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    « Big Tobacco's New Frontier: Developing World | Main | Aung San Suu Kyi's Release: A Bitter Sweet Moment »
    Sunday
    Nov142010

    The Irish Bond Crisis & Looming EU Bailout

    Despite repeated official denials by Dublin that it needs an EU bailout (à la Greece), EU officials insist that not only does Ireland need rescuing, but it needs to do it sooner than later and that talks for such a bailout are already under way. The potential Irish bailout by the EU to the tune of €80 billion ($110 billion) is thus turning into a rather curious situation, with the lenders insisting on lending money while the borrower insists it neither needs nor wants the money. 

    Dublin Montage, Image Source:WikiFactually speaking the Irish state is on the brink of insolvency. The yield on the Irish government's bonds has gone up recently to almost 9%, which in other words means that the cost of borrowing money in the markets has increased substantially for the Irish government.

    This is how government issued bonds work in general: Governments issue bonds (securities) when they need to raise cash for the process of governance. With the purchase of bonds, investors are assured an income based on the interest rate (yield) of the bond for a specified duration and at the end of that period, the investor gets his money - the original investment/purchase price of the bond - back from the government, or sooner (at current market price) if the investor sells the bond prior to it's full maturity date.

    The government in the interim gets to use the cash that the investor has originally paid to purchase the bond, until it's time for the government to repay the investor. So the government has essentially borrowed that money from the investor for a specific period of time. Government issued securities are historically considered the safest investment vehicles since governments rarely go bankrupt unlike corporations. (The fact that this assumption is increasingly being challenged in recent times is a matter of separate discussion.)

    When the investor confidence in the government's ability to actually pay the interest on the bonds or repay the original price of the bond is low, it drives the bond prices down. Everytime the price of a bond goes down, the yield (interest rate paid on the bond) automatically goes up. In other words, the government has to then lure investors to buy it's (less appealing and riskier) financial product by promising higher yield/interest rate.

    Thus higher the yield on a country's bonds, more severe is the crisis of confidence in the government's ability to fulfill it's financial commitments. The yield also represents the interest that the government will have to pay to borrow new money in the market. So, a yield as high as 9% on Irish bonds means, there's little investor confidence left in Dublin's ability to pay plus such a high cost of borrowing money is unsustainable in the long run for Ireland. To put things in perspective, countries like the US, UK, France etc , despite their current economic recession, have been able to offer roughly about 3% yield on their 10-year-bonds, which means they're still able to raise substantial cash in the market at 3% interest rate. Now, compare that to Ireland's interest rate of borrowing at 9% and it's easier to grasp the difference. 

    It was precisely this high interest rate and bond crisis that drove Greece to seek an EU bailout. In plain English, the cost of borrowing money in the market was simply unaffordable. If a country continues to borrow money at such high interest rate, it would be insolvent in no time. Bailout money from EU is not free of interest but it has (relatively speaking) lower interest rate compared to what such countries would pay in the markets, making it a more affordable temporary solution till the country gets it's financial house in order. 

    Now Ireland has temporarily ceased issuing new bonds due to current high interest rates. Dublin maintains that it has sufficient funds to last till the middle of 2011, so it does not need to borrow money from the market right now. When it does have to go back to market next summer, it hopes that it would have been able to address some of it's problems which may lead to improved investor confidence and lower interest rates/bond yield.

    As a member state of the EU the country is required to have a budget deficit of no more than 3% of the GDP. Ireland's current budget deficit is a whopping 32% of GDP and public debt is close to 100% of GDP. Irish PM Brian Cowen has ambitious plans to bring down the budget deficit to meet the EU requirement (i.e. 3% of GDP) by 2014. The government is planning to cut €6 billion from its 2011 budget deficit and another €9 billion in subsequent years. The Irish parliament is set to vote on the budget on December 7th. 

    Ireland, which was at one point one of the poorest nations in the western europe, saw it's fortunes turn for better in the decade leading up to 2007. When Ireland slashed corporate tax rates in mid 1990s (to 12.5%) it attracted many foreign multinationals. This created hundreds of thousands of jobs and gave an enormous boost to the Irish economy, famously earning the nation the title of the 'Celtic Tiger'. There are some who argue that one of the ways for Ireland to raise money now is to raise it's corporate tax rate. But that measure runs the risk of driving the corporations out of Ireland, further sinking the Irish economy.

    Part of this economic growth was unfortunately fueled by the massive property bubble, which was pretty much like the property bubble in the US except many times worse. The Irish property bubble saw prices of properties in some areas (especially Dublin metropolis area) quintuple over the decade. Homeownership rates were as high as 80% at one point. As the property bubble busted in 2008, the economy came crashing with it. 

    The housing crisis brought down with it the Irish banks, which had loaned large sums of money to property developers and builders during the property boom, rather indiscriminately. The government has had to spend billions rescuing the Irish banks. One of the largest Irish banks, the Anglo-Irish Bank was essentially nationalized by the Irish government last year at the cost of €8.3 billion, with a likelihood of it needing another €10 billion later to cover future losses. 

    The Irish government has already employed several austerity measures. It has cut public spending by €4 billion last year. It plans to continue it's efforts to reduce spending. But austerity measures are a double edged sword. On one hand they help to cut spending and on the other they reduce growth and employment at a time when the country cannot afford to lose either. There is an exodus of people emigrating out of Ireland in search of better opportunities and a more stable future, a trend that does not bode well for Ireland's future.

    An article published in the Guardian today says: "Polish immigrants, whose arrival in Ireland less than a decade ago increased the workforce by an astonishing 20%, have left in orderly fashion and with no complaints about their treatment. More worrying is the trend for the young Irish to follow them abroad. Mark Ward, president of Tallaght's student union, says that 1,250 students are leaving Ireland every month. One in five graduates is seeking work outside the country. The Union of Students in Ireland believes that 150,000 students will emigrate in the next five years." 

    Despite all this bad news Ireland is resistant (at least publicly) to the idea of being rescued by the EU while the rest of the EU seems equally insistent that it be rescued. So the question is: can you rescue a drowning man without his consent? The answer according to the EU is a definite 'yes', since the crisis of confidence against Ireland in the financial markets is rattling the rest of europe. The EU, especially German Chancellor Merkel is pushing Ireland to accept a bailout. But the Irish pride apparently dictates that they be given a chance (and some time) to fix this mess on their own. 

    Here's a recent video from the WSJ on the Irish economy. The video is a bit lengthy (9 min 45 sec long), but it's very interesting:

    ~ Gauri

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