From Morgan Stanley on the
Irish debt crisis:
Financial
markets in the periphery (bonds, CDS and in some cases banks) have become rather
volatile in recent days. This escalation follows several weeks of spread widening in the three smaller peripheral
markets (notably Ireland and, to a lesser degree,
Portugal and Greece). While each country has its own interesting idiosyncratic story, the danger of contagion has clearly increased. In this note, we discuss political deliberations on tapping the
European Financial Stability Fund (EFSF). We outline how the process would work if it were to be activated and highlight the likely market reaction that could be expected on the announcement, based on what was observed in
Greece.
On balance, we believe that the sharp rise in market tensions over the last few weeks has increased the chances of the EFSF being tapped. This is in particular true for Ireland, in our view, where it seems increasingly difficult for the government to effectively backstop the problems in the banking system. We would stress, however, that no country will apply to the EFSF lightly or ‘just' to reduce debt-servicing costs: tapping the EFSF is a monumental decision that will shape economic, fiscal and
financial policies in that country for many years to come. It is a step that a government would only take in case of no other viable alternative, in our view.
On balance, it looks increasingly likely to us that Ireland might not be able to avoid going to the
EFSF eventually.
That said, we would expect the Irish government to put up a ‘good fight'. As the Treasury is sitting on a comfortable cash buffer of €20 billion, it is fully funded until next summer. In addition, it can and has used the National Pension Fund Reserve (NPFR) to recapitalise the banks. A proposed change to the discount factor used in calculating the Fund's pension liabilities would free up additional cash reserves. Hence, contrary to Greece back in April,
Ireland should be able to hold out for a while. In our view, the government will likely use this ‘borrowed time' boldly to restore market confidence. The four-year fiscal plan revealed this week is ambitious. It foresees budget cuts of €6 billion for 2011 alone (equivalent to 3.8% of GDP) and a total of €15 billion over the next four years. But because the real source of the Irish issue is not the budget deficit, but the problems in the
banking system, fiscal austerity might not be sufficient to restore market calm. A key obstacle for the
Irish government in the context of going to the EFSF is that other
European governments will likely demand an overhaul of its highly competitive corporate tax system - which the Irish view as key to their attractiveness for inward foreign direct investment (FDI).
Portugal seems less in the
market spotlight than
Ireland - at least at this stage. This does not necessarily mean that the Lusitanian economy will be able to escape going to the EFSF. Rather, it is an observation that
market dynamics look somewhat more benign for now. For example, 5y CDS spreads, at around 440bp, are about 150bp lower than in
Ireland. And the
Portuguese government is also sitting on a cash buffer (around €10 billion), this year's funding looks almost done and there's no need to worry about meaningful redemptions until next spring. What's more, from a fundamental perspective,
Portugal has a productivity problem which causes it to be stuck in a low growth and poor competitiveness situation.
Hence, the genesis of
Portugal's imbalances is different from that of the other
EMU peripherals. While in Greece the key issue is fiscal indiscipline, in Spain a credit-fuelled housing boom-turned-bust, similarly in
Ireland but coupled with an outsized banking sector,
Portugal faces various structural deficiencies. The upshot is that the rebalancing in
Portugal has an inherently structural nature and is unlikely to correct very easily and quickly, e.g., the current account deficit is still in double-digit territory. This is a reason for concern. So is the accumulation of external debt. The fiscal situation is only a by-product. Yet, while sudden shocks to the economy seem more unlikely in
Portugal than elsewhere, the main risk is contagion. If markets behave in ‘systematic mode' and continue to associate the current difficulties in
Portugal with, say, those in
Ireland or Greece, access to funding might dry up to such an extent that
Portugal too might not be able to avoid going to the EFSF eventually.
How Will the EFSF Fund and Then Lend On?
The structure of EFSF debt issuance now put forward not only earns EFSF issues the AAA credit rating that was always planned; it also effectively removes the risk that different EFSF issues will be treated differently by the
financial markets, depending on the composition of the guarantee of each issue. Even though the structure of the EFSF is a rather complex one, and despite the EFSF not being able to prefund, we don't expect the funding to stand in the way of a quick resolution of a bond market buyer's strike on the
EMU periphery.
The funding costs of the EFSF will be key in determining the costs of the emergency lending facility. At this stage, we would expect such a loan to carry an interest rate of 5-6.5% per annum (
EUR asset swap - 1.5% 2y and 2% 5y - plus 300-400bp margin, plus a 50bp upfront service fee distributed across three to five years).
Will Entering the EFSF Help to Resolve the Crisis?
The impact of entering an
EFSF programme on the country in question and the euro area will likely depend crucially on what the emergency funds are being used for. Our colleague Joachim Fels argued in a recent note that the EFSF might become the long-awaited circuit-breaker for the
European sovereign debt and
banking crises (see The Global Monetary Analyst: Crisis, Credit, and Capital, September 8, 2010). This could be the case if the adjustment and restructuring programmes attached to the EFSF loans are clearly targeted to address the
banking sector's woes by directing a part of the EFSF loans to plug holes in
banks' balance sheets.
Our understanding is that, in principle, the
EFSF could help to fund the recapitalisation of the banking system if a
sovereign in the euro area were to find itself unable to raise the necessary funds in the
market (see EuroTower Insights: Stress Testing Europe, June 30, 2010). However, it is unlikely, in our view, that the EFSF will take direct exposure to the
banking sector. In fact, the Greek loan agreement explicitly stresses that it does not involve direct exposure to the Greek banking system.
Ireland, where the banking system is the root of the problem, would seem to be an obvious case for such positive implications of entering the EFSF. For
Portugal, by contrast, where the problems stem from a low productivity and poor competitiveness trap, tapping the EFSF by itself would not be enough. Here everything depends on whether the government is able to implement, over time, sufficient growth and productivity-enhancing structural reforms.
Finally, let's remember that government bond markets tend to overestimate the default risks systematically. The evidence from the emerging market
sovereign debt crises would suggest that bond markets have a rather poor track record in pricing in default probabilities correctly. According to a recent
IMF staff note, the bond market sounds a false alarm very often (see Defaults in Today's Advanced Economies: Unnecessary, Undesirable, and Unlikely,
IMF SPN 10/12). Looking at all episodes in which sovereign spreads were rising considerably since the early 1990s, the authors find that out of a total of 36 cases in which the spreads broke consistently above 1,000bp, only seven led to a debt restructuring (equivalent to only about 20% of the cases where the
market forecast was correct). Of course, many of the countries hit hard by contagion in the course of the Mexican, Asian, Russian and Argentinean crises needed emergency funding from the
IMF. But they did not restructure their debt. The tendency of the bond market to ‘cry wolf' far too often is reminiscent of the "equity market pricing in nine of the last five recessions", as Nobel Prize winner Paul A. Samuelson is famously quoted as saying.
Black Swan Insights
