More questions than answers but progress nonetheless

I have consistently argued that the process of incremental integration, inch by inch, which created the 27 country European Union and the 17 country Eurozone is precisely what is dooming it to failure. Like many other economists, on Thursday I stifled a yawn at the thought of reading the Friday reports of the 20th crisis summit that would, this time, fix it all.

Oh how wrong I was. All European summit have high stakes, but this one had drama. On one side you have the creditor countries, personified by Angela Merkel, who were being asked to hand over their credit cards to their neighbours to pay for what the creditor countries see at their the neighbours’ profligacy. On the other side you had the debtor countries: Ireland, Greece, Portugal, Spain, Italy. They wanted short and medium term debt relief, because without some form of separation of bank-related debt from sovereign debt, each of them was heading for an Ireland-style bailout.

Crucially, the European authorities have learned that incremental steps do not work, and that at some point, the creditor countries will have to pay to keep the Eurozone intact. If there is any major message to take from this summit, it is this.

The drama centered on an apparent outflanking of Dr Merkel by three of the largest Eurozone members. There was a long list of items to negotiate at the summit, including the creation of a pan-European banking regulator. Spain’s Prime Minister Mariano Rajoy and Italy’s Mario Monti blocked any negotiations until the issue of the separation of bank debt and sovereign debt could be discussed. The President of France, Francois Hollande, supported the Italians and Spanish. Merkel gave in. The debtor countries got some of what they wanted. Dr Merkel didn’t break quite as much as other commentators are claiming, but clearly she came to Brussels to do business.

The summit agreed that once the pan European banking regulator is set up, the European Stability Mechanism or ESM, a fund that could be as large as 700 billion euros in a few years’ time, is to be used to directly pump money into the banks, bypassing the sovereign all together.

This is a large step towards solving the European debt crisis, because it breaks the connection between sovereign debt and bank debt. Our leaders rode in on the coat tails of Rajoy and Monti, and Ireland’s bank-related debt is to be `examined’ with a view to pushing much of it into the ESM.

Here’s the thing however: on it’s books, Ireland doesn’t have one ledger item called ‘bank debt’. There are loads of different types of debt, and it is not at all clear that these will be treated in the same way.

The national output of Ireland last year was about 130 billion euros. The total cost of bailing out the banks so far has been roughly 64 billion euros, divided into 30.7 billion euros for promissory notes to balance the emergency liquidity assistance given to Anglo Irish Bank and Irish Nationwide, now part of the Irish bank resolution corporation 20.7 billion euros from the national pension reserve fund, used to buy stakes in AIB and Bank of Ireland, and 11.4 billion euros of direct recapitalization into the IBRC, AIB, and Irish Life and Permanent.

(If you are being uncharitable, you can add the 37.5 billion euros borrowed for NAMA onto that 64 billion of direct banking aid. NAMA has issued bonds to the Irish banks in return for property assets that might make a return for the taxpayer at some point, but they might not.)

So how will the European Stability Mechanism help Ireland’s banks, and more importantly for me at least, the Irish State’s finances? There are a few options.

One way could be that the ESM will take equity in Ireland’s banks to directly recapitalize them. The Irish State has invested around 25.4 billion euros in AIB and Bank of Ireland. The banks would like that, the ESM probably wouldn’t. Essentially the ESM is buying bank shares, either off the government of Ireland, or someone else. These shares aren’t worth 25.4 billion today, they are probably worth 15 billion. The ESM would pay the 15 billion, allowing the government to use that 15 billion to pay down the debt or do some economic stimulus measures. The government clearly loses in this move.

Just think about it. Would you buy bank shares right now? For the ESM, injecting bank equity even though there are diminished or probably nonexistent prospects that the capital injection will earn a fair market return means that the ESM may make a loss on its money unless it pays at or below market value for them. So either the taxpayer or the ESM makes a loss in the transfer. And who would pay for that loss?

Another option would be the banks taking loans directly from the ESM, which would impact the banks’ funding directly. This isn’t clear yet, we’ll probably know more when the high-powered Eurogroup meets on the 9th of July this year to work out the details of the agreement.

Another option concerns the treatment of promissory notes. These notes are pieces of paper written to balance the books of the IBRC when the IBRC’s component banks required something called Emergency Liquidity Assistance to keep them going.
The ESM might be able to replace the promissory notes—which have to be paid back over 10 years at 3.1 billion euros a year—with a loan that needs to be paid back over say 30 years’ time. The benefit would be the reduction of payments year on year in the short term, but it would mean that the loans have extended maturity and hang around on the Irish government’s balance sheets for much longer, and the long run interest rate charged may well be higher.

One final word on the ESM. It is a finite resource. There is no certainty at all that it is large enough to allow Ireland, Portugal, Spain, Greece, and perhaps even Italy to access its resources at the same time. The sequencing of any access is now another variable our policy makers need to keep a weather eye on.

All in all we should welcome this announcement. The perception of Irish sovereign debt has gotten better already, hopefully the euphoria that greeted the large print of this announcement won’t be dulled by seeing the small print of the deal in a few weeks’ time.

Published in the Irish Independent.

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