Viewpoint: Why Ireland should restructure its debt now By Simon Tilford

Centre for European Reform Published duration 26 November 2010

image caption Ireland's bail-out puts the country a further 90bn euros in debt

Was Ireland wise to accept a bail-out from the European Union and the International Monetary Fund (IMF)? Or does the bail-out comprise little more than a sticking plaster, which increases Ireland's overall indebtedness without addressing the country's underlying problems?

Would it not have made more sense to grasp the nettle and restructure the country's debts now - writing off a sizeable chunk - rather than kicking the can down the road?

On the face of it, Ireland had little choice but to accept the bail-out.

The country's banks were unable to borrow, and there were growing signs that depositors were pulling their money out of Irish banks, raising the prospect of a banking sector collapse.

This poisonous mix had further eroded investors' willingness to lend to the Irish government, which took the unprecedented step of guaranteeing the deposit base of the entire banking sector back in 2008.

Bond spreads - that is, the difference between the German government's borrowing costs and those of the other eurozone economies - had ballooned to levels that threatened the solvency of the Irish state.

Contagion

The estimated 90bn-euro bail-out will be used to recapitalise the country's banks, lower the Irish government's borrowing costs, and create a stand-by facility to help in the case of renewed crisis.

Nevertheless, the bail-out will add very substantially to Ireland's already exceptionally high overall level of indebtedness. It is perhaps worth noting that a comparable bail-out of the UK - given that the UK economy is around 12 times the size of the Irish one - would be 1.2 trillion euros (approximately £1 trillion, or around two-thirds of GDP).

Has the bail-out solved the Irish crisis, or will the ultimate debt restructuring now be bigger and more painful?

The answer depends on whether you believe the Irish economy will grow quickly enough to enable the country to service its debts, both public and private.

If investors doubt that Ireland can engineer a return to robust economic growth, they will continue to demand punitively high interest rates to lend to the Irish government and Irish banks will struggle to access funds. The bail-out will have achieved little beyond replacing funds withdrawn by departing investors.

Investors appear to be sceptical. The Irish government's cost of borrowing eased slightly following the bail-out, but remains close to the pre-bail-out peak. There are continuing concerns over the deposit bases of Irish banks.

At the same time, the bail-out has not prevented contagion to other struggling euro economies, such as Portugal and Spain, whose borrowing costs have actually risen sharply in recent days.

It is not hard to see why. These countries' debt problems are slightly less extreme than those of Ireland, but their growth prospects are equally poor.

Stagnation

What are the prospects for the Irish economy?

Under pressure from the rest of the eurozone and the European Central Bank, the Irish government is engaged in a massive fiscal retrenchment.

image caption The Irish government is engaged in a massive fiscal retrenchment

For example, it plans to tighten fiscal policy by more than 4% of GDP next year. By comparison, economists debate whether a tightening of around 1.5% in 2011 will derail the UK's economic recovery.

Irish wages are falling rapidly and the country is experiencing unprecedented deflation (falling consumer prices).

Falling wages are improving the cost-competitiveness of Irish firms within the currency union, and partly as a result exports are rising relatively strongly. But deflation is pushing up the real burden of the debt, while the contraction of the domestic economy is compounding the weakness of the banks and deterring investment.

To add spice to the mix, the European Central Bank has indicated that it will soon raise interest rates.

Rising exports are unlikely to be enough to offset the impact of stagnation and deflation at home. As a result, it is hard to see how Ireland can avoid a debt restructuring.

Misplaced hopes

This prompts the question: Why delay? If the debt burden is not sustainable, why not get it out of the way now?

Politics and uncertainty provide most of the answer. A debt restructuring in Ireland could have serious implications for the rest of the eurozone.

It would make restructuring by weaker members of the eurozone unavoidable. The implications for banks based in eurozone members such France and Germany economies - which have lent heavily to crisis-hit countries - would be far-reaching. The European Central Bank would also book huge losses.

In short, restructuring would be a very painful step to take and Europe's decision-makers are clearly hoping to avoid it.

This is understandable but mistaken.

If debt positions are unsustainable the problem needs to be addressed sooner rather than later.

It will be messy and governments will have to bite the bullet and do things that they have postponed for too long, such as strengthening their banks.