Sunday, April 26, 2009

Ireland: Saved by the euro

LONDON, April 26 — When 20 government ministers resign en masse, it usually denotes a political crisis or a pre-electoral technicality. When they do so because you can’t afford to pay all of them, you know you are in serious financial trouble.

Ireland is so broke that it is cutting back on government.

It was a rare stunt last week that saw 20 junior ministers all step down at midnight on Tuesday so that the prime minister, Brian Cowen, could decide how many could affordably be retained. (The answer: 15).

The savings are, of course, a drop in the ocean of debt and deficit currently washing across the island. If anything, this was a gesture of solidarity to a public that has seen boom turn to spectacular bust in the space of a few short months.

“Whatever savings are made is very small beer compared to the whole of public finances,” notes Bank of Ireland economist Michael Crowley. “The government is trying to send out a signal that the ministers are doing their bit.”

Is Ireland another Iceland? Certainly the government has, in recent weeks, been furiously trying to demonstrate that it is not as financially ruined as its North Atlantic counterpart, that although the two countries have a lot of letters in common, the similarities stop there.

The problem is that the similarities don’t stop there. Ireland, like Iceland, was far too cavalier in the boom years. Cheap money fostered a culture of debt. Reckless lending nourished a housing boom, such that the banking sector and its great sack of debt perched precariously on the real economy like a bloated clown on a tiny unicycle.

When the credit crunch swept the world, loans turned sour and the banking system all but imploded. As in Britain and the United States — and Iceland, for that matter — the state had to step in to prevent an outright collapse.

But Ireland does differ from Iceland in crucial ways, chief among them is its currency. Ironically, the country that has twice confounded its European partners with rejectionist “no” votes can now thank the European Union for the currency that has sheltered it from the storm.

When Iceland’s economy imploded last autumn, the currency collapsed, compounding the crisis and sending even the brave and foolhardy running for the exits. Ireland’s decline has been different.

“Membership (of the euro) helped rather than hindered,” says Crowley. “If we had been outside the euro during the crisis, we would have had a number of difficulties. We would have had a very sharp fall in currency.”

Peter Schaffrik, a fixed-income expert at Dresdner Kleinwort in London, adds: “It actually benefited them a great deal”. Without the euro in Ireland, “people would have pulled their money out because currencies are way more volatile than bond prices. On bonds, you would have lost about 10 per cent, whereas on currency, you would have lost a multiple of that”.

Nonetheless, the prognosis for Ireland is sobering. Gross domestic product (GDP) is forecast to fall by seven per cent this year. The budget deficit is set to soar to more than 12 per cent of GDP.

Unemployment hit 11 per cent last month — the highest level since 1996 — and is forecast to soar to as high as 15 per cent next year. No wonder the government feels the need to make a gesture.

Unlike bigger countries which can essay fiscal stimulus packages confident that they will not be punished by investors, Ireland had few choices earlier this month but to tighten the belt in a way not seen for decades.

An austerity package — which followed two previous attempts to cut costs and restore equilibrium to public finances — cut benefits and imposed new taxes in an effort to save €3.5 billion (RM16.37 billion).

Will it work? Or will Ireland become the first euro-zone country to go bust? The answer will depend on three principal factors: The debt market, the euro space and the global economy.

The most obvious signal of a state going bust is when it can’t refinance its debts. Downgraded by credit rating agencies, Ireland already has to pay a premium over other more robust euro-zone countries like Germany and France when it borrows. The state will have to borrow, moreover, as tax revenues shrink in the recession.

But there are several buts. Ireland’s debt level was relatively low coming into this crisis (debt interest repayments were less than one per cent of GDP last year, at €1.5 billion).

It has already managed to raise substantial funds on debt markets. There are no major refinancing dates looming. And the government has already shown it is willing to take painful measures to prevail.

“There are reasonable people who think there is a risk of default, but I am more optimistic,” says Professor Karl Whelan of University College, Dublin. He says the cost of bailing out banks has been large. “But three (fiscal) packages in eight months show they haven’t been scared to address fiscal problems.”

Secondly, the euro space is something of a double-edged sword. The currency that gave Ireland backbone throughout the credit crunch is now something of a straitjacket: Britain, for example, is starting to benefit mildly from a sharp decrease in the value of the pound, making its exports more competitive.

Ireland is shackled to one of the strongest global currencies, the euro. Competitive devaluation is not on the cards. But the euro zone remains a strength too: As a defaulting country would shake the currency like never before, the authorities in the 16-nation zone have made it clear that there will be some kind of support mechanism to help a teetering member state.

So, Ireland looks like it will muddle through. But whether and when the Celtic Tiger will roar again is a different question. The International Monetary Fund said last week the recession would be “particularly severe”

in Ireland. Economists say much will depend on the global economy — Ireland won’t resurrect itself on its own.

“The prospects for recovery in 2010 at the earliest are the best hope,” says Whelan. — Straits Times

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