That Black Hole...

By Eoin Fahy , Wednesday, 8th September 2010 | 0 comments

What happened? Just a few short weeks ago, Ireland’s policies to deal with the fiscal crisis were being held up as an example to the rest of Europe.  But now Irish bond yields are hitting record highs, and the international media regard us as a pariah. The focus is clearly on the black hole that Anglo has become, but this is a mistake: the impact of Anglo on the annual budget deficit is actually quite small, relative to the overall budget deficit.

We in Ireland know that it was always likely, indeed virtually certain, that Anglo would need more money from taxpayers.  Neither the Government nor Anglo itself seriously denied in recent months that more funds would be required.  But a couple of weeks ago Standard and Poors, the credit rating agency, downgraded Ireland's credit rating due to the additional expected costs of the bank rescue, and the story took off from there.  
The international media picked up on this very quickly, and it gained momentum until it arguably became the biggest story worldwide in the financial media for a time.  It was August after all, when most of Europe's top officials and financiers had taken themselves off to the beaches, so any mildly interesting piece of news was going to get far more attention than would normally be the case.
The negative headlines abounded.  The Financial Times wondered if Anglo would sink the Irish economy.  Bloomberg ran a prominent story with the headline, "Irish Ask How Much Is Too Much As Bank Rescue Trumps Austerity".  The New York Times headline was, "In Ireland, Dangers Still Loom".  Reuters said, "Europe stocks slip on Irish Downgrade".
And as the negative headlines grew, Ireland's cost of borrowing rose, especially relative to that of Germany and other 'core' European countries.  The cost of insuring against an Irish government debt default rose to an even higher level than during the dark days of May, when we seemed to be just days away from a Greek government default. And of the five ‘problem’ countries in the eurozone (Portugal, Spain, Greece and Italy being the other four), Ireland moved backwards into second-last place, after Greece, and is now seen as a worse credit risk than Portugal, Spain, and Italy. Irish bond yields exceeded 6%, for the first time since the inception of the euro.
But is this justified?  Have the financial markets just cottoned on to the reality of the mess that is the Irish banking system?  Or are they focussing on a side issue and ignoring the bigger picture?
My view is that the markets have indeed lost sight of the bigger issue in their concern about Anglo. 
Normally, when looking at either a company or a country, financial markets and financial analysts are much more inclined to look at ongoing, recurring income and expenditure, rather than at once-off items, when passing judgement on credit risks.  Ireland's "ordinary" deficit each year is almost as large as the total amount going to Anglo, which in any case is likely to be spread out over 10-15 years. 
Looking at this in more detail, the amount that will have to go to Anglo will presumably be somewhere between the official estimates of around €25bn, and the most pessimistic estimates which are around €35bn. If we make a simple assumption that the cost of Anglo will be spread into equal instalments over ten years, then the annual cash cost to the Exchequer will be in a range of €2.5bn to €3.5bn per year.
Now I don’t want to make light of that cost. It’s a very substantial amount of money and it’s an utterly unproductive use of funds. It won’t create a single job, build a single kilometre of roads, finance a single hospital bed, or serve any useful productive purpose.  
But it does have to be seen in the context of the overall budget deficit. Last year that budget deficit was €25bn, and this year the government expects it to be around €22bn. So the worst case scenario for Anglo would raise the deficit by about 5%, relative to the best case. It certainly doesn’t help, but neither does it blow Ireland’s finances out of the water.
Usually, as I mentioned above, it’s the recurring or ongoing deficit that would preoccupy the markets, and not once-off items. Indeed, that’s why Ireland was until recently being held up as the ‘poster child’ of how to deal with a fiscal crisis. Ireland showed its commitment to reducing the massive ongoing deficit by cutting spending across the board, including public sector pay and social welfare spending, items that are exceptionally difficult to cut in any country.
But there is one factor which explains why the markets have reacted so badly to the Anglo issue, and that can summed up with just one word, “uncertainty”. Markets hate uncertainty, and prefer a known cost to an unknown cost, almost regardless of how high the known cost is.  So - strange though it may sound - the markets would probably be more relaxed if they knew, for sure, that the cost of Anglo will be (say) €35bn, than being told that so far it has cost €25bn so far but nobody really knows how much more it will cost eventually.  So the very negative market reaction to the Anglo situation relates to the uncertainty, rather than the absolute cost, in my view.
So what can the Irish authorities do to get Ireland back in the good books, so to speak, of the financial markets, from which they must borrow tens of billions of euros each year?
First and foremost the cost of Anglo has to be finalised. As far as the markets are concerned, the amount almost doesn’t matter, within reason, as long as it is definite and clear cut. This can’t be known for sure until after NAMA has finished acquiring loans from Anglo. Isn’t there therefore perhaps a case, in the national interest, for NAMA to prioritise the loans from Anglo over all others, so that we get a quicker outcome to this process?
Secondly, perhaps it’s time to get Minister Lenihan back on the road, if practical. There is little doubt that his meetings with investors in overseas financial centres in the past have gone extremely well, and led to fairly immediate improvements in the perception of Ireland and – more importantly – reductions in the cost of Irish borrowing.
Thirdly, it would help to publicly outline where savings in future years will come from. Work is underway already, on the 2011 Budget, and it’s well known that the government is seeking total savings of €3bn in that budget. But it’s been worrying to see recently that both a property tax and water charges appear to have been ruled out for the foreseeable future. Both were items that could raise substantial revenue for the Exchequer, but administratively neither could be done in time to bring in revenue in 2011. Ruling both out is making the 2012 budget very difficult indeed, and investors are aware of this. So where will the government find €3bn more in savings in 2012, if it rules out water charges and a property tax? It’s not at all clear, and it’s time that the government laid out at least the broad outline of where it hopes to find those savings.
My own view is that Ireland can get its borrowing costs down substantially if we follow the right policies, and of course if the global economy continues to grow. But it’s been a difficult few weeks, and it just serves to emphasise how fragile, still, the national finances are. Even if Anglo didn’t cost a cent, budgetary policy will have to remain very tight for some years to come.


This is an edited version of an article which first appeared in the Sunday Business Post on 5th September, 2010.

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