ANALYSIS:Ireland is fundamentally solvent, but the inclusion of bondholders in the bank guarantee scheme means that our creditworthiness will be tested over the coming months
IT IS not often a newspaper article keeps a country talking for a week. Morgan Kelly’s weekend thunderbolt on these pages did just that. The synopsis: we’re bust; it’s the banks that did it; the way out is to make bank creditors pay for their folly.
The article poses a timely challenge to conventional wisdom. Although I do not share his pessimism on solvency, a nuanced version of his key policy proposal for a bank resolution regime – widely ignored in the post-article reaction – makes sense. My take: we’re not bust; the bank losses are sickening, but need not sink us; we need a policy response that sustains the credibility of sovereign guarantees while making bank creditors bear the costs of their bad investments where we can.
National solvency is a slippery thing. A useful starting point is the idea of fundamental solvency: a country is fundamentally solvent if it is willing and able to pay its debts, provided debt markets expect it to do so. The essential ingredients are low long-term interest rates, decent long-term growth rates, a reasonably low starting point for net debt, and a capacity – political and economic – to bear fiscal pain.
Greece’s problem is that it looks fundamentally insolvent. It has been locked into high interest rates on much of its large debt, has poor growth prospects, and has not convinced markets it can take the necessary pain. Ireland is better positioned on each dimension.
A country that starts out fundamentally solvent should be able to absorb large once-off bank losses. For example, with a gap of two percentage points between the long-term interest rate and the long-term growth rate, even bank losses equal to 30 per cent of GNP would require a permanent increase in the primary (ie non-interest) surplus of roughly 0.6 per cent of GNP. A huge waste of fiscal resources to be sure, but not enough to drive a country over the edge.
Unfortunately, the bond market turmoil during the week of May 3rd proves fundamental solvency is not enough. Governments, like banks, are subject to runs. Where for some reason lenders come to doubt solvency and demand a large risk premium – if willing to lend at all – the fear of default can become self-fulfilling.
With a clear and present danger of runs, it is underappreciated how big a beneficiary Ireland is of the new EU/IMF/ECB stabilisation fund. Like a driver after a crash grumbling about a deployed airbag, complaints about the costs of Ireland’s contribution to the fund miss the point.
The vulnerable underbelly of the economy remains the risk of a bank run. In an analysis this week on the website Irisheconomy.ie, Karl Whelan calculates that €72 billion of the bank debt outstanding at the beginning of the year will mature before the end of the year. This week’s nervous markets remind us of the ever-present risk of not being able to roll over these obligations.
In this environment, the broad backlash against Government guarantees of bank liabilities is misplaced. Credible sovereign guarantees are a hugely valuable defence against a bank run.
The Government’s mistake on the infamous night in September 2008 was not the guarantee, but its extension to providers of existing long-dated bank funding. These bondholders had nowhere to run.
But the mistake in making the original guarantee overly broad should not blind us to the role that guarantees on new bank borrowing of all maturities will play for some time in sustaining the Irish banking system.
The Government faces a delicate policy dilemma. On the one hand, it must protect the credibility of Irish sovereign guarantees. On the other hand, while sticking to the letter of its original obligations, it should seek to make bondholders – senior and subordinated – bear the burden of their bad investments.
By focusing on his criticism of open-ended bank guarantees, most commentators have glossed over Morgan Kelly’s central policy suggestion. Critically, he does not advocate default on the guarantee. Rather, he calls for the Government to follow best international practice and put in place a special resolution regime (SRR) to deal with insolvent or seriously undercapitalised banks after the original guarantee expires.
As things stand, the only way the Government now has to impose losses on bank creditors is to liquidate the bank. (Creditors might “voluntarily” agree to a debt restructuring such as a debt-equity swap, but they would only do so given a credible threat of liquidation.)
But liquidating a bank could be incredibly disruptive and would make it hard to protect depositors and other short-maturity bank funders, increasing the risk of bank runs. This risk in turn takes away any leverage the Government might have, and allows creditors to dump their losses on the public.
An SRR would give the Government special authority beyond the existing bankruptcy code to differentiate between creditors and also keep systemically important banks as going concerns. The Government’s back is then less against the wall, allowing it more scope to put the losses where they belong.
While Morgan Kelly is right to push this policy, I think he overestimates what it can save. His target is the stock of bonds that will be outstanding when the guarantee expires – some €65 billion by his estimate. These bondholders would be subject to a debt-equity swap, forcing losses on creditors and recapitalising the banks in one swoop.
The limitation of this approach is that banks would have to fall below some critical capital adequacy threshold before triggering the resolution tools. The stress tests done by the Central Bank combined with capital-raising efforts suggest that both AIB and Bank of Ireland – where the bulk of the outstanding bonds lie – are likely to pass basic capital adequacy tests.
Not so for Anglo of course. But unfortunately, the over-broad guarantee will have allowed most of the bondholders to escape by September, leaving at most €7 billion of bonds at risk. Not the kind of money we might hope for, but still very much worth pursuing.
The coming months will test Ireland’s creditworthiness. International debt markets are in a capricious mood.
I believe Ireland is fundamentally solvent, but unfortunately this is not always enough to stop a run. While putting in place the special resolution regime machinery to impose legitimate losses, it is essential not to waiver on the commitment to meet the letter of all sovereign obligations.
John McHale is established professor and head of economics at the JE Cairnes school of business and economics, NUI Galway