The Irish problem

Ireland's financial problems could see the country going bust. How did things get so bad? And how might they affect the UK?.

Ireland's been in the news the last few days due to its financial problems, sparking debate over whether it'll follow Greece in needing an EU bailout. Let's take a look and gauge the size and implications of Ireland's mounting debt.

What's the problem?

After several years of boom Ireland has been heading towards bust since the credit crunch. Government debt has been growing fast, thanks in no small part to bailing out banks, and continues to rise. Ireland's ongoing Budget deficit is prompting fears over its ability to repay debt, sending the yields on Irish Government bonds soaring. This creates a vicious circle, just as it did with Greece, because it becomes too expensive for the Irish government to issue more debt (i.e. borrow further) leaving little choice but to either secure an EU bailout or risk going bust when the money runs out. The Irish government is maintaining it has enough cash to see it through until mid 2011 by which time Budget cuts will have eased the situation. But, as we'll see, this might be a tad optimistic...

How bad is it?

At the end of September 2010 the Irish national debt stood at €88.6 billion. This might sound like peanuts compared to the UK's £953 billion of debt, but the Irish economy is about one tenth the size of the UK's (when measured by output, i.e. GDP). More importantly, Ireland's debt is growing at a faster pace than the UK's - over the last two years it's soared by 75% (€38.2 billion), compared to about 50% in the UK.

The real problem is that the Irish Government will very likely need to borrow more money to keep its head above water, but with markets increasing sceptical that Ireland can repay its debts the rate of interest being demanded has soared. At the time of writing the yield on 10 year Irish Government bonds is around 8.2% (almost double a year ago), versus just 2.5% for equivalent German Government bonds. If Ireland is forced to borrow more at these levels the cost of debt interest will become overwhelming, creating a downward spiral.

The Wall Street Journal reckons the Irish Government had €22.4 billion of cash at the end of October, which could last up to 8 months. But it could also run out a lot sooner unless hard hitting spending cuts and tax hikes don't stifle slash the deficit without stifling economic growth (which looks unlikely), in which case it'll have little choice but to follow Greece in seeking an EU bailout.

How did Ireland get into such a mess?

It's the usual story of a country believing its own hype and spending far too much cheap borrowed money in the good times, creating an unsustainable bubble that eventually bursts (not dissimilar to the UK, but on a more aggressive scale). Banks lent too freely prompting a flood of money into the property market. House building and prices soared (Ireland built half as many homes as the UK in 2007 despite having one thirteenth the population), so when an increasing number of borrowers found they couldn't afford to keep up their mortgage repayments the house of cards started to collapse. This left Irish banks taking a massive hit from 'toxic' debts and the Government having to step in with a bailout package believed to total around €40 billion - pushing Government debt to unsustainable levels and prompting markets to demand a sky high rate of interest on Irish bonds.

Plunging tax revenues as a result of recession have then rubbed salt into Ireland's wounds.

Solutions?

The Irish Government plans to reduce its 2011 Budget by €6 billion more than previous projections via spending cuts and tax rises in a bid to manage its debt. The trouble is the Government projections assume the Irish economy grows by 1.75% next year and unemployment of 13.25% (it was 14.1% at the end of September). This seems overly optimistic to me, especially given the looming Budget cuts, and I can't see it happening.

I think it's almost inevitable the EU will have to step in with a bailout and that Ireland's road to economic recovery could be long and very expensive.

How might this affect the UK?

If an EU bailout is required then the bulk will come via the eurozone countries, so the UK's contribution is likely to be relatively small. But Ireland's troubles could hit us harder in other ways.

The UK banks who've lent around £143 billion money to Irish borrowers could suffer from rising bad debts. RBS alone has £53.3 billion of Irish loans on its books.

British exports to Europe, already falling, could further decline in light of Ireland's woes. Austerity measures in Ireland and the strain of a EU bailout on constituent country finances will almost certainly be bad news for British exporters.

Conclusion

While not a major surprise, Ireland's troubles are bad news and a reminder of just how big a mess global economies are still in. Stockmarkets continue to surprise with their ignorance of the dark cloud overhead, or maybe I'm just too pessimitic...

Read this article at http://www.candidmoney.com/articles/article172.aspx