Ireland on the Right Path; Targets too Ambitious

October 8th, 2010

A realistic estimate of the costs required to recapitalise the banking system following the
Irish people’s ill-fated love-affair with ‘bricks and mortar’ was revealed last week, and
the numbers involved can be described as nothing less than appalling.
The gross fiscal cost amounts to more than 30 per cent of GDP, a figure that is on a par
with well-documented crises that include, the South East Asian meltdown of 1997, the
Russian collapse of 1998, and the Turkish implosion almost a decade ago. If that wasn’t
shocking enough, the gross cost per taxpayer ranks first among recent crises, a fact that
lends credence to the notion that the bigger the party, the greater the hangover.
Financial markets had already turned decidedly against the Irish sovereign as the yield on
ten-year bonds jumped from below 5 per cent at the start of August to as high as 6.8 per
cent towards the end of last month, the highest level since 1997 and a record spread
versus German bunds.
The negative sentiment was apparent and it comes as little surprise that government paper
rallied on the news with yields dropping by more than half a percentage point in
subsequent trading sessions, though current spreads still imply a high probability of
default that ranges from one-in-three to one-in-two depending on the assumed recovery
rate.
Market sentiment clearly sides with the bears who like to trump the notion that
imbalances as serious as those evident in the fallen tiger economy have never been
corrected without currency adjustment. The history books confirm that such self-serving
views are bogus; there are numerous examples from the past to the present day that saw
the correction of serious macroeconomic imbalances that included neither devaluation
nor default.
The British experience post the Napoleonic wars is undoubtedly a classic case. Public
debt soared from £273 million in 1793 to £792 million in 1816, an amount equivalent to
some 250 per cent of national income.
The British neither defaulted nor devalued and the public debt ratio declined throughout
the nineteenth century, as the economy enjoyed a period of sustained growth. The bears
will note that our neighbour’s experience hardly proves the case, as the accumulation of
debts was a function of war and not structural fiscal deficits. Nevertheless, the example
is worthy of mention because the British people took the post-war taxes on the chin and
helped deliver a remarkable turnaround in the public finances.
More recent history reveals examples of countries that viewed their currency anchor as
the key to macroeconomic stability and stuck to the peg even in the face of a traumatic
internal devaluation. Barbados for example, pegged its exchange rate to the U.S. dollar
in 1975, nine years after it secured independence from the British. It ran into difficulty in
the early-1980s and once again in the early-1990s at which time the IMF recommended
that it should devalue. The Barbadians ignored the recommendation and introduced a
one-time cut in real wages of almost ten per cent, which restored competitiveness and
allowed the economy to recover.
Latvia is the most recent example of a country that has resisted populist opinion and
remained steadfast in its commitment to its peg to the euro. The Baltic nation was
expected to roll over following the demise of Iceland and became the subject of repeated
vitriolic comment from respected economists including the Nobel laureate, Paul
Krugman, and ‘Doctor Doom’ himself, Nouriel Roubini. The country didn’t flinch and
following a mind-numbing collapse in GDP, looks set to return to growth. Furthermore,
the recent election results show that the people place the nation’s long-term interests over
populist opinion, and devaluation and default is now nothing more than a distant
memory.
The examples serve as a reminder to Irish populists that there is only one acceptable route
to take and that is the path of fiscal rectitude. The road however, is fraught with danger
and a reduction in the fiscal deficit to just three per cent of GDP by 2014 looks like too
much, too soon. The necessary adjustment cannot be achieved without buoyant private
sector domestic demand and/or a sizable current account surplus. The former is unlikely
to stage a V-shaped recovery given impaired balance sheets and negligible income
growth, while the improvement in the current account is unlikely to prove sufficient
given the high import-content of exports and tepid foreign demand.
The true extent of the banking collapse is now evident, and it is time to move on and map
the road forward. A default remains a remote possibility given a liquidity buffer that
amounts to some 15 per cent of GDP and more than 25 per cent including the National
Pension Reserve Fund. Nevertheless, the fiscal adjustment required by 2014 looks far
too ambitious; the targets are unlikely to be met and consequently, market turbulence
should persist. Irish government paper does not yet satisfy the criteria for long-term
investment, but might well be worth a punt for the brave.

www.charliefell.com

The views expressed are expressions of opinion only and should not be construed as
investment advice.
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