By Invitation: Ireland's Bailout -- One Year On

This article was contributed by Dick Roche. Dick was Ireland's Minister for European Affairs until March 2011. At this time, national elections resulted in a loss of the Fianna Fail party, which had been in power during the 2008-2011 Irish financial crisis. In this article, Dick Roche provides an exclusive, inside view of the state of public finances, the impact of bank lending to the real estate sector, and the negotiations which led to the Irish bailout.

This is part of a paper delivered to the "Quo Vadis Europe" conference organised by Suomen Keskusta, the Finnish Centre Party and the European Liberal Democrat and Reform Party (ELDR), held in Helsinki on Monday 14 November. Dick is Vice President of the ELDR and a member of the European Consulting Network's  Advisory Board.

A year on since the IMF and ECB arrived and the events of the first 3 weeks of November 2010 are still shrouded in something of a fog. It will take time before a full, dispassionate and objective history of all the events of those fateful November days is written. It is instructive none-the-less to look back a year later at the events that convulsed the nation and that brought about such a fundamental political change.

THE CREDIT CRUNCH: A DOUBLE WHAMMY

Between 1995 and 2006 the Irish economy boomed, fuelled in part by cheap capital raised in the interbank market. New operators arrived on the banking sector with ‘less restrictive’ policies an issuing loans. The ‘new competition’ and ‘greater flexibility’ in banking was widely welcomed at the time.

The massive inflow of cheap capital and the dumping of traditional banking standards fed a property bubble of historic proportions.

From the mid 1990s to 2007 property prices rose to astronomical levels. This in turn triggered an explosive expansion in the building industry, particularly home building.

In spite of record housing output, property prices continued to escalate: the ‘law’ of supply and demand was stood on its head – a classic property bubble.

Employment in the building industry rocketed. Tax take from that sector boomed so much so that there where demands for cuts in stamp duty.

The ‘Celtic tiger’ lost its stride in 2007.  It came to a juddering halt in 2008. Following the Lehman debacle credit virtually disappeared. Banks that had been pushing loans would not part with a cent. Building projects were abandoned, property sales crashed, prices plummeted, major developers failed and tens of thousands of building workers lost their jobs.

State tax revenues went through the floor. Irish public finances that had been in a state of rude good health for years became terminally ill.

From mid 2007 the Irish banking system experienced serious difficulty financing day-to-day operations. Alarm amongst senior bankers grew and as the summer of 2008 drew to an end, turned to outright panic.

A final blow for the ‘Celtic tiger’ came in September 2008. Inadequate and lax supervision by the Irish regulatory bodies and criminally irresponsible behavior by some bankers had undermined the entire banking system. The Irish Government was asked to rescue the banks.

Faced with the prospect of a bank meltdown the Irish Government introduced its controversial, but later widely copied, bank guarantee scheme.

PAINFUL CUTS

Two years later and Irish banking was still on life support, kept afloat through ECB intervention, state recapitalization, by selling off non core businesses and by being relieved of its assets (including some regarded as ‘toxic’) at written down prices by the creation of a state asset management agency. Non-Irish players were getting out of Irish banking.

On top of all the other woes  Eurostat demanded a reclassification that had the effect of  revising Ireland’s  budget deficit upwards to 14.3 % from 11.7 %. The Finance Minister pointed out that "There is no additional borrowing associated with this technical reclassification” and that it would not deflect from reducing the deficit to below 3 percent of GDP by 2014," Lenihan said.

Dramatic and painful steps were also taken on public expenditure.

By October 2010, €15 billion in adjustments had already been implemented. A further €6 billion in spending adjustments were signaled for Budget 2011.

It was planned that by December 2011 Ireland would be 2/3 of the way to meeting the EU target of bringing our deficit below 3% of GDP by 2014, in spite of the Eurostat reclassification.

On the surface, things were beginning to look positive. Exchequer returns for end October showed tax take ahead (1%) of profile. Exchequer spending was below expectations. Ireland was fully funded until mid 2011. There was a cash balance of €22bn in NTMA and an additional €25bn in the National Pension reserve.

Work was underway on a four-year plan to map out a way forward to national recovery.  There was even a degree of political consensus on what had to be done.

Ireland’s efforts to halt the slide were widely acknowledged.

Commissioner Olli Rehn pointed out that Ireland had formidable strengths; strong economic fundamentals; well-educated labour force, strong export growth and a strong private sector.

A communiqué issued by the EU Economic and Finance Council acknowledged the ‘significant efforts of Ireland’ to address our problems, welcomed the four year budgetary strategy, expressed  ‘full confidence’ that it would ‘firmly anchor’ the 2014 date Ireland’s deficit.

The Council also approved Ireland’s intended frontloading a further €6 billion in adjustments in 2011 and acknowledged that proposed ‘structural reforms’ would result in Ireland being able to ‘return to a strong and sustainable growth path’.

Read the full article on ECN By Invitation. 

Toward a Grand Deal on Bank Refinancing and Sovereign Loans

The recent move by central banks in the United States, the United Kingdom, Switzerland, Australia, Japan and the Eurozone (the European Central Bank) to extend US dollar credit facilities to the banking sector may presage the beginning of a "grand deal" on sovereign debt and bank refinancing. 

The signs of this are visible in several decision and results of this past week. 

On Wednesday, November 30th, the central banks made a coordinated move to reduce the interest rate on US dollar swap lines by 50 basis points through February 1, 2013. At the same time, China reduced its bank cash reserve ratios by 50 basis points. While this brought about a short-lived market rally as liquidity fears were alleviated, it does little to manage the fundamental problem. Signs of this became visible later in the week. 

Negotiations reported today in Bloomberg indicate a plan for $ 270 billion in central bank loans, including the European Central Bank, to the International Monetary Fund, for the purchase or refinancing of European sovereign debt, including Italian and Spanish debt. This would enable the ECB to bypass restrictions on direct purchases of Eurozone sovereign bonds, and would bring the IMF in as a co-lender, as well as to enforce austerity programmes. 

Der Spiegel reports that so far, the ECB has purchased EUR 173.5 billion in sovereign bonds. This probably caps the amount the ECB can spend on further sovereign purchases, absent a larger political decision. However, the Financial Times reports that bank deposits with the ECB have risen to above EUR 300 billion, indicating once again that a fundamental driver of the current credit crunch is a lack of trust, not necessarily a lack of funding. 

Bloomberg reports the scale of refinancing needs in 2012, quoting a Citigroup report that Eurozone governments need to refinance EUR 1.1 trillion in 2012, while European bank s have a further $ 1,035 billion due in the same year. Der Spiegel reports that French, Italian and Spanish bond maturity to April 2012 amounts to EUR 425 billion.  

The scale of the problem is therefore clear: governments must refinance a large amount of bonds maturing in 2012 (these numbers do not include the United States, the United Kingdom, or other indebted countries such as Turkey). Banks are reluctant to refinance, or unable to given the Greek PSI and increased capital requirements. 

A grand deal would seek to solve these two factors in parallel, using the following steps: 

1.     Extending ECB lending as well as maturity terms to banks. This would require quantitative easing for the private sector by the ECB, and also extending maturities from 1 year to possibly 5 years. 

2.     As part of such an agreement, banks agree to repurchase a certain share of Eurozone sovereign debt, most likely in the range of 60-65% of total outstanding debt.

3.     The IMF steps in with a formal austerity programme for Italy and Spain, enabling them to refinance part of their needs using ECB-IMF resources. It is likely that IMF-ECB resources of at least EUR 200-250 billion will be needed. 

4.     The ECB is given limited authority to continue secondary market sovereign bond repurchases, perhaps by another EUR 100-150 billion. 

5.     The banks agree to participate in the European Financial Stability Facility (EFSF) capital increase, perhaps to EUR 800 billion. This add about EUR 400 billion to the fund, which is then used to repurchase sovereign bonds as well as possibly bank refinancing. 

6.     The Eurozone adopts much stricter rules on the public finances of its member states. It is not impossible that a "new Eurozone" emerges. 

7.     The European Banking Association (EBA) delays its core capital increase, or alternatively allows an exemption for central bank guarantees or ECB credit lines. It is difficult to see exactly how this would work, but some solution will no doubt be found. 

A key problem with this scenario is the capital shareholding of the ECB. At present, its capital is only EUR 10.76 billion, not counting of course the capital of its constituent national central banks. Nevertheless, a substantial increase in the ECB's capital will be needed to sustain a further EUR 300-400 billion increase in lending capacity.

While this is a technical operation, legal resistance to ECB lending policy among some countries, and the impaired status of certain Eurozone NCBs, will almost certainly complicate matters. But a formal capital increase will no doubt be necessary (unless of course this can of worms is kept in the dark, with the mutual agreement of all parties).

But at the end of the day, this exercise is all about two things: trust and credibility. If the Eurozone comes up with a credible grand bargain, the banking sector has no choice but to participate, since the alternative is too frightening to imagine.

Such a decision will have to be taken as soon as possible, certainly within December, if panic is to be avoided. 

(c) Philip Ammerman, 2011

Navigator Consulting Group 

www.navigator-consulting.com