Significance: Although Ireland's government is the most pre-funded of Eurozone sovereigns and does not need to tap the bond markets until July 2011 to refinance its debts, contagion in the form of higher borrowing costs for other Eurozone members has provoked a strong official European Union (EU) reaction.

Implications: As borrowing costs rise for other Eurozone members because of lingering Irish banking problems, the idea of ring-fencing Ireland with a firewall has come to the fore; just as happened with Greece in May. Throwing Ireland a credit lifeline from the newly set-up European Financial Stability Fund may stem the contagion and emerge as the cheaper option for all involved, despite the Irish government's deep reluctance and reservations. Even a "contingent line of credit" would come in useful.

Outlook: Ireland is inching closer to some form of EU and International Monetary Fund (IMF) aid package to prevent the country's problems from spreading to others and to shield the country while it resolves the banking system problems from within. This is the current crisis management strategy, but the details have yet to be refined; the IMF and EU task force is currently in the Irish capital, Dublin, to undertake "due diligence" to identify more clearly the problems before any aid and a resolution plan is provided.

Ireland's government is the most pre-funded of Eurozone sovereigns as it does not need to tap the bond markets until July 2011. However, secondary market anxieties in the form of sharply rising yields have led to contagion in the form of higher borrowing costs spreading to other countries (Portugal, Spain, and even Germany) not as well pre-funded as Ireland. The latest rumours suggest that Ireland is under pressure to accept a European Union (EU) bailout as the least costly option for all involved. What are the events that have triggered this situation?

Unresolved Banking Issues

Those looking at Ireland may ask, "Where is the risk?" It is in the banking system—the suspicion that there are still uncovered, property-related losses undermining bank capital. Currently, Irish banks cannot access the inter-bank market for their usual liquidity purposes as they are seen as a counter-party credit risk by other banks. As a result, Irish banks are almost totally reliant on the European Central Bank's (ECB) emergency liquidity repo facilities set up after the collapse of U.S. investment bank Lehman Brothers. The ECB wants to withdraw these emergency facilities by end-2010. It is estimated that whereas other European banks have weaned themselves off these ECB emergency repo liquidity lines, Irish banks still use some one-third of all those made available by the ECB. These repo facilities can only be a "band-aid"—they do not have permanence and cannot be used indefinitely. If banks become addicted to them, like the Irish banks, then it suggests that they are not sorting out the credit risks—i.e. covered losses elsewhere on their balance sheets. This is the primary issue for the Irish government, and one reason why the ECB wants Ireland to access the European Financial Stability Fund (EFSF) set up in May at the height of the Greek crisis, so that the ECB can proceed to withdraw the emergency repo facilities.

Ring-Fencing and What Needs to Be Done

The current EU crisis management strategy has been to ring-fence (i.e. provide a firewall) wherever and whenever there is financial stress, and to resolve separately "whatever the problem is" from within the ring fence. For Greece and Portugal the "problem within" is clearly fiscal in origin and outcome and they need to demonstrate fiscal responsibility and stick to it. For Ireland the "problem within" is, at source, the banks (not fiscal), with core bank capital ratios of about 7%, which are deemed insufficient by counterpart banks. What needs to be done is to reaudit the Irish banks, reveal all property losses in a completely transparent manner, and mark down the collateral aggressively. Bad debts are then taken off the Irish banks and put into the state's "bad bank"—namely the National Asset Management Agency (NAMA). Germany and Spain have their own versions of these state-owned "bad banks". Then the Irish banks will have to be recapitalised (yet again) with clear "excess capital" above regulatory requirements in order to re-instil market confidence. By ring-fencing and creating firewalls they can stem contagion—i.e. the spill-over effects of rising yields on other EU members' debt markets. The EU has undertaken this ring-fencing exercise with some success so far with Greece. The second crucial stage after ring-fencing for Ireland is to separate all the bad loans in the system as a whole from the good, performing loans, which remain on the Irish banks' balance sheets. The special-purpose state-owned "bad bank" is the vehicle used in this loan separation process, to sweep together and place into one corner all the bad debt in the system onto the (state-owned) "bad bank". This "bad bank"—or NAMA in the case of Ireland—is eventually dissolved after the crisis and Irish banks can stand on their own balance sheet feet again. Finally, the bad debt of the "bad bank" is added to the sovereign's own existing debt and serviced out of the central government budget.

Can the Irish Banks Actually Be Saved?

With sufficient capital injections and by clearing all of the bad debt onto the state's "bad bank", the Irish banks can survive. The goal must be to recreate a healthy banking system "willing and able" to lend again—otherwise Ireland will not achieve the growth it desperately needs to alleviate rising sovereign debt ratios and regain an AAA rating. No government can let the banking system itself go, but clearly some individual insolvent banks with no economic future can and should be wound down—or absorbed by stronger banks—after NAMA or the state's "bad bank" has done its work, typically after shareholders have been wiped out. This is the bank crisis management theory.

What Would a Bailout Look Like?

EU and IMF officials are currently in the country re-examining the situation thoroughly as part of the preparatory "due diligence" process, as they should, before refining any resolution plans with aid attachments. If the resolution plan succeeds in re-establishing an incontrovertibly sound Irish banking system, then it has to convince everyone—including the inter-bank and debt markets and other counterparts and depositors dealing with Irish banks. The full cost in the form of "bad debt" is collected by the "bad bank" and eventually placed on the sovereign's balance sheet. IHS Global Insight estimates that these banking-related costs will eventually amount to some 30% of Irish GDP. On a banking crisis "Richter Scale", this is a "very severe crisis" of about 7–8 out of 12. In the United Kingdom and United States the ultimate banking crisis costs will be 10–15% of GDP or 4–5 on the banking crisis "Richter Scale". For Iceland it was about 10–12—i.e. nearly at the highest level of severity.

What Are the Odds That Sovereign Ireland Will Default?

The IMF and Eurogroup will not let sovereign Ireland default; we are nowhere near that situation yet. The contagion consequences of such an event would be enormous and unmanageable in any case. Sovereign Ireland will probably end up carrying a heavy debt burden of about 120% of GDP post-crisis and bank clean-up, but this is manageable in principle and can be worked off over many years—as long as GDP growth comes back to lower key debt metrics. Ireland cannot be described as "insolvent" on any conventional debt metrics and ultimately we need to judge whether its economy will be able to grow out of its new debt burden. On this score we are more positive: Ireland is an open, flexible economy exhibiting high levels of human capital and a track record in successfully attracting foreign direct investment (FDI). The economy has recently been able to generate an external current-account surplus, clearly demonstrating that it is internationally competitive even when global demand is weak.

Spectre of SDRM Sows Investor Uncertainty

However, what may happen some time in the future—after 2013 at the earliest—is the formation of some form of Sovereign Debt Restructuring Mechanism (SDRM). This was the recent German proposal passed at the last EU summit in October, which has thrown a spanner in the works recently for the weaker EU sovereigns and rekindled tensions and anxiety in bond markets, leading to higher yields and risk spreads. As ECB chairman Jean-Claude Trichet had correctly warned, such a proposal has sown uncertainty and raised borrowing costs, particularly for weaker sovereign credits trying to undertake painful adjustment. At the very least the SDRM proposal shows poor timing and communication, even if there are merits to the underlying idea of limiting moral hazard to taxpayers and providing debt investors with more appropriate risk incentives. It is still more likely that a permanent SDRM will involve Greece as the first candidate, but not Ireland.

Why Is a Ring Fence the Preferred EU Option?

The motive behind a bailout is—as always—clear and founded on basic economics; it is not altruistic or an act of "European solidarity"—although these do exist. Contagion from Ireland is already driving up borrowing costs not only for Portugal and Spain but also for Germany itself, and a few basis points higher for Germany adds up to a lot of euro. Therefore, on a simple opportunity cost basis, it may become far cheaper to throw Ireland a credit lifeline now—i.e. the basis of the ring-fence—than to carry the higher borrowing and contagion costs for others in the EU. The same principle may also apply to Portugal and Spain, but this depends on how investors react to the Irish rescue. On the European level, the EU is not ready for sovereign debt restructuring, but it is working towards it with this SDRM. The SDRM will be pushed through on Germany's insistence at some point and is essentially "payback" for underwriting the existing, temporary US$1.2-trillion IMF and Eurogroup backstop package set up in May. All in all, Greece, Ireland, and Portugal are not threatening the euro project itself; they are simply too small and ultimately quite manageable in scale. The biggest weakest link is Spain—not because it has the most risks but because of its sheer size, accounting as it does for 10% of Eurozone GDP and over US$1.2 trillion of inter-bank debt alone, owed to other Eurozone banks.

Outlook and Implications

We have to be careful about looking at the current sovereign risk travails in Ireland and Portugal through the prism of the last crisis, i.e. Greece last May, as we may be overstating the parallels here, with distinctions only being revealed as time passes. After the initial fumbling over the Greek crisis—or calculated German deliberations to others—there is now a huge and sufficient US$1.2-trillion IMF-Eurogroup back-stop facility in place and the presence of the IMF, as well as a clearer understanding of the issues. Growth is also coming back slowly, but not really where it is needed most on the EU periphery—except perhaps Spain, which is receiving some benefit from the strong V-shaped German recovery. If the current IMF-EU task force in Dublin believes from its "due diligence" fact-finding exercise that extra funds are required to strengthen the Irish banking system and also to protect the Irish sovereign from refinancing difficulties, then a firewall of "aid" will be provided swiftly. Even the provision of a "contingency line of credit" along the lines of that already made available by the IMF—something that would be used only if needed—would provide reassurance and go a long way towards allaying market concerns and addressing the Irish insistence that it does not require the money any time soon. This ring fence, like that for Greece earlier in the year, will help stem contagion in the form of higher borrowing costs and allow space and time for Ireland—together with its Eurozone and IMF partners—to resolve its banking–related problems once and for all from within this firewall.