Why talk of a unilateral default is hopelessly naive

 

ECONOMICS:A co-ordinated approach by the euro area as a whole to debt issues is one that cannot be ruled out, writes DONAL DONOVAN

IN THE days leading up to the announcement of the IMF-EU agreement last Sunday, calls mounted for some form of credit default (or “burning of the bondholders”) to be part of the deal. The argument was simple – foolish lenders had contributed in no small measure to the problem so they should be forced to bear some of the cost.

Some had even suggested that since the bailout money would substitute for market financing, we would not have to worry about the adverse reputational effects of any loan default. But the clear statement from the IMF-EU representatives last Sunday that there is no question of any default being part of the agreement put paid to that line of thinking – which was hopelessly naive to begin with.

A major part of the whole deal, especially so far as the EU is concerned, is to try to restore market confidence in the euro area as a whole. Any talk of loan default right now is anathema to that objective.

Apart from the IMF-EU “bosses” saying no, are there other reasons not to pursue the default route? Proponents of haircuts sometimes refer to the defaults by Argentina and Russia of about 10 years ago, observing that despite taking such a dramatic step, Argentines and Russians do not appear to be living in abject penury. Might there be a case for Ireland being able to get away with the same approach?

Argentina and Russia had ended up with very large foreign debt – yes, partly reflecting prior reckless lending behaviour – and had exhausted all market sources of financing to roll over the debt. Even the IMF, which had been continuing to lend (albeit somewhat controversially), finally gave up due to the lack of progress on reform.

The house of cards collapsed and the governments of both countries, in the absence of any funding, announced unilateral debt defaults. Eventually, after many years of acrimonious negotiations, a settlement of between 30 and 50 cents on the US dollar was in essence imposed on a “take it or leave it” basis.

Both Argentina and Russia, of course, suffered enormous reputational damage and their access to credit markets 10 years afterwards remains highly restricted.

The same, presumably, would happen in Ireland’s case – a point that the pro-default lobby would reluctantly accept (although they would argue that “eventually” the markets reopen for defaulters). But how have these countries been managing in the meantime? There were two critical features that distinguish their situations from that of Ireland.

First, both countries had independent currencies; in the wake of the financial collapse, massive devaluations occurred. These helped the adjustment process, encouraging exports and compressing imports. Argentina and Russia achieved rapid growth during much of the ensuing decade. They also had the option, as a back-up measure, to print money to make up for any possible budgetary shortfall that might still remain, despite the default removing most debt service payments from expenditures.

Second, Argentina and Russia experienced good luck. Both depended heavily on primary commodities for exports and associated budgetary revenues. Primary product prices shot up in the years following the default and this provided a further major boost to growth and bolstered government taxes.

But these features are absent from the Irish economic landscape. Following a “forced” haircut by Ireland, how would we finance our ongoing budgetary deficit – of the order of €20 billion or so – since we cannot print our own money?

If markets were to shut us off in the wake of a default, the provision of basic services by the State could grind to a halt quickly. Moreover, we would not experience the pro-growth stimulus associated with a currency devaluation. Finally, we have no reason to expect a jump in export prices that helped Argentina and Russia.

If one is really serious about trying to make a go of the “default route”, it would be necessary to contemplate life outside the euro area so as to take advantage of some of the economic flexibility that comes with an independent currency. The political and economic consequences of such a step – even if it were legally and financially possible, which is doubtful – are enormous.

Not all of the bondholders are speculative types from abroad.

Unfortunately details on the institutional composition of the bondholder category have not been made available publicly, probably because of data problems and confidentiality reasons. However, as pointed out by Antoin Murphy of TCD, there is reason to believe that Irish institutions, such as pension funds, represent a significant component. There is thus a clear risk that with a default operation we could end up partly shooting ourselves in the foot.

In all fairness, the position of others in the pro-default group can be interpreted as advocating a co-ordinated approach by the euro area as a whole to the issue, as opposed to a unilateral action by Ireland. This is a very different matter. We know that “burning the senior bondholders” has been ruled out until 2013 by the IMF and EU.

The current EU approach rests on the gamble that the problem can be contained sufficiently so that whatever bailout packages are required can be pushed though, despite public misgivings in contributing countries. But if the costs – probably involving more countries than currently foreseen – were to go beyond a certain level, the German taxpayer might run out of patience. Under such a scenario, and despite all the current assertions to the contrary, bringing forward the 2013 date in order to effect a haircut earlier would by no means be ruled out.


Donal Donovan was a staff member of the IMF during 1977-2005 before retiring as a deputy director. He is currently adjunct professor at the University of Limerick and a visiting lecturer at Trinity College Dublin.