The luck of the Irish?
On May 31st Ireland passed the European Fiscal Compact referendum to ratify the Fiscal Stability Treaty (or “Fiscal Compact”). There was some concern about the possibility of voters rejecting the referendum, aimed at forcing concessions.
The “Yes” vote was important because it allows potential access to European bailout funds from the European Stability Mechanism (“ESM”). This provides some degree of reassurance to investors, which in turn could theoretically help the country return to the bond markets. While the result had little impact on global markets, it does confirm the belief that Ireland remains committed to dealing with its economic and financial challenges. For several months the country has been perceived as the “good student” among the crisis-stricken eurozone countries. Ireland’s austerity measures have been approved at each quarterly assessment during 2011, allowing the receipt of instalments from the €85 billion four-year bailout programme signed in December 2010.
Investors rewarded Ireland accordingly. Yields on government bonds dropped sharply since July 2011 and there was an evident de-coupling from the other peripheral countries in the clutches of the European Commission, European Central Bank and IMF troika. Irish sovereign bonds have been among the best performing assets across markets, at least until the renewed turmoil of recent weeks. The yield on the 2020 government bond hit a peak of over 15 per cent in July, and is now yielding seven per cent.
A degree of investor concern on Ireland has recently re-surfaced, partly as a result of the run up to the referendum. From the official perspective, policy implementation continues to be viewed as effective. In the “Statement by the EC, ECB, and IMF on the Review Mission to Ireland” last month, it was confirmed that fiscal targets for 2011 were achieved successfully. Indications are that this trend continued through the early part of 2012. The 2011 general government deficit (excluding bank support costs) is now estimated at 9.4 per cent of GDP (compared to the ceiling imposed by the programme of 10.6 per cent). According to the IMF, the authorities are expected to reach the 2012 target of 8.6 per cent of GDP.
Crucially, progress was also acknowledged in the restoration of health to the financial sector. Over the past three years, bank capital has been strengthened in several steps. There are efforts to improve bank asset quality, particularly in relation to mortgage loan arrears.
The importance of banking system soundness cannot be underestimated. It was banking sector woes that brought the country to its knees. The credibility of banking stress tests of July 2011 triggered the sovereign debt rally and decoupling of borrowing costs from other peripherals.
Further clarity is sought on the treatment of various types of guarantees to banks and contingent liabilities. Promissory notes were one of the instruments, with the government committing to pay €31 billion to Anglo-Irish in 2010. The objective was to enable the institutions to present these notes as collateral when receiving liquidity assistance from the Central Bank (which in turn borrows money from the ECB). If these notes are included in the calculation of government debt in addition to equity injections to banks, while excluding government guaranteed debt issued by banks and the National Asset Management Agency (“NAMA”), the general government debt is expected to peak at around 120 per cent of GDP.
Several other challenges lie ahead. At the macroeconomic level, while encouraging given the current scenario, the IMF is forecasting only anaemic growth. Ireland is a very open economy, and is therefore particularly vulnerable to global economic trends. Unemployment is expected to remain high and domestic demand will recover only at a slow pace.
Financial sector reform will need to be further enhanced. Many analysts expect mortgage arrears to continue to worsen, raising the prospect of Ireland’s banks requiring further recapitalisation. NAMA, the state run agency established to help banks shed their “bad” assets, will struggle to recover costs. In an end of May report, the country’s budget watchdog claimed that NAMA overpaid for loans acquired from lenders by 20 per cent, even after a write down of 57 per cent at acquisition.
From the markets’ perspective, continued turmoil in sovereign debt markets is likely to impact funding costs. The government is likely to be restricted to official funding and issuing short term Treasury bills until 2014. While still held up as the role model for euro peripheral countries, sentiment could shift as contagion spreads. Investors could become less willing to discriminate positively in favour of the nation’s debt.
This article is the objective and independent opinion of the author. The information contained in the article is based on public information. Curmi and Partners Ltd. is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.
Mr Falzon is a credit analyst at Curmi and Partners Ltd.