Warily on the way back

When Germany’s sovereign bond auction came up short two weeks ago, it sent shudders across the eurozone and around the world. But in Ireland, any sense of looming financial apocalypse was curiously muted.

As the republic’s 4.6m people absorb Tuesday’s seventh round of budget cuts and tax rises since the onset of the debt crisis, Irish policymakers take grim satisfaction at the resilience of their economy. They also sense an opportunity – to get the vast bank debts the previous government took on at the start of the crisis written down to manageable proportions.

“We’ve identified one of the risks to a successful outcome to Ireland’s [recovery] programme: that is the overall level of the debt,” says Michael Noonan, the finance minister. “We’ve made it clear we will negotiate as the opportunity arises.”

That sends a sharp signal to its 16 fellow members of the single currency just as the crisis laps at the toes even of mighty Germany, subsuming Ireland’s problems into a larger and evolving dynamic. The way Mr Noonan characterises it is the sober version of a development that has produced something close to exhilaration in some quarters. “Schadenfreude and large Schnapps all round” was the reaction of one prominent Irish economist to the misfired Bunds auction.

Bundled by its euro partners a year ago into a rescue programme it did not want, Ireland is now being touted as proof that the severe fiscal austerity imposed by the European Union and International Monetary Fund as a condition of eurozone bail-outs is not necessarily an impediment to economic growth. Including Tuesday’s dose of budgetary consolidation, the country will have ripped €25bn – equivalent to nearly 15 per cent of current gross domestic product – out of the economy since mid-2008, through a painful sequence of tax increases and pay, pension and public spending cuts. Almost half as much again is still to come.

Yet unlike in Greece, Portugal, Spain or Italy, unit labour costs have been significantly reduced, amounting to an “internal devaluation” that the government estimates at more than16 per cent. Exports are now above their pre-crisis peak and the current account of the balance of payments is back in surplus. GDP may end up expanding this year by 1 per cent as a result.

“An economy undergoing a 4 per cent contraction [in 2011], with banks that are not lending and a massive overhang of housing debt, yet that ends up with a positive [economic growth] number – that’s a remarkable performance,” says Karl Whelan, professor of economics at University College Dublin. “I am surprised we’ve done this well but I’ll be surprised again next year if we’re still on track,” he cautions.

This modest growth is indeed fragile. The prospects of recovery continuing depend on export demand from Ireland’s main trading partners in Europe, Britain and America – and, not least, the survival of the eurozone. “We’re like a cork bobbing on the water here,” says one senior official.

If the euro fails to hold together, Ireland fears it will cease to be the magnet for inward investment into Europe it became 20 years ago. In 1990, the largest foreign direct investor was Fruit of the Loom, making T-shirts in Donegal. Now the country is clustered with investments by Intel and Pfizer, Google and Merck, Apple and Siemens. In all they generate €110bn in exports and account for two-thirds of both corporation tax revenue and private sector research and development spending.

Yet these capital-intensive multi-nationals employ 240,000 people, or less than one in eight of the workforce, and while exports have powered ahead the domestic economy is on its knees, weighed down by the detritus of the property and banking collapse. Net take-home pay, as a result of cuts and additional pension contributions, has fallen sharply and, along with cuts in public spending and households hanging on to cash, has devastated demand. Ireland’s battered surviving banks have been recapitalised but lending has seized up. Worst of all, though, is the weight of Ireland’s national debt.

The Fianna Fáil government thrown out of office this year gave a blanket guarantee to Irish banks in 2008. Then, in the EU-IMF bail-out a year ago, the European Central Bank firmly rebuffed Dublin’s efforts to get senior bondholders in the banks to share the cost of their collapse with the taxpayer. Thereafter, sovereign borrowing and private bank debts became indivisible.

The official narrative, of both the EU-IMF-ECB “troika” that all but dictates economic policy and the Fine Gael-Labour coalition that took over from Fianna Fáil, is that Ireland can “work through” its deficit and debt – reducing the budget deficit from a projected 10.3 per cent of GDP this year to 3 per cent in 2015, and with a peak or “exit” debt-to-GDP ratio of 118 per cent in 2013 – after which it can return to the bond markets.

“I want to be the taoiseach who retrieves Ireland’s economic sovereignty,” Enda Kenny told the nation this week in the first televised address by a prime minister for 25 years. Yet it is hard to find anyone genuinely convinced by this narrative – even if the eurozone is salvaged. The new government is not going to capsize the euro boat by doing anything unilateral. It is playing a long game – at the end of which it expects debt relief.

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Considered so grey he nearly lost his job as Fine Gael leader ahead of this year’s election, Mr Kenny has since found his voice. He has held his own in EU councils, winning a reduction in the rate of interest charged on the EU portion of the bail-out and resisting French bullying to raise Ireland’s 12.5 per cent rate of corporation tax. His withering broadside against the Vatican this summer, accusing it of helping cover up the “rape” of children by Irish clerics, “articulated the majority view and outrage of middle Ireland”, says Stephen Collins, political editor of the Irish Times.

Now he will have to find a way of articulating the equally widespread view that not all Ireland’s debts are fully payable. “If the banks and the bondholders want surety of getting, say, 80 cents on the dollar, then they have to let the economy function,” says Neil O’Leary, the chairman of Ion Equity, a private equity house. “Why does the best boy in the class get beaten the hardest?”

While Dublin remains dependent on EU loans and ECB liquidity, the government is publicly cautious. But, like its citizens, it believes that for Ireland to have borrowed fecklessly, European banks must have lent recklessly – and not to the government but to banks on a property lending spree. Until the bubble burst in 2008, Irish sovereign debt stood at just 25 per cent of GDP and Dublin had run a fiscal surplus averaging 1.6 per cent of GDP over the previous nine years.

The burden of sovereign debt – pumped up by rescue funds that ensure creditors to banks that no longer exist, such as Anglo Irish Bank, are paid in full – is likened to being lashed to a dead horse. Taxpayers were put on the hook by the state’s guarantee to banks, the government acknowledges, but then were kept there by the EU and ECB to help prop up other European banks.

“It’s analogous to getting Newcastle City Council to backstop Northern Rock,” says Colm McCarthy, who teaches economics at UCD and drew up a national public spending review in 2009. “The best solution for this country is to pay the sovereign debt but we have to have a deal on our portion of financing the European banking crisis.”

The government faced down public outrage at a recent $1bn payment to legacy bondholders in Anglo-Irish, the bank at the rotten core of the property binge. But observers of Dublin’s debt policy believe there is even now a discreet quid pro quo operating between Europe and Ireland. “Europe has a working model of how much Ireland can pay and that it’s at the limit, and that if you pay $1bn for Anglo then it has to come from somewhere else” such as an easing of the cost of funds, says Philip Lane, professor of economics at Trinity College. The government reckons it is cheaper to pay than not to – for now.

“I suspect what Enda wants is a second deal and more rope,” Prof Whelan says of the prime minister. That can only come from parking the promissory notes issued against Anglo-Irish debts in a long bond of at least 30 years at low interest, most analysts agree. The current total cost of these notes after interest, the government admits, is €47bn – “the difference between sustainability and non-sustainability”, says Prof Whelan. If these payments of €3.1bn each year until 2023 are not converted into “zombie debt”, the backlash against Europe that Ireland has so far held at bay will gather strength.

“No one in Ireland has a problem with Europe if it means more prosperity, but if it means we have to pay Deutsche Bank’s gambling debts then there is a problem,” says David McWilliams, an economist and broadcaster. Ireland, says one senior official, “took one for the team . . . protecting Europe from another Lehman”. Soon it expects a payback.

“The government I’d say would like to have assurance that instead of having [the Anglo paper] paid off as promptly, it would like to have it amortisable over a longer period of time,” explains another official. In Europe, “this is understood”.

“We’re not making it public,” says Mr Noonan, “but one possibility is a longer lending period at a lower interest rate” for the Anglo-Irish debt, non-binding technical negotiations on which are already under way.

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The government has political leverage. Treaty changes on eurozone governance sought by Germany would require a referendum in Ireland; they would not have a prayer of getting through without a saleable European gesture.

“Our assessment of the public mood is that it would be difficult to get a referendum passed,” says Mr Noonan, cannily adding: “but we’re certainly not going to hold up the progress of Europe.” Joan Burton, Labour’s minister for social protection, says: “I would think that treaty change would have to be part of a package including some of the issues Ireland has.”

No movement on debt might even let in Sinn Féin, the anti-EU republican party that is increasingly occupying the nationalist territory of Fianna Fáil. It was Pearse Doherty, a new Sinn Féin MP untainted by the “Troubles” in Northern Ireland, who smoked out the full details of the Anglo-Irish debt in a parliamentary question and who in Prof Whelan’s view is “effectively the leader of the opposition”.

Prof Lane at Trinity concurs. If the economy fails to recover, Sinn Féin is “going to be the next government”.