22/4/2012: Sunday Times 15/4/2012 - What if Ireland Defaults?

With some delay, this is my article for Sunday Times April 15, 2012 - an unedited version, as usual.

Since 2008, judging by a number of parameters and metrics, Ireland has been firmly in the grip of a historically unprecedented financial, fiscal, banking and economic crises. This is the consensus that emerges from book, titled What if Ireland Defaults? published by Orpen Press last week and edited by myself, Professor Brian Lucey and Dr. Charles Larkin (here is the link to Amazon page for the book and for ebook version). The book brings together views on sovereign and other forms of default by twenty two academic, media, political and social policy thinkers is designed to re-start the debate about the future trajectory of the Irish economy saddled with unprecedented levels of public and private debt. Coincidentally, What if Ireland Defaults? Was published in the same week as the IMF Global Financial Stability Report that focuses on the issues of household debt overhang. The IMF report too stresses the dangers of the excess debt levels across the economy and provides strong argument in favor of a systemic restructuring of private debt in countries like Ireland.

The roots of the Irish debt problem are historical in their nature, not only in the magnitude of the debt overhang involved, but also in terms of the correlated economic, fiscal and financial crises that define our current economic environment.

First, the Irish crisis has resulted in a deep and protracted contraction in the economy that is unparalleled in the modern history of advanced economies. In current market prices terms, and not taking into the account inflation, our national output is down 24.2% on pre-crisis peak, having fallen to 2003 levels. Investment in the economy is down 59.6%. These rates of decline are so far in excess of what has been experienced in Greece and are ten-fold deeper than those experienced in an average cyclical recession.

The duration of the Irish crisis is also outside the historical records. Since Q1 2008, Irish economy recorded fourteen quarters of nominal contraction in GNP and thirteen quarters of contraction in GDP. In effect, the economic crisis has already erased 8 years of growth. At an average nominal rate of growth of 4% per annum, it will take Ireland fifteen years to regain domestic output levels comparable to 2007. And this is without accounting for inflation.

Second, Ireland is now a worldwide record holder when it comes to the cost of dealing with the banking sector crisis. Combined weight of banking sector capital injections, and Nama is now close to 80% of our GNP. Irish Exchequer exposure to the Central Bank of Ireland ELA and the ECB borrowings by the state-owned banks lifts this number well beyond 200% of the national output. No advanced economy has ever experienced such a massive collapse of the domestic banking sector.

Another unique feature of Irish crises is their inter-connected nature. Economic recession – driven originally by the external demand contraction and debt overhang in the domestic economy was further compounded by the asset bust which itself is of a historic proportions. To-date, Irish property markets are down 49.3% on pre-crisis levels and the decline continues unabated. Large numbers of 30-50 year old families – the most economically-productive cohorts of our population – are now deeply in negative equity and are increasingly unable to sustain debt servicing. Officially, over 14% of our entire mortgages are currently either in a default, officially non-performing or short-term restructured.

The property bubble collapse, twinned with the debt crisis, didn’t just undermine the banking sector and cut into household wealth. The two have also left Irish economy without a growth driver that fuelled it since 2001-2002 when the property and lending bubble replaced the dot.com bubble implosion. Put differently, we are witnessing a structural economic recession. Since 1998-1999, Irish economy has lived through one bubble into another. Currently, excessive indebtedness and lack of a functional financial system are leaving Ireland without even a chance of finding a new growth catalyst.

In these conditions, the most significant problem we face today is the debt crisis. Our combined real economic debt – the debts of households, non-financial corporations and the Government – relative to our GNP is the highest in the advanced world. And, unlike our closest competitor for this dubious distinction, Japan, we have no means for controlling the interest rates at which our economy will have to finance Government and private sector debts.

It is the totality of the real economic debts, not just the debt of the Irish Government, that concern those economists who are still capable of facing the economic reality of our collapse. This point is referenced in the What if Ireland Defaults? by a number of authors, and as of this week, their views are being supported by the IMF, the Bank for International Settlements and a growing number of academic economists internationally.

Frustratingly, at home, our views are seen as contrarian, alarmist, and even populist. As the crisis has proven, year after year, the official Ireland Inc is simply unequipped to deal with reality.

Majority of Irish economic analysts incessantly drone about the threats arising from the Exchequer debts. Some, occasionally, add to this the banking debts. Fewer, yet, might reference the households. None, save for a handful of usually marginalized by the establishment economists, bother to treat the entire debt pile carried by our economy as a singular threat.

The silence about Ireland’s total debt, and the ongoing denial of the long-term disastrous economic and social costs of the total debt overhang are the frustrating features of our current state of the nation. It is this frustration, alongside the realization that Ireland can be blindly stumbling toward a renewed debt crisis, that informed myself and two of my co-editors to re-launch the debate about the potential inevitability and consequences of debt restructuring.

To re-start this debate, What if Ireland Defaults presents a range of views on the current Irish situation, from the basis of sovereign, banking debt and household debt restructuring.

The very idea of what constitutes a default is a complex one. In the book we interchangeably use the term ‘default’ as denoting a restructuring of the debt to reduce the overall level of debt. This can be accomplished by reducing the debt level itself, restructuring interest payments, extending the maturity of debt, or any combination of the above. In addition, a default can take place in an relatively orderly and coordinated fashion, as for example in Greece, or as a disorderly, unilateral action, as in the case of Russia in 1998. Lastly, default can be pre-announced, as in the case of Iceland, or unannounced – as in the case of Argentina. All of these differences are reflected in the chapters of the book dealing with historical experiences relating to sovereign defaults.

In the case of Ireland, there is a broad consensus within the book that a sovereign default is neither desirable nor inevitable. In other words, no author sees the situation where Irish Government debt will have to be restructured unilaterally, without prior cooperation with the EU authorities via the ESM or a similar collective structure. However, substantive disagreements do arise among the authors as to whether Ireland will require a structured default on banking and household debts. In this context, some of the contributions to the book pre-date and preclude the research on the necessity of household debt restructuring published by the IMF this week.

The overriding sense from What if Ireland defaults? is of an economy on a knife edge. Given favourable economic circumstances, especially in regard to our exports, a positive change in EU’s political attitudes with regard to the legacy bank debt, and the return of domestic economic growth, the debt levels which Ireland now faces can become sustainable, in that a default on either private or public debts is not probable. However, we cannot consider these developments as guaranteed, and in their absence, restructuring of debts may become inevitable.

In short, both the IMF report this week and the wide range of contributors to What if Ireland Defaults? are in a broad agreement: Ireland should be putting forward systemic policy measures to restructure household (and by a corollary, banking) sector debts. Absent such measures, a combination of the long-term continued growth recession and debt overhang, further compounded by the risks to interest rates and debt financing costs in the medium term future will force us to face the possibility of a sovereign debt default. Avoiding the latter outcome is more than worth the effort of creating a systemic resolution to the household debt crisis.

CHART: 

Sources: Haver Analytics, National Central Banks, McKinsey Global Institute, NTMA and DÁIL QUESTION  NO 122, 14th September 2011, ref No: 23793/11

Box-out:

A recently-published Cleantech Global Innovation Index 2012 shows the potential for the development of the green-focused economies in Ireland. The study ranked 38 countries across 15 indicators that relate “to the creation and commercialisation of cleantech start-ups, …measuring each [country] relative potential to produce entrepreneurial start-up companies and commercialise technology innovations over the next 10 years.” Overall, as expected, North America and Northern Europe “emerge as the primary contributors to the development of innovative cleantech companies, though the Asia Pacific region is following closely behind.”

Ireland is ranked ninth in the world in the cleantech league tables and scored strongly on general innovation drivers (underpinned by the presence of innovation-intensive sectors dominated by MNCs and some domestic exporters) and commercialised cleantech innovation (also largely linked to MNCs and a handful of Irish indigenous companies). We fall below average on cleantech-specific innovation drivers, such as policies supporting innovation in energy and green-IT and IT-for-Green. Ireland has only average scores for supportive government policies and access to private finance, which is disappointing.

What the global rankings, and the Irish experience clearly show is that globally there is an extremely weak positive relationship between cleantech-specific innovation and commercialized cleantech innovation. In Ireland this relationship is stronger than average. This is most likely due to the more advanced MNCs and exporting base in the Irish economy in general, whereby domestic innovation activities, including those booked by the MNCs into Ireland for tax purposes, is aligned with commercialization via exports.

19/03/2011: Updated probabilities of default

Updated probabilities of default and spreads on Irish bonds. As usual, a preventative disclaimer - this is just simple mathematical estimate - what the numbers say. No comment to be added.
Cumulative spreads tell us how much more we are expected to pay for our borrowings over Germany's cost of fiscal deficit financing, over the period of bond maturity. 85% more for 10 years borrowing currently.

Economics 5/12/10: Probability of default

This is an unedited version of my December column with Business & Finance magazine. Note, the copy was filed before the EU/IMF deal was announced for Ireland, so some assumptions have deteriorated since then.


At this point, it is pretty much certain that the events of the last month will have a lasting and profound effect on Ireland’s economy and society at large. So much is clear. What remains uncertain – in these news-saturated times – is the exact nature of the short-term outcome of three processes at play: the Budget 2011, the IMF/EU ‘bailout’ and the end state of Irish financial markets.

Over the last 24 months this column has predicted, with surprising even to myself, accuracy the following events:

• The complete and total failure of the Irish Government attempts to repair our collapsed banking sector – with even Nama cheerleaders of the past now coming around to recognise that the entire policy has delivered nothing but a powerfull new bureaucracy that put banks and property markets onto a permanent life-support;
• The true extent of the expected losses in the banks, totalling around €67-70 billion ex-mortgages defaults, in contrast to successive rosy estimates by the public officials, the banks, our stockbrokers and the Government;
• The inevitability of the banks nationalization and the risk of the Government vastly overpaying for the eventual ownership of the banking system (my estimates suggest that the taxpayers will end up paying some €40 billion more for the banks than necessary, due to the waste built into the system of previous recapitalizations and Nama);
• The continuation of the economic recession, with a clear and concise prediction of the double dip collapse in GDP and continued contraction in GNP;
• The inevitability of the IMF/EU taking over the reigns of power at the Department of Finance; and
• The losses of tens of thousands of Irish and foreign younger and better-educated workers to emigration and unemployment.
  

Calling it right in these circumstances doesn’t give myself any sense of accomplishment or pride. To put simply, as a taxpayer and a parson calling Ireland home, I would rather have been wrong in my predictions. Unfortunately I, along with a number of other independent analysts, including Peter Mathews, Brian Lucey, and Cormac Lucey, and a number of others, was right.

Even more unfortunate is the fact that the latest events suggest that some of our past predictions are now being overtaken by reality. So let us start with what the future is likely to hold.

First, consider the budgetary arithmetics. The failed spectacle of last week’s release of the multi-annual budgetary framework for 2011-2014 horizon was a clear exercise in Government’s evasion of reality.

Take the headline figures, first.

The Government aims to cut €6 billion from its deficit in 2011. Yet, the very same Government will now require to borrow some €120-130 billion over the next 4 years to finance its day-to-day operations, the redemptions of maturing bonds, write-downs of bad loans, banks recapitalziations and shoring up countless mortgages that are either in a default or heading there. At the rates that ECB and IMF charge Greeks for their emergency funding, this figure can be in excess of €6.1-6.8 billion. At the rates that should apply under the EFSF formula, the interest bill for our new borrowings would add up to roughly €8.6 billion.

In other words, up 58% of the planned 2014 budgetary savings will go up in smoke once the ECB / IMF loans are drawn down.

Add the numbers up. Even if we were successful in driving the deficit to 3% in 2014 as the Government plan – not that there’s a chance in hell that this can be achieved in reality, especially with the new IMF/ECB inetrest charges bills coming, something that the Govenrment has completely failed to even account for in its budgetary framework – Ireland will face continuously increasing debt levels through 2016-2017 due to the cost of new borrowing.

By my estimates, the overall debt levels of the Irish Government will rise to €210-220 billion by the end of 2014, requiring between €12.1 billion and €15.4 billion in annual interest charge against the state. Almost half of 2010 tax receipts will be eaten up by interest charges alone. Put differently, if the Irish Government were to be compared to a household with average income and a mortgage with cost of financing at around 50% of the revenues it bring in, we would be looking at a mean wage earner living in a property with a mortgage that exceeds 11 times its annual pre-tax income. Only a person with absolutely zero understanding of basic finance can think that this type of a scenario can lead to anything other than bankruptcy.

And this is assuming that in the medium term, our collapsed banking sector will be miraculously restored to rude health and the sovereign bond markets will greet Ireland back as a full-fledged issuer of government debt. Both assumptions would stretch the imagination even of the most optimistic forecaster.

Next, take a look at the sub-components of the Budgetary framework.

This Government clearly believes that Ireland’s recession is over. In fact, it believes that we are now on the cusp of a roaring economic growth. Otherwise, how can the Department of Finance hope to raise some €5 billion in new taxes through 2014 and €1.9 billion in 2011 alone? Such a level of tax increases would mean that every working man and woman of this country will be expected to contribute €8,300 annually on top what they already pay the Exchequer.

The Government thinks that Ireland’s economy can grow at 2.75% per annum on average through 2014. My own view is that we cannot hope to deliver such rates of growth. My mid-range forecast for average growth in the Irish economy in 2011-2014 is closer to 0.75-1% per annum, with a significant likelihood of further economic contraction in 2011.

Assuming the average rate of growth in the economy of 1% per annum through 2014 – at the top of the range of my estimates – the new taxes will add up to 25% of the projected average earnings in 2014. Again, this is on top of taxes already being collected.

Someone is clearly smoking something funky out in the rarefied atmosphere of the Government buildings.

The Budgetary framework appears to avoid factoring into the deficit calculations the full costs that the Exchequer is likely to face in years ahead. For example, it is difficult to understand how the announced provisions can cover both the need for day-to-day operations of the Government and the forthcoming additional borrowing costs related to the bailout funding, as mentioned above.

The framework also fails to provision for the expected future impact of mortgages defaults. Should, as widely expected now, the Irish households face a rising cost of mortgages finance due to banks shifting more and more burden of capital and operating costs adjustments onto the shoulders of ordinary mortgage holders, we can expect the number of mortgages in official default to reach over 100,000 over the next 2 years. Again, Govenrment’s rummaging through our pockets through higher taxes will accelerate this process. Pushing ca 60,000 new mortgages into default can cost, roughly speaking, €700 million to the annual social welfare and interest relief bills of the Government.

In other words, say whatever you may, but the so-called ‘draconian cuts’ envisioned by the Government are not enough to plug the hole in public finances without a significant reduction in levels and cost of public sector employment and a much more dramatic revision of the social welfare and health spending. We might not like these measures to be put on the agenda, but the reality bites – without shaving off some ¼ of the public sector wages, pensions and employment costs, and without reducing our social welfare and health spending by at least 1/5th each, Ireland is unlikely to begin repaying its vast debt accumulated since 2007 anytime before 2020.

In addition, let us not forget that the entire Government budgetary framework rests on a number of crucial, but economically and politically unjustifiable assumptions. First, there are the assumptions of extremely benign interest and exchange rates environments – the ones that crucially underpin the real cost of borrowing by the state, but also the implicit rate of growth in our exports, the cost of our imports of inputs into exports production and consumption, the rates of mortgages defaults and other economic variables.

Perhaps the only really progressive measure introduced in the programme is the Site Value Tax – a tax levied on the value of land for residential and zoned land, but exempting for the political reasons agricultural land. The idea of the site value tax, advocated by me in these very pages, before is that it should replace transactions taxes on property without penalizing households who invest in improving their homes and properties. The tax can be effectively used to recover the benefits of public investment in schools, infrastructure and other public amenities that currently accrue to the private land owners. Although the Government hopes to raise €530 million from this measure, little detail is provided in the plan as to the specifics of the SVT application.

Government puts much faith into its plans for reinvigorating the economy. These too were outlined in today’s document. The Government that brought us into insolvency through its handling of the crisis over the last 2 and a half years is aiming to “remove potential structural impediments to competitiveness and employment creation” (something that they failed to achieve since 2001) and “encourage exports and a recovery of domestic demand” (with domestic demand clearly identified in the very same document as the sacrificial lamb on the altar of fiscal adjustment).

A net positive, if unfortunately timed to coincide with deep recession, the reduction in minimum wage is hardly the core to the sustained jobs creation in this economy. By Government own admission, even with this measure, Ireland will retain one of the highest minimum wage rates in the EU.

More important are Government plans to strengthen its labour market “activation policies” for the unemployed and “promote rigorous competition in the professions”. Both would be welcomed were we to have any confidence that they can delivered on. The very same Government that promises now liberalization of professional services has presided over a decade-long preservation of non-competitive marketplace in professions. And as far as employment activation policies go, it is patently clear that barring a deep root and branch reshaping of Fas, there is no chance any efficiency can be gained from the existent activation systems.

Which brings us to the point where the evidence of the last few weeks converges to a point which warrants the following prediction. Regardless of the IMF/EU ‘bailout’ loans, Ireland is now firmly on the course toward a restructuring of its debts at some point in the near future. The only choice we have, as a nation, is the path of this restructuring. The options we face are dark. Irish Government can either recognize the gravity of our situation and force an orderly debt for equity swap within the Irish banking sector, simultaneously imposing significant writeoff on the household debts of at least 15-20%. Or we can muddle through more borrowing, more debt, toward a disorderly, market-driven default on the very same banks debt and potentially (depending on the extent of our future borrowings) sovereign debt.

The choices we have, therefore, are unpleasant, painful and unprecedented by the standards of an advanced economy. But their real causes – the failures of the last 2.5 years of crisis management policies – make them virtually unavoidable.