The Irish Crisis
“This article has three goals. First, it seeks to explain the origins of the Irish crisis. Second, it provides an interim assessment of the Irish government’s management of the crisis. Third, it evaluates the lessons from Ireland for the macroeconomics of monetary unions.”
Introduction
While the global financial crisis has affected all economies to varying degrees, it has been especially severe in Ireland with a cumulative nominal GDP decline of 21 percent from its peak of Q4 2007 to the trough of Q3 2010 (the economy has since grown modestly) in Ireland. This ranks Ireland among the worst-affected countries in terms of output performance during this period. Relatedly, after a long period of running surpluses, the fiscal balance shifted from positive territory in 2007 to baseline deficits of 10-12 percent of GDP during 2009-2011. Much of this fiscal deficit is structural in nature, such that the resumption of economic growth on its own is not sufficient to restore fiscal sustainability. In addition, the one-off costs of recapitalising the banking system pushed the overall general government deficit to 14.5 percent of GDP in 2009 and 32 percent of GDP in 2010.
The boom and bust in Ireland
The main factor behind these developments has been the devastating boom-bust cycle in the Irish property market. Since the property boom was financed through aggressive lending by the Irish banking system, the decline in property prices and the collapse in construction activity have resulted in severe losses in the Irish banking system. In turn, this has contributed to the economic crisis through a credit squeeze and the fiscal crisis, both directly through the costs of recapitalising the banking system and indirectly through the loss of asset-driven revenues.
“The recession in Ireland in 2008-2009 was driven by a dramatic decline in construction investment, with the sudden reversal in Ireland’s fortunes inducing a pull back in domestic consumption.”
Crisis management , The economic and fiscal crisis
In relation to the real economy, the recession in Ireland in 2008-2010 was driven by a dramatic decline in construction investment, with the sudden reversal in Ireland’s fortunes also inducing a pull back in domestic consumption. In contrast to many other advanced economies, the export sector was a stabilising factor, with the decline in output concentrated in the domestically-orientated sectors of the economy. In a mirror image to the boom period, negative feedback mechanisms kicked in. Banks pulled in lending, which in turn amplified the downturn in the property sector. The increase in bad loans further curtailed the supply of credit by Irish banks. The recession has led to a sharp increase in unemployment, which climbed from 4.6 percent in 2007 to 14.3 percent in 2011. In addition, participation rates dropped and net emigration resumed, so that the total fall in employment was about 12 percent.
The scale of these problems meant that the sovereign spread on Irish debt rose sharply in 2010, with doubts concerning whether the government could achieve the triple play of fixing the banking system, restoring economic growth and achieving fiscal sustainability. In the end, this resulted in a shift to official sources of funding in November 2010, with a three-year deal agreed with the IMF and the European Union.
Even before entering the EU/IMF programme, Ireland had been proactive in responding to the crisis but the scale of the economic and financial collapse was just too big. Taken together, the cumulative size of the discretionary fiscal tightening over 2008-2010 amounted to €14.6 billion, which is 9.3 percent of 2010 GDP. The fiscal tightening measures were certainly a procyclical force that has contributed to the scale of the recession. It certainly would have been better to have run larger surpluses during the good years and even accumulated a liquid rainy-day fund that might have been deployed as a buffer against the impact of the severe negative economic shock.
In November 2010, the government announced a four-year fiscal plan for 2011-2014 which would involve a further €15 billion in discretionary fiscal tightening. In turn, this four-year plan forms the basis for the fiscal component of the EU/IMF deal, which is further discussed below. Under current forecasts, this fiscal austerity package is projected to stabilise the debt/GDP ratio by 2013 at 118 percent of GDP.
“In addition to the baseline fiscal problem, the sovereign balance sheet in Ireland has been further strained by the government’s role in resolving the crisis in the banking sector.”
The banking crisis
In addition to the baseline fiscal problem, the sovereign balance sheet in Ireland has been further strained by the government’s role in resolving the crisis in the banking sector. At the end of September 2008, the most immediate concern was to stabilise the banking system. At the time, the belief was that the main problem was the loss of market liquidity. Accordingly, the Irish government sought to improve the funding situation by guaranteeing the vast bulk of its liabilities for a two-year period (deposits, senior debt and dated subordinated debt). This was followed later in 2008 with by the provision of extra capital for the banking system, as it became clear that losses on property-related loans would be greater than previously calculated. (However, these initial capital injections would prove small relative to subsequent estimates of the underlying scale of potential losses.) In April 2009, the Irish government also established the National Asset Management Agency (NAMA), with the mandate to purchase the universe of development-related loans (above a certain value) from the banks.
This triple-track strategy had an internal coherence, even if the execution of the strategy turned out to be quite problematic in several respects. One basic problem was that the initial guarantee of liabilities was too broad. By guaranteeing existing senior bonds and some types of subordinated debt, the capacity to allocate some part of the ultimate loan losses to bondholders was compromised, raising the taxpayer cost of resolving the banking crisis.
In relation to asset transfers, the aim was to cleanse bank balance sheets by transferring development-related loans to NAMA, since this category was the main source of uncertainty concerning total loan losses. During 2009-2010, NAMA purchased most of these loans at a steep average discount, such that the transfer also forced the banks to crystallise the losses on these loans.
While the asset transfer approach had the virtue of transparency, it also meant that the banks required substantial upfront recapitalisation programmes. Only one bank (Bank of Ireland) has been able to raise significant new private capital, such that the State has ended up with extensive control of the Irish banking system. In turn, the high recapitalisation costs led to a sharp increase in gross government debt and increased the riskiness of the sovereign debt profile, in view of the ongoing uncertainties regarding ultimate losses in the banking sector.
While all banks have suffered considerable losses, the most extreme losses (relative to the size of loan books) were incurred by two marginal banks that have been revealed to have had very weak corporate governance. The biggest offender has been Anglo-Irish Bank, which was nationalised in early 2009. While it had little presence in the retail deposit market, this bank had grown very rapidly through aggressive property-related lending which was largely funded on wholesale markets. The losses at this bank have been by far the largest contributor to the overall losses in the Irish banking system. In addition, a smaller mutual bank (Irish Nationwide Building Society or INBS) has also incurred catastrophic property-related losses. However, the losses at the two main commercial banks (Bank of Ireland and AIB) and the tail-risk exposures of these banks to further deterioration in the economy has meant that the entire banking system has been compromised.
The EU/IMF deal
The Irish government ultimately requested assistance from the EU and IMF in November 2010. In relation to the banking system, the expiry of the State guarantee in September 2010 led to an exit of private-sector funders that had committed funding under the guarantee. In turn, this resulted in a marked increase in the reliance of the Irish banks on liquidity support from the ECB and the extraordinary liquidity assistance facility of the Irish central bank. Apparently, the view from the ECB was that this liquidity support could only be maintained if the process of downsizing the Irish banking system were accelerated and the capital ratios of the Irish banks further improved as a buffer against tail-risk losses.
The total financial package under the EU-IMF deal is valued at €85 billion, which is about 54 percent of 2010 GDP for Ireland. However, €17.5 billion of the total is domestically sourced, from the assets held by Ireland’s sovereign wealth fund (the National Pension Reserve Fund) and the cash balances held by the agency responsible for managing the national debt (the National Treasury Management Agency). The external component of €67.5 billion is evenly split with €22.5 billion from the European Commission’s European Financial Stability Mechanism (EFSM); €22.5 billion from the International Monetary Fund (IMF); and €22.5 billion from the European Financial Stability Fund (EFSF) and bilateral loans (from the UK, Sweden and Denmark).
In terms of composition, the original intention was to provide €50 billion for the funding of sovereign borrowing, with the balance of €35 billion to be reserved to assist in the recapitalisation and deleveraging of the banking system. However, it has subsequently emerged that the banking system may not need this scale of funding, such that more of the funding is now intended to directly support the funding needs of the sovereign, in view of the deterioration in the European sovereign debt market.
The agreed programme involves discretionary fiscal tightening of €15 billion over 2011-2014, with €6 billion of this total to take place in 2011. Under current projections, this is intended to lead to a peak debt/GDP ratio in 2013 and a budget deficit to GDP ratio in 2015 that is just under the 3 percent limit.
The combined interest rate across the different funding lines was initially of the order of 5.8 percent per annum for a 7.5 year loan. While this is in line with standard IMF funding conditions, it is arguable that the European component of the funds could have been priced at a lower rate. While it is certainly important that such official funding contains a premium to discourage moral hazard, the 300 basis point premium built into this funding rate made it more difficult to achieve fiscal sustainability. Such a high premium limited the degree of solidarity across EU partners, while also increasing the risk facing other European governments in view of the potential contagion from doubts about the sustainability of the Irish sovereign position. In July 2011, the European leadership eliminated the penalty premium from its official lending to programme countries, having come to recognise the self-defeating nature of imposing a high interest rate in countries with non-sustainable fiscal position.
In terms of structural reforms, the main objective under the deal is to de-risk the banking system. First, the extra capital injections are intended to enable banks to accept significantly greater loan losses while allowing core Tier 1 capital ratios to remain at a high level. Second, the banking sector is being downsided, through asset sales and deleveraging, with the aim that the loan-deposit ratio falls to about 120 percent by end 2013.
Taken together, the goal is that these banking sector reforms will result in a smaller, less-risky and better-capitalised banking system. In turn, these changes improve the sustainability of the ECB liquidity provisions and also increase the likelihood that the Irish banks can return to the private wholesale funding markets. By summer 2011, there has been considerable progress towards these goals and it is projected that the official funding required for the banks will be far below that projected in the EU/IMF deal.
An important issue in the negotiation of the deal was the appropriate scale of burden sharing by bank bondholders in the recapitalisation of the Irish banking system. If the holders of bonds issued by the Irish banks absorbed some of the losses, the fiscal burden would be lightened. It seems that there were about €32 billion of non-guaranteed bank bonds outstanding at the time of the EU-IMF deal, consisting of €12 billion of subordinated debt and €20 billion of senior debt. These are bonds that were issued before the introduction of the September 2008 guarantee (which has now expired) but have not yet reached their maturity dates. In addition, about €25 billion of guaranteed senior bonds have been issued under the 2009 Eligible Liabilities Guarantee scheme for new debt issuance.1
The EU-IMF deal envisages that holders of subordinated debt will not be repaid in full. There is currently a bond exchange programme for the Anglo-Irish subordinated debt which offers the bond holders 20 cents on the euro. Over the last two years, there have been other voluntary exchange programmes for subordinated debt holders in several banks, with an estimated €7 billion obtained in discounts. (It is arguable that these earlier exchange programmes were premature in that the appropriate level of discount could not be properly determined before the full systemic evaluation of prospective loan losses had taken place.)
However, it also seems that there was serious discussion of writing down the value of some non-guaranteed senior bonds as part of the IMF/EU negotiations. While the legal tradition in Ireland has been to view senior bonds as pari passu with depositors, it seems that there may be legal options to break that link. For instance, in situations in which the scale of State capital injections exceeds the pre-crisis level of capital, it may be possible to argue that senior bondholders should have no legitimate expectation of full repayment.
However, no agreement was reached for restructuring the non-guaranteed senior bonds. Media reports indicate that European policymakers took the view that the restructuring of senior debt would create a new precedent in European banking that could severely disrupt bank funding markets. However, the counter-argument is that a set of objective criteria could be developed that would clearly delimit the scenarios under which some types of senior debt should be written down, thereby limiting the scope for contagion.
Indeed, to the extent that the restructuring of senior bank bonds improves the sovereign fiscal position, it might even be a calming influence on sovereign debt markets. The ultimate treatment of the non-guaranteed senior bank bonds remains an unresolved issue, at least in relation to the main disaster banks (Anglo-Irish and Irish Nationwide) that are in wind-down mode.
In terms of other structural reforms, the main priority is to improve the operation of the labour market in order to facilitate a reversal in the sharp increase in unemployment (much of it now long-term) since the onset of the crisis. In relation to product markets, there are aspirations to reduce monopoly rents in sheltered sectors (such as the legal and medical professions) and boost productivity in the public sector.
However, the growth payoff from such reforms may occur with a long lag and cannot be relied on to improve growth substantially within the period of the deal. Similarly, public sector reform has the potential to boost efficiency considerably, but the overall growth payoff will only occur over a long period. Accordingly, it is not realistic to expect a sizeable direct short-term growth payoff.
Overall, the EU/IMF deal provides an environment in which Ireland can make progress in resolving its crisis. Both the debt dynamics and the health of the banking sector are dependent on the rate of nominal GDP growth in the coming years. In this regard, there is considerable uncertainty about the path for GDP. One view is that a small open economy can rely on export-driven growth, further boosted by the return of domestic spending once uncertainty declines and consumer confidence recovers. Against that view, the cross-country historical evidence is that output growth is typically very slow after major banking crises, even if these historical examples do not precisely match the current Irish conditions.
Overall, the main source of the Irish crisis was the failure to regulate the banking sector to guard against systemic risk factors. This was especially problematic under EMU, since access to the area-wide financial markets meant that the scope for Irish banks to take on too much risk was amplified. The weaknesses in banking regulation have been extensively analysed in three major reports that were commissioned by the Irish government.
“The Irish crisis reaffirms the principle that rigorous discipline in fiscal policy and financial regulation is essential if membership of a currency union is to be compatible with macroeconomic and banking stability.”
Ireland and EMU
In relation to the banking sector, membership of the euro area has also provided considerable stability during this crisis period. Most directly, the Irish banks have heavily relied on the liquidity provided by the European Central Bank as a substitute for the loss of access to private wholesale funders. In addition, highly-indebted Irish households have benefited from low ECB interest rates during the crisis.
Had Ireland not joined the euro, the foreign liabilities of the banking system would most likely have been in foreign currency and the banking crisis would have been amplified by a parallel currency crisis. Moreover, an independent currency would not have offered a guarantee against the onset of the mid-2000s credit boom. This credit boom affected many non-EMU economies in Europe (Iceland, Central and Eastern Europe) and many countries have experienced the problems associated with currency overshooting that can act to amplify the impact of credit booms, only to be followed by a deeper crash with currency depreciation exacerbating balance sheet problems. Moreover, even under an independent monetary policy, it is not clear that the central bank would have been able to neuter the housing boom solely through its interest rate policy, in view of the weak relation between interest rates and housing prices and the potential output costs of targeting asset prices ahead of real indicators.
In terms of the broader reform of the institutional framework for the euro area, the failures in domestic macroeconomic policy and financial regulation during the pre-crisis period means that the proposals by the European Commission for tighter surveillance are welcome in terms of reducing the risk of future crisis episodes.
However, the absence of an EU-wide special resolution regime for failing banks has made it more difficult and more costly to resolve the Irish banking crisis. In relation to future crises, the types of proposals currently being developed by the European Commission should help (for instance, in allowing for the bailing in of senior unsecured bond holders in the event of severe bank losses) but these are too late to be helpful in resolving the current crisis. More broadly, the creation of the European Systemic Risk Board and the associated European Supervisory Authorities should help in monitoring European-wide risks in the financial system.
Finally, despite the shared interest in preserving European financial stability, the EFSF can only provide loans to member governments. In terms of promoting financial stability, a more flexible mechanism that could also offer tail-risk insurance might have been better suited to tackling the underlying fiscal exposure of the Irish government in relation to resolving the Irish banking crisis. In particular, the European banking system would be more stable if a common European fund could underwrite deposit insurance across the euro area and the risks posed by failing banks to fiscal sustainability would be weakened if the costs of recapitalisation could be partially shared across the system.
The current proposals for the permanent European Stabilisation Mechanism (ESM) that will replace the EFSF in 2013 do not extend the remit of the ESM to include this type of risk sharing mechanism. However, the greater clarity about the potential for burden sharing by bondholders under the ESM should prove helpful in providing greater market discipline in relation to future fiscal management. However, the uncertainty about the transition towards the ESM arrangements is a source of instability in dealing with the current sovereign debt crisis.
Conclusions
At a domestic level, a primary lesson from the Irish crisis is that it reaffirms the principle that rigorous discipline in fiscal policy and financial regulation is essential if membership of a currency union is to be compatible with macroeconomic and banking stability. At an EU level, the Irish crisis has highlighted the costs of the incomplete institutional design of the monetary union and the importance of deep-level reforms both to reduce the probability of future crises and to increase the resilience of the European banking system in the event of a crisis.
About the author
Philip Lane is Professor of International Macroeconomics at Trinity College Dublin and Director of the Institute for International Integration Studies (IIIS), having previously been Assistant Professor at Columbia University. He is also a CEPR Research Fellow, and a regular visiting scholar and consultant at the International Monetary Fund, World Bank, and several central banks in Europe. His research interests include international macroeconomics, economic growth, European Monetary Union and Irish economic performance. He is a member of the Royal Irish Academy and the Euro 50 Group, as well as on the editorial boards of several academic journals. He holds a PhD in Economics from Harvard University.
Notes
1. A small amount of new non-guaranteed bonds has also been issued.
