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Ireland, EMU and the grand bargain

by Niels Thygesen, Advisory Board

Ireland, EMU and the grand bargain

Ireland is at the centre of the search for a ‘grand bargain’ over economic and monetary union (EMU), comprising a threefold quest for lower interest rates on official borrowings, a wider mandate for the EFSF European rescue fund, and a restructuring of Irish debt.

The negotiating parties have very different perspectives and priorities. The creditors, led by Germany, are primarily interested in longer-term improvements in the policy framework which could bring euro area economic governance back to the original concept of largely national responsibility for non-monetary policies, subject to close monitoring. The present and prospective debtors wish for the mirror image – access to conditional lending from their partners to help them reach sustainable performance and protect them against contagion.

The scope for a bargain is there, but it will be difficult to drive home at forthcoming March meetings of government leaders, first of the euro area and then of all 27 EU members.

Uppermost in their mind will be the 25 February Irish election which ejected the government responsible for the wild construction boom and the subsequent bust with its disastrous impact on the Irish financial sector – leading to a €85bn loan (of which the Irish pension system provided €17.5bn) from the EU institutions and the International Monetary Fund. The new coalition government accepts the constraints imposed by the loan, but wants to renegotiate some of the terms. Ireland’s perspective is clear. The 5.8% interest rate may represent a compromise between the rates at which the European Financial Stability Facility is able to finance its lending and the rate at which Ireland could borrow if it were to return to the market in 2011.

For Ireland – as Greece (paying 5.2%) – the borrowing rate is the sole determinant of fiscal sustainability that can be influenced in the short run. The other two factors are the growth rate of nominal GDP and the primary budgetary surplus. Nominal GDP growth is likely to remain below the interest rate for some time, since it will be held back by low inflation even if the Commission’s assumption of a rapid convergence to 3% real growth from 2014 proves realistic. The primary balance is already on an ambitious trajectory, moving into small surplus from 2013, barely enough to stabilise the debt ratio. As Dublin tries to make public finances sustainable, a lower borrowing rate than the current penal level must be Ireland’s main target in adjusting the framework.

A wider mandate for the EFSF (later European Stability Mechanism), enabling these funds to buy back Irish and other risky sovereign bonds and convert them into claims by the European institution at a discounted value, is a step advocated by several academics and policy-makers – including the European Central Bank. It would have the advantage of making the ECB bond purchasing programme superfluous. Whether it would provide significant resources to the debtors and ease their return to financial markets is questionable, particularly if the new sovereign lending is given senior status. Anyway, the idea is meeting strong resistance in Germany and other creditor countries as an undesirable step towards common bond issues.

The third issue concerns debt restructuring. This is more urgent in Ireland than in other debtor countries, not because of the level of debt which is well below that of Greece, but because of the exceptional role of the Irish sovereign in guaranteeing bank debt when the crisis broke in 2008. The debt figures are subject to upward revision reflecting rises in mortgage foreclosures and the Irish authorities’ postponement of bank recapitalisation. All of these elements are inconvenient reminders, also to Ireland’s partners, that serious problems of banking undercapitalisation persist – and not only in Ireland, in view of the imminence of a new round of stress tests, ahead of efforts by the European Banking Authority in other EU countries. Reflecting how bank debt aggravates perceived risks of sovereign insolvency, the EU authorities should consider forcing private sector creditors to participate in the refinancing of outstanding debt now, rather than saying this can only take place after 2013.

With its good record of structural reforms, Ireland should have fewer problems than most with the competitiveness agenda advanced by Germany and France. Yet Ireland may be an inconvenient negotiating partner when the grand bargain is tackled this month. After all, the creditors of Ireland, and of the Irish banks in particular, could have shown greater prudence in lending in the run-up to the crisis – as could their supervisors; avoidance of moral hazard for creditors as much as for debtors suggests that some burden-sharing is worthwhile in the case of senior bank debt. This was also strongly argued by former Irish Prime Minister John Bruton in a London speech on 7 March. More will have to be done to resolve the current crisis before the EU’s political leaders can focus on governance for the future.