The devil is in the detail

By Eoin Fahy, Friday, 29th June 2012 | 0 comments

The deal agreed at last night's EU summit contains a number of references to "could", "consider", "possibility", "should", "examine", and "urge". In other words, it is far from a done deal. But it would be wrong to be too dismissive of the deal - it represents a substantial change in Germany's attitude to this crisis, under extreme pressure, and has the first explicit commitment to look favourably at Ireland's "bank debt" issue. It's too early to conclude that this is a turning point in the crisis - but certainly too early to conclude that it is not!

In the series of EU summit meetings (19, at last count) to deal with the eurozone fiscal crisis, expectations were probably never lower than they were for this meeting. Yet at 4am this morning EU leaders surprised everyone - including themselves? - by announcing that they had reached agreement on a series of measures. The statement is short and, by EU standards, reasonably intelligible, so it is worth printing most of it below.

* We affirm that it is imperative to break the vicious circle between banks and sovereigns. The Commission will present Proposals ... for a single [bank] supervisory mechanism shortly. We ask the Council to consider these Proposals as a matter of urgency by the end of 2012. When an effective single supervisory mechanism is established, involving the ECB, for banks in the euro area the ESM could, ... have the possibility to recapitalize banks directly. This would rely on appropriate conditionality... The Eurogroup will examine the situation of the Irish financial sector with the view of further improving the sustainability of the well-performing adjustment programme. Similar cases will be treated equally.

* We urge the rapid conclusion of the Memorandum of Understanding attached to the financial support to Spain for recapitalisation of its banking sector. We reaffirm that the financial assistance will be provided by the EFSF until the ESM becomes available, and that it will then be transferred to the ESM, without gaining seniority status.

* We affirm our strong commitment to do what is necessary to ensure the financial stability of the euro area, in particular by using the existing EFSF/ESM instruments in a flexible and efficient manner in order to stabilise markets for Member States respecting their Country Specific Recommendations and their other commitments .... These conditions should be reflected in a Memorandum of Understanding. We welcome that the ECB has agreed to serve as an agent to EFSF/ESM in conducting market operations in an effective and efficient manner.

* We task the Eurogroup to implement these decisions by 9 July 2012.

There are a number of key issues here:

*   There is a very strong and explicit statement that, "it is imperative to break the vicious circle between banks and sovereigns". There cannot be any economist (or taxpayer!) anywhere who does not agree with this statement, but it is very helpful to have the EU (and Germany in particular) state this formally and explicitly.

*   There will be a new bank supervisory system for the eurozone. At the moment, individual countries regulate (or in some cases, didn't regulate!) their own banks, with no ECB involvement. EU leaders have now decided to set up a new system "involving the ECB" to regulate the banking system. It's not clear if this will apply to all banks or just very large banks, nor is it clear if "involving the ECB" means that the ECB will take charge, or just be 'involved'. But this does address a major structural flaw in the eurozone and is very much to be welcomed.

*   After the new bank regulatory system is established, the ESM (the eurozone bail-out fund) can recapitalise banks directly. In other words, the money would go to the banks, not be lent to the bank's government and thus be added to the national debt. However, this will only happen on strict conditions. And although the statement doesn't say so, Merkel has already told the German media that this will only happen if there is a unanimous vote - in other words Germany will still have a veto.

*   Ireland was specifically mentioned in the statement, as EU leaders said that they would, "examine the situation of the Irish financial sector with the view of further improving the sustainability of the well-performing adjustment programme". This is obviously a very important issue for Ireland and I will come back to this below.

*   In a technical, but important, move, it was agreed that bailout funds for Spain's banks will not get seniority over other lenders. In other words, money being lent from the EU to Spanish banks will not have to be repaid ahead of all other borrowing. This significantly improves the credit quality of other Spanish borrowing, at least on paper. Though it has to be said that many market analysts still think that if Spain had to default, in practice the default would affect private sector lenders (bond holders) much more than EU taxpayers, as happened in Greece.

*   There was agreement to use existing policy tools in order to stabilise markets in countries that are complying with EU policy recommendations. While what this means in practice was not spelled out, it is likely to mean that existing EU bailout funds (the EFSF and/or ESM) will be used to buy Spanish and Italian bonds on the open market, though only after a Memorandum of Understanding is signed with those countries, imposing some conditions in terms of meeting budget deficit targets, etc.

*   Finally, it was agreed that all these decisions should be implemented in the next twelve days. This is of course absurdly optimistic - most obviously in the case of setting up a new bank supervisory regime but even in terms of signing Memorandums of Understanding with countries like Spain and Italy. Still it at least shows an aspiration to move quickly.

Implications for Ireland

At this stage (Friday morning), it is far from clear what, exactly, the commitment to "examine the situation of the Irish financial sector with the view of further improving the sustainability of the well-performing adjustment programme" actually means, and yet this is absolutely vital.

Let's look at both the most optimistic and most pessimistic interpretations, in turn:

In the "rosy scenario", the agreement that the bailout funds will be used to recapitalise banks directly would also be applied retrospectively, for Ireland. Thus the infamous IBRC promissory note of about €28bn would be funded/paid for by EU bailout funds in its entirety. At a stroke, Ireland's national debt would be reduced by €28bn, in what would amount to a charitable gift from EU taxpayers to Irish taxpayers. In addition, perhaps, Ireland's equity stakes in AIB and ILP could be sold to the bailout funds, at cost value (well over €20bn). And finally, in the event that those banks needed more capital in future, the bailout funds would also supply that capital.

If that really is what it intended to happen, it would be a considerable understatement to say that this would be a dramatic development. The Irish taxpayer would get back almost every cent it had put into the banks to date, and would write off the outstanding promissory note debt. Ireland's financial position would be vastly improved, and Irish bond yields would surely fall very sharply indeed.

But let's be realistic here. While a strict reading of the EU statement would allow for such an interpretation, this would, as mentioned above, essentially mean that European taxpayers were giving a straight "gift" of many tens of billions to Irish taxpayers. That's hardly likely (to date all bailout funds have been loans, not gifts).

Let's look next at a much more realistic scenario which I will call the "re-engineering scenario", where the reference to "improving the sustainability" of Ireland simply means that there is some imaginative financial re-engineering of the promissory note, and perhaps a commitment to supply any future capital requirements of the viable Irish banks. In this scenario, the EU bailout funds would fill the black hole of capital in the IBRC, and Ireland would repay that money to the EU over, say, thirty or fifty years at a very low interest rate (instead of over the current schedule of ten years, to the ECB). Perhaps the "tracker mortgages" of the viable banks could also be incorporated into the IBRC.

This scenario would have two key benefits. Firstly, the cash amount that Irish taxpayers would have to pay over each year, to pay off the promissory note, would be significantly reduced (though not reduced to zero, obviously). Secondly, financial market investors would presumably take note of this, and the fact that, in an accounting sense at least, the debt to GDP ratio might be reduced (the risk of further credit rating downgrades for Ireland and indeed other peripheral economies may also be reduced). They may then be much more willing to buy Irish bonds, helping us to avoid the need for a second bailout package in 2014 when the current package runs out.

Conclusion

The "rosy scenario" above seems almost too good to be true. Could it really happen that up to €50bn of Irish debt could simply be wiped out? But pending better clarification from the Irish and EU authorities, it remains a theoretical possibility. However, even the "re-engineering" scenario would have significant benefits to the Irish debt situation. At the time of writing, Irish bond yields have fallen by about 30 basis points, and this certainly seems fully justified on the basis of the "re-engineering" scenario. And if the "rosy scenario" actually turned out to be correct - which seems quite unlikely - its significance would be such that we could certainly say that today's summit marked a major turning point for Ireland.

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