Will the ECB pull the plug on Ireland?


BBC business editor Robert Peston on Dublin's financial woes

The gap between what Ireland spends on public services and what it receives in tax revenues, the classic public-sector deficit, is substantial and unsustainable, at around 12% of GDP.

But, funnily enough, that is not Ireland's biggest problem.

Ireland's weakness - what has sparked the pressure from other EU members and the European Commission for some kind of bailout of the Irish state - is its bloated, lossmaking banking system.

The country's banks are largely state controlled, with Bank of Ireland the only substantial Irish bank where the taxpayer shareholding is relatively small.

And yet these banks find it fantastically difficult to borrow from other banks or financial institutions.

The point is that investors and professional lenders are reluctant to lend either to the Irish state directly, by purchasing government bonds, or indirectly, by lending to Irish banks.

And it is their refusal to lend to banks that is the real liquidity crisis for Ireland, in that the Irish government's deficit is fully funded until well into next year.

So it is not an exaggeration to say that there would not be a banking system in Ireland - and therefore not an economy in any conventional sense - if it weren't for the generosity of the European Central Bank in providing loans to Irish banks that the markets won't provide.

The latest published figures, which almost certainly understate the true picture, show that the European Central Bank had lent 83bn euros to Ireland's domestic banks by the end of September and it had lent 130bn euros to all Irish credit institutions at the end of October.

Or to put it another way, ECB loans to Irish financial institutions were more-or-less equivalent to the current annual value of Ireland's Gross National Product.

To repeat, without the financial support of the ECB, Ireland would be bust right now.

According to Barclays Capital, more than 10% of all the loans and investments made by Ireland's banks - their assets - are financed with ECB cash (which looks to me like a bit of an under-estimate).

The important point is that Ireland's banks, and those of Portugal, and even some of Germany's Landesbanks, have been on life support provided by the ECB for many many months now.

So there has already been a European Union rescue of Ireland - and arguably of Portugal too (where some 7.2% of bank assets are financed by the ECB, according to Barcap) - but that rescue has been carried out by the backdoor, by the European Central Bank.

Now standard central banking theology, that goes back to Bagehot in the 1870s, says that central banks are only supposed to provide liquidity support to inherently viable institutions. However the evidence is accumulating that a number of Irish banks are not viable, even after the recent multi-billion euro injections of new capital by Irish taxpayers.

Also, the ECB must be concerned, for example, that Portugal's government may be funding itself by selling government bonds to its banks at a high rate of interest, which in turn may be financing those purchases by borrowing from the ECB at a lower rate of interest. Another article of central banking theology is that central banks should not indirectly recapitalise weak banks or finance over-stretched states.

Which means that the moment is fast approaching when the ECB, if it behaves as many would say a central bank must behave to preserve the value of the currency, will announce that it is phasing out liquidity support for those weaker European banks - in Ireland, and Portugal and even Germany - which have become too dependent on it for loans.

But if the ECB were to be true to its central banking instincts and announced a timetable for removing the life-saving funding drip, what could be done to keep Ireland's banks and economy alive?

The governor of the Central Bank of Ireland, Patrick Honohan, put it like this in evidence last week to Ireland's Joint Committee on Economic Regulatory Affairs: "Presumably over-capitalising the banks could help build confidence, but this is not something which the state can be lightly asked to do, given the pressures on its finances".

Arguably, Mr Honohan has given the game away, by saying that investors are taking the view that Ireland's banks need bigger injections of capital from taxpayers, but that Ireland's taxpayers cannot afford to invest any more in the banks.

What follows from that?

Well, it means that if the Irish can be persuaded to take funds either from the European Financial Stability Fund or from the European Financial Stability Mechanism or from the International Monetary Fund, that money should probably be invested in the banks, to provide them with more protection against future losses.

As Mr Honohan pointed out, investors don't believe that Irish banks have seen the worst of losses on residential mortgages taken out when Ireland's housing market was booming (them were the days), even if they believe that the worst of the banks' commercial property loans are being shipped out to a taxpayer-backed, specially created toxic bin, the National Asset Management Agency.

This is what it boils down to.

The Irish government does not want a new formal bail out. But if there is the faintest sign that the ECB wants to withdraw the succour it has provided to weak eurozone banks, Ireland will no longer have a choice: it will have to go cap in hand either to its EU partners or to the IMF.

By the way, that choice of whether to go to the EU or IMF will be a nightmarish one for the Irish.

On the one hand, their pronounced communautaire spirit would point them towards Brussels for help; but the IMF is much less likely to bully the Irish government into abandoning cherished pillars of its economic policy, such as its low corporate tax rate (which the German government would dearly love to squish).

And there is one other thing: a conspicuous missing ingredient in the debate about what Ireland should do is about who should shoulder the bulk of the losses in the long run.

Few deny that the Irish state has borrowed far more than it can afford to repay in the form of bank debt, public-sector debt, household debt and corporate debt.

There are going to have to be haircuts and write-offs, big losses, as the debt is shrunk to an affordable size.

The seemingly open question is how those write-offs, those losses, will be shared between Irish taxpayers, European taxpayers and commercial lenders.

Right now, which some will see as unfair, the burden seems to be falling on taxpayers, with the commercial lenders apparently getting off very lightly indeed.‬‪

You can keep up with the latest from business editor Robert Peston by visiting his blog on the BBC News website.

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