Markets ‘overstating’ euro area sovereign risk, say economists

Market concerns about the solvency of the euro area’s weakest sovereigns, in particular Ireland, are “probably overstated”, according to economists.

In recent days, Ireland has come under renewed scrutiny on concerns that the government’s contingent liabilities in the banking sector continue to mount. But according to Societe Generale analyst James Nixon, although Ireland’s problems are serious, the mechanisms to deal with the funding problems facing Europe’s weakest and smallest sovereigns are in place.

“Should Ireland, for example, end up having to ask for assistance from the European Financial Stability Facility (EFSF), there will follow a four-week period when the IMF, the European Central Bank and the European Commission pore over Ireland’s finances,” points out Nixon.

“This will look and feel a lot like another sovereign debt crisis and will no doubt trigger another bout of marked risk aversion and a weaker euro.”

But once this process is over and a rescue is put in place, the end result, he adds, is likely to be significantly tighter fiscal consolidation than the Irish government could credibly pursue alone. Additionally, Ireland would have access to European-wide funding at relative modest interest rates.

In any case, Nixon notes, the EFSF’s total issuance to cover the funding needs of Ireland (and potentially Portugal) is likely to be “no more than €150 billion.” That is a “relatively modest amount” and should not have a marked impact on other core European bond yields. Risk appetite, in his opinion, should bounce back quickly, prompting an equally quick reversal in bond yields and currency.

Ireland’s GDP contracted by 1.2% q-o-q in the second quarter, but Barclays Capital economist Antonio Garcia Pascual reckons that positive4 growth will resume in the third quarter, given the positive readings from higher frequency indicators of economic activity, including industrial production.

“The GDP composition shows a contraction in domestic demand, but a positive behaviour of net exports relative to the second quarter of 2009,” he adds.

“Specifically, consumer spending declined by 1.7% and capital investment contracted by 19.9%y-o-y.” On the other hand, net exports increased (in constant prices) relative to the second quarter of 2009.

Ireland’s problems, notes Nixon, are structural and deep rooted. “The logic of Ireland’s debt dynamics probably dictates that ultimately, however reluctantly, Ireland will be forced to seek additional funding from the EFSF.”

Such a request would trigger a process whereby the Eurogroup would ask the IMF, the ECB and the EC to analyse the situation, which would then report back.

“As with Greece, any funding from the facility would bring
with it a tough IMF-sponsored austerity programme with funding released quarterly on strict conditionality.”

In Nixon’s view, this would enable the Irish government to adopt greater fiscal austerity than would otherwise have been politically possible — and simultaneously guarantee Ireland access to fuding at around 5%.

“Moreover, Ireland’s total funding needs over the next five years are likely to amount to no more than €80 billion.” This, he adds, should prove a “relatively easy amount” for the EFSF to raise, now that its AAA rating has been agreed upon.