Last October, I highlighted the issue of bailout extensions to Ireland and Portugal and so I want to re-visit this theme now that Portugal and Ireland are in the news looking to change the terms of their existing bailouts.
Here’s the issue: Ireland and Portugal received Troika bailouts about two years ago. Ireland was first in late 2010, followed by Portugal in mid-2011. The question for both nations has always been whether they would be able to regain market access within the three year time frame in Troika programs that would allow them to self-finance on public debt capital markets. To wit, in downgrading Portugal two months after its bailout, Moody’s wrote:
The following drivers prompted Moody’s decision to downgrade and assign a negative outlook:
1. The growing risk that Portugal will require a second round of official financing before it can return to the private market, and the increasing possibility that private sector creditor participation will be required as a pre-condition.
2. Heightened concerns that Portugal will not be able to fully achieve the deficit reduction and debt stabilisation targets set out in its loan agreement with the European Union (EU) and International Monetary Fund (IMF) due to the formidable challenges the country is facing in reducing spending, increasing tax compliance, achieving economic growth and supporting the banking system.
Now that we are more than halfway through both bailout programs, it is still questionable whether these countries can self-finance. Ireland seems to be much closer than Portugal in this regard, having recently conducted a series of successful government and bank bond auctions. But the question still remains.
So, the latest is that the Irish and Portuguese have joined in a united front in insisting upon equal treatment with Greece which had its Troika loan terms extended and bettered. While the specifics are still being discussed, want Portugal and Ireland want is the ability to stretch the existing Troika programs over a longer time-period rather than having to repay the loans and face public markets for refinancing those loans and for new commitments when the programs expire. I have heard no word yet from the EC or politicians in countries like Germany regarding support for this.
Clearly, this move by the Irish and the Portuguese was expected. Wall Street Journal reporter Matina Stevis tweeted earlier today, “Can i just say that when i said Ireland & Portugal were going to ask for maturity extension when Greece got one,officials bit my head off.” And Marc Chandler of Brown Brothers Harriman predicted in October that the Portuguese and Irish would want equal terms to Greece:
Recall that 2011 mid-year summit, European officials adopted a principle of equal treatment under the framework of the EFSF. Essentially, this means that consideration given to Greece out to applied to the other countries who are receive EFSF assistance, namely Ireland and Portugal.
Ireland and Portugal are consistently evaluated positively by the Troika, but are now required to have a more onerous debt servicing burden–higher interest rates and shorter maturities than Greece. Some market participants see the likelihood that the official sector restructures Ireland and Portuguese debt. Portugal’s benchmark 10-year yield has fallen 14 bp today, second to the 24 bp decline in Greece’s 10-year yield. Counter-intuitively, Irish yields are slightly higher on the day.
So, there you have it. That is the antecedent for today’s events.
Here’s the problem: Peripheral bailout extensions will be unwelcome during a German election year. That was my take in October. The result, I wrote, was that “there will be no more bailouts for Portugal (or Ireland or Greece). That means they must be able to tap markets (unlikely), default (not politically feasible except in Greece) or have their debt monetized in the newfangled ECB-led austerity regime (likely).” In November, I said that this meant OMT-style bailouts for Portugal and Ireland. Well apparently, there is a fourth option, extend the maturities of the existing programs in lieu of letting them expire and rolling into an OMT-style bailout. And that’s what the Irish and Portuguese are now seeking.
I believe that Ireland will be ready for an OMT-style regime when their Troika deal lapses in November. They have access to bond markets already. Their export volumes are growing. The economy is growing. And, importantly, the housing market is rising again. House prices in Dublin were up 2.2pc in 2012, while transaction volume was up an astounding 27pc, according to figures from the Property Price Register. That means Ireland’s core economic variables look good and credit can add an accelerator to this instead of a decelerator because of the recovery in housing.
Portugal, on the other hand, is not looking anywhere near as good. In fact, within the Troika, the IMF wants even more austerity in Portugal so that they can hit their targets. Is this likely, even after the largest tax increase in Portuguese history? As I wrote in April 2011, when predicting a Portuguese bailout, “[l]ast week, we also learned that the Portuguese had missed their deficit target of 7.3pc last year. The deficit ended at 8.6pc. The country also revised 2009′s deficit up to 10pc from the previously reported 9.3pc figure. And now they are expected to hit a 3pc hurdle by 2013? That’s way too optimistic.
The IMF has said that it underestimated the negative economic impact of austerity following the crisis. It believed the government cuts would have a negative multiplier of only 0.5, meaning that the cuts would be partially made up for by increases in the private sector. Instead, what they saw was an up to 1.7 multiplier effect, meaning the government cuts were accompanied by a 70% reduction in the private sector. Anyone using the sectoral balances approach would have seen this coming. A cut in government spending in an economy constrained by private debt will not lower its private savings to partially accommodate the loss in public demand. Instead, the private sector attempts to maintain net savings in order to reduce debt, such that a cut generates another cut. But now the IMF is saying this dynamic has receded and it is doubling down on its prior failed strategy of encouraging front-loaded austerity – at least in Portugal.
So, I am optimistic about Ireland but not about Portugal. Here’s what I see happening. Ireland will continue to benefit from its improving macro profile and regain access to markets – at least until contagion from a negative Spanish surprise intercedes. This positive dynamic is greatly enhanced by the dearth of safe assets. And given that Ireland is relatively small, the demand for Irish assets will increase while we are in a risk-off phase. On the other hand, I do not see Portugal hitting its deficit targets because I believe the fiscal drag will be so large that it causes a contraction in the private sector due to the private sector’s desire to net save. This will cause Portugal to remain in the throes of the Troika program and preclude it from an OMT-style bailout. The positive here is that Portugal still has another 16 months to make the grade, whereas Ireland only has 10.
Will the EU accede to Portugal and Ireland’s demands for an extension? It should have to given that Portugal and Ireland must get equal treatment to Greece. And this could be massaged politically in Germany since no new funds are to be contributed to these bailouts. That is the crux from an electoral standpoint. Nonetheless, this turn of events complicates things for Merkel who has already lost in the recent election in Niedersachsen. The political effect is likely a hardening of the austerity for bailout quid pro quo in Portugal and an increasing realisation that the CDU will need the SPD or the Greens to form a government.
Overall, this is most positive for Irish bank and government bonds and assets more than any other asset classes.