Ireland: Bail-Out With A Boomerang

Submitted by Alex Gloy, CIO of Lighthouse Investment Management

Ireland: Bail-out with a Boomerang
European government bond spreads have widened dramatically with the second country going bankrupt: Ireland.
10 year Irish government bond yield. Source:
An example of low indebtedness as recently as 2007 (25% debt-to-GDP ratio compared to 65% for Germany)  – the country has descended into financial chaos within 3 years. And, contrary to Greece, Ireland has not overspent, nor falsified government statistics.

This year alone, saving its banks from collapse will cost Ireland 32% of GDP.
But the EU/IMF rescue package saddles the country with another EUR 85bn of debt – more than 50% of GDP (remember, Maastricht criterion was 60%). The ratio would look even worse if you used the gross national product (GNP) instead (EUR 139bn vs. GDP 170bn for 2009[2]). A lot of global firms have shell companies in Ireland, where – due to the low corporate tax rate of 12.5% – profits are being booked. Royalties are charged towards holding companies in higher-tax countries to  avoid paying higher taxes. These tax shells are run by few employees and do not add much to the industrial output or tax base of the country. Hence GNP would be a better measure of economic strength.

It seems Ireland tried to resist a bail-out, but was forced to accept (Irish banks are hanging on by a thread of EU 130bn of loans from the ECB).
But wait a minute – non-Irish banks make up EUR 35bn of this amount[3].  And didn’t some foreign banks (among them German Depfa, which was bought by Hypo Real Estate which in turn had to be rescued by the German government and has so far cost more than EUR 100bn) move their headquarters to Dublin to escape stricter regulation at home? And now the EU/IMF forces the Irish tax payer to bear the cost of bailing out those banks?
The government is doing its citizens a disservice by accepting a bail-out. The “National Recovery Plan 2011-2014″ intends to save EUR 15bn (“front-loaded” 6-5-4bn for the years 2011-13) by cutting expenses (10bn) and raising taxes (5bn) in order to reduce the budget deficit to less than 3% by 2014.

The budget plan sees GDP increasing by 1.75%, 3.25%, 3% and 2.75% in the years 2011-14.
Can anybody explain to me how an economy, which was shrinking by 11% (GNP) last year, that will be saddled with austerity (demand-reducing) measures of another 10% of GNP is supposed to grow? Not only have government tax revenues declined by 33% since 2007[4] but also will increased interest burden (because of the bail-out loans) eat up 20% of revenues by 2014 (up from 8% in 2009)[5].

The sanity of the authors of this “recovery plan” has to be questioned.
Everything happens for a reason. Probably the Irish tried first avoiding a bail-out. Then, as it became unavoidable, putting “fantasy” numbers in the budget just to get over with it and to be able to sell it to the people as a “recovery” story. The plan could have been to take some EU/IMF money (paid out in tranches) and then default (or hope for a miracle).  Or, more elegantly, let the banks go bust (like Iceland) and avoid bearing the costs for bailing them out.
The guys from the IMF/EU are no amateurs. Seeing through this possibility they mischievously demanded the Irish contribute EUR 17.5bn of money from the National Pension Reserve Fund and from the country’s own cash reserves. Perversely, Ireland is rescuing itself with its own money. Hence, should the government dare to default, those pensioners will feel the cold as their money goes up in smoke.

I have rarely come across anything so blatantly opposed to the interests of the people. Comments by readers of Irish newspapers reflect the outrage, but a protest after the bail-out announcement counted only 50,000 participants.

One last chance to escape from this draconian bail-out is the government vote on December 7. The government could fall apart, individual members could defect – anything is possible. If the plan passes -  good luck and all my sympathies to you, Irish people.

The bond market has already reached its verdict: Ireland will eventually default. The 10-year government bond yield (9.35%) is now higher than before the bail-out announcement (roughly in the 8-9% range).

Why would the EU and IMF subordinate a country to such an endeavor guaranteed to fail?
Some point towards the 12.5% corporate tax rate being a thorn in other governments’ sides. Some point towards EUR 139bn owed to German banks, among them apparently some Landesbanken (WestLB is said to stagger after Bayerische Landesbank recently walked away from a merger).

The message seems to be that one country’s people has to pay because another county’s people doesn’t want to pay for its banks’ mistakes.

When, according to credit default swap prices[6], Greece and Ireland have, despite bail-outs, the second and third highest default probability (55% and 40%) on earth, something has to – and will – give. We are talking about bankruptcies of entire countries. And, as outlined in earlier letters, the cohesion of the Euro zone. Which leads us to the next topic: how complacent must equity investors be not to see the imminent risks in Europe? Are they waiting for the German Constitutional Court to possibly veto any bail-out (as demanded by the “no bail-out clause”) in February 2011?

The only solution for a last-minute attempt to save the Euro would be to abolish individual sovereign debt issuance and to replace by a supra-national issuer. Of course, Germany’s credit rating would suffer, and its government bonds would tumble significantly. And even such a move would not solve one of the main problems: divergence in unit labor costs within the Euro zone over the last decade.

Half-hearted solutions could be a split into a “North-Euro” and “South-Euro” as proposed by Hans-Olaf Henkel[7]. But even that would lead to a run on banks within the weaker currency zone.

[2] Quarterly National Accounts, CSO Irish Central Statistics Office, March 25, 2010, page 1
[3] “Sharp rise in Irish banks’ ECB borrowings” in: RTE News, October 29, 2010
[4] “The National Recovery Plan 2011-2014″ by the Irish Government, page 10
[5] “The National Recovery Plan 2011-2014″ by the Irish Government, page 8
[6] “Highest default probabilities” by: CMA, November 30, 2010
[7] “Wirtschaftsexperte Henkel fordert “Euro-Nord” und “Euro-Sued”, dpa-AFX November 26, 2010