Is Ireland the next Greece?

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Spanish Prime Minister José Luis Rodríguez Zapatero declared to The Wall Street Journal this week that the economic crisis in Europe has ended. “I believe that the debt crisis affecting Spain, and the euro zone in general, has passed,” Zapatero said. He probably hasn’t been watching the ongoing trials and tribulations of Ireland. Once the zone’s official poster child of reform, Ireland has found itself in the bright spotlight of investor concern in recent weeks. Bond markets have signaled that investors consider Irish sovereign bonds increasingly risky to hold. The spread between the yields on Irish bonds and benchmark German bonds has been widening, even reaching a euro-era high earlier this week (before tapering back slightly). Ireland has not yet been shut out from fresh borrowing – the government successfully sold $2 billion of bonds on Tuesday. But the government only raised such funds at a cost much higher than in previous auctions.

That begs the crucial question: How vulnerable is Ireland to a sovereign debt crisis?

The worry is that the country’s ongoing banking crisis, continued poor economic performance, high government deficits and rising sovereign debt could combine to bring into question Ireland’s solvency. Ireland’s banking sector has been slammed by property-related losses and the government is still digging the economy out of the problem. Nonperforming loans – which were 9% of total loans in 2009 — likely haven’t bottomed out yet. In August, rating agency Standard & Poor’s estimated the total cost to the state of bailing out the banking sector would reach the equivalent of 58% of Ireland’s GDP and that as a result, its government debt-to-GDP ratio, the primary measure of a country’s sovereign debt burden, could hit 113% by 2012. Earlier this month, in a bid to calm investors, the government moved to split nationalized Anglo Irish Bank into two pieces, one which would house its deposits and the other that would attempt to recover as much as possible of its beleaguered loan portfolio.

Ireland’s problems go well beyond the banking sector. In a recent report, Credit Suisse summarized just how ugly things have gotten: GDP is 10% below its peak (in real terms), the budget deficit could hit 12% of GDP this year, and government debt has risen by 60% of GDP since 2007.

But despite these woes, some analysts have argued that Ireland is not in the same predicament as Greece. That Credit Suisse report goes on to say that Ireland seems to have its problems under control. Here’s a bit of the reasoning:

Markets are right to be concerned about Ireland. But there are several positive points that shouldn’t be disregarded. The process of deficit consolidation is well on track: the deficit has already started to fall…Ireland is also in an extremely strong financing position. This year’s funding needs have almost all been met. We estimate next year’s financing needs to be a manageable €30bn (18% of GDP). That’s especially the case as we think the Irish government holds over €20bn in cash, providing a considerable buffer if market conditions become problematic. And perhaps more importantly, recovery is underway…The euro’s recent decline, boosted by falling prices in Ireland, has led to a sharp improvement in competitiveness. That’s having an effect – industrial production is already back above its pre-recession peak.

So Credit Suisse concluded:

Ireland’s problems are considerable, and will likely remain so for some time. But, so far, the government and the economy seem to be doing reasonably well at coping with and addressing them.

Barclays Capital in a recent report reached similar conclusions:

We believe a default is unlikely because of: the Irish government’s policy track record; the potential willingness of the EU to help Ireland should it suffer additional problems; the global search for yield; and finally, the more comfortable liquidity position.

But that doesn’t mean Ireland is out of the woods. Barclays expects the Irish economy to contract again in 2010, by 0.5% compared to the year before. Barclays also holds out the possibility that Ireland may need aid to get through its financial crisis:

However, the lack of fiscal space over the medium term to tackle future unexpected losses in the banking system does constitute a source of market instability. In our view, if the macroeconomic conditions deviate from our baseline recovery scenario and unexpected losses crop up in the financial sector, then the government’s best option at stabilizing adverse market dynamics would indeed be by drawing on financial assistance from the EU-IMF… We believe that the Irish government has, to a large extent, deployed the right economic and financial policies thus far. The problem is that, despite these policy efforts, the government has very few options left of its own.

Perhaps more worrying than Ireland’s specific problems is that we’re constantly asking which European nation is the next Greece. That shows how Europe has not yet arrived a true, comprehensive solution for addressing its debt and growth problems, or the investor concerns created as a result. Mohamed A. El-Erian, chief executive of fund management firm PIMCO, wrote on the FT’s Alphaville blog that the persistence of high bond yields for countries like Ireland shows that Europe’s entire strategy for dealing with its weaker economies needs to change:

The failure to reduce risk spreads means that the public sector bailout is not working. Rather than provide assurances of better times ahead and, thus, encourage new investments, ECB/EU/IMF support funding is being used by existing investors to exit their exposures to the most vulnerable peripheral European countries. This situation cannot be sustained forever. It undermines any chance that the most vulnerable countries (e.g., Greece) have of limiting the collapse in their GDP and maintaining social cohesion; it contaminates the balance sheet of the ECB; it exposes the revolving nature of IMF resources to considerable risk; and it raises the risk of renewed contagion.

I’m happy that Spain’s Zapatero is feeling more confident. And he probably has good reason to be, since Europe has made progress in solving the problems that sparked its debt crisis. But not enough progress.

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