SERIOUS MONEY:THE SICK men of Europe's monetary union are in the spotlight once again, and none more so than Ireland, as fears that the eventual cost of recapitalising the ailing banking sector will bring the State to its knees have precipitated panic in the domestic bond market.

The yield on 10-year bonds has jumped from below 5 per cent at the start of August to as high as 6.7 per cent in recent sessions – the highest level since 1997 and a record spread against German bunds. Meanwhile, the premium for five-year Irish credit default swaps (CDS) soared to 520 basis points ahead of yesterday’s update on the cost of the banking bailout, a level that is exceeded only by Venezuela, Argentina, Greece and Pakistan.

Market psychology has clearly turned against the Irish sovereign and commentators are divided as to whether a humiliating default can be avoided.

It is true that Ireland walks a fine tightrope, as the ultimate cost of recapitalising the banking sector versus GDP is likely to rank alongside the South Korean and Turkish crises of 1997 and 2000 respectively. Meanwhile, the fiscal adjustment required to bring the deficit down to 3 per cent of GDP in 2014 is equivalent to that achieved over a nine-year period between 1981 and 1989.

In spite of the herculean task facing the Government, however, a default is highly unlikely in the medium-term and the necessary adjustment can be made, although perhaps over a longer timeframe.

The current panic is clearly related to solvency and not liquidity, as the Government holds very large cash reserves as a funding buffer that amount to roughly 15 per cent of GDP. This means that liquidity does not become an issue until next summer at the earliest.

Furthermore, the National Pension Reserve Fund offers the Government further liquid resources as a buffer that amount to roughly 12 per cent of GDP. Thus, an immediate default is simply out of the question.

In relation to solvency concerns, a financial balance approach suggests that the necessary fiscal adjustment can be achieved, in which case the outstanding stock of public debt will peak at circa 100 per cent of GDP. It is important to recognise that the sum of the fiscal balance and the domestic private sector financial balance equals the current account balance. Thus, an improvement in the fiscal position must be accompanied by a declining private sector balance, an improving current account balance or some combination of both.

In this respect, the Irish fundamentals compare favourably with its ailing European neighbours, as the private sector is running a large surplus that is in double digits as a percentage of GDP, and the current account deficit has narrowed to just 1 per cent.

The current account should move to surplus next summer while a reduction in the private sector surplus is possible, so long as confidence and the global economic climate remain conducive. Thus, the fiscal adjustment is possible.

The fundamentals are not as poor as current bond yields suggest, but market psychology dominates in the current climate.

The Government’s efforts are not being helped in this respect by negative commentary which relies on spurious examples and the selective use of data to prove a point.

A recent example argues that the Irish Government should follow Iceland’s example and default. Readers are led to believe that Iceland is enjoying a vibrant economic recovery and international investors are chomping at the bit to return.

The truth of the matter is that the Icelandic economy remains mired in deep recession; output shrank more than 3 per cent quarter- on-quarter in the three months to June 30th and has now registered eight consecutive quarters of negative year-on-year growth.

Furthermore, the latest data available from the World Bank show that Iceland’s gross national income per capita has shrunk from parity to a level one-third below that of Denmark, Finland and Sweden.

Unemployment is indeed declining, dropping by one percentage point to 8.3 per cent during the second quarter. However, the improvement is a mirage, as changes in the methodology used to calculate unemployment have caused the rate to measure half to one percentage points lower than it would have otherwise been. Furthermore, the figure has been affected by emigration.

It is argued that declining interest rates demonstrate that confidence has returned. Short-term rates have been cut from a peak of 18 per cent two years ago to 6.25 per cent today, but they still remain among the highest in the developed world. Furthermore, interest rates have been cut in response to an appreciating krona, which has benefited from a firm lid being placed on capital outflows.

Long-term yields rose on the latest cut, as the gradual removal of capital controls draws ever nearer and there is understandable fear that the holders of Glacier bonds will exit at the first opportunity. Needless to say, the notion that international investors are set for an imminent return is bunkum.

Ireland does indeed stand on the precipice, but the idea that we follow Iceland’s example is simply ludicrous. Investors would do well to ignore such spin and base their opinions on fact-based analyses.

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