Monday, November 15, 2010

Q&A with Suzanne Lynch - Irish Times

The Irish Times - Tuesday, November 16, 2010


Why all the fuss, if Ireland is fully funded until next year? SUZANNE LYNCH
There are two reasons. First, the “contagion effect” – the unsustainable level of Irish 10-year bond yields has pushed up the borrowing costs of other euro-zone countries. Even though Ireland may well be fully funded into next year, this is not necessarily so for other countries. Secondly, while the State has enough money to sustain its expenditure into next year, there is a fear that the Irish banks do not. Because the State is now responsible for the banks, the Government must fill any capital hole that may arise in the banks.
Banks source funding from depositors and international markets. A trading update from Bank of Ireland last Friday showed that, while retail and commercial depositors have kept their money in the bank, international customers withdrew an estimated €10 billion over a five- to six-week period ahead of the expected expiration of the bank guarantee at the end of September.
International investors have all but exited the Irish banks completely, with the result that the ECB is providing almost all the banks’ funding. Figures also released on Friday, showed the ECB had €130 billion on loan to Irish banks at the end of October, 7.3 per cent more than the previous month. Evidently the ECB is becoming increasingly uneasy about the level of its exposure to Irish banks.
Why has the bond market reaction been so aggressive and why does it matter? 
Governments, and companies, issue bonds to raise money to fund themselves. In exchange they pay a fixed rate of interest. These bonds are then traded on the financial markets. As the value of Irish bonds fall, the yield, or real interest rate, on these bonds increases.
The yield on government debt has soared to unsustainable levels in recent weeks, signalling that investors have lost confidence in Ireland’s ability to repay its debts. While this does not directly affect the country’s interest payments – the annual yield is set when a bond is issued – the yield has soared for those buying and selling bonds in the market and sets the price of subsequent government bond issues.
But is this high interest rate not good for investors in Irish bonds? 
Yes – 8 or 9 per cent represents a colossal return for investors, but, as one Dublin trader put it yesterday, it is simply too good to be true.
While there was a certain category of investor buying in when yields were at 5 or 6 per cent, once they hit 8 and 9 per cent, there was a sense that something must be amiss. The seemingly unrelenting rise in yields becomes self-perpetuating as more investors sell in a bid to get out of the market.
The other difficulty in analysing the movements in bond and yields on the debt markets is that the market is highly illiquid.
The demand for Irish bonds has virtually dried up, with only the 16 financial institutions or “market makers” who are recognised by the NTMA as the primary dealers of Irish bonds buying and selling. The other main buyer is the ECB, although information released yesterday shows it did not of late increase its level of buying by as much as may have been expected.
Why can’t Irish investors buy more Irish bonds to support the market? 
As Donal O Mahony of Davy pointed out yesterday, there is a disproportionate scale of foreign ownership (80-85 per cent) in the Irish bond market. Foreign domestic pension fund and insurance companies own only €6 billion in Irish government bonds from a pool of €65 billion.
Irish pension funds are benchmarked across German bond rates. There is a school of thought that argues that this should be switched to a “sovereign annuity”concept based on Irish government bonds.
As well as creating a demand for Irish bonds, it would also reduce the funding deficits of Irish pension funds that have arisen because of record low German yields.
The problem is that it is doubtful whether pension trustees could justify investing a disproportionate percentage of their members’ funds in a potentially risky investment.
What happens if Ireland taps the fund? 
The fund in question is the €750 billion EU fund created in May. Approximately €450 billion of this relates to the European Financial Stability Facility.
The remainder of the fund comprises a €250 million contribution from the IMF and €60 billion from the European Commission to which Britain also contributes.

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