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Date Posted: 18:30:36 01/23/09 Fri GMT
Author: Lynn
Subject: Lean times for the Celtic Tiger (MoneyWeek)

Lean times for the Celtic tiger
By Associate Editor David Stevenson Jan 23, 2009

Investors are getting very jittery about the possibility of European governments defaulting on their debts. David Stevenson investigates whether Ireland could be the first.

Why the growing fears?

All three major credit-ratings agencies – Standard & Poor's (S&P), Moody's and Fitch – look set to chop Ireland's credit rating. In fact, having downgraded Greek and Spanish government bonds, and warned that Portugal's sovereign debt is under the microscope, S&P has already cut its outlook on Irish government debt to negative. The cost of insuring against non-payment of Irish government bonds has also soared in the last two weeks. Prices now imply there's a more than 18% chance of the country defaulting on its debt, compared with a 4% 'non-payment' risk attached to German bunds, the least-risky EU debt. The gap hasn't been bigger since the euro's launch in 1999.

What's gone wrong for Ireland?

In the early years of the decade low eurozone interest rates and easy credit created a housebuilding and borrowing boom as banks lent e110bn to a handful of local developers – with property prices rising almost fourfold over the ten years to early 2007. But now the party's over, say The Observer's Richard Wachman and Henry McDonald. Dublin house prices are already down 28% from the peak and there's a nationwide glut of unsold property. Ireland has been in recession since mid-2008, and in September the government was forced to guarantee deposits at Irish-owned banks amid fears of a run on the sector. The latest problem, last week's nationalisation of Anglo Irish Bank, the country's third-biggest lender and a big player in commercial property, spooked the markets further. On Monday, described as "the worst day in Irish financial history" by Professor Brian Lucey of Dublin's Trinity College, the Irish banking index dived by 50%.

What else has gone wrong?

GDP forecasts for 2009 are dire; the European Commission (EC) expects a 5% fall. As well as the property slump, Ireland has another big problem. Low taxes lured multinationals to its shores, but high wage inflation and the strong euro have made its labour costs uncompetitive. Indeed, US computer giant Dell is to move manufacturing from Limerick to Poland, where costs are two-thirds lower. That's bad news for jobs – Dell was Ireland's second-largest private-sector employer. With the construction collapse, more than 10% of the population is likely to be unemployed by the year-end, says the EC.

What does this mean for the future?

Ireland faces "an economic disaster unlike anything in my lifetime", says Unilever's ex-chief Niall Fitzgerald. Investors unhappy with Gordon Brown's attempts to "rescue" the British economy can simply sell sterling. But individual countries within the eurozone have no currency to devalue so investors are more likely to dump riskier government bonds. Lower bond ratings increase debt funding costs, putting more strain on government budgets, while downgrade threats suggest debt should be cut and public spending brought under control. So while most countries are pinning their hopes on Keynesian spending sprees, Ireland will have to cut back. That's bad news for state employees, with the Taoiseach expected to "deliver the bitter pill that the government will demand pay cuts in the public sector", says the Irish Independent.

Will cutbacks help?

To an extent. But the slump also means that tax revenues are falling. Consumer spending is tumbling along with house prices, which the gloomiest commentator – Professor Morgan Kelly of University College in Dublin – reckons could slide by as much as 80% in real terms before that glut of empty homes has been sold. That means this year's budget deficit is likely to rise sharply to over 9% of annual output (EU rules target 3%), pushing the national debt higher from 2008's 41% of GDP. The Department of Finance expects several years of double-digit annual budget deficits to come, with the national debt surging to at least 60% of GDP, the eurozone limit, by 2012.

Could Ireland really default on its debt?

"What if one of the member states of the eurozone were to default on its debt?" asks Wolfgang Munchau in the FT. European Central Bank president Jean-Claude Trichet said last week he would "totally exclude" the possibility, but "if the financial crisis has taught us one thing, it is to take perceived tail-risks more seriously". And markets are scared because it's unclear what would happen in this scenario. "Eurozone governments have a mutual 'no bail-out' arrangement and it's not obvious what role the ECB could play," say Ralph Atkins and David Oakley in the FT, "but in a worst-case scenario, a rescue by a multinational institution such as the IMF would probably be arranged."

Could the eurozone break up?

Munchau reckons the eurozone "won't fall apart". Any departing country "would also face a currency and banking crisis". But what if the stakes are raised? "This is war: countries have to defend themselves, and it's essential we go to Europe and say we have a serious problem", says former Irish central banker and journalist David McWilliams. "We say, either we default, or we pull out of Europe". That's "broken the ultimate taboo by evoking threats to precipitate an EMU crisis", says Ambrose Evans-Pritchard in The Daily Telegraph. By staying in, the country's turning itself into "a large debt-repayment machine", says McWilliams. He believes Ireland must become "an export country again... But we've ruled this out by our euro membership". While there's no Irish public support for pulling out yet, as times get harder, they may well change their minds.
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