Open Dissent (19 page)

The concept of pouring good money after bad might yet register with the Chancellor's office in Germany. For it is only two years ago, on 18 October 2008, that Chancellor Merkel went to her parliament to seek a €500 billion bailout of toxic property debts on the German banks' balance sheets. On that occasion, the German state marked to market the portfolio of assets and put them into cold storage for ten years – a nice way out of a difficult situation if you can afford to do it. This was technically correct, I am sure, but the day of reckoning will come in due course.

Currently, the Germans are adopting a genuine partnership approach in order to spread the risk and the price of economic mayhem throughout the member states. If
Germany grasped the leadership role, this would most likely lead to fractiousness among the other union members or, worse still, perhaps raise lingering doubts about the potentially Machiavellian aspirations of Germany. If we in this country think that such aspirations are unlikely, perhaps we should ask Germany's closer neighbours, though it is likely they are exercising silent dissent on this matter. If, because of its strong economic position, Germany is asked again and again to take charge, then maybe she will eventually accede. Then Merkelvelli might have achieved in one charitable move that which her predecessors failed to do by conflict. A sobering thought.

In May 2010 the financial stabilisation package that took EU finance ministers some eleven hours to cobble together amounted to a €750 billion facility, which was a combination of contributions from the EU, the EC and the IMF. In broad terms, the IMF provided a 50 per cent supplement to the €500 million agreed by the EU. These funds may be used for the various purposes of the indebted sovereigns, but the price of these facilities goes far beyond the level of interest being charged. The fiscal deficits of the borrowing sovereigns will have to be reduced in line with a predetermined plan, with scant regard for the domestic consequences in each country.

It appears that, in the first instance, the EC, ECB, EU and IMF condone the use of debt, even if the debt is not used for productive purposes but to repay the amount of existing debt. Perhaps this was the blueprint Irish developers and banks were working from. Surely if you have to borrow
billions to pay back billions then perhaps you should not have borrowed or lent in the first instance.

One might like to ask when and how all these sovereign debts are going to be repaid. If the new borrowings by sovereigns are not put to productive use, there will be no new cash flows to repay the old debts or the new extra debt that has been taken on to defer the repayment of the old debts. A banker's dream; compound interest at its best. Who are we kidding? The need for credit for both investment and consumption is required for any expanding economy. If, however, the majority of the borrowings are used to defer the day of reckoning, we have simply created a neverending cycle of borrowing to repay the debt on which the borrower has the potential to default, with the total debt mountain growing on each occasion. Under this scenario, better referred to as ‘the deferral system of stabilisation', the sovereign borrowers are unlikely to be in a position to repay the ever-increasing core debt. A large portion of this core debt is an interest bill that could not be paid in the first instance and adds to the repayment burden of the sovereign borrower. Those who lend the money believe their investments are secure because they hold the guarantees of some perceived credible entity. If the borrowers are unable, rather than unwilling, to repay because of domestic financial issues then the guarantors, because of circumstances, may turn out to be less creditworthy.

As this relatively new phenomenon of potential sovereign debt defaults looms over Europe, we might consider looking to the emerging markets where firms like Morgan
Stanley International have had substantial experience in sovereign restructuring and defaults. The lessons learnt from the experiences of the emerging markets are worth noting as the characteristics of the challenges are common to the situations in many European states today.

First, looking at the instances of default in emerging markets from the macro-economic perspective, we note that fiscal deficits combined with recession have been prevalent features in what eventually turned out to be sovereign debt default episodes. The fiscal side of the economy has played a more influential role than government debtto-GDP ratios. The market concern over default relates more to repayment prospects and the sustainability of the debt rather than the overall debt burden. This red flag is blowing in the financial winds over many European nations today, including Ireland.

The second element to consider is the age-old concern of credit analysts everywhere: the ability and willingness of the debtor to repay. Sovereigns in emerging markets tend to default when there is no possibility of refinancing, combined with domestic political considerations. The dimension of external versus internal constituent factors influences policy makers to retain scarce resources for domestic residents over external creditors. The option of default exists but the consequences are punishing in varying degrees. It is worth noting that, in cases of default, there was no clear evidence of the original loans being used for consumption, productive investment purposes or exotic developments of a non-commercial nature.

In the midst of restructuring due to sovereign crisis, it is common to encounter denial. Liquidity and solvency are the soul mates of more new money and extended time for repayment. The process resulting in episodes of sovereign bond defaults in emerging markets does not take a straight line from the market sensing payment duress to default. Most episodes involve policy makers denying the existence of payment duress and attempting many approaches, including outside assistance and support, before considering a restructure or movement towards default.

Sovereign defaults in emerging markets tend to happen in periodic clusters and are rarely isolated incidents. They are typically linked to boom-bust cycles, with easy credit leading to a boom in borrowing and tight credit leading to difficulties in refinancing and ultimately default. Does this sound familiar? So, hopefully, we can learn lessons from what might be described as the experiences of our less fortunate emerging market debtors and take heed of what we must consider in approaching solutions to financial turmoil in Ireland and Europe.

For the moment, let us avoid denial and recognise the dimension of the European problem. The fiscal deficits that plague many of the sovereign states in Europe need a coordinated response that pleases the investor community. Is the easing of the burden of this crisis not best served by creating a two-tier euro with the express intent of returning to one euro for all within a specified time frame? The countries that would join the second tier would be those that have failed to manage their economies in line with the
Maastricht Treaty, while Germany and France and a few more countries would share the first tier, creating a super euro. This action would permit the devaluation of the euro and at the same time a revaluation of the super euro. It would enable the countries in the second tier to devalue their euro by an agreed percentage or see the birth of a super euro which would revalue upwards. In time, the separation of the two could be bridged with a reconcilement treaty at new agreed rates of exchange. This process would recognise that the financial maturity of all member states was not equal from the outset. It would also serve the political wish to continue with the ambitions of the EU while showing a much needed flexibility in dealing with fiscal deficits. This would allow the domestic, economic and social issues within Ireland and other deficit countries to be addressed over an agreed period of time before they rejoin the EMU.

The difficulties of this proposal might be far more palatable to the electorate in all countries than the more rigid solution facing us today: reducing our budget deficits through draconian measures while limiting the borrowing of the indebted countries to more moderate levels. It is worth noting that, whatever the political costs that might be incurred, the economic and social costs would be less severe this way.

What we are experiencing as a result of the financial crisis is an ever-increasing domestic, European and global debt problem. At some point, the nations with surpluses will
conclude that investing in these deficit states in the long term puts at risk the future of pension schemes, investment plans and allied welfare projects. When a country's reserves are invested in defaulting sovereign bonds, it is the taxpayer who ultimately suffers. Thus, the national reserves which were once viewed as safe may no longer be worth the IOUs they are written on. Is it any wonder the German electorate is concerned?

It is a global dilemma that may continue for some time unless the borrowers and investors sit down together to work out a solution, a solution that requires the deleveraging of the investors' assets. An unpalatable solution that might be arrived at would be an acceptance by sovereign investors (banks) that interest is not permitted to be rolled up and that any interest payments over the next three to five years goes towards the reduction of the outstanding principal. This suggestion, while giving heartburn to investors, will provide an orderly way for debtor nations to get into equilibrium with the investor community. Some twenty years ago, Russia did the unbelievable and defaulted on her debts. To no one's amazement she returned to the international capital markets this year. There has been a healing process and the patient has recovered to be a respected issuer in the markets once again.

The solutions that have worked for developing countries in the past may have every bit as much application today for developed nations that have over-borrowed and are on the verge of defaulting. Debt relief for developing countries on the part of their creditor banks was a key element of the
March 1989 Brady Plan in the US. The Brady Plan called for the US Treasury and multilateral lending agencies (including the IMF and the World Bank) to cooperate with bank creditors in restructuring and reducing the debt of those developing countries, including Mexico, that were pursuing structural adjustment and economic programmes supported by these agencies. A haircut of 30 per cent of the outstanding debt was taken and new bonds were issued to replace the bank loans.

The stigma attached to a bailout may be deemed unpalatable for developed nations experiencing debt management problems that are of their own making. If the money that has been borrowed in the past by several of the debt-ridden states in Europe has not been invested into productive projects, it is unlikely that the provision of further monies by the ECB, World Bank, IMF or whomever to assist the debtor nations from defaulting will do anything other than defer the day of reckoning. The likes of Greece have bought time, at most eighteen months. However, the Greek debt mountain has continued to grow and the ability of the country to repay its principal and interest inside the current time frame has magnified the problem.

Sovereign bailouts are far more complicated than bank bailouts. Be that as it may, there would appear to be a series of these bailouts looming in Europe unless an alternative is found that is economically acceptable at the sovereign level and politically acceptable at the European level. The EU can afford to bail out a single sovereign if it so wishes, but it would be a dangerous precedent and might leave the EU
open to the burden of multiple country bailouts. The single currency is the trap that will cause the reappraisal of the viability of the EU.

A solution similar to that of NAMA could be introduced for Europe. A new European entity called SAMA (Sovereign Asset Management Agency) could be established, the principal objective of which would be to resolve the debt crisis by whatever means agreed. This entity might buy back a certain percentage of each troubled nation's maturing debt in exchange for bonds newly issued by the ECB or by the debtor nation with the guarantee of the ECB. The existing bond holders would have a lot to say about the price to be paid for the maturing debt, but these negotiations are likely to be between the surplus sovereign states and those in deficit in the EU.

Economic challenges will exist for many years to come for the member states of the EU. Whether a solution for any EU member in financial difficulty is negotiated or imposed, the need for certainty and clarity to restore confidence in the markets is a must.

From this vantage point, we can look back at where we were in Ireland some twenty years ago. Ireland emerged from the 1970s and 1980s as one of the least prosperous countries in the EU. Our income per capita compared to the rest of Europe was at the bottom of the scale. The infrastructure in the country was not up to European standards and so a national plan was put in place. The improvements that have been achieved since then are remarkable, and are a testament to the fact that not all that was invested in the country's infrastructure was a waste. One can argue that there might have been more invested and this more efficiently used. But who could have foreseen in 1990 what the country looks like today? We got ahead of ourselves, but that does not mean we should dismiss the incredible economic success of those sixteen years from 1991 to 2007. Our expectations grew faster than our ability to deliver, but we need to sit down and produce another twenty-year plan for Ireland that will bring us into a position that the next generation will be proud to inherit.

We have been the beneficiaries of the grace and favours bestowed on us as members of the EU since we joined in 1973. Our membership of Europe has to have balance in all aspects, particularly in relation to our culture, our sovereignty and the price we pay for our economic and financial independence. Have we unwittingly surrendered these precious aspects of our society as the price of EU membership? As we search for solutions to the crisis, we should pay attention to what might provide the best outcome in the long term for the country. In this context there is another option that is, I believe, worth a glance: if all else fails then perhaps we should stretch our thinking, widen our view and look west, not east.