IT CAN seem churlish to be too critical of Ireland’s economic rescue. Shut off from the bond markets, the Government would otherwise have been forced to default and cut the primary deficit to zero once reserves were exhausted.
Yet the rescue is not working by one key measure. The provision of official liquidity support is, if anything, making Ireland less creditworthy. Yields on 10-year bonds have stayed stubbornly above 8 per cent, indicating markets continue to price in a high probability of an Irish default.
Ireland continues to be viewed as un-creditworthy despite reasonably good news on growth and a demonstration of political capacity to push through harsh budgetary adjustments since the rescue was announced. Now Portugal, and even Belgium, has entered the markets’ sights. Rather than the recent rise in bond yields indicating the need for a rescue, it sometimes seems as if fear of a rescue is driving up yields. The relatively successful bond issues by Portugal, Spain and Italy this week will provide only temporary respite.
Of course, one explanation for the failure to restore creditworthiness is that the markets consider the targeted countries as fundamentally insolvent. There is reason to suspect, however, that part of the failure stems from design flaws in the rescue mechanisms themselves – flaws that go beyond the 5.8 per cent interest rate and the prohibition against imposing losses on unguaranteed senior bank bondholders that were (rightly) the focus of early criticism.
The proposals floated this week to increase the size of the bailout funds will be of limited use unless these structural problems are fixed.
The acid test for successful liquidity support is that it allows a fundamentally solvent country to regain market access. Clearly, the official funders want to protect themselves – hence demands for “preferred” (or senior) creditor status and burden sharing. These protections though are often at odds with convincing private investors to commit new money.
The way the (non-IMF) part of the rescue works at present is that European countries provide guarantees to the European Financial Stability Mechanism (EFSM) and the European Financial Stability Facility (EFSF). This allows these official funds to borrow from the markets with a triple-A credit rating. The money is then lent to rescued states based on terms negotiated in the bailout agreements. Risk to the guarantors is reduced by the funds’ implicit or explicit preferred status.
This preferred status is to be made explicit for the European Stability Mechanism (ESM), which will provide a permanent replacement for the EFSF in 2013. But even where it is not explicit (as with the EFSF ), the guarantors can be confident from experience that a borrowing country will prioritise official creditors.
The rescue then changes the seniority structure of the outstanding debt and devalues the claims of non-official creditors. By channelling their support through official entities, assisting governments minimise their risk. However an unfortunate side-effect is becoming clear – the rescued countries are seen as an even riskier bet by market investors. They enter a sort of rescue trap.
As the IMF has traditionally enjoyed de facto preferred creditor status, non-official creditors find themselves bumped even further to the back of the repayment queue by IMF involvement; and possibly even further back again as the ECB increasingly becomes the owner of outstanding bonds through the secondary market.
The threat of “burden-sharing” on post-2013 bond issues is another obstacle to restoring creditworthiness. Details are murky, but the basic proposal is that the ESM will only provide support to states deemed insolvent if haircuts are imposed on existing investors.
Today’s potential investors worry that Ireland will find it difficult to roll over maturing debt. They may also worry that they will be snagged directly if these burden- sharing arrangements are brought forward as the idea gains acceptance or the crisis deepens.
The crowding out of non-official creditors is most pronounced for longer-term debt. Shorter- term investors can be more confident they will get their money back before burden-sharing is imposed. But an increased reliance on short-term borrowing brings its own problem – a heavy rollover burden and consequent persistent vulnerability to market sentiment.
In retooling the rescue mechanisms, the focus must be on making it attractive for longer-term private investors to put in new money. The challenge will be to ensure that the mechanisms are consistent with market discipline, without which there will be limited support from Germany and other stronger euro zone members.
A possible alternative has been proposed by Brussels-based economist Daniel Gros: provide limited explicit guarantees directly on market borrowing. The guarantees would leave some risk with the investor, but would put a floor under their losses.
Crucially, direct guarantees to market investors avoid the risk-increasing effect of having (preferred) official creditors in the debt structure. The beneficiary would pay a fee for the guarantee and they would face increased policy conditionality. This would dissuade countries from relying on them unnecessarily.
The possibility of providing limited explicit guarantees would also make it easier to credibly remove the almost unlimited implicit guarantees that now exist, thereby facilitating market discipline over the longer run.
A variant of the guarantee idea is the E-bond proposal of Jean-Claude Juncker and Giulio Tremonti. They recommend allowing European countries to issue collectively guaranteed bonds with a value up to 40 per cent of GDP. Market discipline is preserved under the proposal by governments’ continuing need to issue non-guaranteed debt in addition to the E-bonds. But provided these two forms of debt rank equally in the debt structure, this form of support should allow a solvent country to regain market access.
A rescue that makes the rescued permanently dependent on the rescuers is not in anyone’s interest.xref As European policymakers revisit the mechanisms in the coming weeks, it important they address a critical question: How does the rescue affect market incentives to provide new money to the rescued country?
Source: http://www.irishtimes.com
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