World - Ireland: A Work In Progress

Ireland: A Work In Progress
Gillian Edgeworth

Ireland's International Monetary Fund/European Union programme is built upon three key pillars: a restructuring of the banking sector, a restoration of competitiveness, and fiscal consolidation.

In reality, success on the second and third pillar is likely to prove insufficient unless the first is addressed in a sustainable manner. Agreeing on a re-structuring plan for the banking sector is complex, not least because of the number of competing stakeholders involved. Upon announcement of the IMF/EU programme at the end of November last year, Ireland agreed to make good on the senior debt of the banks and quickly reduce the size of the banking sector. From the outset, it was obvious that Dublin was dissatisfied with the agreement, but having underestimated banking sector losses for more than two years and increased its reliance on European Central Bank (ECB) liquidity to close to one hundred percent of GDP, the domestic authorities found themselves with little bargaining room. Since then, Dublin has been working towards generating some protection for the sovereign's balance sheet from any further banking sector losses. While it is feasible that the package is successful in its current form, it leaves little cushion in the event of a negative shock. The coming weeks will be crucial in determining the outcome. Recent news flow suggests some compromise may be found. The shape of this compromise will play a role in determining Irish sovereign solvency and growth prospects, as well as overall market perceptions on the viability of the Economic and Monetary Union's (EMU) solution to the current crisis.

In assessing progress on the three pillars to Ireland's package to date, the banking sector remains the crucial weak link at this stage. According to data for the end of December, the package announcement failed to stem deposit outflow. At this stage, withdrawals are generated largely by non-residents rather than residents, but still leave an ever gaping hole for the banking sector to fund. From 228 billion euros at the end of 2009, non-resident deposits had fallen to 137 billion euros by the end of 2010 (a decline equivalent to 58 percent of GDP). The fourth quarter of 2010 saw the seventh consecutive quarter of negative credit extension.

Fiscal performance and efforts to restore competitiveness are more encouraging. Following four austerity budgets since late 2009, recent months have finally seen central government revenue growth in year over year terms turn positive once again.

From a primary deficit of 9.6 percent of GDP in 2010, excluding bank support measures, the programme targets a primary surplus of 1.2 percent of GDP by 2014. The main opposition party, Fine Gael, has pledged support for these targets. Meanwhile, both services and manufacturing exports show expansion, while the central bank's real harmonised competitiveness indicator - real effective exchange rate deflated by GDP - shows a return to where it stood in the third quarter of 2002, down 12.3 percent from its peak. From almost seven percent of GDP in mid-2008, the current account deficit should have narrowed to within one percent of GDP by the end of last year. After a cumulative peak to trough decline in GDP over in excess of 13pp, the programme assumes GDP growth of 0.9 percent this year, followed by 1.9 percent in 2012. This looks viable assuming Ireland's main trading partners continue to show gains in economic activity.

Slimline Banking

With assets at 470 percent of GDP at the end of December, the domestic banking sector in Ireland remains excessively large relative to the size of the economy. The results of the Prudential Capital Adequacy Review (PCAR) will not be made public until the end of March, but are likely to identify a further capital shortfall in the banking sector. Both issues need to be addressed to return the banking sector to a position where it can once again support the economy in a sustainable manner.

The approach will be multi-pronged. On top of approximately eighty billion euros in property and development loans transferred to National Asset Management Agency (NAMA), the banks have pledged to run down non-core assets. The PCAR will be accompanied by a Prudential Liquidity Assessment Review (PLAR), in which target loan to deposit ratios and net stable funding ratios will be agreed upon. The core tier 1 capital requirement ratio will be permanently increased fromeight percent to 10.5 percent. To establish some confidence in these tests, all involved aim to put 'as much detailed information on the condition of the banks' balance sheets and their prospective profitability in the public domain as possible'.

Separating The Sovereign

While all of the above is necessary, concerns about the extent to which the sovereign's balance sheet will be further damaged by banking sector losses means that convincing both the domestic general public and markets on the viability of the plan is a struggle. Since the end of 2007, the sovereign has seen gross public debt rise from 25 percent of GDP to just below one hundred percent last year. Net debt (adjusting for assets held by the National Pension Reserve Fund and liquid resources at the treasury) rose from9.5 percent to 49.9 percent of GDP over the same period. The rapid increase reflects a sharp deterioration in the government's fiscal position but also a series of government injections to the banking sector. To date these total 46.3 billion euros, equivalent to 29.3 percent of GDP, and have been made in a variety of forms: issuance of promissory notes, cash injections, preference shares financed with injections from the National Pension Reserve Fund. Of the 85 billion euros package agreed in November, 35 billion euros is available for the banking sector. The National Pension Reserve Fund and government cash balances funds 17.5 billion. European Commission documents also state that the treasury cash balance and discretionary portfolio of the NPRF will remain well above five billion euros throughout the programme period in case 'further unexpected needs arise from either the fiscal or the financial side'. Assuming the full 35 billion euros of banking sector funds are drawn down, public debt to GDP is projected to peak at 124.5 percent of GDP in 2013. If only ten billion euros of the 35 billion is drawn upon, public debt is estimated to peak at 109 percent of GDP. In its current form, any negative shocks that translate into further banking sector losses in the future will once again be absorbed by the sovereign.

Weighing the costs of the banking crisis to the sovereign relative to other countries since the collapse of Lehman Brothers is not clear cut, but relative to Iceland, Ireland's costs appear increasingly large. Insufficient resources meant that the Icelandic authorities were not able to offer much of the banking system support in October 2008, translating into a default on bank debt. Direct costs are made up of recapitalisation of the central bank (18.5 percent of GDP) and recapitalisation of some banks and the Housing Financing Fund (12.1 percent of GDP but likely to rise). The third major cost is the Icesave deal - originally estimated at thirteen percent of GDP but now re-negotiated to less than two percent. This brings total government costs to just under 33 percent of GDP. The social cost arising from the imposition of capital controls in Iceland is also difficult to quantify. In Ireland's case, costs to date amount to 29.3 percent of GDP - these will rise to 35.6 percent if the government injects the initial ten billion euros set down in the plan, to 51.2 percent of GDP if the full 35 billion in the plan is used. Of course it is difficult to cost the absence of ECB liquidity - without this, the Irish banking sector and economy, as well as asset prices, would undoubtedly have undergone a much more severe and rapid adjustment. But it is also glaringly obvious at this stage that the bank bailout was far from 'the cheapest in history' that the Finance Minister Brian Lenihan characterised it to be in late 2008.

Crunch Time

The event calendar over the coming months is jampacked. By the end of March the PCAR and PLAR results will be made public, determining any additional capital shortfalls to be met. By end of February, the banks must submit plans to reduce the size of their balance sheets. A general election is scheduled for February 25, with the potential for the new Taoiseach (prime minister) to take up his position by the second week in March. Meanwhile an EU summit scheduled for March 25 is expected to focus on a comprehensive solution to the EMU crisis.

Some re-negotiation of the IMF/EU package appears inevitable. Getting the mix right will be central to Ireland's growth and in turn solvency prospects over the coming years, but will also play a role in market assessment of the viability of the EMU's response to the crisis as a whole. A reduction on the interest rate is likely, as is an outcome whereby Ireland continues to make good on all senior bank debt. But there are other important details to be hammered out, in an effort to achieve the correct mix between creating a more manageable banking sector that can support economic activity while minimising further costs to the sovereign. Agreement on these vital components of the package represents one key challenge for the EU's much hyped end of March summit.

Gillian Edgeworth works as Chief EEMEA Economist for Unicredit Bank, and was previously at at Deutsche Bank responsible for economic coverage of Central Europe.