Investors face uncertainty of political support
The idea was that getting Ireland under the umbrella of a large and comprehensive support package would relieve the severe strains in what had become a very prominent stress point for financial markets, and thus exert a stabilising influence on market conditions in other vulnerable countries.
However, for a variety of reasons, markets didn’t follow that script last week. There was a modestly positive initial reaction: Irish government borrowing costs relative to Germany did fall to a two-week low of about 5.2% during last Monday’s morning trading session. However, this early move quickly gave way to renewed pressure, and the so-called Irish bond spread was under considerable pressure for the remainder of the week. On Friday, the spread made a new crisis high of about 6.55%.
Domestically, the uncertainty surrounding the political situation certainly ramped up a few notches over the week, culminating in the Government’s decision to call an election for early in the new year.
From an investor’s perspective, political uncertainty is never a positive theme for a country in need of decisive policy change. Developments in Kildare Street last week gave rise to doubts about the ability of the government to successfully get its December budget through.
With a general election virtually certain to produce a change of government, it made it very difficult for the outgoing administration’s National Recovery Plan (NRP) to make much impact. Ordinarily, a comprehensive, multi-year programme of fiscal correction would be music to the ears of bond market investors. But with the Government not likely to be around to see its own plan enter reality, investors face greater uncertainty about the degree of political support for the large-scale fiscal consolidation that is absolutely needed in the years ahead.
And uncertainty continues to prevail over the nature and scope of the EU/IMF package. While it has emerged that the size of the package will be about €85 billion, it remains to be seen how much of this is to cover the needs of the government and how much will be directed at the capital and /or funding needs of the banks. Plus, it is not clear what type of “restructuring” will apply to the banking sector or the degree to which bond investors in the banks may take losses on their investments as part of any such changes.
At the EU level, tough talk from the German Chancellor Angela Merkel did little to calm the situation as she expressed the view that Ireland was a source of great concern and highlighted the “exceptionally serious” situation faced by the eurozone. Furthermore, her persistence in calling for private investor involvement as part of a permanent crisis mechanism is actually adding to the strain in periphery debt markets as investors assign a higher probability of some form of debt restructuring or default taking place in the future.
It’s a case of so far so not so good in terms of the market response to Ireland’s decision to apply for EU/IMF aid. Not only have funding conditions not eased for Ireland, they have actually deteriorated. And perhaps more worryingly, the price action over the past week reveals clear evidence of contagion. Portuguese bond spreads are again under upward pressure as speculation mounts that it will be the next country to file for assistance.
But the bigger concern is Spain where spreads hit new crisis highs at the end of the week. With the size of the Spanish economy amounting to almost double the combined size of Ireland, Greece and Portugal, European policy makers need to act quickly and decisively to stem the slide in market conditions. Possibilities here include a beefed-up ECB sovereign debt purchase programme, though it might be hoping for a bit too much to expect such an initiative to emerge from this Thursday’s December meeting of the bank’s Governing Council.
Simon Barry, Chief Economist,Ulster Bank Capital Markets
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