After quietening down for a few months, the European sovereign debt crisis has hit the headlines again over the past couple of weeks, with Ireland now firmly in the market's firing line. On 11 November 10Y Irish bond yields hit 8.7%, according to Bloomberg, 630bps above the benchmark German Bund yield. Five year yields also spiked to levels that, on a purely financial basis, would make it worth the Republic's while to ask for help from its neighbours.
The market consensus now seems to be that Ireland is all but doomed. But, unlike Greece, the picture is not quite as clear. Ireland is a small, very open economy – exports and imports typically both account for over 80% of GDP. It has a large fiscal deficit that the government is trying very hard to bring down, with dire consequences. But, unlike Greece, Ireland was not running persistent trade deficits in the run-up to the crisis, and was not too reliant on domestic demand to drive growth. In fact, Ireland was running persistent trade surpluses, even if the proceeds were often then repatriated to foreign owners of Irish businesses. Ireland wasn't even running small persistent fiscal deficits before the crisis – indeed, its pre-2008 fiscal record was arguably the best in the euro area, with gross government debt shrinking to just 25% or so of GDP in 2007. Greece and Ireland do have some fundamental differences.
Unfortunately, one of those fundamental differences is the banking sector. While Greek banks are understandably under pressure, the Greek banking system is nowhere near the size of the Irish one, in relation to the overall economy. Back when governments first started underwriting their banks, the Irish guarantee stood out as being a bit of a stretch – because, at the first attempt, the Irish state underwrote every penny of the banking sectors' deposits and debts, to the tune of 240% of GDP. Even the US would struggle with that, let alone a small open economy.
Despite updating (and restricting!) this guarantee, these chickens have now come home to roost. The Irish banking sector is essentially bust, in an operational sense, and entirely reliant on the state. Earlier this year we witnessed the ridiculous spectre of all the Irish banks passing the European banking stress tests, only for Anglo Irish Bank to then need yet another bailout just weeks later. Unlike the financial sector interventions in the UK – which, provided Osborne is not a muppet, I still think the UK taxpayer will ultimately make a small amount of money on – the Irish taxpayer will foot a big bill for their bail-outs. The big problem is that no-one knows just how big that eventual bill will be.
To its credit, the Irish government recognised fiscal worries early on, and has been doing its best to take steps to get the public finances back under control. The problem is that they are trying to hit a moving target, because the eventual losses from the banks are endogenous – there is something of a viscous economic circle at play. The government raises taxes and cuts spending to cut its deficit and restore market confidence. But that then undermines economic growth – the Irish economy shrank a further 1.2%Q/Q in the second quarter of 2010 – and ultimately threatens deflation. In fact, Ireland has already been here: according to the Irish CPI, prices started falling in October 2008, with twelve-month inflation staying in negative territory from the start of 2009 right up until July of this year, troughing at -6.6%Y/Y in October 2009. This pushed Ireland into a sharp, but thankfully temporary, period of debt deflation, where the real burden of household (and bank) debts rose far more quickly. That pushed more borrowers into trouble and default, which pushed up bad loan rates and provisions at the banks, meaning they required more government support. And, with the fiscal position already under scrutiny, that puts pressure on the Irish government to do more to get the public finances back under control, and we are back to square one.
Hopefully, this economic cycle is now much diminished; the fact that Ireland has exited deflation, for one, is very encouraging. But the market is demanding further action despite the fact that Ireland has enough funding to get it to June or July, and after that can survive for a while by rolling short-term debt (even Greece is rolling t-bills right now). The Republic's next big repayment is not until November 2011, when around €4.5bn of principal and interest falls due.
Ireland, then, has time. And its small size, and relatively small debt stock, means that the European Financial Stability Fund – which has resources totalling €750bn, with the IMF's support – is more than capable of providing it with support. In fact, European policymakers have a fantastic opportunity to inflict massive losses on hedge funds and investment banks right now. All they need to do is announce a conditional facility for Ireland – something big, say of the order of €80bn, covering around 60% of Ireland's total debt stock – to provide a clear signal they are backing Ireland up. The Irish would not need to draw on those funds straight away, although they might want to use a bit, just to scare people. But the very fact a large lump of money was sitting there waiting to be used would drive bond yields and CDS spreads lower – imposing massive losses on those who have come along for the ride and are selling off Irish debt because they pay too much attention to the Telegraph. Come on, Europe. You have a chance not only to save Ireland, but to hit 'em where it hurts too. Don't waste it.