By Satyajit Das, the author of “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives”
In early 2010, drawing on the military leadership of President George W. Bush, European leaders declared the economic equivalent of “mission accomplished”. A bailout – whoops support! – package of Euro 750 billion had shocked and awed speculators into submission. Like the Bush pronouncement, the European prognosis provided premature. The return of European sovereign debt problems in late 2010, culminating in the bailout of Ireland highlighted the deep seated and perhaps intractable problems of some over indebted European nations.
In the first half 2010, the trigger was the large budget deficits and high debt levels of the “PIGS” (Portugal, Ireland, Greece and Spain) or “PIIGS” (including Italy). For Greece, a lethal cocktail of the need to finance maturing debt and deficits, use of derivatives to disguise debt levels and general lack of candour about its borrowing, exacerbated the problem.
The European Union (“EU”) responded ultimately with a variety of measures, including an Euro 110 billion bailout for Greece and the Euro 750 billion European Financial Stability Funds (“EFSF”) designed to underwrite the liquidity of the besieged Euro-zone members.
The European Central Bank (“ECB”) separately supported the EU measures. The ECB’s role, presumably with the tacit agreement of the EU and members, was crucial, avoiding the problems of lack of consensus and disagreements at the political level.
The ECB purchased bonds issued by Greece, Ireland and Portugal in the secondary market to support prices. By mid-December 2010, the ECB had purchased Euro 72 billion as part of these operations.
More importantly, the ECB supported banks in the troubled companies, providing funding when money markets would not finance these institutions. The funding was at attractive rates (around 1%), against security of government bonds lodged as collateral for the loans. A delicious arbitrage and backdoor way of financing the troubled borrowers ensued.
Domestic banks in Greece, Ireland, Portugal and Spain purchased their own government’s debt, ensuring crucial demand and “successful” auctions. The purchased bonds were used as collateral to secure funding from the ECB. The illusion that the countries had access to commercial funding sources at reasonable rates was maintained. The banks also earned large returns, the difference between the yield on the bonds and the ECB funding rates.
As of August 2010, the level of ECB funding was as follows:
Following the Irish crisis in the second half of 2010, the funding demands on the ECB have increased. Ireland’s borrowing from the ECB has reached Euro 136 billion (86% of Gross Deposit Product (“GDP”)), around a quarter of Euro-zone member drawings on the facility.
The ECB has expressed concern about Europe’s “addicted financial groups”. But with banks affected by their sovereign’s debt problems and maturing debt not being rolled over, the ECB has little option but to continue the arrangement.
The approach of the EU/ ECB assumed that the problem was temporary liquidity not solvency. The solution was to ensure that the troubled countries could continue to finance. The restoration of confidence would enable a rapid return to market financing and the status quo.
Nothing exemplified this better than the ill-conceived and poorly designed EFSF. Amongst the multiplicity of problems were the limited guarantees from Euro-zone countries and a reliance on CDO rating methodology. The preliminary analysis of the EFSF by the credit rating agencies confirmed the view that the facility was not designed for use. Close inspection also revealed that the facility was only capable of being drawn for an amount as low as Euro 250 billion, well short of the advertised Euro 750 billion. It was a pure confidence trick.
As concerns about the underlying solvency of the countries continued, markets became increasingly nervous. The tensions focused around Ireland. While the problems of Ireland are well documented, the sequence of events was curious.
Ireland had sought “prime mover advantage” in austerity, reducing its budget deficits through severe cuts in government spending and tax increases. It established a state bank restructuring agency – National Asset Management Agency (“NAMA”) – to deal with bad loans made by banks. Ireland had completed its 2010 financing program, not expecting to come to market until early 2011. It also had Euro 20 billion in surplus cash.
A series of related events focused attention on Ireland. Bank bad debt problems re-emerged, especially at Anglo-Irish Bank. Forecast loan losses were revised upwards significantly, in turn increasing the demand on the state to finance the bailout of the banks. The cost, still unclear, was estimated at around Euro 50 billion (30% of Ireland’s GDP). This had the effect of pushing the 2010 Irish budget deficit to around 32% of GDP.
German Chancellor Angela Merkel raised the prospect of bondholders being forced to “share” losses in any debt restructuring. After a sharp increase in rates for many European countries in response to the suggestion, at the G-20 summit in Korea, European leaders clarified the proposal. It would only apply after 2013, when the current bailout arrangements expired. This drew attention to the temporary and short term nature of the EFSF and related support mechanisms.
Independently, Anglo Irish Bank offered to repurchase its outstanding subordinated debt for 20% of face value, warning that the return to investors in bankruptcy or restructuring would be far worse. This highlighted the risk of loss on Irish State or bank debt.
At the same time, Austria withheld its share of the due instalment of funds to Greece, arguing that key hurdles had not been met. While the Austrian posturing was mainly driven by domestic politics and funds were eventually released, the fragile nature of European support for the troubled borrowers was highlighted.
The parlous state of Ireland’s economy was unhelpful. The Irish economy shrank by 1.2% in the third quarter, a surprise to economic forecasters.
Markets pushed up yields on Irish debt inexorably. Higher rates caused losses on holdings of Irish bonds, triggering further selling. As rubber-necked accident voyeurs joined the party, the costs for Ireland to borrow commercially reached economically unsustainable levels closing access to financial markets. Depositors started shifting their money abroad, threatening a fully-fledged bank run.
They say if a politician denies that he is going to resign stridently often enough, he almost certainly will. Strenuous denials of the need for a bailout ended inevitably in one. A grim Irish Prime Minister Brian Cowen announced that Ireland would be receiving aid from the EU subject to meeting EU/ International Monetary Fund (“IMF”) conditions. It would, the Taioseach insisted, “secure Ireland’s future.” No one believed him.
The Irish bailout facility totalled Euro 85 billion, made up of Euro 35 billion for the banking system (Euro 10 billion for immediate recapitalisation and Euro 25 billion to be provided on a contingency basis) and Euro 50 billion to cover the financing of the State. The average interest rate would be of the order of 5.8% per annum, depending upon the timing of the drawdown and market conditions.
After a brief rally, familiar concerns re-appeared. Estimates suggested that the Irish banks alone required around Euro 16 billion in capital and a further Euro 38 billion in financing. This totalled Euro 54 billion, 64% of the Euro 85 billion package. Given that Ireland required Euro 70 billion to meet maturing debt until 2013, the size of the bailout facility was arguably inadequate. As in the case of Greece, the bailout package dealt only with short-term liquidity, failing to address Ireland’s longer term solvency.
The arrival of an IMF/ EU team to prescribe a “cure” did not inject the expected confidence in an imminent recovery. Ireland had been self administering the same medicine for some time, with indifferent results.
The Irish economy has not recovered from recession, with GDP only registering growth in one quarter since 2007. Overall, the economy has shrunk by nearly 20% from its peak. Gross National Product (“GNP”), which is a better indicator of living standards, has fallen for nine successive quarters. The official unemployment rate is around 14%, though the level of real unemployment and under employment is greater. House prices are 36% below their 2006 level. Consumer spending has fallen sharply, the result of lower income and increased savings levels of around 12% of income (an increase from 3.9% two years ago).
Cuts in government spending and higher taxes have mired the economy in recession. Falls in tax revenue necessitate increasingly deeper cuts in spending to try to stabilise public finances. In 2010, the budget deficit was forecast at 12% of GDP, even after spending cuts and tax rises worth Euro 14.5 billion
The problems of the banking sector are increasing due to the poor economic conditions. Hitherto largely confined to commercial property, problems are now spreading to the broader economy. Unemployment and lower incomes mean that householders are unable to meet payment obligations on mortgages and other loans. Weak economic conditions have affected businesses, increasing default levels.
Following the bailout, the Irish government announced further cuts in the budget deficit of Euro 15 billion, with Euro 6 billion scheduled for 2011. The package included Euro 10 billion of spending cuts covering social welfare, health care, education and the public sector. There were Euro 5 billion of tax increases, including increases in value added tax (VAT), income taxes and property taxes. Controversially, the low 12.5% corporate tax rate, crucial to maintaining Ireland’s competitive position, remained unchanged, despite complaints and pressure from the EU.
The ability to meet the required targets is uncertain. Forecasts are predicated on “aspirational” growth of 2-3%. Moody’s Investor Services, the rating agency, cut Ireland’s debt rating by five notches Baa1, two notches above junk, with a negative outlook.
The experience of Greece under the IMF/ EU plan is instructive. While there has been some progress, Greece is struggling to meet its budget targets due to a shortfall in tax revenues, forcing ever more aggressive spending cuts exacerbating Greece’s deep recession. Planned asset sales and structural reforms are unlikely to stabilise public finances. Faced with the unpalatable choice of withholding funding due to non-compliance with the plan or allowing default, the EU/ IMF have continued to disburse funds propping up the economy. The maturity of the bailout package is likely to be extended, acknowledging that it cannot be repaid.
In the absence of strong economic growth, inflation and a massive devaluation, the peripheral economies, such as Ireland and Greece, may be unable to shrink themselves to solvency.
A simple relationship demonstrates the unsustainable position:
Changes In Government Debt = Budget Deficit + [(Interest Rate – GDP Growth) X Debt]
In order to restore solvency, overburdened borrowers must stabilise debt and begin to reduce the level of borrowing. This requires GDP Growth exceeding interest rates, a budget surplus (through spending cuts and/or tax cuts) or a combination of these.
EU/ IMF assistance to Ireland was designed to address the high yields on Irish bonds, which curtailed the State’s ability to borrow. But the 5.80% cost of the bailout debt requires an equivalent growth rate and a balanced budget simply to stabilise debt at current very high levels.
Based on the IMF’s best estimates, there is little prospect of many European countries returning to balanced budgets any time soon. Given the toxic conjunction of high cost of funding, low growth and high starting level of debt, it is near impossible for these countries to contain the spiral to a restructuring of their debt or default.
When asked for directions, the old joke is that some wise guy pipes up: “If you want to go there, then I wouldn’t start from here.” The same could be said of rescuing overburdened European countries.