Ireland takes a gamble on cutting its deficit

While its government is still bailing-out banks, there's the small matterof a €3bn shortfall to take into account. Deirdre Hipwell reports
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Ireland has always been a record breaker.

For years it was hailed as Europe's fastest growing economy. Even the country's most famous export, Guinness, is synonymous with world-beating human achievement through its Guinness World Records – itself the best-selling copyrighted series of all time. In the midst of the financial crisis, Ireland continues to break records, but for all the wrong reasons.

Ireland's Finance Minister, Brian Lenihan, revealed details of a second round of capital support for some of its banks last week and outlined a final, higher than expected, cost of bailing-out its banking system. Ireland is now headed for a deficit of 32 per cent of its GDP, he said. (See box.)

This staggering shortfall in the public finances is 10 times higher than the cap set by the European Union as an acceptable deficit level. It positively dwarfs even that of Ethiopia, one of the poorest countries in the world, which expects its deficit to be just 3.2 per cent of GDP this year.

Lenihan himself characterised the bill Ireland faced after decades of rampant and feckless lending as "horrendous". He warned that an already severe budget-cutting programme under way would have to get even tougher to reduce this "substantial deficit spike".

The international markets have welcomed this final reckoning on the cost of bailing-out its banks even if it has been a long time coming. But fears are rising in other quarters that Ireland is in danger of, to use the local parlance, losing the run of itself.

Should a country in dire financial straits implement such harsh budget cuts and dedicate a third of its GDP to keeping its banks afloat at a time when its future economic growth is looking uncertain? Has Ireland doomed itself to a decade of depressed growth and falling revenues while money pours out of the country to repay external debts?

Lenihan's opinion on need for his bailout and the rebalancing of Ireland's books is firm. Failing to prevent the collapse of a bank, such as Anglo Irish, could "bring the country down" given its size relative to the national balance sheet, he says. "No country could contemplate the failure of such an institution. The overall level of state support to our banking system remains manageable and can be accommodated in the government's fiscal plans in the coming years.

"It is imperative that we remain focused on our major challenge, which is to ensure that our public finances are returned to a stable and sustainable path. This is the only course to follow if we are to ensure the future economic well-being of our society."

Jim Power, an economist at Friends First, says it helps to know how deep the bottom of Ireland's fiscal hole is, but the government should have been quicker off the mark in finalising the rescue costs. "They have been extremely tardy in working out the costs of the bailout of Anglo Irish. It is not rocket science to value the loan book and they should have devoted the correct expertise 18 months ago," he says.

The cost of not detailing the full damage has meant uncertainty over Ireland's credit risk, which has steadily ramped up its borrowing costs during the summer to 6.791 per cent last week – another dubious record high. Lenihan has since cancelled bond auctions planned for this month.

ING analysts applauded this plan to "come clean" and take the full hit of the damage up front and then slowly fund the deficit over the next decade, but said it must come beside a cost-cutting programme. Lenihan has not disappointed. He told Ireland's four million citizens to brace for an even steeper than expected cost-cutting programme and will make more than ¤3bn in cuts in this year's budget.

Next month, under pressure from the EU, Lenihan (inset below) will also have to reveal a four-year budget plan outlining how it will reduce its deficit to less than 3 per cent of GDP by 2014.

It is seen as a forlorn hope by all but the most optimistic commentators. But Power says that rebalancing Ireland's finances and cutting costs will not push the country off the precipice.

"Businesses are not investing. Jobs are not being created and consumers are not spending. The economy is weak even if the rate of decline has lessened," he says. "And taking ¤3bn out of the economy in the midst of a deep recession could exacerbate the situation. However, there is a requirement [on the government's part] to push the connection between the public finances and the economy. If you spend too much and take in too little in taxes you have a problem which cannot continue for ever."

Rating agency Standard & Poor's, which caused a furore last month when it downgraded Ireland's sovereign credit profile, said Ireland must continue to reduce its fiscal burden after a "decade of rapid credit growth". But there is growing dissent about the wisdom of Ireland's plans. Since December, the government has slashed pay for state workers, cut welfare benefits and imposed new taxes on fuel. Lenihan said then that about a fifth of the workforce would suffer pay cuts ranging from 5 per cent to 15 per cent and that the Prime Minister, Brian Cowen, would cut his salary by 20 per cent. Unemployment is 13.7 per cent.

With the prospect of these cuts becoming deeper, the number of dissenters may swell. Mike Turner, the head of global strategy and asset allocation at Aberdeen Asset Management, says: "The UK has similar problems in principle to Ireland. The magnitude is different. If magnitude has an influence on the resolution of the problems, the UK has less of an issue than Ireland." Ireland has pumped ¤33bn into its banks, equivalent to roughly 20 per cent of GDP. The equity that the UK Government injected into Royal Bank of Scotland, Lloyds and Northern Rock is equivalent to only 6 per cent of GDP.

For now, Ireland's crisis is one of sustained severity. Its debt is funded until the middle of next year, and Goodbody economist Dermot O'Leary believes that a "debt level of 115 per cent of GDP at the end of 2014 is sustainable as long as the deficit is reduced over that period of time".

By next year, Ireland's cost of debt could fall and its economy could beat expectations for growth. This is an extreme calculated economic gamble which Lenihan will hope has paid off.

Final Reckoning

The costs of bailing-out Ireland's banks

Ireland's Finance Minister, Brian Lenihan, pledged further capital support to some of its banks last week and finally detailed what the total cost of bailing-out its banking system would be.

Anglo Irish Bank, once Ireland's foremost property lender, requires €6.4bn further capital support, bringing its total bailout cost to €29bn. However, Lenihan said the final cost could, at worst, be €34.3bn.

Allied Irish Bank, the country's second largest bank, must raise €3bn additional capital and the government's National Pension Reserve Fund will inject up to €7.2bn and likely hold more than 80 per cent of its shares and take majority control.

Irish Nationwide is to receive another €2.7bn. Ireland has, with the permission of the EU, extended its €440bn blanket guarantee of its six domestic banks until December.

Total cost of the bailout of its six domestic lenders is €45bn, or €50bn if its worst case scenario for Anglo Irish is realised.

Lenihan said that no additional borrowing was required to fund this capital support, which is as well given Ireland's debt to GDP ratio is now nearly 99 per cent. However, government stakes could pay off if the banks return to profit.