With the yield spread between 10-year Irish government bonds and German bunds reaching 4.5 percentage points yesterday, what can we see in Ireland’s fundamentals to help separate uncertainty feeding on uncertainty from justified caution?
Some of the fears already seem a little overdone. Moody’s decision to downgrade Anglo Irish senior subordinated debt by three notches on Monday was a rejection of finance minister Brian Lenihan’s comment last week that a default on senior debt was “unthinkable”. But the Irish Independent reported yesterday that it had learned senior bondholders would see their debt honoured, contradicting Moody’s take. We shall soon find out who is right.
Either way, Ireland’s problems are straightforward. David Haugh, Patrice Ollivaud and David Turner, in a 2009 working paper for the OECD, find that a main driver of Ireland’s bond spread against the bund was the sharp relative deterioration of Ireland’s fiscal position from June 2007 to June 2009. They note “an increase in expected fiscal deficits is likely playing a large role in the increase in spreads across all countries and particularly Ireland”. Hardly surprising, but powerful nonetheless.
It’s certainly true that whatever the figures announced tomorrow the Anglo Irish bill will help push the Irish deficit higher, up to around a quarter of GDP. Still, it is worth bearing in mind that Ireland’s weaknesses have much to do with the brutal impact of the financial crisis and less to do with persistent economic failings. Carlos Caceres, Vincenzo Guzzo and Miguel Segoviano, in a 2010 IMF working paper, point out that countries hit hard by the crisis like Ireland were replaced as the greater source of contagion and default risk by countries like Portugal, Greece and Spain, where long-term fiscal sustainability remains in greater question. According to the European Economy Statistical Annex, Ireland’s deficit may be high but its debt to GDP ratio in spring 2010 was 77.3 per cent, lower than the UK’s at 79.1 per cent and utterly different from the Greek ratio of 124.9 per cent or the Italian ratio of 118.2 per cent.
Still, as Haugh, Ollivaud and Turner also point out, the relationship between fiscal performance and bond yield spreads appears to be non-linear, with incremental deteriorations in fiscal performance bringing ever larger increases in the spread. Financial market reaction constrains fiscal policy more than ever, a lesson that all economies need to remember, not just Ireland.