Follow the Irish & Restructure Zombie Banks

Liam Halligan Daily Telegraph October 5, 2010

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Tuesday 05 October 2010 | Liam Halligan feed

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By Liam Halligan Published: 8:55PM BST 02 Oct 2010

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Jean-Claude Trichet, European Central Bank President, called Ireland a "role model" urging other countries to "face up to their problems.

The following day, Brian Cowen's government unveiled its plan to pump an additional €6.4bn into Anglo Irish Bank – the real-estate lender at the heart of the Republic's property meltdown. Having been nationalised in January 2009, the total cost of rescuing Anglo Irish could now be almost €30bn.

An additional €3bn capital injection into the much bigger Allied Irish Bank was also announced last week, with the state becoming majority shareholder in Ireland's second-largest lender. Finance Minister Brian Lenihan also admitted that even more rescue finance could be needed under a "severe hypothetical stress scenario" if Irish property prices fall further, and then fail to recover.

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In sum, Ireland's bank rescue, we now know, could cost this relatively small country an eye-watering €50bn – more than a quarter of total annual economic output. So huge are the immediate bail-out costs that the 2010 Irish budget deficit is now on course to hit an astonishing 32pc of GDP – 10-times bigger than eurozone member guidelines.

These are absolutely ghastly numbers, of course. But guess what? The fact that they're now in the public domain, that the government forced the banking sector to "fess up" its losses, meant that Irish sovereign debt rallied after ministers made their move. That's right – borrowing costs fell, a lot, as the all-important bond market signalled its approval at Dublin's determination to impose "full disclosure".

Back in 2009, Cowen and his team were widely

By Liam Halligan Published: 8:55PM BST 02 Oct 2010

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Back in 2009, Cowen and his team were widely praised as they took genuinely decisive action to get Ireland's fiscal house in order. The previous year, the Celtic Tiger had been severely wounded – after Ireland's runaway housing market and related construction boom went bang, the country enduring an economic implosion. This was made worse by the pound's fall against the euro, which meant Ireland lost competitiveness vis-a-vis the UK – still its biggest trading partner.

All this caused an unprecedented 7.5pc contraction in Irish economic output last year. Excluding profits made by the numerous multinational companies operating in Ireland, the drop was an even more shocking 11.3pc. As the economy went into a tailspin, borrowing costs surged, preventing the investment needed for recovery and turning bad debts even worse. As a result, Ireland's budget deficit soared to 14.3pc of GDP last year.

Cowen responded by imposing a one-off fiscal squeeze equivalent to around 6pc of GDP – through a combination of pay restraints, tax rises and curtailed public spending. The Irish were implementing in 12 months cuts roughly equivalent to those which British ministers insisted would take four years.

Jean-Claude Trichet, European Central Bank President, called Ireland a "role model" urging other countries to "face up to their problems, as the Irish so clearly have done – something that's now widely recognized". Sure enough, by April this year, the "spread" the bond markets charge to hold Irish 10-year debt over the German "bund" equivalent was down to 139 basis points, less than half as wide as the year before.

Since then, this spread has widened once more, reaching 450bp prior to Cowen's announcement.

Ireland is now being presented in a very different light. As anti-austerity protests raged across Europe last week, trade unionists argued that Dublin's predicament shows what happens if governments "fail to support the economy", by piling debt on ever more sovereign debt.

In the UK, senior Labour politicians, who earlier in their careers showed signs of economic literacy, are peddling the same economic snake oil. Ireland shows the "extreme dangers of austerity", they say. That's the message, of course, they must deliver to their public-sector union paymasters – manipulative, selfish men who represent less than a fifth of the British workforce. Senior Labour figures should know better – and they do! They've simply allowed their intellect to be trumped by their ambition.

A closer look at Ireland highlights the absurdity of what trade unionists are now saying. Ireland isn't Greece. Dublin hasn't tapped the European Union's €750bn rescue fund and last week's announcement makes it less likely it will do so – which is why 10-year sovereign bond yields fell more than a quarter percentage point, from 449bp to 422bp.

Yes, in recent months, Ireland's "bund spread" has widened – but so has that of all eurozone "peripheral" nations. This has been partly due to Germany's economic recovery – which has lowered yields on Berlin's sovereign debt – but also been because the eurozone has so far resisted printing money on the same grotesque scale as the US and UK. That's kept the euro relatively strong, making it even harder for small export-driven member states such as Ireland to recover.

A lot of the reason Ireland's new headline fiscal numbers look so bad is that they're far more honest than equivalent data being presented elsewhere – in the UK, for instance. Ireland's gross government debt is now expected to rise from 64pc to 98pc of GDP this year. That's not high by international standards, but the increase is obviously sharp.

Having said that, because Ireland has large cash balances in its National Pension Reserve Fund – net government debt will actually be around 70pc of GDP, not much more than in the UK. Consider, also, that in contrast to Ireland, the vast majority of Britain's massive public sector pension liabilities are unfunded and off-balance sheet.

Ireland's annual deficit figure – projected to balloon to 32pc of GDP – also warrants examination. This number actually includes the cost of the bank bail-outs, unlike its UK equivalent. Labour buried the cost of the RBS and Lloyds capital injections, not including them in the published deficit figures, a convention the Tories look set to continue. If Ireland followed the same methodology, its 2010 deficit would be 11pc of GDP, similar to the UK.

British ministers argue that bail-outs are "financial transactions" from which the government may eventually reap a return. So they shouldn't be included in the deficit. Such a position not only undermines the UK Government's fiscal credibility – effectively "banking" a return before it has been made. It also means the UK Government is petrified of taking the necessary steps to force banks to disclose their smouldering off balance-sheet liabilities, write-off losses and engage in root-and-branch restructuring – as that would cause the public finances to collapse.

Yet, as Japan's experience shows, such restructuring needs to happen, lest Britain's new "zombie banks" drain the life-blood out of the economy for years to come. Such necessary events can now take place in Ireland, given that the losses are "out there" and already on the Government's books.

No-one is saying the Irish economy is out of the woods. The situation is fragile – and could deteriorate. But amidst the scary headline numbers last week, few commentators noticed that Ireland cancelled bond auctions planned for October and November. That's because after a lot of pain, and some very tough decisions, the Irish government already has the cash it needs to fully-finance its budget until the middle of next year. Very few Western countries are in a similar position.

Ireland has a lot more to do. The losses that will now soon be imposed on junior creditors of its bombed-out banks should eventually spread to senior creditors too – so lightening the taxpayers' load. But, by revealing the banking sectors' vast losses and outlining a credible plan to fund them, the Irish have taken a step that others have not yet taken. Ultimately, they'll have to.

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