Restructure Ireland’s debt

Economic policy is difficult enough. Economists must be especially careful in offering opinions on policy issues for other countries. But the Irish debt problem is a European problem in its causes and implications (Hesse and González-Hermosillo 2011), and we would like to think that a European identity is some qualification.

Ireland is being made to pay for deciding to socialise its private debt at the end of September 2008. That was the original sin. Advised by Merrill Lynch and pressured by Eurozone authorities, Ireland gambled that its banks were fundamentally sound. A state guarantee would turn markets around, restore liquidity, and give them time to show they could deal with their problems. Not so. Merrill Lynch should at least return its fee. And now policymakers are talking about privatising state assets in order to pay for part of the costs of the socialisation. Whatever the other merits of privatisation, this does not make sense – the right solution is to (re)privatise the debt.

After many subsequent capital infusions of taxpayer funds, the latest stress tests and restructuring plans are supposed to draw a line under the shocking costs of the guarantee and to launch recovery. But the burden of the debt on the sovereign is now unsustainable. The projections in the original IMF programme, endorsed by the European Commission and the ECB, see the debt-to-GDP ratio peaking at 120% in 2013. The IMF itself clearly thinks that the downside risks to the programme are high, likely to materialise, and difficult to mitigate. The government has not convinced the markets – Irish sovereign spreads are today about the same as in November before the IMF programme, and the latest actions have led the ratings agencies to downgrade the sovereign (while upgrading the banks). Yes, a couple of investment banks are now saying Irish debt is a good buy – doubtless because they are now convinced the new government will not dare to restructure the debt. The programme requires some access to market funding from next year. That is not credible unless the debt is restructured.

But can’t Ireland grow out of its debt – as indeed it did from the late 1980s onwards, to achieve a very comfortable fiscal position before the crisis? One need not accept the claim that historical evidence shows a debt-to-GDP ratio over 90% is normally fatal. But there has already been 9% discretionary fiscal tightening in 2009-2010, and the required further turnaround in the primary fiscal balance from -9% of GDP in 2010 (excluding the enormous one-off charge) to 2% in 2015 is heroic. Moreover, that assumes the interest rate will exceed the growth rate by only 2%. What plausible combination of interest rate and growth rate would give that? Ireland’s 10-year bond rate is currently a bit under 10%, and experience elsewhere shows that growth is typically slow for many years after a major banking crisis. Indeed, the latest review of the programme concedes that growth this year will be lower than previously assumed (IMF 2011). If the excess of the interest rate over the growth rate were 6%, the required primary surplus would be 7%, a tax and expenditure shift totalling a further 16% of GDP. Even if feasible, that would just stabilise the debt at 120% of GDP!

Many years of continued austerity would have to follow. Any likely concession on the European Financial Stability Facility interest rate would not make much difference. At best, the future would be similar to Latin America’s “lost decade” in the 1980s. The future tax burden of the debt overhang acts as a tax on investment and growth.

The key to the earlier turnaround was very rapid growth, catching up to the more developed countries of Europe – a convergence dynamic. But Ireland caught up and that growth is not reproducible. And where will the growth come from, in a world in which export markets will be more difficult than ever? The real effective exchange rate has already depreciated by over 10%. “Internal devaluation” cannot go much further, and given likely ECB monetary policies, one cannot expect the euro to depreciate significantly. Foreign direct investment might help, but domestic demand will remain depressed, especially since strong fiscal consolidation is necessary whatever happens to the existing debt.

So the right policy is debt restructuring (or “reprofiling”), negotiating haircuts so as to reduce the present value of the debt. A decade ago, this was conventional wisdom. “Bailing-in” and “private-sector involvement” were to be the norm – Germany took a particularly hard line here. And there are indeed now many examples of such consensual debt restructurings, in which creditors are presented with an exchange offer, sometimes a menu of alternative modifications of their holdings, and they choose in the light of their tax positions and other desiderata. The IMF has much experience here (Roubini and Setser 2004, Sturzenegger and Zettelmeyer 2007).

It would be easier with collective action clauses in the bond debt (Eichengreen and Portes 1995), of the kind planned for the EU from 2013 onwards, but they are not essential. The same holds for the other institutional changes suggested by Cohen and Portes (2003). But an exchange offer would be more “market friendly” and appealing to bondholders if it were to rest on solid collateral for the new instruments. This could be provided by the European Financial Stability Facility (analogous to the “Brady bond” arrangements), in a much more constructive use of its resources than loans to an insolvent sovereign1,2.

For the non-guaranteed bank debt, one could just say this will not be shouldered by the state and let the banks negotiate with their creditors. For the guaranteed bank debt, the government would have to repudiate its predecessor’s commitment.3 The legal consequences of reneging on the guarantee are unclear, but wide experience in similar restructurings elsewhere would give the government plenty to appeal to if it went to court. The sovereign debt must be restructured too, using the menu approach. Perhaps some time ago, reneging on the guarantee and imposing haircuts on the private-sector debt would have sufficed, but not now: restoring solvency will also require restructuring the sovereign debt.

A reasonable target would be a debt reduction of €40-50 billion, in present value. That is on the order of 30% of GDP and would bring the debt ratio down to a sustainable 80% or so. The required haircuts would be in line with current market valuations of Irish sovereign debt.

Aside from the legal objection, there are other arguments against debt restructuring. We can ignore threats of trade sanctions, long-term loss of market access, or a significant increase in Ireland’s borrowing costs. Extensive experience shows that well-managed sovereign debt restructuring simply does not bring such consequences. This would not be Argentina. And once a settlement has been agreed with creditors, the markets are remarkably forgiving, because they are forward-looking.

There might be contagion effects – on Greece, Portugal, Spain…This is debatable, especially since the markets are already discounting debt restructuring at least for Greece, and FT Deutschland reports that finance ministries expect it too. In any case, “solidarity” goes only so far when a fundamental national interest is at stake. Let us be clear, the “solidarity” of Ireland’s partners in the Eurozone is limited, at least when it comes to the interest rate on the Irish borrowing and Ireland’s tax regime.

Debt restructuring would impose significant costs on German and British banks, as well as others. That might reduce moral hazard, going forward. But the underlying issue is even more fundamental. The European governments have in effect bailed out their own banks exposed to Ireland, transferring the fiscal costs to the Irish taxpayers through the European Financial Stability Facility, all the while maintaining the moral and political high ground of creditors. So far, there is in fact no ‘transfer union’ of the kind so castigated in Germany (no solidarity there)4. There have been no transfers from the creditor countries, just loans. The true transfers have been going from debtor countries to the banks of the creditor countries, making good their bad loans.

Yes, Ireland had more than its share of crony capitalists and reckless lenders – but there were plenty of reckless foreign lenders, too, and they are being made whole by the Irish state. So much for financial integration in Europe – Anglo-Irish Bank was not in practice a domestic bank, and the other banks also channelled huge lending from elsewhere in Europe. Should Delaware be responsible for Citibank’s liabilities? Not only were Ireland’s bank supervisors at fault – those in the lending countries were equally culpable. This is indeed a strong argument for true European-level supervision, which has lagged behind the cross-border lending. But that is for the future.

According to Ireland’s new Minister of Finance, “the ECB says you can’t”. With great respect, where in the world can the central bank tell the government what it can or cannot do in fiscal matters? And what authority has the ECB to do this under the treaties? Ministers ask who will pay for Irish teachers, nurses – indeed, parliamentarians and ministers – if “Europe”, including the ECB, calls back its loans. But “Europe” is not so foolish. The costs to the ECB and member states would far exceed the benefits. As Keynes once said, if you owe the bank one million, it’s your problem – if you owe them 100 billion, it’s their problem. And even if foreign financing were completely cut off, the current-account deficit is now only 2%, so adjustment should not be too difficult, and no more public servants need be sacked (or go unpaid) than currently planned. The restructuring of the Irish banking system would have to go beyond what is currently planned, but that would not be a disaster either.

This is not to minimise the ECB’s problem. It would be difficult to do a proper debt restructuring without including the ECB’s own holdings of Irish debt. The ECB courageously intervened to take sovereign debt while governments prevaricated. But it did take the bonds at a discount, so the most it can expect is to be repaid at those discounted market prices.

The government appears to believe that protecting bondholders will appease the French President and get a concession on the interest rate and an end to talk about corporate tax rates. That might work, or it might not. The IMF-European Commission-ECB examination of the programme’s ‘progress’ just completed produced no such result. But even if the mood changes, that would not promote debt sustainability with anything like the impact of a substantial debt reduction. And it leaves Ireland subject to similar threats and political pressures going forward.

Finally, the Irish people and government should be clear. This is not a matter of “honour”. That would be a profoundly unhistorical view. History teaches that when debt burdens become excessive, they are restructured to make them sustainable (Eichengreen and Portes 1986 and 1989). Many, many countries have done this, including in Europe (e.g., Poland, Russia, Turkey in recent years). And the reputational costs are likely to be low. Unlike some countries, Ireland did not get into its present situation because of public sector overborrowing.

Of course, there is a way for Ireland to escape responsibility. Just wait for Greece to restructure its debt, at which point there will be general confusion and the markets will shun Ireland anyway. Then restructure, when it will be widely accepted as unavoidable. Maybe that is the unspoken strategy. If so, there may not be long to wait.
-----------------------------------------------------------------------------------------------------------------------------

1 This might be seen as a variant of the interesting proposal in Kaletsky (2010).
2 Elisa Parisi-Capone of Roubini Global Economics makes two important technical points: (1) “Under current accounting rules, as long as the implied net present value loss does not exceed a certain threshold, a debt exchange at par with longer maturities and a lower coupon rate can be carried at 100 cents on the dollar by hold-to-maturity investors. This would prevent large-scale capital writedowns among banks, pension funds, insurance companies and the official sector. As under the Brady bond plan, a discount bond could simultaneously be offered to investors on a mark-to-market basis”. (2) “Under new International Swaps and Derivatives Association (ISDA) sovereign CDS rules, an exchange offer does not qualify as a Restructuring event as long as neither collective action clauses (CACs) nor legislation is used to change the financial terms of the new bonds”. 6 April 2011, see here.
3 The nature of the guarantee has changed somewhat, but the difference seems immaterial. The 2008 guarantee covered liabilities until September 2010. In 2009, there were some bonds issued under a new law (ELG - Eligible Liabilities Guarantee) that guaranteed new bonds issued and also deposits etc expiring after September 2010. It seems that most bonds issued under the ELG are 'self-issued' bonds – the banks retain them and use them as collateral with the ECB, which would be take losses if these guaranteed bonds were hit.
4 Many criticise the ‘transfer union’ which has not happened while ignoring the transfers that have happened (e.g., H-W Sinn, quoted in FT Deutschland 15 December 2010).
 

References
Cohen, D and R Portes (2003), Crises de la dette: prévention et résolution, Documentation Française (for the Conseil d’Analyse Economique, Office of the Prime Minister of France).
Eichengreen, B and R Portes (1986), “Debt and Default in the 1930s: Causes and Consequences”, European Economic Review, 30:599-640.
Eichengreen, B and R Portes (1989), “Settling Defaults in the Era of Bond Finance”, World Bank Economic Review 3:211-239.
Eichengreen, B and R Portes (1995), Crisis? What Crisis? Orderly Workouts for Sovereign Debtors, CEPR.
Hesse, Heiko and Brenda González-Hermosillo (2011), “Global market conditions and systemic risks after Greece and Ireland’s financial crises”, VoxEU.org, 10 March.
IMF (2011), “Statement by the EC, ECB, and IMF on the Review Mission to Ireland”, 15 April.
Kaletsky, A (2010), “A new idea to save the euro”, GaveKal Ad Hoc Comment, 2 December.
Roubini, N and B Setser (2004), Bailouts or Bailins: Responding to Financial Crises in Emerging Economies, Institute for International Economics.
Sturzenegger, F and J Zettelmeyer (2007), Debt Defaults and Lessons from a Decade of Crises, MIT Press.

--------------------------------------------------------------------------------

Editor’s note: A brief version of this appeared in the Wall Street Journal 13 April 2011.

(“VoxEU.org”)