24/8/2012: Perverse logic of Berlin?

An interesting article in the Irish Times today (link) quoting Germany's Fin Min on Irish debt-relief proposals, saying that Ireland's "massive" reform progress should not be compromised by the country efforts to gain relief on banks-related sovereign debts. From the Irish Times: "We cannot do anything that generates new uncertainty on the financial markets and lose trust, which Ireland is just at the point of winning back."

While we should be careful not to read too deeply into Mr Schauble's comments - which can be interpreted in a number of ways - the logic of the German Fin Min is worrisome.

Ireland has raised exceedingly expensive funds in recent bonds and T-bills auctions with explicit desire to test the markets appetite for Irish paper. In many ways, the relative success of these auctions was underwritten by external dynamics in debt markets, but also by the markets perception of Irish progress on reforms and by the markets expectation of the decline in future debt liabilities related to the banks debt deal. In other words, Ireland has paid a hefty price so far for starting the process of recovering some market access for the Sovereign. This is a net positive, albeit severely limited by the cost of funding raised.

Hence, we have a bizarre situation:

1. a member state in the Euro zone is undertaking all the right (from the markets & policymakers point of view) steps, achieving measurable progress, and generally behaving like the best pupil in the class, yet 
2. German leadership - the proxy for the Euro zone leadership - is unwilling to help that state in its efforts.

Surely, if Germany really wants stabilization and recovery in Europe's periphery, writing down €30 billion of promissory notes would be the cheapest approach to take toward reinforcing Irish efforts to deliver on the programme. Since the funds are fully linked to the ELA, this would imply absolutely no negative effect on private markets expectations. If anything, it will signal Europe's willingness to use the monetary system to support the process of resolving banking insolvency-induced stress on the sovereigns. Reduction in Ireland's debt burden in this context will be non-trivial and will help restore bonds markets confidence in both Ireland and the Euro zone system.

The bond markets operate - basically speaking - at the following level of logic:

• If an action reduces supply of debt, ceteris paribus, price of debt goes up, yields go down. Restructuring Irish Government's banks-linked debt will act to deliver exactly this effect.
• If an action reduces future potential haircuts that can expected by the private sector holders of debt in the event of prababilistic restructuring, price of debt goes up and yields go down, since future expected losses on privately held debt will be lower. Restructuring officially (Euro system) held ELA will deliver exactly this.
• If an action improves debt sustainability of the sovereign, yields will go down. Restructuring ELA will do exactly this.
• If an action does not introduce new moral hazard into future funding incentives for the sovereign, longer-term yields will be lower. By restructuring ELA - which has nothing to do with Irish exchequer past poor performance or policy choices, but has to do with rescuing risk-taking behaviour of the foreign funders of the Irish banks - the Euro zone can achieve exactly such long-term consistent repricing of Irish debt.
• If an action reduces the need for future funding, expected future bonds issuance falls and with it, the yields will fall. By removing the need to fund future repayments of promissory notes, the EU can achieve exactly this effect.
• If an action improves economic growth prospects for the nation, thus lowering risks associated with future tax revenues growth, deficits and debt financing, it will reduce yields on Government debt. This, again, is something that a restructuring of ELA/promissory notes will achieve.

Any way you spin it, aggressively restructuring the promissory notes and the ELA will deliver the benefits for the Irish exchequer. If, as Mr Schauble clearly believes, there is a case for contagion of risks across the peripheral sovereigns, such benefits will also be positively felt by other peripheral economies. In addition, such benefits will also help give some much needed credibility to the Euro zone overall policy efforts in dealing with the crisis.