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 

To Bank or not to Bank

One of the inevitable consequences of the Greek and European debt crisis is the question of whether bank account deposits are safe. This question has been asked a number of times recently, but no clear answer is possible given the rapid changes in the financial sector. Another frequent question concerns the consequences of a Greek Eurozone exit: what practical effects would this have on banking, loans and deposits?

Some thoughts on the subject follow. These should not be construed as financial recommendations, and the author disclaims any and all liability for actions taken by readers as a result of this post.

Banking Safety

The Greek banking system is only functioning due to the extension of approximately EUR 150 billion in sovereign guarantees and emergency liquidity assistance issued by or through the Greek government. Moody’s estimates that non-performing loans in Greece will reach 20% over the next 18 months. A number of Greek and Cypriot banks have faced important write-downs in the past two quarters. On the wider European field, Standard & Poor’s recently downgraded 30 international banks, including major players such as Citibank, Bank of America, Merrill Lynch, Goldman Sachs and others. The recent collapse of Dexia, together with the massive share price falls of BNP, Societe Generals and others, compound the doubts most people have as to the security of their deposit accounts.

In most countries, holders of individual accounts are insured up to a specific level. However, the assumptions behind this insurance have never been tested in a system-wide financial panic. Given the dual threat of a large-scale sovereign financial meltdown together with a banking panic, it is impossible to tell what would happen in the worse-case scenario.

In choosing a bank for the purposes of asset safety in a worse-case scenario, I would use the following criteria:

a.     Jurisdiction: The bank should be located in a country with a well-regulated banking sector, where each bank must publish detailed financial accounts and a risk assessment. For obvious reasons, this should be outside the Eurozone, and outside the United States. (And probably not in Japan).

b.    Retail: The bank should be a retail bank as far as possible. I would avoid banking with any of the global giants with derivatives and public debt exposure. In other words, I would avoid keeping a deposit with a large investment bank which happens to have retail banking operations, unless this is in the United States.

c.     Currency Sovereignty: I would choose a country which is not in the Eurozone, and which has a positive trade balance, or other unique currency reserves or resources.

Drawing up a shortlist of non-Euro currency banks, I would probably choose Canada, Norway and possibly Switzerland* as countries in which to choose a bank if the priority is to gain deposit security in an independent currency.

Canada has one of the best-regulated retail banking systems in the world. It has been relatively untouched by toxic retail mortgages and, so far, by exposure to sovereign debt. Its oil shale resources mean that the country has strong economic growth in its future (with some caveats due to its exposure to the United States). The fact that it has its own currency and a well-functioning central banking system means that any damage will hopefully be limited in case of a downturn.

Norway is another solid bet. It is outside the European Union, but in the European Economic Area, and has natural gas and oil resources which feed into a sovereign wealth fund (the Global Pension System, or Oil Fund) considered a model in the industry. Its exposure to dodgy investments is moderated by ethical investment guidelines. In 2010, 38.5% of the Fund was invested in fixed-income securities; this rose to 44% in Q3 2011. The Fund is exposed to US, UK, French and German government bonds, and also to movements in EUR, USD and Yen. Its Central Bank is also well-governed and transparent.

Switzerland is a perennial favourite, but does have some significant systemic risks. UBS and other Swiss banks have accrued large scale exposure to foreign investment banks via loans and derivatives contracts, and also to foreign government bond holdings. The large scale of UBS compared to the Swiss GDP means that any downside movement in USB’s portfolio may have a disproportionate effect on its own capital structure, and on Switzerland’s capacity to recapitalise it. On the plus side, banking accounts for a major share of Switzerland’s economic success, and it is likely that any crisis will be managed adequately.

Looking at banks in the Eurozone, I would focus on retail banks in countries such as The Netherlands or Luxembourg. Luxembourg has a debt:GDP ratio of only 18%, and a fairly strong banking sector. Its small size (0.5 million) also means that its participation to any Eurozone bailouts will be limited. If your income is in Euro, and your expenses are in Euro, it is likely that opening a deposit account in a well-regulated, retail bank in these two countries is a safe bet.

Impact of a Greek Eurozone Exit

I’ve also been receiving lots of questions on what the impact of a Greek eurozone exit would be. I should make it clear in advance that I don’t believe this will happen, although the possibility is becoming increasingly possible given the wider financial crisis.

In the case Greece does exit the Eurozone, we can anticipate the following decisions being made as national policy:

a.     All Euro deposits will automatically be converted from Euro to the new currency

b.    All loans in Euro will be automatically re-denominated from Euro to the new currency

c.     It’s impossible to know what the exchange rate target will be, but the pre-ERM entry rate of 340.75 GRD:EUR is possible. If I were a Central Banker, I would push for a 1:5 or even 1:1 parity to try to lessen the “sticker shock” of such a change.

d.    In the run-up to the change-over, and for some time thereafter, it is likely that the government will impose capital controls to prevent capital flight. Thus, I would expect a limit on physical cash withdrawals, to a limit of EUR 500 per week, and a selective ban on international transfers.

We can anticipate that in the case of a Euro exit, the new currency will rapidly devalue against the Euro as Greek households and companies change the new currency for Euro. This is inevitable, given the large current account deficit. (About 50% of Greece’s imports are from the Eurozone; a large share of other imports are from China, Russia and the Gulf and are denominated in USD).

We can also anticipate that Greek inflation will rise in response to the currency devaluation. Inflation rates of 10-20% (CPI) are not impossible to imagine.

It will be impossible to tell what interest rate the banks will set for existing or new loans. This will be a key issue in debt service and wider consumer prosperity.

In any case, my personal opinion is that the Greek banking system is no longer solvent. Its exposure to Greek government bonds and non-performing loans in Greece, as well as its exposure to hard-hit sectors such as real estate and shipping, lead me to the conclusion that holding deposits in a Greek bank is no longer safe. My own strategy since 2010 has been to reduce my exposure and deposits as far as possible.

But I do not believe a Greek Eurozone exit is likely, unless this is driven by external factors, i.e. a break-up of the Eurozone for factors not relating to Greece itself. We should remember that the Euro is a real currency used by 17 countries and over 250 million citizens, and that there have been many cases where a sovereign debt and banking sector crash have occurred while a national currency has remained usable. We should also remember that the benefits of a Greek eurozone exit are miniscule, given Greece’s small GDP share of the Eurozone, while the contagion and moral hazard risks are disproportionately high. But this is not to say it couldn’t happen.

(c) Philip Ammerman, 2011

Navigator Consulting Group

www.navigator-consulting.com