Coalition's primary task is to reassure the markets

 

OPINION:The Government has a job to do to convince foreign investors that its banking and fiscal policies are on course, writes PHILIP LANE

LAST WEEK’s stress tests of the four Irish-owned “live” banks carries a high fiscal cost. The injection of an extra €24 billion into these banks is intended to assure the markets that they will have more than enough capital to deal with adverse scenarios in the coming years.

While part of the extra capital can be raised through debt reduction exercises with subordinated bondholders and other private-sector strategies, the direct sovereign contribution is expected to be in the region of €19 billion, give or take a billion or two.

Accordingly, the net liquid financial position of the State will decline by this sum (with a reduction of €10 billion in the National Pension Reserve Fund and the addition of the balance to the gross public debt).

In time, some proportion of the €19 billion may be recovered if bank losses do not reach the levels envisaged in the adverse stress scenario outlined in last week’s scenario. However, a significant part of the State’s contribution will be eaten away by loan losses over the next several years, in addition to the €13 billion in capital losses that are envisaged through the asset sales required as part of the banks’ deleveraging over the next three years.

While the publication of the stress tests is a necessary step in the recovery of the banking system, it is vital to emphasise the health of the system ultimately rests on the underlying fiscal position of the State. The four banks hold about €11 billion in Irish sovereign bonds and €13.4 billion in Nama bonds.

Accordingly, the markets recognise these banks are directly exposed in the event of a restructuring of Irish sovereign debt. In addition, these banks heavily rely on State guarantees to fund their positions, in terms of the deposit guarantee and the guarantee of some bonds. The sustainability of the Central Bank in providing emergency liquidity assistance is also underpinned by the quality of the State’s finances.

More generally, the history of fiscal crises shows governments often turn to the local banking system as a source of implicit or explicit funding. While such financial repression measures are surely a more limited option for a member of a currency union, it remains the case that the future net profitability of the Irish banks would be more assured if the current uncertainty about the sovereign fiscal position were resolved.

The market focus is now fully directed at the many open questions concerning Ireland’s fiscal position. A core issue is whether the new Government is fully resolved to implement the fiscal adjustment that has been agreed with the “troika” – the EU, IMF and ECB.

In the near term, investors will be looking at the outcome of the first major review of the programme that is taking place over the next couple of weeks for assurance that the external funders are satisfied with the progress so far and the plans for the future.

More generally, the programme requires the implementation of many individual reforms and the Government has yet to fully clarify how it will execute a number of these.

Both the investor community and the international policy community are also looking to the Coalition to communicate its adjustment and recovery strategy in a consistent and integrated fashion. Here, it is important to strike a balance between taking local responsibility for fixing the structural budget deficit and returning the public debt to a less risky level, and explaining that the State funding of the rescue of the banking system has been in part provided on the basis of supporting European-wide financial stability.

While there is a good degree of domestic understanding of this narrative, this is not the case in all corners of the international system.

In relation to the sustainability of the high public debt, the Government faces a number of challenges. While a one percentage point reduction in the interest rate on the European component of the troika funds would be a valuable contribution, the scale of the associated interest savings is not a game changer. Moreover, to assure investors of its commitment to fiscal sustainability, the savings from such an interest rate reduction should be applied to reducing the debt level, rather than scaling back the volume of fiscal adjustment.

More broadly, the key problem facing Ireland is that there is a wide dispersion of beliefs concerning the prospective growth rate of the Irish economy. This uncertainty will not be resolved in the near term, since the biggest divergence in views concerns growth rates in 2013 and beyond.

An important line of thinking rests on the international pattern that output growth tends to be very slow for up to a decade in the wake of a banking crisis. A more optimistic view points to the capacity of a small, flexible economy to adopt an export-led strategy that can deliver a more rapid recovery.

Since the medium-term growth path for Ireland will not be revealed for a considerable period, the ability of the Irish government to re-enter the sovereign debt market would be facilitated by a redesign of the troika loan that allows for this core uncertainty. In particular, the repayment terms of the loan (the interest rate and/or the duration of the payback period) should vary with the performance of the economy, with greater net payments if the economy does well and lower net payments if economic growth is disappointing.

As with any insurance scheme, such a facility would require intense monitoring by the funding agencies to ensure that Ireland pursues maximal pro-growth policies. But Ireland’s fiscal position would be significantly stabilised by such a reform, to the benefit of Irish taxpayers and international creditors.


Philip Lane is professor of international macroeconomics at Trinity College Dublin