External bailout seems likely option as Ireland teeters on brink of abyss

Wednesday, September 29, 2010

Any rescue puts us between the devil and the deep blue sea, writes Constantin Gurdgiev

IT’S time to face reality. By all possible metrics, Ireland is in the deepest economic crisis known to the developed world this side of 1945.

Over the last six trading days we have posted consecutive Eurozone-wide records in terms of bond yields. The cost at which our Government can borrow funds is now in excess of 6.7% and climbing.

Our probability of default, as measured implicitly by CDS spreads on Government debt is several times higher than that of the embattled BP.

The problem faced by Ireland in the bond markets has moved beyond the liquidity crunch and straight into the realm of the impossible.

We are facing a solvency crisis fuelled by a runaway current spending deficit that this year – ex-banks’ recapitalisation measures – is likely to reach pretty much the same figure as in 2009.

Banks’ appetite for taxpayers cash – predicated on the erroneous choices made in structuring NAMA and direct capital injections – is adding fuel to the rapidly spreading fire. But the core problem is that despite two draconian budgets of 2009 and 2010, the Exchequer finances continue to show no real improvement.

The end game of the Government’s inability to reform its spending is that Ireland is teetering dangerous on the edge of the abyss, where any further fiscal deterioration is likely to require some sort of an external bailout.

Compounding this is the fact that buying time through piecemeal deficit reductions of €3 billion annually – as planned by the Government for 2011-2012 – won’t enable us to avoid this outcome.

At the rate things are going, by the end of 2012, interest charges on banks’ recapitalisation measures are likely to exceed the net savings gained in budgetary cuts.

The problem from Ireland’s point of view is the uncertain nature of any potential external resolution mechanism that we can engage to backstop our sovereign solvency crisis.

In theory, Ireland can either apply for IMF assistance or draw down funds available through the European Financial Stability Facility (EFSF) set up this year to rescue Greece.

In practice, however, the IMF funding for Ireland will be politically unacceptable for Brussels and for the ECB. It will de facto destroy any credibility the euro as a young currency has left and will threaten the very survival of the common currency. The EFSF funding, on the other hand, is likely to carry prohibitive costs – both in terms of fiscal deficits adjustments required from Ireland by our euro area partners and in terms of fiscal policy changes that access to such funding will entail.

Earlier this year, as Greece and alongside it the rest of the PIIGS (Portugal, Ireland, Italy, Greece and Spain) were facing similar pressures, it took round-the-clock work by the French President Nicolas Sarkozy to get Germany to agree to set up the EFSF.

The end result, despite tough talk from Chancellor Merkel, was that her political capital at home was destroyed. German voters, preferring low inflation and stable currency to a Mediterranean-styled fiscal profligacy nightmare gave Merkel a trashing in polls and elections.

The end result was the deeply entrenched unwillingness of German leadership and electorate alike to underwrite any further rescues.

Something will have to give on our side for Ireland to avail of the EFSF assistance. Both, to make it sellable in Germany and to prevent other countries from asking for cash.

Last month, Germany’s powerful Green Party has clearly indicated its price for supporting any rescue – our corporate tax will have to move up towards the German rate.

This price suits not only German Greens, but the rest of Berlin, as well as Brussels and Paris. It fits within the new Franco-German tax convergence framework under development and the EU’s continued efforts to bring about harmonisation of the corporate taxation measures across the union.

About the only economy for which such medicine will be worse than the disease it faces will be Ireland. At this point, – regardless of what we are being told by the official analysts and experts – tax arbitrage is the only comparative advantage we hold over our British and Continental partners.

Short of a miraculous turnaround in our economic fortunes or an equally miraculous turnaround in government fiscal policies to face the reality of our solvency crisis, we really are living on borrowed time.

Dr Constantin Gurdgiev is adjunct lecturer in finance with Trinity College, Dublin.

This appeared in the printed version of the Irish Examiner Wednesday, September 29, 2010