by Mike Soden
As this relatively new phenomenon of potential sovereign debt defaults looms over Europe, we might consider looking to the emerging markets where firms like Morgan Stanley International have had substantial experience in sovereign restructuring and defaults. The lessons learnt from the experiences of the emerging markets are worth noting as the characteristics of the challenges are common to the situations in many European states today.
First, looking at the instances of default in emerging markets from the macro-economic perspective, we note that fiscal deficits combined with recession have been prevalent features in what eventually turned out to be sovereign debt default episodes. The fiscal side of the economy has played a more influential role than government debtto-GDP ratios. The market concern over default relates more to repayment prospects and the sustainability of the debt rather than the overall debt burden. This red flag is blowing in the financial winds over many European nations today, including Ireland.
The second element to consider is the age-old concern of credit analysts everywhere: the ability and willingness of the debtor to repay. Sovereigns in emerging markets tend to default when there is no possibility of refinancing, combined with domestic political considerations. The dimension of external versus internal constituent factors influences policy makers to retain scarce resources for domestic residents over external creditors. The option of default exists but the consequences are punishing in varying degrees. It is worth noting that, in cases of default, there was no clear evidence of the original loans being used for consumption, productive investment purposes or exotic developments of a non-commercial nature.
In the midst of restructuring due to sovereign crisis, it is common to encounter denial. Liquidity and solvency are the soul mates of more new money and extended time for repayment. The process resulting in episodes of sovereign bond defaults in emerging markets does not take a straight line from the market sensing payment duress to default. Most episodes involve policy makers denying the existence of payment duress and attempting many approaches, including outside assistance and support, before considering a restructure or movement towards default.
Sovereign defaults in emerging markets tend to happen in periodic clusters and are rarely isolated incidents. They are typically linked to boom-bust cycles, with easy credit leading to a boom in borrowing and tight credit leading to difficulties in refinancing and ultimately default. Does this sound familiar? So, hopefully, we can learn lessons from what might be described as the experiences of our less fortunate emerging market debtors and take heed of what we must consider in approaching solutions to financial turmoil in Ireland and Europe.
For the moment, let us avoid denial and recognise the dimension of the European problem. The fiscal deficits that plague many of the sovereign states in Europe need a coordinated response that pleases the investor community. Is the easing of the burden of this crisis not best served by creating a two-tier euro with the express intent of returning to one euro for all within a specified time frame? The countries that would join the second tier would be those that have failed to manage their economies in line with the Maastricht Treaty, while Germany and France and a few more countries would share the first tier, creating a super euro. This action would permit the devaluation of the euro and at the same time a revaluation of the super euro. It would enable the countries in the second tier to devalue their euro by an agreed percentage or see the birth of a super euro which would revalue upwards. In time, the separation of the two could be bridged with a reconcilement treaty at new agreed rates of exchange. This process would recognise that the financial maturity of all member states was not equal from the outset. It would also serve the political wish to continue with the ambitions of the EU while showing a much needed flexibility in dealing with fiscal deficits. This would allow the domestic, economic and social issues within Ireland and other deficit countries to be addressed over an agreed period of time before they rejoin the EMU.
The difficulties of this proposal might be far more palatable to the electorate in all countries than the more rigid solution facing us today: reducing our budget deficits through draconian measures while limiting the borrowing of the indebted countries to more moderate levels. It is worth noting that, whatever the political costs that might be incurred, the economic and social costs would be less severe this way.
What we are experiencing as a result of the financial crisis is an ever-increasing domestic, European and global debt problem. At some point, the nations with surpluses will conclude that investing in these deficit states in the long term puts at risk the future of pension schemes, investment plans and allied welfare projects. When a country’s reserves are invested in defaulting sovereign bonds, it is the taxpayer who ultimately suffers. Thus, the national reserves which were once viewed as safe may no longer be worth the IOUs they are written on. Is it any wonder the German electorate is concerned?
It is a global dilemma that may continue for some time unless the borrowers and investors sit down together to work out a solution, a solution that requires the deleveraging of the investors’ assets. An unpalatable solution that might be arrived at would be an acceptance by sovereign investors (banks) that interest is not permitted to be rolled up and that any interest payments over the next three to five years goes towards the reduction of the outstanding principal. This suggestion, while giving heartburn to investors, will provide an orderly way for debtor nations to get into equilibrium with the investor community. Some twenty years ago, Russia did the unbelievable and defaulted on her debts. To no one’s amazement she returned to the international capital markets this year. There has been a healing process and the patient has recovered to be a respected issuer in the markets once again.
The solutions that have worked for developing countries in the past may have every bit as much application today for developed nations that have over-borrowed and are on the verge of defaulting. Debt relief for developing countries on the part of their creditor banks was a key element of the March 1989 Brady Plan in the US. The Brady Plan called for the US Treasury and multilateral lending agencies (including the IMF and the World Bank) to cooperate with bank creditors in restructuring and reducing the debt of those developing countries, including Mexico, that were pursuing structural adjustment and economic programmes supported by these agencies. A haircut of 30 per cent of the outstanding debt was taken and new bonds were issued to replace the bank loans.
The stigma attached to a bailout may be deemed unpalatable for developed nations experiencing debt management problems that are of their own making. If the money that has been borrowed in the past by several of the debt-ridden states in Europe has not been invested into productive projects, it is unlikely that the provision of further monies by the ECB, World Bank, IMF or whomever to assist the debtor nations from defaulting will do anything other than defer the day of reckoning. The likes of Greece have bought time, at most eighteen months. However, the Greek debt mountain has continued to grow and the ability of the country to repay its principal and interest inside the current time frame has magnified the problem.
Sovereign bailouts are far more complicated than bank bailouts. Be that as it may, there would appear to be a series of these bailouts looming in Europe unless an alternative is found that is economically acceptable at the sovereign level and politically acceptable at the European level. The EU can afford to bail out a single sovereign if it so wishes, but it would be a dangerous precedent and might leave the EU open to the burden of multiple country bailouts. The single currency is the trap that will cause the reappraisal of the viability of the EU.
A solution similar to that of NAMA could be introduced for Europe. A new European entity called SAMA (Sovereign Asset Management Agency) could be established, the principal objective of which would be to resolve the debt crisis by whatever means agreed. This entity might buy back a certain percentage of each troubled nation’s maturing debt in exchange for bonds newly issued by the ECB or by the debtor nation with the guarantee of the EC
B. The existing bond holders would have a lot to say about the price to be paid for the maturing debt, but these negotiations are likely to be between the surplus sovereign states and those in deficit in the EU.
Economic challenges will exist for many years to come for the member states of the EU. Whether a solution for any EU member in financial difficulty is negotiated or imposed, the need for certainty and clarity to restore confidence in the markets is a must.
CONCLUSION
Don’t Waste the Crisis
From this vantage point, we can look back at where we were in Ireland some twenty years ago. Ireland emerged from the 1970s and 1980s as one of the least prosperous countries in the EU. Our income per capita compared to the rest of Europe was at the bottom of the scale. The infrastructure in the country was not up to European standards and so a national plan was put in place. The improvements that have been achieved since then are remarkable, and are a testament to the fact that not all that was invested in the country’s infrastructure was a waste. One can argue that there might have been more invested and this more efficiently used. But who could have foreseen in 1990 what the country looks like today? We got ahead of ourselves, but that does not mean we should dismiss the incredible economic success of those sixteen years from 1991 to 2007. Our expectations grew faster than our ability to deliver, but we need to sit down and produce another twenty-year plan for Ireland that will bring us into a position that the next generation will be proud to inherit.
We have been the beneficiaries of the grace and favours bestowed on us as members of the EU since we joined in 1973. Our membership of Europe has to have balance in all aspects, particularly in relation to our culture, our sovereignty and the price we pay for our economic and financial independence. Have we unwittingly surrendered these precious aspects of our society as the price of EU membership? As we search for solutions to the crisis, we should pay attention to what might provide the best outcome in the long term for the country. In this context there is another option that is, I believe, worth a glance: if all else fails then perhaps we should stretch our thinking, widen our view and look west, not east.
Alaska and Hawaii are the forty-ninth and fiftieth states in the US. Both of these states are geographically and, it could be argued, culturally further away from Washington, DC than Ireland. Just for a moment let us question why our hands are tied at this time as a member of the EU. If we are in search of a solution and Europe finds it difficult to accommodate the needs of the Irish electorate, should we look elsewhere? Although because of geographic proximity we are associated with Europe, previous generations of Irish emigrants have chosen the US as their home, perhaps because we have never been strong linguistically. We have a special place in US history and society, but maybe we could take this further and become the fifty-first state. Fifty years from now, out of the new fifty-first state could come a young, ambitious Irish person with the potential to be the new President of the United States.
We might consider this option unthinkable but fifty years ago we may have thought membership of a European Union or United States of Europe to be impossible. Whatever route we take, the country has and will have to make sacrifices in the context of its sovereignty. Surrendering our independence would never be palatable but that’s what we have done through our membership of the EU. This may be the wrong time to put forward a negotiated plan that could result in a form of economic and political surrender. However, if we cannot make a decision on the financial aspects of our economy without referring to the EU or the ECB then we have done just that. This being the case, if there was an alternative to the EU, should we not examine the benefits of it as well as the negative consequences? This is not an exercise in futility if such consideration would open our eyes to the advantages of being associated with the current world economic power. In this time of crisis, every avenue open to us as regards our recovery and associated dependencies must at least be entertained. The possible consequences of political and economic association with the US would be a massive influx of foreign direct investment, a link to the US dollar, a reduction in unemployment and, who knows, maybe an annual payment for a number of years to get our finances back in balance. Of course, there are obvious downsides to this route, including the massive disapproval of our closest neighbours. In any case, our advances could easily be met with rejection by Uncle Sam. While, politically, the US might see us as a foothold in Europe, what would be the cost?
As I proffer ideas for a domestic recovery in this book, I am aware that the global recovery will be fragile. The numerous sovereign problems that need remedying throughout Europe, together with the potential political and economic backlash of the German electorate, may pose quite serious problems for the EU in the not-too-distant future. As a nation, we must stay focused on those issues we can control while trying to influence those that are outside our remit but can affect us negatively.
We find ourselves in a strained partnership with Europe that needs massaging. There is a need for open dissent by both our European partners and ourselves. This openness will lead us to an acceptable solution that requires honesty and clarity in our discussions that may also demand a reappraisal of the EU and what its aspirations are and the price that needs to be paid. Will the political agenda outmuscle the economic one, leaving social discomfort and unrest on the sidelines of the field of progress? If there were only one or two countries within the union suffering a crisis then perhaps a solution would be more easily achieved. What, in effect, we are faced with is a lack of political leadership.
The major players in Europe that have diligently moved towards a United States of Europe have done so against relatively weak opposition. Political opposition due to the loss of economic sovereignty or the perception of being treated as a second- or third-tier member of this great union prevails in some quarters. But the political juggernaut will not be stopped in its quest for a unified Europe. If only a couple of the major players have the financial strength and political will to continue on the unification road then they must answer the challenge in terms of the costs.
Are the major decisions on the future of Europe made from an economic perspective or in the context of a strategic political long-term vision? Between the IMF, ECB, EU and Germany, are there sufficient resources and political ambition that will insist on taking a long-term view of the political status of Europe? Will the current situation and economic sovereign weaknesses force referenda to be taken on the question of the viability of a united Europe one more time? The electorate in Germany would be entitled to ask what the process of unification has cost them and if it will continue to do so. If the fulfillment of some economic and political vision creates nothing more than a loose confederation of dysfunctional members in a union, would Germany be better off withdrawing from the original vision and re-establishing itself as a strong central neighbour?
We have looked at the option of a two-tier euro, which I believe gets to the heart of resolving the economic difficulties of many of the ailing economies in Europe. Resolutions that put the interests of the investors and the markets before those who should be protected (the taxpayers) lead to suffering and social unrest. Many market observers want instant decisions, preferably wrapped in a couple of succinct sound bites that will help people understand more easily the need for swift, callous financial decisions. Those who influence the market and call for certain decisions to be taken with regard to the various troubled economies are unlikely to feel the consequences of their recommendations. Is it possible that we can call a halt to this continuous spiraling foreign debt that plagues not just Third World developing countries but major countries from the US to European states such as Spain, Greece and Ireland?
Whatever about the EU having a coherent plan, what about Ireland? What domestic steps could be entertained by Ireland to see us out of the current crisis? I feel I have identified many of the problems that the country is going to face over the coming years in terms of economics, banking and politics. I have tried to offer
solutions to these problems, some straightforward and others far-reaching and complex. Whatever the decisions that are ultimately taken to resolve the problems we are faced with, we would be best served by a recovery plan and a clear vision of how the country should look after a couple of years of its implementation. We must establish a time frame within which we will consider our decisions and achieve our objectives, in line with the agreed financial protocols of Europe. I believe it would be a lot easier to take the economic and fiscal medicine to reduce our debt-to-GDP ratio and run a fiscal deficit of less than 3 per cent if we had a clear national plan. There would be nothing preventing us adjusting this plan if we are faced with further challenges domestically or from the international markets.
Recovery is likely to find its roots in those sectors of our economy where we have skills, interest and experience. Outside of an immediate injection of liquidity into the SME sector, plans should be put in place to foster and grow the technology, agriculture, financial services, media, and arts and entertainment sectors. Selective and considered investment into these sectors should produce positive returns and increase employment. Whatever national strategy plan is put in place, it would be folly not to find room for a modest revival of the construction industry. Our future is dependent on the export sector but we must avoid exporting our most valuable asset – our educated and ambitious youth.
Hopefully, whatever recovery plans are put in place, the Government and opposition will find it in their best interests to work together with a common objective. It is easy to argue that national mismanagement has placed us where we are today, but recriminations are not going to fix our problems; they are only going to add to them. There are a number of prerequisites to our recovery: the successful implementation of NAMA, a robust solution to the fiscal deficit, a substantial reduction in the number of people unemployed and strong measures to ensure the enormous public sector cost base is reduced.
