This is an unedited version of my Sunday Times article from June 10, 2012.
Last week, the Irish voters approved the new Euro area
Fiscal Compact in a referendum. This week, the Exchequer results coupled with
Manufacturing and Services sectors Purchasing Manager Indices have largely
confirmed that the ongoing fiscal consolidation has forced the economy into to
stall. Irish economy’s gross national product shrunk by over 24% on the
pre-crisis levels and unemployment now at 14.8%. The most recent data on
manufacturing activity shows a small uptick in volumes of production offset by
significant declines in values, with profit margins continuing to shrink.
Deflation at the factory gates is continuing to coincide with elevated
inflation in input prices. In Services – accounting for 48 percent of our
private sector activity – both activity and profitability have tanked in May. The
Exchequer performance tracking budgetary targets is fully attributable to
declines in capital investment and massive taxation hikes, with current
cumulative net voted expenditure up 3.3% year on year in May.
On
the domestic front, the hope for any deal on bank debts assumed by the Irish
taxpayers, one of the core reasons to vote Yes advocated by the Government in
the Referendum, has been dented both by the German officials and by the ECB. Furthermore,
on the domestic front, the newsflow has firmly shifted onto highlighting the
gargantuan task relating to cutting our deficits in 2013-2015 and the problem
of future funding for Ireland.
Per
April 2012 Stability Programme Update, Ireland’s fiscal consolidation path will
require additional cuts of €5.55 billion over the next three years and tax
increases of at least €3.05 billion. Combined, this implies an annual loss of
€4,757 per each currently employed worker, equivalent to almost seven weeks of
average earnings. This comes on top of €24.5 billion of consolidations
delivered from the beginning of the crisis through this year. The total bill
for fiscal and banking mess, excluding accumulated debt, to be footed by the
working Ireland will be somewhere in the region of €18,309 per annum in lost
income.
This
has more than a tangential relation to the Government’s main headache –
weaselling out of the rhetorical corner they put themselves into when they
solemnly promised Ireland’s ‘return to the markets’ in 2013 as the sole
indicator for our ‘regained economic sovereignty’.
Even
assuming the Exchequer performance remains on-target (a tall assumption, given
the headwinds of economic slowdown and lack of real internal reforms), Ireland
will need to raise some €36 billion over 2013 and 2014 to finance its 2014-2015
bonds rollovers and day-to-day spending. In January 2014 alone, the state will
have to write a cheque for €8.3 billion worth of maturing bonds. The rest of
2014 will require another €7.2 billion of financing. Of €36.5 billion total,
€19.3 billion will go to fund re-financing of maturing government bonds and
notes, plus €6.9 billion redemptions to Troika. Rest will go to fund government
deficits.
At
this stage, there is not a snowball’s chance in hell this level of funding can
be secured from the markets, given the losses in economy’s capacity to pay for
the Government debts. Which means Ireland will require a second bailout. And
herein lies the second dilemma for the Government. Having secured the Yes vote
in the Referendum of the back of scaring the electorate with a prospect of
Ireland being left out in the cold without access to the ESM, the Government is
now facing a rather real risk that the ESM might not be there to draw upon. In
fact, the entire Euro project is now facing the end game, which will either end
in a complete surrender of Ireland’s economic and political sovereignty, or in
an unhappy collapse of the common currency.
The
average cumulative probability of default for the euro area, ex-Greece, has
moved from 24% in April to 27.5% by the end of this week. For the peripheral
states, again ex-Greece, average cumulative probability of default has risen
from 45% to 52%.
Euro peripherals, ex-Greece: 5-year Credit Default
Swaps (CDS) and cumulative probability of default (CPD), April 1-June 1
Source:
CMA and author own calculations
These
realities are now playing out not only in Ireland and Portugal, but also in
Spain and Cyprus.
Spain
has been at the doorsteps of the Intensive Care Unit of the euro area for some
years now. Yet, nothing is being done to foster either the resolution of its
banking crisis, nor to alleviate the immense pressures of it jaw-dropping 24.3%
official unemployment rate. Deleveraging of the banks overloaded with bad loans
has been repeatedly pushed into the indefinite future, while losses continue to
accumulate due to on-going collapse of its property markets. At this stage, it
is apparent to everyone save the Eurocrats and the ECB, that Spain, just as
Greece, Ireland and Portugal, needs not loans from the EFSF/ESM funds, but a
direct write-off of some of its debts.
Spain’s
problems are immense. On the upper side of estimated demand for European funds,
UBS forecasts the need for €370-450 billion to sustain Spanish banking
sector and underwrite sovereign financing and bonds roll-overs.
Mid-point of the various estimates is within the range of my own forecast that
Spanish bailout will require €200-250 billion in funds, a move that would
increase country debt/GDP ratio to 109.9% in 2014 from current forecast of
87.4%, were it to be financed out of public debt, as was done in Ireland or via
ESM.
Overall,
based on CDS-implied cumulative probabilities of default, expected losses on
sovereign bonds of the entire EA17 ex-Greece amount to over €800 billion, or
well in excess of 160% of the ESM initial lending capacity.
Europe
is facing three coincident crises that are identical to those faced by Ireland
and reinforce each other: fiscal imbalances, growth collapse, and a banking
sector crisis.
Logic
demands that Europe first breaks the contagion cycle that is seeing banking
sector deleveraging exerting severe pressures and costs onto the real economy.
Such a break can be created only by establishing a fully funded and credible EU-wide
deposits insurance scheme, plus imposing an EU-wide system of banks debts
drawdowns and debt-for-equity swaps, including resolution of liabilities held
against national central banks and the ECB.
Alongside
the above two measures, the EU must put forward a credible Marshall Plan Fund,
to the tune of €1.75-2 trillion capacity spread over 7-10 years, with 2013
allocation of at least €500 billion. This can only be funded by the newly
created money, not loans. The Fund should disburse direct monetary aid to
finance private sector deleveraging in Spain, Ireland and to a smaller extent,
Portugal. It should also provide structural investment funds to Greece, Italy
and Spain, as well as to a much lesser extent Ireland and Portugal.
The
funds cannot be allocated on the basis of debt issuance – neither in the form
of national debts, nor in the form of euro bonds or ESM borrowings. Using debt
financing to deal with the current crises is likely to push euro area’s
expected 2013 debt to GDP ratio from 91% as projected by the IMF currently, to
115% - well above the sustainability threshold.
The
euro area Marshall Plan funding will require severe conditionalities linked to
long-term structural reforms. Such reforms should not be focused on delivering
policies harmonization, but on addressing countries-specific bottlenecks. In
the case of Ireland, the conditionalities should relate to reforming fiscal
policy formation and public sector operational and strategic capabilities.
Instead of quick-fix cuts and tax increases, the economy must be rebalanced to
provide more growth in the private sectors, improved competitiveness in provision
of core public services and systemic rebalancing of the overall economy away
from dependency on MNCs for investment and exports.
Chart: Euro Area:
debt crisis still raging
Source: IMF WEO, April 2012 and author own calculations
The
core problem with Europe today is structural policies psychosis that offers no
framework to resolving any of the three crises faced by the common currency
area. Breaking this requires neither harmonization nor more debt issuance, but
conditional aid to growth coupled with robust resolution mechanism for banking
sector restructuring.
Box-out:
This
week’s decision by the ECB to retain key rate at 1% - the level that represents
historical low for Frankfurt. However,
two significant developments in recent weeks suggest that the ECB is likely to
move toward a much lower rate of 0.5% in the near future. Firstly, as signalled
by the euro area PMIs, the Eurozone is now facing a strong possibility of
posting a recession in the first half of 2012 and for the year as a whole. Secondly,
within the ECB governing council there have been clear signs of divergence in
voting, with Mario Draghi clearly indicating that whilst previous rates
decisions were based on a unanimous vote, this time, decision to stay put on
rate reductions was a majority vote. A number of national central banks heads
have dissented from previous unanimity and called for aggressive intervention
with rate cuts. In addition, monetary dynamics continue to show continued
declines in M3 multiplier (which has fallen by approximately 40 percent year on
year in May) and the velocity of money (down to just under 1.2 as opposed to
the US 1.6). All in, the ECB should engage in a drastic loosening of the monetary
policy via unsterilized purchases of sovereign debt and cutting the rates to
0.25-0.5%, with a similar reduction in deposit rate to 0.25% to ease the
liquidity trap currently created by the banks’ deposits with Frankfurt. The ECB
concerns that lower rates will have adverse impact on tracker mortgages and
other central bank rate-linked lending products held by the commercial lenders
is misguided. Lower rate will increase banks’ carry trade returns on LTROs
funds, compensating, partially, for deeper losses on their household loans.
