Colm McCarthy on EU debt deal

With apologies to irisheconomy.ie where this type of blogpost would normally have been created, but at midday today it hasn’t been. Veteran economist Colm McCarthy today writes in positive terms about the EU deal reached in the wee hours of last Friday morning. As well as welcoming the latest developments in the context of the pan European project, he believes the deal will be positive for Ireland. Let’s hope he is correct, but he seems to be optimistically latching on to some hooks offered on Friday, and this optimism may turn out to be unjustified.

The only solid black-and-white hook we have is the brief summit communiqué and in particular its first paragraph shown here with emphasis added.

“We affirm that it is imperative to break the vicious circle between banks and sovereigns. The Commission will present Proposals on the basis of Article 127(6) for a single supervisory mechanism shortly. We ask the Council to consider these Proposals as a matter of urgency by the end of 2012. When an effective single supervisory mechanism is established, involving the ECB, for banks in the euro area the ESM could, following a regular decision, have the possibility to recapitalize banks directly. This would rely on appropriate conditionality, including compliance with state aid rules, which should be institution specific, sector-specific or economy-wide and would be formalised in a Memorandum of Understanding. The Eurogroup will examine the situation of the Irish financial sector with the view of further improving the sustainability of the well-performing adjustment programme. Similar cases will be treated equally”

There are three hooks in the statement

“it is imperative to break the vicious circle between banks and sovereigns”

This is potentially positive but also potentially negative, but what does it mean for Ireland where most of the losses in the banking system have already been crystallised. Might this mean that our premature good-faith intervention to rid our banks of property related losses, through NAMA and stress testing, with consequently massive recapitalising bills, mean that Ireland has ruled itself out of future measures to address bank failures? A distinction needs to be drawn between a European fund like the ESM recapitalising viable banks which have the potential to repay the capital on one hand, and zombie banks that have incurred losses so big resulting in such large recapitalisation requirements that the capital will never be repaid. I cannot see the ESM funding the latter, and that’s what we mostly had in Ireland with Anglo, Irish Nationwide, AIB, EBS and Irish Life, and to a large extent Bank of Ireland. And the ESM fund to which Ireland contributes may be used to capitalise non-Irish banks, and Ireland will be on the hook for additional losses should that capital be ultimately lost.

“The Eurogroup will examine the situation of the Irish financial sector with the view of further improving the sustainability of the well-performing adjustment programme”

Colm says that sustainability means debt sustainability, but here there is a problem, because both our Department of Finance and the bailout Troika believe our debt is sustainable – take a look at the quarterly IMF staff report, there’s a whole section on debt sustainability and even with 120%-plus debt:GDP, the IMF gives this country a big tick for having sustainable debt. Our Department of Finance believes that if you can show debt reducing from a peak, then that meets the definition of sustainable, regardless of the underlying fiscal adjustment needed. So if “sustainability” means “debt sustainability” then why would there be grounds for optimism. And let’s not forget that the EU regards Greek, Italian and soon Portugese debt:GDPs of 120%-plus as acceptable.

“Similar cases will be treated equally”

Colm believes this means that any concessionary treatment of bank debt in Italy and Spainwill be retrospectively gifted to Ireland. Again, it seems unlikely from this perspective that the ESM will gift dead money to individual countries’ banks. If it does, who will foot the bill? At best, it seems the ESM might buy the State’s shares in Bank of Ireland, AIB/EBS and Irish Life. What are those shares worth today. A couple of billion perhaps, better than a kick in the teeth but derisorily small in comparison with the €68bn cost of the bank bailout to date – €63bn in cash, loans and promissory notes and €5bn of NAMA state aid for which we may need pay in 2020.

I hope Colm’s belief in the promise of the latest developments is justified, and that his interpretation of the words above is correct. I wouldn’t bet on it though.

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When it comes to EU debt deals, always (always) look a gift horse in the mouth

Our Finnish friend Olli Rehn impressed nations all over Europe with his Zen-like sayings – remember “better not paint the devil to the wall unless you can wash it off from there” and “salmon is such a noble fish that it is worth fishing even if you don’t finally catch one”. Here in Ireland, we have quite a few sayings of our own. “Don’t look a gift-horse in the mouth” is one and literally means that if some kind donor turns up on your doorstep offering you a horse for free, the last thing you should do is prise open its jaw and examine its teeth, traditionally a way to assess the overall health of a horse. Because if you do, at the very least you might sour the kindness and you might even offend the donor so much that he takes his horse back, and never display kindness to you again.

This saying – “don’t look a gift horse in the mouth” – must be at the root of the complete failure of our media to scrutinise the deal done in the wee hours of Friday morning in Brussels at the EU summit. An Taoiseach Enda Kenny emerged from the meeting giving a thumbs up and his Tanaiste did a lap of honour through the media. We have grown cynical to claims made in the aftermath of such summits – and we are now on our 20th – but at least in this case, we could see in black-and-white in the summit communiqué thatIreland was specifically mentioned. And that mention gave cover of sorts to An Taoiseach and he wasn’t pressed on exactly what deal had been done, and specifically what it meant for Ireland.

Three days later and I am still scratching my head to see any benefit for Ireland. What does an expression like “separate bank debt from sovereign debt” even mean? This isn’t sarcasm or cuteness, I honestly am lost.

To recap, Ireland will have national debt of around €190bn in 2013. So far we have incurred €63bn to bail-out out the banks with cash, loans and promissory notes. We also have guaranteed NAMA’s bonds and we know that NAMA has paid €5bn of state aid to the banks in acquiring its loans so far, but this state aid is not accounted for as part of our national debt, though if by 2020 NAMA hasn’t seen a recovery in prices, then those billions will be footed by the Irish state – yes, we’re supposed to be able to levy the banks but we own Anglo, INBS and most of AIB and EBS and still have 15% of BofI. So ignore NAMA’s state aid for the time being. Otherwise we have incurred €63bn in bailing out the banks. So what does “separating bank debt from sovereign debt” mean?

There seems to be a vague suggestion that bank debt will be transferred to the shoulders of the European Stability Mechanism (ESM) but how would that work? The ESM gets capital of €80bn from 17 countries and borrows up to €500bn on the strength of that capital, and ultimately the 17 countries might be called upon to put €700bn of capital in the ESM. So the ESM might refund Ireland€63bn, thereby cancelling the entire cost of our bailout. But this is largely dead money. Which means the ESM will not get it back, which means the ESM will have a loss of €63bn. Who is paying for that? Remember the ESM borrows money from the markets but that has to be paid back. Do the 17 countries that put in capital into the ESM pay? If so, someone might want to tell the Germans who foot 27% of the ESM, because they are not aware of any commitment to pick up the tab for bank losses elsewhere in Europe.

Here’s what I think “separating bank debt from sovereign debt” means.

A bank, for example a Spanish bank, decides that it has incurred €50bn of losses on its property loans. The bank has a viable business for the future, but it needs an injection of capital now to cover the losses. The ESM might provide €50bn of capital to the bank in return for 99% ownership of the shares. The bank then recovers, makes profits and the ESM sells its shareholding for €55bn in a couple of years. The ESM uses the €55bn to repay its lenders with interest. Everyone’s happy.

Except, I would have said the above example is rare. How many Anglos are there in the Spanish banking system which will never be viable or able to repay a capital injection? Who knows, but we do know that in Ireland, most of the €63bn is dead money. And if lost causes will not be covered by whatever has been agreed, does that mean Ireland will not benefit but may, in contrast to the promise of Friday’s developments, find itself on the hook for potential losses in Spanish banks which the ESM presently deems viable?

It might behove our media to think of our bank debt like any other debt. This debt is presently on the nation’s shoulders and its repayment is dictated by very specific loan terms. So if there is any write-down or relief on this debt, it follows that there is an equal and opposite sacrifice on the part of our creditors. And a very good check of the overall soundness of a debt deal would be to contact our creditors and confirm with them that they have indeed made a sacrifice. Because sadly, in this case, for Ireland, I think we’ll find that no such commitment has been made.

Funnily enough, there is a lesser-heard saying “always look a gift horse in the mouth” which derives from the Trojans experience with the Greeks in the Trojan war, where the crafty Greeks feigned a withdrawal from the battlefield leaving a giant wooden horse behind as an apparent token of the respect they held for fellow fighters. The giant horse was brought inside castle walls, and in the dead of night, the Greeks concealed inside the horse emerged and slaughtered the vulnerable Trojans. You all know that story, so why do we suspend scrutiny when Enda Kenny claims a game changing victory?

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