Deal or no deal?
Buoyant markets are allowing the European Central Bank to play tough. The ECB’s governing council has rejected a plan by Dublin to restructure its 2010 bank bailout, on the grounds that it would breach its rules against funding governments. And with markets still docile from the ECB’s own bond-buying promise, the pressure to cut a special deal for Ireland is receding.
The Ireland/ECB spat hinges on the 31 billion euros of promissory notes, or IOUs, used to recapitalise Anglo Irish Bank and Irish Nationwide three years ago. Anglo, now called the Irish Bank Resolution Corporation, is currently funding itself by pledging the promissory notes for emergency liquidity assistance (ELA) through the Irish central bank, a form of lending that doesn’t directly affect the ECB’s balance sheet.
The situation is bad for everyone; the ECB doesn’t like ELA in principle. Furthermore, funding a nationalised bad bank in wind-down mode already smacks of monetary financing. The Irish government would happily hold on to the cheap funding provided by its central bank, but wants the promissory notes restructured in a friendlier way. They need to be paid down each year, hanging over its bond market, and carry an interest rate of about 8 percent. This interest rate is academic – it is paid by one branch of the government to another – but it still pushes up the government deficit, which translates into extra austerity for the Irish. Dublin’s initial proposal was to replace the IOUs with a long-term, lower-interest rate bond, which would have been cheaply funded through the ECB.
Ireland has been trying to rejig the IOUs for over a year. Its negotiating position has weakened as bond markets have become more comfortable with Irish risk. Its 10-year bonds now yield a percentage point less than Spain’s, and investors rushed to buy a five-year bond earlier this month.
Still, there are reasons to hope for a deal, the absence of which would damage the credibility of the Irish government, and weaken domestic support for the bailout. If Ireland’s current good market standing were to be eroded, the ECB might have to buy a lot more debt through its bond-buying programme, which remains controversial. That suggests there is room for a compromise, although maybe not one quite as good as Ireland would like.