Tuesday, November 9, 2010

On the Road Out of Ireland

Ireland has been celebrated as the European Union poster child for eurozone austerity.  Yet, its efforts have received little respect from the bond market, which has become increasingly aware that austerity will not make Ireland again prosperous.  In attempting to be the good European Union partner, Ireland created a "bad" bad bank which gave government guarantees to all liabilities of three private banks which had engaged in risky investment policies and poor management.  In doing so, the government bailed out incompetent management and bondholders at the expense of the Irish people.  Rather than providing equity for toxic assets, the Irish government issued government bonds for the toxic debt of three Irish banks of which Anglo Irish, whose senior debt has become a serious international problem, had to be nationalized. While junior bondholders have had to accept subsequent haircuts and the three banks significant reductions in assets as toxic assets were stripped out, the depositors and senior bondholders have been untouched.  Questions on the guaranteed status of the senior bondholders has had detrimental effects on Ireland's ability to obtain and pay for credit as the position does not appear in the best interests of the Irish people while the bond market fears a haircut to senior bond holdings despite guarantees, because the austerity budget is viewed as too ambitious.  Some observers have even questioned whether it would be in the best interest of Ireland to default on these senior bonds as Iceland refused to accept responsibility for private bank debt and just as the Irish Free State, under de Valera, refused to pay the land annuities (an annual payment of 250,000 pounds for Britain's loans to finance land reform) to Britain in 1933, which led to the Anglo-Irish Trade War in which Ireland did not fare well.  In fact, these guarantees of Irish private bank debt have come to amount to 32% of Ireland's GDP.

The people of Ireland have endured centuries of oppression and economic servitude and a tumultuous transition to Irish Free State in 1922, Ireland in 1937, and Republic in 1949 with a bitter refusal to remain in the Commonwealth.  After a long period of poverty and out bound emigration, the 1990's saw the beginning of economic growth built on exports which lasted until the 2008 financial crisis.  Now, the Irish people face being prisoners of debt and indentured servants to the banks of the eurozone, who are the senior bondholders, almost 100 banks including Goldman Sachs, being protected by the Irish government.

Ireland is not Iceland, which has its own fiat currency, and it has sought to appease the European Union upon which it is dependent for monetary policy and economic support.  As NAMA, the Irish agency responsible for sorting the private bank mess out, has dug into the assets and finances, it has issued haircuts up to 47% on assets stripped from the banks and proposed 80% haircuts to junior bondholders, which has led the bond market to fear similar threats to subordinated debt in other eurozone countries.  While bondholders are the source of funds which keep banks functioning, the investment is one of acknowledged risk in a private bank.  It is even feared that an Anglo senior bond default/haircut would bring Ireland down.  To give bondholders immunity from losses is recognized by many as removing the assessment of risk from the investment process and increasing systemic risk.   Switzerland has required its large banks to issue contingent convertible bonds which can be used to write-off losses in cases of non-viability.

It is being argued that revenue will not be sufficient for deficit reduction and has increased concern that bond investors must not be discouraged and market perception is more important than fiscal or monetary policy.  Debt costs have jumped for Ireland and Portugal, Greece, Spain, and Italy.  European Union support has become all the more important if Ireland is to succeed.

Yet, this current chapter in the Pan-European Credit Crisis has been spawned by European Union leaders in the midst of debate on the ESFS, due to expire in 2013,  bailout continuation and political upheaval in the eurozone as Germany has pushed a proposal for orderly insolvency and debt restructuring, which has rattled the bond markets.  The Franco-German proposal would require a treaty change and a permanent debt resolution system with sanctions, but it has largely gained acceptance by the EU.  When Germany threatened to veto any financial crisis resolution authority unless a treaty change was approved, it painted the eurozone into a corner surrounded by bond vigilantes.  In an attempt at deficit economic ideological purity, Germany threw the peripheral eurozone countries to their fate while demanding that bond holders share the burden, which spread fear in the bond market and directly threatened German banks which have a significant exposure to private Irish debt.

Bond and swap prices escalated, despite proposed budget cuts  with a sense of impending doom settling in as to whether Ireland, as well as Greece, Portugal, and Spain, can execute their austerity budgets.  Even sovereign default swaps surged.  As credit costs ramped up, bond investors dumped bonds and the perception of risk spread.  Perhaps at the urging of one wealthy Russian bondholder, the Russian sovereign wealth fund took Ireland and Spain off their eligible investment list and a European clearing house warned that members might have to deposit more cash to trade in Irish bonds.  All of this has aggravated the bond market perception that the peripheral countries cannot control their European Union imposed austerity budgets.

In fact, Ireland's budgeting, as well as Spain's budget and economic forecasts, have been increasingly questioned as scary as Ireland has taken a three month holiday from bond auctions to avoid the current spreads as it has enough money to last into Q2 of 2011 and as it seeks European Union agreement and assistance with its 6 billion euro proposed budget cuts.  All of this has left the Irish wondering, if they knew all along that the budget cuts would be contractionary, what do the bond markets want?  Unfortunately, Ireland does not have its own currency and, therefore, is more at risk to market perception which may not always be in the best economic interests of a sovereign country.  Despite projections, Ireland cannot depend on substantial export growth in its budget.  As long as Germany and France pursue an irresponsible ideological exercise which threatens other eurozone countries, if not the monetary union, then the efforts of Ireland and the other peripheral countries risk nullification.

While the U.S. Federal Reserve plan to buy more Treasuries helped revive the bond market for Spain, Portugal, Greece, and Italy, the ensuing weaker dollar will not help the euro and its effect on bond prices.  While the ECB has stepped in and bought bonds from time to time to stabilize markets from time to time, it has not been easy to determine when and exactly how much and some reports have been mistaken.  Since Ireland was encouraged to protect senior bondholders, which includes eurozone banks which have a large exposure to Irish private debt as shown in the BIS September Quarterly report on international banking (page 6) with Germany followed by great Britain leading the way as of Q1 2010 with other European areas close behind and then France, it would be in the best interests of the European Union, eurozone, and the ECB to assist and support Ireland.  A failure to support Ireland or hesitation to act will endanger the very European banks Ireland got suckered, as a eurozone team player, into protecting.

The European Union needs to get beyond the ESFS temporary bailout to a permanent financial crisis resolution which does not acknowledge too big to fail banks and holds investors accountable for a share of the burden of restructuring systemically risky financial institutions rather than foisting the losses off onto government and the citizenry.  As long as the European Union and the eurozone members refuse to learn the lessons of deficit reduction in a monetary union in which the sovereign countries have no monetary control to combine with fiscal policy and member nations continue to engage in "smokestack chasing" as Germany is doing with its treaty change proposals which directly undermine other eurozone countries, if not the monetary union itself, the welfare of the monetary union as a whole and each of its members, including Germany, are endangered from within.

Given Ireland's continued attempts to please the ECB and the European Union, it may find, given its budget cuts already, the IMF a more practical partner in economic recovery, which does not say much about the ability of the ECB to act and of the European Monetary Union to assist members in order to strengthen the economy of the monetary union as a whole.  The Irish government's surrender to the private bank bondholders doomed them to bailout.  In as much as the ECB and European Union may have encouraged and supported that bad economic decision in order to protect other European banks makes it all the more necessary that the ECB and European Union, most especially those countries whose banks are being protected at the expense of the Irish people, support Ireland's unwinding of the three private banks and the Irish debt created by the banks and its investors.  Ireland faces insolvency and its people indentured servitude to the very European banks (with German banks heading the list) given immunity from investment risk, as the Irish people choose which bills to not pay in order to pay mortgages as mortgage losses mount, which will only increase the pressure on banks and the government's liability guarantees.

One has to ask, if Ireland found it unavoidable to offer equity or some other haircut to senior bondholders, would a currency crisis ensue?  Has the ECB and the European Union, with the help of Germany and France, boxed itself in to the point it has no choice but to help Ireland or abolish the monetary union?

The road out of Ireland is submerged.  The people of Ireland may have to do it all by themselves again, if they wish to remain free.

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