Making sure Ireland is no 'lab rat' in experiment

 

BUSINESS OPINION:Should the Government keep trying to convince the market its ‘repaying’ plan is working, asks JOHN McMANUS

THE MARKETS – as represented by a cabal of foreign commentators and large global banks – seem to be daring the Irish Government to orchestrate a structured default by the banks, Anglo Irish Bank and Irish Nationwide in particular, on their secured bond holders.

The proposition that is being formulated is that making the banks’ bond holders share the pain of rescuing the sector will take the pressure off the Government finances and thus actually underpin the creditworthiness of Irish Government debt rather than undermine it.

Many domestic commentators have been banging this particular drum for quite a while, but have been marginalised easily enough by proponents of the new orthodoxy that a default or quasi default – ie by one of the Government-backed banks – would be calamitous for the sovereign rating.

This consensus has taken on the same mantle of unchallengeable truth worn by the “soft landing” view of Ireland’s economic prospects three years ago. For this reason alone, the whole default debate probably deserved a far more serious airing than it has received. In any case it is now getting one in the international debt markets, with rather frightening consequences for the cost of borrowing.

The likelihood of an Irish default – and the pros and cons of one – have been the subject of numerous substantial pieces of “research” published by big investment banks, notably Barclays Capital and Citi.

They all come with the health warning that these banks are big players in the market for Irish Government debt and that, by and large, anything that adds to volatility in the price of Irish bonds equates to an opportunity for profit for them.

But the common theme is that a point will come when the Government could argue that the cost of rescuing the banks is so high as to be counter-productive because so much money is being sucked out of the exchequer to support the banks that the State’s ability to service its debts is jeopardised. At this point it would make sense to stop putting money into the banks, however, this would result in their bond holders having to meet the losses.

This is the opposite of the message promulgated by the same international banks for the last two years; ie that burning the bond holders would so badly damage the Government’s ability to borrow the money it needs to keep the show on the road that it would jeopardise the solvency of the State.

The two positions are not as incompatible as they seem. It is really a question of the amount of money involved and once you pass a tipping point the logic reverses.

The pertinent question is whether we have passed that point. The answer is that no one knows. The current level of Irish bond yields – teetering as they are on the verge of unsustainability – is an indication that lenders to Ireland are in two minds.

The Government seems adamant that we have not reached this point and is engaged on a rather belated campaign to convince the market. Hence the tough talk about the coming budget and the attempts to provide a degree of certainty about the cost of bailing out Anglo Irish Bank.

Indeed, Barclays and Citi would seem to agree with them, but their support is very heavily caveated. Two or three things could tip the balance they argue, the most relevant is that the bill for the banks exceeds current estimates forcing the Government to suck more money out of the economy, stalling growth and pushing up interest rates in some sort of death spiral.

The unpleasant truth is that this scenario is somewhere between possible and probable. The disappointing second quarter growth numbers of last week highlight the fragility of the situation. Likewise, the jury remains out on whether the banks have a handle on their non-Nama loan losses and can absorb them without needing more money from the Government.

One way of looking at the crisis surrounding Irish bonds is that the Government is being asked by its potential lenders what plan B is if the current plan does not work out.

The high rate of interest being demanded probably represents a mixture of concern that the current plan may not be working and also that there does not seem to be an alternative plan, bar vague talk of unspecified assistance from Europe in return for not provoking a secondary European banking crisis.

The dilemma for the Government is whether it should persevere with trying to convince the market its plan – which envisions repaying Anglo Irish and Irish Nationwide bond holders – is working, or engage in the debate about alternatives, which has to include looking at a structured default.

That, of course, is not the end of the matter, with the debate then quickly moving on to – at what point do you pull the trigger on plan B? Do you wait until things get really desperate or try and get out in front of the issue as some of the more gung-ho commentators suggest?

The only thing that can be said with certainty about such an unprecedented course of action is that Ireland would become a lab rat in some sort of massive macro economic experiment to see if an orchestrated default on the debt of a nationalised bank would actually engender confidence in the sovereign. And it is worth remembering lab rats don’t tend to survive experiments.