of the ESM. But direct bank recap very likely will become a new instrument, an additional instrument, and again we are preparing ourselves.
SL Do you have any views on its suitability for a country like Ireland. Politically a lot of store is put on something like this . A lot of ordinary tax payers feel that while the changes in banking union shifts away the burden from the tax payer and onto private creditors, that’s too late for Ireland, that wasn’t available for Ireland, so Irish people feel they are entitled to get some of the money they put into the banks. Do you agree with that? Or do you think that Ireland doesn’t necessarily need this to regain private market funding? How important do you think it is?
KR: It is easy to say it would help, but the eurogroup communiqué said that the decision to use the direct bank recapitalization instrument retroactively would be taken on a case by case basis and by mutual agreement. It will be up to the political level in the euro area to decide how that is interpreted. At the same time I hope Ireland realises that a lot of help has been provided, because the financing we provided, that the IMF has been providing, and also third countries have provided over the last two and a half years comes at very low interest rates, so Ireland benefits from this low interest rate.
Our own lending is provided at less than one and a half per cent for instance so that’s a big benefit for Ireland as it is for other countries that borrow from the EFSF. There are also special arrangements with the ECB that have been found, where the Irish banking sector benefits greatly. We know that the crisis has put a huge burden on the Irish taxpayer, the Irish population, but there has also been a lot of solidarity from Europe and the international partners.
SL: There is a sense that the Irish government is quite wary, quite concerned about signing up to a precautionary credit line that would have onerous conditions. Does it actually need a precautionary credit line. Could it go it alone? Do you think the government has a strong argument there?
KR: It’s very hard to say because the programme still runs until December.
SL: Well that’s less than six months away.
KR: I think it makes sense to think about it. It’s an option. The conditions are clear but then it is up to the Irish government to decide whether to make a request or not.
SL: Michael Noonan said last week that a 12 month credit line would be appropriate. Do you think a longer credit line would be better?
KR: We would always start with a 12 month credit line. It can be extended, two times six months , but it would always start with a one year credit line if that is requested.
SL: You were involved in one of the early banking reports on Ireland. There’s a call in Ireland at the moment for a banking enquiry. Do you’ve any ideas of how a banking inquiry might work, and would it be helpful for Ireland to have a banking enquiry?
KR: I don’t have a view on that. The report I did three years ago with my co-author Max Watson was something different, it was about the origins of the crisis, what had happened and how the problem had become so big. I am happy to see that the report is still read in Ireland and has been useful. There have been other reports, from the governor of the Central Bank. I can understand that the Government wants to dig deeper into this, but I cannot really give advice.
SL With your experience, particularly during the report you highlighted problems such as lack of regulation, pay etc. Where do you think Ireland has made the most progress. Is it in competiveness, for example?
KR: When I look back, the origin of the crisis was of course a combination of a macroeconomic environment including very liquid markets, pro-cyclical policies in the later years and a lack of adequate regulation. There were also governance problems in banks, so it was a whole list of things, and what you mentioned, a loss of competitiveness, which has improved greatly now. Policies have been implemented to address that issue. If you look at competitiveness measured by unit labour costs: In the first decade of monetary union, unit labour costs in Ireland increased by more than any other country in the monetary union and about 50 per cent more than in Northern Europe and that’s why the current account deficit of Ireland was around 6 per cent of GDP. It became unsustainable, but the adjustment already happened 5 years ago . Starting in 2008, competitiveness has improved. It’s still above the level in Northern Europe but has come down a lot from the earlier peak, and is now maybe 15 - 20 percentage points above Northern Europe when it used to by 50 percentage points. That’s the positive implications of nominal cuts in civil servants salaries, pension payments and of course also a lot of progress on the fiscal side. On the whole banking and regulatory side there has also been significant of progress.
BANK STRESS TESTS
SL: There is a worry about the bank stress tests next year. Do you have a concern that this could damage the recovery, or show up capital holes?
KR: I don’t know if it is a concern but I think it is very important to have the asset quality review . We have two steps. First the ECB before taking over as a common supervisor will do the asset quality review for the banks it will supervise. This is important as they have to know what they’re getting into. Then, on top of that there will be the stress tests in the second quarter of next year. I hope this is not a concern, I think this should be very positive, to discover whatever problems there are. If there are problems it is better to know about them, and do something. The worst from a confidence point of view would be not to look into this and to leave some fears and worries which exist in international markets, and I’m not talking about Ireland now, but I am talking about the entire euro area. There are some concerns in markets that there might be problems in individual banks and banking systems. It’s very important to address those concerns, through credible asset quality reviews, and credible stress tests to put those concerns to rest and if there are problems we will have to deal with them.
SL: And will the ESM play a role?
KR: We know that there’s agreement among ministers about the Bank Recovery and Resolution Directive. Of course now this needs to be discussed with the European Parliament so we don’t know the final form, but there will be a certain sequence in how to involve bank creditors, and when public money might be used if it’s needed. The hope is of course that no public money is really needed. If it’s needed then ultimately of course the ESM could play a role so I think we have several lines of defence here that can be activated. So again I think it’s really important to do these reviews, these stress tests, see if there are problems. My expectation is that there are not too many, but it’s very important to really dig into it in a credible way so that these concerns in markets once and for all can be put to rest.
SL: when you talk about credible lines of defense, are you talking about something like you have for Spain, for example...that kind of model?
KR: That’s one instrument that we have and that continues to exist even after the direct bank recapitalisation might become an additional instrument. The instrument we used in Spain consists of helping a bank or a national banking system by providing a loan earmarked for bank restructuring but providing the loan to the government. That instrument will continue to exist. It’s always an option. Of course the expectation is that only countries use it that need outside help. Countries that are in a fiscally sound situation are not expected to request assistance from the ESM.
SINGLE RESOLUTION AUTHORITY
SL: Just on the banking union, there have been suggestions with the Commission’s proposal on the Single Resolution Authority, that the ESM could play a role there. What’s your views on that?
KR: There’s not much on that in the Commission proposal. But there’s a debate out there. The first point I would like to make is that the Single Resolution Mechanism, the SRM is an important complement to the ECB’s role as an SSM, as a Single Supervisory Mechanism. I think there is agreement on that among the euro area countries that we need something like the SRM. Now there are different ways to do it, to organise it. I think a discussion has now started in a serious way after the Commission put out its proposal. We know some countries believe it cannot work that way, that a treaty change is needed to give legal certainty about the procedure.
A sound legal basis is of course very important, because to close banks, to have bank resolutions is a very serious interference in property rights and we have to expect that when this happens litigation will follow in many cases. So a sound legal basis is very important. It’s very good to have a serious debate now with the Commission, the European Parliament and the Council on how to organise this, but in the end there has to be a single resolution mechanism. That’s important for the functioning of the banking union. It must be on a sound legal basis. That’s what counts for me. It’s not important who does it.
SL: Do you think the Commission is the right body to do it.
KR: The Commission has of course a lot of experience, particularly its Competition Directorate General. In the context of their state aid rules, it has gained a lot of experience in the last few years in restructuring banks. Therefore the Commission will always play a role because state aid rules will always come into play when a bank gets public money.
SL: And do you think the ESM would be a suitable institution?
KR: I’m not lobbying for that. There’s not much synergy that I can see for the ESM to play the SRM role . It’s different with the single resolution fund which will also be needed to collect the money from the banking industry. There the ESM can probably offer some synergies, but that is only a very small aspect of the whole operation.
SL: It was suggested last week that the ESM could play a role in dealing with tracker mortgages in Ireland, moving tracker mortgages from bank balance sheets.
KR: I was a bit surprised because that instrument doesn’t exist at all for the ESM. And I don’t see an appetite among the euro area countries to create a new instrument.
IMF ROLE IN TROIKA
SL: You’ve mentioned before the IMF’s future role in the troika, questioned that. Vivian Reding last week said something similar...
KR: It was not similar. I said the same that the ECB and Olli Rehn have said: that we need the IMF in the troika in the short and medium term. Only in the long run one could reconsider that. So I think for the assistance programme that we have at the moment, for five countries, the IMF plays an important, complementary role that I would not question.
SL: How important is banking union and is it progressing fast enough?
KR: I think it’s the most important project we have at the moment. It’s partly to improve confidence for now, but also very important to prevent the next crisis. It’s important now because there’s good progress in the different countries in fiscal adjustment and the improvement of competitiveness where it is needed. More than half or maybe two thirds of adjustment in these two fields has happened. On the banking side we see continued problems with the renationalisation of banking. There’s a fragmentation of markets, which leads to substantial interest rate spreads, not only for the sovereigns, but for private sector borrowers in countries in the periphery compared to countries in Northern Europe. These high borrowing costs, for all borrowers, SME’s and non financial corporations in the countries in the periphery are a burden for the real economy, for the recovery of these countries.
SL: But the ECB keeps saying this, but should they do something about it then?
KR: The ECB is doing things about it by making refinancing easier, for example through the so called LTRO. But banking union is the other means through which we try to address this problem, because the different steps that comprise banking union are designed to create confidence in the market, about the sustainability, the irreversibility of monetary union. This will improve confidence in the banking system in the euro area and if we succeed in doing that, if confidence comes back, then these spreads will come down.
SL: When you say banking union, deposit insurance scheme is one plank of that and that seems to be losing support among member states significantly.
KR: That is one of the elements and probably the one that will happen last in the sequence of steps. It’s very complicated because every country has a different system, every country in the euro area has a deposit insurance scheme but the way it is set up differs from country to country. Some countries have actually accumulated money that has been sitting in a pot, others have just promises and guarantees in place, so to put all that together is very difficult.
SL: And Germany is particularly concerned?
KR: Germany has particular difficulties because inside Germany there are different schemes, three different schemes. If everything is being harmonised they would also have to be harmonised. This takes time, it cannot be done overnight.
SL: What we’re seeing now is that even though the threat of a euro zone exit has receded , bond spreads have come in, there seems to be a potentially more insidious problem of entrenched unemployment and also challenges politically. There are tensions in Portugal and Greece in implementing fiscal consolidation measures. Do you think these fiscal consolidation measures still need to be sustained, or have they worked?
KR: Without the fiscal consolidation measures we would not have seen stabilisation of markets. The spreads show it very clearly. It’s very painful for the population. That’s not a contradiction to other improved macro-economic indicators unfortunately, because labour markets always react later than the other indicators. There are very good reasons that markets have stabilised and calmed down. In this phase incomes are cut, consumption is weak, domestic demand is weak, GDP drops. This is unfortunately unavoidable. If one moves from a situation where incomes were too high, one has to move to a new equilibrium. But experience elsewhere in the world and in Europe shows that it works particularly well if these measures are combined with structural reforms. We know from experience that structural reforms combined with fiscal adjustment, over time leads to higher growth and employment.
This has been confirmed, over the last 50 years, in all the IMF programmes. Many people in Europe believe what we are doing now in Europe is completely new. It’s perhaps new for Europe, but it’s not new when you look at economic history. It happened in the Latin American debt crisis in the 80’s and 90’s . It happened in the Asian crisis in the 90’s. There’s always the same sequence. Initially incomes drop during the adjustment phase, but if this phase is combined with structural reforms, conditions are created for a period of sustainable growth afterwards.
I was just in South America last week. Brazil, for the last 5,6,7 years was one of the star performs of the world economy. They went through a very serious difficult adjustment, with high unemployment and declining incomes in the 80’s and again in the 90’s . The same happened in South Korea, Indonesia Thailand in the late 90’s, the same happened in Turkey 13, 14 years ago. This adjustment period is always difficult, but then there’s a turning point.. and all these countries that went through a difficult period ten or 20 years ago, are now performing very well.
SL: This is a different situation though because we have 17 euro zone countries, with a single currency
KR: It’s not so different. The one difference is that countries don’t have the exchange rate to adjust. That’s the reason why all these countries in the periphery have decided to cut incomes. Nominal income cuts have become a substitute for the exchange rate instrument. That is new. This has not happened in other countries, but the effect is comparable because countries like Brazil, Indonesia, Turkey had a serious devaluation of the exchange rate , subsequently followed by high inflation, so in real terms the income also fell. The effect is the same. As a result competitiveness is restored, exports are growing and the current account deficits disappear.
SL: But the effect of falling incomes has had a knock on effect on the ability to pay back private debt , for example in Ireland, the fall in income has accelerated, for example, the problem with the mortgage books.
KR: But you can do an experiment in your mind and think about what would have happened if Ireland had had its own exchange rate. It would have devalued, inflation would be much higher, interest rates would have gone up a lot in response to high inflation and weak exchange rate, so everybody with a variable mortgage would really have suffered more.
EXIT STRATEGY AND OMT
SL: In the next few months in the run up to exiting the bailout, would you like to see more aggressive, more frequent, bond issuance by the government?
KR:I cannot give advice on that. I see that Ireland like other countries has done some prefunding. That’s positive. It helps confidence in the markets. But as to whether more or less of that would be good I cannot give advice. That’s for the Irish debt office to decide.
SL: But presumably the troika is giving advice. It’s going to be a very powerful force in the next few months.
KR: Yes, but not so much in terms of debt issuance.
SL: Do you think Ireland should be eligible for OMT?
KR: Well you know what the conditions are for OMT. There has to be an ESM programme in place that allows for the possibility of primary market purchases, and then it’s up to the ECB to decide. In my view, at the current interest rate level, there’s no need for OMT at all.