Another financial storm, another bailout. In May, it was Greece. Now, it’s Ireland, an economy that accounts for just.0.3% of world GDP. Over the past few weeks, Ireland has been the central figure in an unfolding tragi-comedy . The EU was pressing Ireland to accept a rescue package. Ireland insisted it didn’t need one. It has finally settled for a bailout estimated to cost €80-90 billion.
The drama has not impressed the financial markets. There have been huge sell-offs in several markets, including India. You have to wonder how a country , which registers as a place where men sport skirts, can give the jitters to the world economy.
Ireland is being mentioned in the same breath as Greece. But the two situations are different. In Greece, the EU bailout was necessitated by the refusal of private investors to provide funds to the Greek government. Ireland contended that its government finances were fully funded until the middle of 2011. And yet the EU has pushed funds down Ireland’s throat. Why?
The immediate problem in Ireland is with banks, not with government finances . In 2008, at the height of the subprime crisis, the government assumed full or partial ownership of three large banks and guaranteed the liabilities of the entire banking sector until the end of 2010. The guarantee was recently extended up to June 2011.
But these measures have not stabilised the Irish banking system. Bank losses from real estate have mounted. Corporate deposits have been fleeing Irish banks. Ireland’s banks are on ventilator support — they now survive on liquidity provided by the European Central Bank.
The markets rightly believe this can’t go on. Today’s banking problem will become tomorrow’s sovereign debt problem . The banks will require massive infusion of funds. The funds will have to come from the government. With public debt at 100% of GDP, the government will find it difficult to borrow. Yields on Irish government bonds have gone up by over 200-basis points in recent weeks. That raised the spectre of a default on Irish government guarantees of bank debt.
Should this happen, two consequences will follow that could prove lethal to the world economy. One, there will be a run on banks in other troubled economies such as Portugal and Spain. Two, banks in UK, France and Germany will incur huge losses on the substantial exposures they have to banks in Ireland.
As with Greece earlier, saving Ireland is all about saving banks elsewhere in the EU. A more accurate analogy would be with the Iceland crisis in 2008. In Iceland too, banks went bust leaving other EU banks heavily exposed. The operative word is ‘contagion’
Any more bailouts anyone ?
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