Ireland is No Iceland

October 1st, 2010

The sick men of Europe’s monetary union are in the spotlight once again, and none more
so than Ireland, as fears that the eventual cost of recapitalising the ailing banking sector
will bring the sovereign nation to its knees, has precipitated panic in the domestic bond
market.
The yield on ten-year bonds has jumped from below 5 per cent at the start of August to as
high as 6.7 per cent in recent sessions, the highest level since 1997 and a record spread
versus German bunds. Meanwhile, the premium for five-year Irish credit default swaps
(CDS), soared to 520 basis points, a level that is exceeded only by Venezuela, Argentina,
Greece and Pakistan. Market psychology has clearly turned against the Irish sovereign
and commentators are divided as to whether a humiliating default can be avoided.
It is undoubtedly true that Ireland walks a fine tightrope, as the ultimate cost of
recapitalising the banking sector versus GDP is likely to rank alongside the South Korean
and Turkish crises of 1997 and 2000 respectively. Meanwhile, the fiscal adjustment
required to bring the deficit down to three per cent of GDP in 2014 is equivalent to that
achieved over a nine-year period between 1981 and 1989. In spite of the herculean task
facing the government however, a default is highly unlikely in the medium-term and the
necessary adjustment can be made, though perhaps over a longer time frame.
The current panic is clearly related to solvency and not liquidity, as the government holds
very large cash reserves as a funding buffer that amount to roughly 15 per cent of GDP.
This means that liquidity does not become an issue until next summer at the earliest.
Furthermore, the National Pension Reserve Fund offers the government further liquid
resources as a buffer that amount to roughly 12 per cent of GDP. Thus, an immediate
default is simply out of the question.
In relation to solvency concerns, a financial balance approach suggests that the necessary
fiscal adjustment can be achieved, in which case the outstanding stock of public debt will
peak at circa 100 per cent of GDP. It is important to recognise that the sum of the fiscal
balance and the domestic private sector financial balance equals the current account
balance. Thus, an improvement in the fiscal position must be accompanied by a
declining private sector balance, an improving current account balance or some
combination of both.
In this respect, the Irish fundamentals compare favourably with its ailing European
neighbours, as the private sector is running a large surplus that is in double-digits as a
percentage of GDP, and the current account deficit has narrowed to just one per cent.
The current account should move to surplus next summer, while, a reduction in the
private sector surplus is possible, so long as confidence and the global economic climate
remain conducive. Thus, the fiscal adjustment is possible.
The fundamentals are not as poor as current bond yields suggest, but market psychology
dominates in the current climate. The government’s efforts are not being helped in this
respect by negative commentary that relies on spurious examples and the selective use of
data to prove a point. A recent example argues that the Irish government should follow
Iceland’s example and default. Readers are led to believe that Iceland is enjoying a
vibrant economic recovery and international investors are chomping at the bit to return.
The truth of the matter is that the Icelandic economy remains mired in deep recession;
output shrank more than three per cent quarter-on-quarter in the three months to June
30th, and has now registered eight consecutive quarters of negative year-on-year growth.
Furthermore, the latest data available from the World Bank show that Iceland’s gross
national income per capita has shrunk from parity to a level one-third below that of
Denmark, Finland, and Sweden.
Unemployment is indeed declining, and dropped by one percentage point to 8.3 per cent
during the second quarter. However, the improvement is a mirage, as changes in the
methodology used to calculate unemployment has caused the rate to measure half to one
percentage points lower than it would have otherwise been. Furthermore, the figure has
been helped by emigration, as Iceland’s population fell last year for the first time since
1889.
It is argued that declining interest rates demonstrate that confidence has returned. Short-
term rates have been cut from a peak of 18 per cent two years ago to 6.25 per cent today,
but they still remain among the highest in the developed world. Furthermore, interest
rates have been cut in response to an appreciating krona, which has benefitted from a firm
lid being placed on capital outflows at the height of the crisis. Long-term yields actually
rose on the latest cut, as the gradual removal of capital controls draw ever nearer and
there is understandable fear that the holders of Glacier bonds will exit at the first
opportunity. Needless to say, the notion that international investors are set for an
imminent return is bunkum.
Ireland does indeed stand on the precipice, but the idea that we follow Iceland’s example
is simply ludicrous. Investors would do well to ignore such spin, and base their opinions
on fact-based analyses.

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