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Ella Kavanagh

Ella-Kavanagh An Irish default would prove costly, but the EU needs to learn lessons from transferring banking debts to the sovereign, writes economist Ella Kavanagh.

Irish government debt is €169.3 billion, or 108 per cent of GDP, with the Department of Finance forecasting it to rise to over €200 billion by the end of 2015. Although similar to Portugal, our debt is still less than that of Italy at 120 per cent and Greece at 165 per cent of GDP prior to its recent debt exchange. Surely this amount of debt can never be repaid. Why not default and simply wipe it out?

A sovereign debt default happens when a country does not meet a debt payment, principal or interest. It would be impossible for us to wipe out our entire debt. In reality we could only potentially default on €54 billion of the €85.3 billion of Irish Government bonds, as the remainder of these bonds are held by the Irish banks, the Irish Central Bank and the ECB. Wiping out 50 per cent, like Greece, would mean eliminating €27 billion of the debt, a not inconsiderable amount, but which needs to be assessed against what Ireland could potentially lose by following this plan1.

Currently, there is no support in Europe for an Irish default. Jörg Asmussen of the ECB executive board warned on his recent visit to Ireland that “any desire to offload this debt could have dire consequences”. Therefore a decision by Ireland to default would be a unilateral one and mean repudiating the troika programme (and the funding provided) and possibly exiting the euro zone.

Under this scenario, the primary deficit in Ireland (forecast to be €6-7 billion in 2012) would have to be closed overnight meaning much greater austerity than the €3.8 billion already planned for this year. Government guarantees would have little credibility and, combined with the expectation of a euro zone exit, would cause bank runs, capital flight, default by the private sector on its debt (why should it pay if the Government does not?) and a possible banking system collapse.

The disruption of the payments system would have dire consequences for domestic and exporting businesses. The result would be major social unrest and contagion. In 2002, the year after its default, the Argentinian economy contracted by 11 per cent, with 46 per cent of households living below the poverty line.

Even without exiting from the euro zone, there is a serious risk to the reputation of a country like Ireland, with no previous history of default. This is identified as one of the main incentives for avoiding default. It would certainly change the opinion, of international investors and FDI decision makers, of Ireland as a country that pays its way to one that is unable or at worst unwilling to do so. This is a valid concern. In the 1980s when we paid off our debts, interest repayments were around one third of total tax revenue compared to 15 per cent today, undoubtedly difficult but still manageable. We are also currently able to meet the troika programme.

Defaults are not costless. Argentina has still not re-entered the global credit markets ten years after its default and it is expected that they will have to pay twice the interest rate of Brazil, when they do. Paying a higher risk premium on sovereign debt would also affect the cost of Irish banking and corporate debt. A sovereign default (with or without an exit from the euro zone) would surely necessitate continued fiscal consolidation and structural reform as Ireland rebuilds its reputation particularly with weak global economic growth.

The cost of the recapitalisations of the Irish banks to date is €63 billion. To reduce the pressure of future banking debts on governments, the EU needs to acknowledge that the interconnectedness of banking makes it a shared risk beyond the sovereign and requires a European or even a global response. Transferring this debt to the sovereign is not the answer.

Dr Ella Kavanagh is a lecturer in University College Cork’s School of Economics.

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