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11/22/2010

EU Rescue Fund: Ireland - Sending Out An SOS?

Christoph Weil, Commerzbank, Frankfurt.

This article appeared in the November 2010 issue of Current Economics with permission of the author.

Key Concepts: Rescue Fund | European Union | Fiscal Consolidation |

Key Economies: Ireland | Euro Zone |

 

By now, yields of ten-year Irish government bonds have risen above 8%, while Portugal’s are not much lower at 7% (chart 1). When Greek bonds were flirting with similar markers, the government waved the white flag and opted to call on the IMF and EU for bailout. Are Ireland and Portugal now queuing up for the EU emergency lending facility?

The rescue fund for deficit-stricken Euro zone countries (European Financial Stability Facility, EFSF)1, established on May 9 by the Heads of State and Government, can now be mobilised to make loans up to a maximum of EUR 440 bn to Euro zone member states in difficulty2. On top of that, EUR 60 bn in loans are coming from the EU budget and up to EUR 250 bn from the IMF.

The ESFS facility will only act after the country requesting support has negotiated an austerity programme with the IMF and the EU Commission and after the programme has been accepted by the Euro zone finance ministers. The Greek example suggests that the public deficit would have to be slashed to less than 3% of GDP over a three-year period. Provided these conditions are met, the ESFS will disburse the loan in tranches covering the capital requirements at the time.

Although it is not binding, the blueprint for interest to be paid on ESFS loans is the financial aid package to Greece, where the basis for variable-rate loans is the three-month Euribor, while fixed-rate loans are based on swap rates for the relevant maturities. In addition, there is a charge of 300 basis points for maturities up to three years and an extra 100 basis points per year for loans longer than three years, which makes longer maturities unattractive (chart 2). On top of that, a one-time service fee of 50 basis points has to be paid to cover operational costs. At present, interest on fixed-rate ESFS loans with a three-year maturity would come to roughly 5%.

The Greatest Advantage: Buying Time for Reforms and Consolidation

A country will only slip under the EU rescue umbrella if the associated economic and political benefits outweigh the costs. The great advantage of the ESFS safety net is that it helps to secure public financing over a three-year period, at conditions that are acceptable. As in the case of Greece, the aid programme would probably cover the country’s capital requirements until it expires, giving the deficit state the time needed to consolidate its budget and launch reforms.

The Costs of a Bailout are High

Obviously, a country will only apply for aid if it has to pay lower than market interest rates. However, the benefit of lower-cost financing has to be weighed against the considerable drawbacks coming with a support request.

Loss of Economic and Fiscal Independence

While deficit reduction is already part of the national stability programmes, it would have much more serious consequences if a country failed to meet the conditions set out in the negotiated austerity programme. In a worst-case scenario, the loan disbursements could be interrupted, with the result that the state has to declare bankruptcy. As in the case of Greece, the country programme would probably also include interim targets to see whether consolidation is making headway. If the targets were not met, additional austerity measures would have to be launched immediately, leaving virtually no room for independent economic and fiscal decisions. From a political point of view, the price to be paid is exorbitantly high.

Chart 1: It becomes increasingly expensive for Ireland and Portugal to borrow
Ireland's borrowing costs
Chart 2: Only three-year ESFS loans are attractive

ESFS loans

Returning to Capital Markets Could Prove Difficult

In addition, a country seeking support from the ESFS stands to lose its investor base. Amid the ongoing debate about the long-term sustainability of Irish sovereign debt, many investors have already become reluctant to invest in Irish government bonds. If the country submitted a request for ESFS support, it would de facto admit that it is unable to pay its debts, scaring off investors who are seeking safety. Before returning to the capital market, the country would have to convince investors that its default was a one-off, for example by launching structural reforms. This is not an easy task, as the Greek government recently had to learn. Although consolidation is on track, Greece has so far been unable to regain the confidence of investors.

The Critical Interest Rate Level Should Vary from Country to Country

The higher the risk premium on government debt, the more attractive it becomes for a country to apply for ESFS loans. Like in the case of Greece, markets should eventually develop their own dynamics, arguing that rising risk premiums will spiral higher yet, which could rapidly push interest rates up to the critical level.

However, the view as to when interest rates breach the critical level, prompting the government to pull the emergency brake, is likely to differ from country to country. Greece’s finance minister turned to the EU for aid after ten-year bond yields had climbed above 6%. As an Anglo-Saxon country, Ireland should be less inclined to give up its economic and fiscal independence, particularly in the light of still-considerable reservations about Brussels.

But the higher interest rates rise, the greater the degree of consolidation needed to stabilise government debt relative to GDP over the medium term. If real interest rates persisted at their current level of 10%, the budget balance before interest payments would have to be slashed by more than 15% relative to GDP.

It is Getting Tight for Ireland

There is some evidence to suggest that Ireland is approaching the critical level. Against this backdrop, it does not really come as a surprise that the Irish multi-year stability programme is overhauled in cooperation with the EU Commission. As a joint revision is not common practice, there is reason to suspect that the grounds are being laid for the austerity programme required to apply for financial support.

The Irish government will present its four-year fiscal consolidation plan by mid-November, which is to be followed by the 2011 budget at the beginning of December. More likely than not, this will be Ireland’s final chance to regain the confidence of investors. However, this will not be easy in the face of huge debts forcing Ireland to cut its structural deficit by more than 10% of GDP over a three-year period (chart 3).

If Ireland fails to stop the upward movement of risk premiums for its bonds, it will have to seek help from the EU rescue fund in the spring, at the latest. While the Irish government indicated it does not need to raise new capital before mid-2011, we argue that this only holds if the consolidation measures produce useful results and if no additional funds are needed to bail out the banking system. Moreover, a country cannot wait until the last minute to make its request. The ESFS itself expects that it will take four to five weeks after a country has applied for help to disburse the loan.

Chart 3: Still a strong need for consolidation

Consolidation in periphery

Source: Commerzbank Research


Debt Crisis Has Market Holding its Breath

One thing is clear: Discussions about government finances in the peripheral countries will continue to have a strong impact on the European sovereign bond market. The growing probability that Ireland will seek help from other euro countries is likely to increase demand for Bunds as a safe haven still further, thereby causing Bund yields to fall somewhat in the coming weeks. Furthermore, it is possible that, under the long-term crisis mechanism currently being discussed, private investors will no longer escape unscathed in the future when a country is unable to obtain funding in the capital market and therefore has to ask for assistance.

Discussions about a possible request for help from Ireland are likely to drive up the risk premiums of the other peripheral countries, at least temporarily. If Ireland has to be rescued, Portugal will also come knocking on the door of the EFSF, as investors will barely distinguish between Ireland and Portugal. Both countries are lagging well behind their consolidation targets. Even after Ireland has asked for help, the yield spreads of Irish government bonds relative to Bunds could go on increasing. After all, help from the EU and IMF would hardly put an end to discussions about a rescheduling of sovereign debt, though we regard this as unlikely during the term of the programme. The rating agencies are likely to downgrade the country’s creditworthiness still further – as in the case of Greece – while referring to growing doubts about the sustainability of the government’s debts. If Ireland loses its investment grade rating, this would put further pressure on Irish government bonds.





Notes:

1 www.efsf.europa.eu

2 The EU member states will provide guarantees for this sum in accordance with their share in the paid-up capital of the European Central Bank.


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