ECONOMICS:Our bank guarantee misdiagnosis can be remedied if the creditworthiness of the State and banks is reinstated, writes JOHN McHALE
IT’S ALL about the banks. So went the Government’s line for most of the week as it tried to explain the pressure coming from our European partners to take financial assistance. In puzzling contrast, the funding situation facing the State itself was not seen as posing any such urgency, with various Ministers pointing nonchalantly to cash reserves sufficient to see us through until June.
We are partly in this fix because of an earlier misdiagnosis. In September 2008, the Government made a double mistake: first confusing a solvency problem for a liquidity problem; and then providing a blanket guarantee for practically all funding, when what was required was a much more limited guarantee of short-term and new borrowing.
To stop a run, a guarantee was provided to bondholders who could not run. That decision made it impossible to share fairly the burden of bank losses without the State defaulting on its guarantee. The result was an erosion Ireland’s “fiscal space”, compounding our deficit-induced loss of creditworthiness.
There is no doubt the European Central Bank’s concern over its large and rising exposure to Irish banks was the trigger for pressure to accept outside support. With the markets’ ongoing doubts about capital adequacy, the banks had been relying on the Eligible Liabilities Guarantee – the guarantee on new borrowing in place since December 2009 – to secure wholesale funding. Unfortunately, the value of the guarantee eroded along with the creditworthiness of the State. The flare-up of the banking crisis is thus a (very significant) symptom of the deeper creditworthiness problem.
The idea that the State’s creditworthiness is not an urgent problem because of the availability of a cash buffer is simply wrong. One factor supporting creditworthiness since the crisis began has been the large cash reserves accumulated by the National Treasury Management Agency, with the further backstop of the assets in the National Pension Reserve Fund. These reserves provided investors with protection against self-fulfilling runs, making it less likely that such runs would get started in the first place. Burning through the cash would make it harder to establish market access.
While hugely challenging, the path to renewed creditworthiness is clear enough. With a minimal amount of luck on economic growth and an affordable interest rate, a credible commitment to a €15 billion adjustment over the course of the four-year plan should produce a primary budget balance that stabilises the debt/GDP ratio, the critical requirement for State solvency.
While doubts about growth and interest rates have fuelled market concerns, the biggest doubt about our creditworthiness is whether we have the political capacity to push through the needed adjustments to our spending and taxes. Political squabbling and attempts to pass the burden between different interest groups has not helped. The announcement of the four-year plan and the budget provide our best chance to demonstrate that we can do what is necessary.
Whether we call it a “bailout” or a “contingency fund”, an EU/IMF financial support package on reasonable terms would provide an invaluable backstop in this effort.
Such support works at two levels. First, it sets an upper limit on the interest rate, taking away a large part of the risk of explosive debt dynamics. Second, by making any disbursements conditional on following through on the measures committed to in the four-year plan, it helps build credibility for those measures.
Understandable concerns have been raised about the loss of sovereignty that comes with conditional financial support. While past IMF interventions have come with too much interference, I think the threat to sovereignty is easily exaggerated in our case. If the four-year plan is being designed as it should be, there should be very little additional conditionality necessary.
Our European partners in particular have little interest in being seen to force policies on us against our will. In the context of an adequate plan of our own, we should in any case resist unreasonable interference. Our corporation tax rate is a case in point.
On the other hand, we need to recognise the need to bring income demands into line with what if is feasible to pay. Unfortunately, the Croke Park deal looks increasingly unaffordable given the size of the adjustment needed. It is also an impediment in the design of a broadly fair plan.
Central Bank governor Patrick Honohan provided a needed dose of reality and clarity on Morning Ireland yesterday. Ireland needs a significant support package, with the majority coming as a credit line to the State.
Given their funding difficulties, a portion of this could be used to bring the capital of the main banks up to levels demanded by the markets. (One bit of useful conditionality would be to require that losses are shared with unguaranteed bondholders in insolvent banks in the context of a fast-tracked special bank resolution regime.) Effectively, it would be a belt and braces approach to finally fixing the banking mess: ample buffers of capital to meet market demands underpinned by State guarantees with renewed credibility.
The Government got its diagnosis wrong with the blanket guarantee – with horrible consequences. Both it and the Opposition must now recognise the urgent requirement to regain the creditworthiness of the State. With everyone focused on the four-year plan and the budget, there will not be a better opportunity to convince the markets that Ireland’s political system can deliver. Once we get over the initial shock, a non-intrusive package of funding from our international partners in support of our efforts will significantly increase the chances of success.
Prof John McHale is head of economics at the school of business and economics, NUI Galway.
