Irish debt downgrade raises fears of international deflation spiral

The colossal expense of rescuing Ireland's troubled banking sector has hit the republic's international credit rating once again.

Despite an apparently successful austerity programme and drive to reduce government borrowing, Standard & Poor's yesterday cut its credit rating on Irish sovereign debt by one notch, from AA to AA-. It reflects renewed concerns about the cost to the public finances of supporting failed banks and building societies.

The news helped to push already unsettled international markets lower, as did disappointing news from the US real-estate sector, where new home sales dropped to an all-time low in July.

Irish government securities were marked sharply lower, in an uncomfortable echo of the sovereign debt crises that rocked the eurozone in May.

The additional premium that investors are demanding to hold Irish debt over its German equivalent soared to 346 basis points, the highest level for three months.

A statement from S&P read: "The projected fiscal cost to the Irish government of supporting the Irish financial sector has increased significantly above our prior estimates.

"We are therefore lowering our long-term sovereign credit rating on the Republic of Ireland to 'AA-' from 'AA'.

"The negative outlook reflects our view that a further downgrade is possible if the fiscal cost of supporting the banking sector rises further, or if other adverse economic developments weaken the government's ability to meet its medium-term fiscal objectives."

Specifically, S&P argues that the costs associated with Anglo Irish Bank will push Ireland's net national debt toward 113 per cent of GDP in 2012, well above the European norm.

S&P has increased its estimate of the cumulative total cost to the Irish government of providing support to the banking sector from about €80bn (£65bn) to €90bn.

The Irish authorities reacted angrily. John Corrigan, the chief executive of the National Treasury Management Agency, said: "It's a bit like waking up the patient in the middle of an operation to tell him he's not feeling well.

"We know the situation is pretty painful but we have to get to the end of the operation, which will be in December."

The Irish Treasury has refused to put a final price tag on its bank rescues before the year end, because the new state-owned "bad bank" will only then have completed its purchase of toxic assets from the financial sector. Markets are unhappy with that approach.

The S&P downgrade of Ireland to AA- levels the rating to the same as that of rival Fitch, and one lower than rival Moody's, which downgraded Ireland last month because of the growth outlook and public finances.

The danger – also faced by Spain and Greece – is that the very austerity programmes designed to solve the budget deficit may actually make matters worse by raising unemployment and depressing tax revenues, creating a vicious deflationary circle.

Critics of the UK's Coalition Government also point to these examples to illustrate the downside of deficit reduction. The IMF said in May that Ireland might have to make even deeper budget cuts if her growth is slower than anticipated.

A simultaneous international fiscal retrenchment, as now, adds to the dilemmas faced by governments.