SERIOUS MONEY: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 gross domestic product (GDP), a figure that compares unfavourably to a list of well-documented crises that includes the southeast Asian meltdown of 1997 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 when the yield on 10-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. However, 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 show that such self-serving views are bogus; there are numerous examples that saw the correction of serious macroeconomic imbalances without either devaluation or default.
The British experience after 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 19th 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 debt was a function of war and not structural fiscal deficits. Nevertheless, the example is worthy of mention because the British 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 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 International Monetary Fund recommended that it should devalue.
The Barbadians ignored the recommendation and introduced a one-time cut in real wages of almost 10 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 state 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 ahead of 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 is fraught with danger, however, and a reduction in the fiscal deficit to just 3 per cent of GDP by 2014 appears to be 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 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 (more than 25 per cent including the National Pension Reserve Fund).
Nevertheless, the fiscal adjustment required by 2014 looks far too ambitious and is unlikely to be met. 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
