What If Ireland Defaults? (21 page)

In the Third World budget deficits and government debt are often very high so sovereign debt carries a perceived default risk. High risk means high sovereign debt costs which adds to the drain on social budgets due to the need to siphon off money paying more interest when rolling over debt. Add corruption or perhaps corrosion to this toxic mix, in the form of a group of political and economic actors who believe they are immune from prosecution, and there you have it: your basic Banana Republic.

Loans to high-risk governments are considered of ‘sub-investment' standard, which means the speculative bond markets view them with a mix of trepidation and avarice. Participating governments pay through the nose for bond issuance due to the perceived risk of default. As an Argentine default was becoming obvious to the markets, the
Financial Times
wrote in an editorial on 20 August 2001:

Investors in government debt would take losses. But they have been happy to receive the fat yields offered by Argentine paper: they must now be prepared to accept that rewards of this kind entail some element of risk.

In other words, investment risk is par for the course; the risk of default is already priced in with the high interest rates, analogous to sub-prime mortgage interest rates on high-risk personal mortgages.

Argentina was not always a third world nation. At the turn of the twentieth century it had a gross domestic product (GDP) similar to that of the US; not any more. If you fall out of the protected rich nations club then your cheap debt privileges are revoked; credit becomes expensive whether you default or not. It is better not to lose one's membership as becoming a member is a difficult process. The European peripheral bond markets in 2011 are starting to look decidedly South American in nature; especially those of Ireland, Greece and Portugal. All three nations are hovering dangerously close to a debt spiral. Their new governments face tough choices.

Latin America has a sad history of sovereign debt and regional debt contagion. In Argentina's case the government has been struggling with the issue of sovereign debt burdens since the first million pound loan by Baring Brothers to President Rivadavia in 1822. Experience has led to some Latin American governments developing useful techniques for dealing with the sovereign debt markets and the IMF. Some of these are less well known outside the region. Applying these techniques to the Irish situation might help avoid an uncontrolled sovereign default.

Tequila Effect, Ouzo Effect

Some sovereign debt crises are not about national economic problems; instead they are spread throughout a region by contagion. One example was the tequila effect that precipitated the Argentine economic collapse in 2001–2002. There are some parallels with the current contagion among the European peripherals.

Latin America's most recent regional sovereign debt crisis was sparked off by the sharp devaluation of the Mexican peso in 1994. A tidal wave of financial damage spread across Latin America in the next few years. The national economies embroiled in the crisis had little in common except a high debt to GDP ratio. The sovereign bond markets meted out similar treatment to all. This sudden change of market confidence was referred to as the ‘tequila effect'. It hit Argentina in 1995, so Argentina turned to the IMF for help. After six painful years of slow collapse the Argentine economy finally succumbed, despite, and in some ways because of, advice from the IMF. The default lasted three more years until the Minister for Economics, Roberto Lavagna, finally reached a substantial agreement, partially restructuring the debt with creditors in 2005. This experience makes Argentine economists only too familiar with the relentless silent panic of a sovereign debt spiral. The longer it is drawn out, the greater the exit of capital and the harder the fall.

Ireland now finds itself enmeshed in a new regional sovereign debt crisis. The crisis began in Athens not Mexico City; might we call it the ‘ouzo effect'? Some characteristics are similar. A speculative attack is launched against various regional governments with high debt to GDP ratios. In a debt spiral, interest payments become unbearable leading to more debt and pushing governments toward default. The problem cannot be solved without international intervention so the IMF is called in (with the ECB in Europe). Speculators enter the market exchanging the risk of taking a nominal loss on bond investments for higher interest rates or cut-price bonds. Their strategy is clear: the longer the payments are drawn out, the less likely they are to lose money. The only hope for the bond buyers to walk away whole is a state rescue with minimal haircuts. As luck would have it, that is what they got from the Irish government.

Before we push this analogy too far it is important to note that Ireland (whose S&P bond rating in September 2011 was BBB+) does not yet pay the interest premium on new debt that Argentina does (S&P rating ‘stable' B), but the quantity of Irish sovereign debt and the relatively small population (one-tenth that of Argentina) puts Ireland in 2011 in a similar position to Argentina in the late 1990s. Buenos Aires had different problems to Mexico City, and Dublin has more in common with Reykjavik (in terms of the source of its new debt) than Athens, but traders in sovereign debt derivatives differentiate little. A speculative attack means there is lots of money to be made (or lost) in risky sovereign debt in the European peripherals.

What can Ireland Learn from South America?

Conventional options available to the Irish Department of Finance to reduce sovereign debt obligations are few and far between. Growing the economy is currently not an option. It becomes less likely the harder the IMF-recommended austerity measures bite. The fact that Irish sovereign debt is denominated in Euro (a currency whose exchange rate the Irish Central Bank does not control) means that the common strategy of devaluing one's way out of debt – ‘quantitative easing' (or printing money) – is also out of the question.

A large increase in taxation is possible but this can also lead to economic contraction. The Irish government raised various taxes in 2010 and 2011. This unpopular option does help Ireland reduce budget deficits but there is too much debt to be paid off. Also, in Ireland's case, the source of national debt is not chronic budgetary problems. Instead this debt is the result of a financial rescue gone awry. Ireland's focus on austerity measures and interest rates is misplaced. Restructuring the rescue debt might be a more appropriate option.

When in 2011 Ireland called in the multilaterals, Dublin five-star hotels were filled with financial consultants. Local commentators described their visitors as ‘the carpetbaggers' or simply ‘the Germans'. There were formulaic calls for austerity from the luxury suites. Investors were on the look-out for possible bargains in future privatisations. The IMF/ECB advisors mandated austerity, despite the advice of Nobel Laureates such as Joseph Stiglitz and Paul Krugman. Both argue that cutting national expenditure causes the national economy to contract, thus making the option of growing your way out of the debt spiral even less likely.

In the late 1990s in Argentina austerity measures were also an intrinsic part of the IMF's ‘structural adjustments.' Just as Stiglitz and Krugman now suggest, Argentine belt tightening pushed the economy deeper into recession. It delayed the default by about five years. This provided time to pressurise the government to a fire sale of state assets (as now advocated in Greece, Portugal and Ireland). A lack of capital controls also gave more time for outflows of capital that further aggravated the financial problems. Again we see parallels in the European peripherals.

In Argentina the IMF advocated privatisations of pension and energy assets. Removing access to pension funds proved especially egregious to public finances. The fire sale of public assets to private companies was unpopular but was managed with the assistance of corrupt representatives in the national parliament and senate. The largest sale was that of state oil company YPF to the Spanish multinational Repsol. Similar fire sales occurred all across Latin America. For example, in Brazil the state-owned Vale steel company was also sold off for an anomalously low price. It is now part of the world's largest private steel company.

Argentine state finances were further weakened by the privatisations, resulting in the loss of public income. The government had even less economic control over critical infrastructure, especially in the energy sector. The privatisations occurred and then the default happened anyway in 2001–2002.

Given the lack of conventional economic options available to the Irish government in 2011 the consequences of Ireland's debt spiral are quite predictable. Unless Ireland negotiates a reduction in sovereign debt, unless it employs other successful unconventional alternatives, or unless there is a miraculous improvement in economic conditions, the best case scenario is that the Irish taxpayers will pay more debt than they should, and in the worst case scenario Ireland will default sooner or later. If a default is inevitable it is better to do it sooner rather than later, employing tough negotiating practices, and in a controlled manner.

Lessons from the Argentine Default

If anything can be learned from the Argentine default it is that an
uncontrolled
hard default (such as that which occurs after a prolonged debt spiral) should be avoided at all cost. The Argentine economy resisted the pressures of the tequila effect for a few years but by the second quarter of 1998 the Argentine economy fell into steep decline. The GDP dropped 19 per cent and foreign direct investment fell by 60 per cent in five years. Many businesses failed and factories closed, primarily because of the artificially high peg of the peso exchange rate with the US dollar (1:1). This exchange rate affected the competitiveness of Argentine exports so local manufacturers could not compete with cheaper imports in a shrinking local market. Unemployment increased to 24 per cent, slightly above 2011 levels in Spain.

In 2001 the Minister for Finance, Domingo Cavallo, tried to prevent a run on the banks. He limited ATM withdrawals to 250 pesos per week. The ‘smart money' had already left the country in dollars. The middle classes came into the streets demanding access to their accounts in marches (called ‘cacerolazos') men, women and children marched beating pots and pans like drums. The political crisis escalated, each new government played ball with the IMF. The streets became more violent and police reacted with more violence: 34 people were killed. Many thousands more were to die in the next three years from suicide, health problems and malnutrition. Eventually, starvation occurred in remote regions of the country. The middle classes were decimated. The government collapsed again and again. In January 2002 the Argentine peso was devalued by 75 per cent. A peso was then worth between 25 and 30 US cents. Ordinary citizens lost much of their savings. There were more suicides.

Subsequent governments declared a unilateral cessation of debt payments including a cessation of interest payments (a default). The default continued for 38 months while the government used their taxes for national recovery instead of interest payments. Finally, just over 50 per cent of the debt was renegotiated (the technical term is ‘restructured') with about 70 per cent of the creditors accepting just less than 40 cents on the dollar with no interest.

Sovereign debt was reduced but the financial problems did not end there. Argentina is still on a fragile road to recovery. One of the most obvious legacies is a more regressive distribution of wealth. The rich got richer and the middle classes got poorer. The poor, as ever, bore the brunt, and some of them starved.

In 2012 Argentina has about the same nominal sovereign debt as in early 2002. An average GDP growth rate of 8 per cent for a decade means this represents very much less as a percentage of GDP, which has almost doubled since 2003. A higher proportion of Argentine debt is now denominated in pesos. This is easier to pay as Argentina can print pesos.

Argentina is now a member of the G20. Though still shut out of the private debt markets for government bonds, it is currently renegotiating its debt with the ‘Paris Club' (an international arrangement representing large groups of sovereign and private lenders which is the final arbiter in default negotiations, with offices in Paris),
⁶
and is under extreme pressure to come back into the fold. Argentine loans from the Inter-American Development Bank are being blocked by the US.

The government has undone the privatisation of the national airline, national postal system, many city water services, and, critically for public finances, the private pension funds. All of this came at a very high cost to the Exchequer. Many services which were previously public remain privatised, their profits going to multinationals instead of being recycled in the local economy. The country faces countless litigations in the World Bank court (the International Centre for Settlement of Investment Disputes).

No one in Argentina would say that they wish to experience such a default ever again.

Unconventional Options for Irish Policy Makers

Unconventional economic thinking offers alternative policy options to Ireland's new government. These have been employed in South America with varying degrees of success. Use of similar strategies in an Irish context might at least offer Ireland a fighting chance of avoiding a hard default or paying back too much sovereign debt. Two unconventional options may have applicability in an Irish context:

• A government-sponsored national sovereign debt audit with subsequent debt reduction activities
  
• Alternative solidarity finance
  

Option One: Sovereign Debt Audits

The independent University of Limerick debt audit (completed in September 2011) was modelled on the debt audit used by the Ecuadorian government to their advantage in negotiations with the debt markets; as an independent audit it lacked access to certain information not in the public domain. An audit cannot itself reduce debt, but it can provide negotiators with arguments for doing so.