Making Bondholders Pay?

The Irish Economy debates the merits of proposals from Fine Gael to allow the banks to default on bondholders. There have been naïve claims from the government that such a move would increase the cost of lending for the state.

Meanwhile, such talk pushes up the cost of lending for Irish banks. It effectively makes the guarantee of bank debt by the government null and void in the minds of investors, and chills them to the prospect of lending.

Fine Gael are suggesting that the government announce that the wholesale guarantee on bank liabilities will not be renewed beyond September 2010. This would have the impact of pushing up the cost of lending for Irish banks, who are having difficulties as it currently stands raising any money even with the government guarantee.

This would be the final nail in their coffin. Given that the market for bonds is already saturated and favours buyers, banks will find the cost of capital skyrocket if such talk continues. Regardless of the incumbent government’s denials, bondholders will take this as a signal from the possible incoming government.

It’s very clear that this talk, in such a public arena, was politically motivated and not considered in the context of a broader strategy to tackle the banking crisis. Unfortunately, tax-payers will pay the price for such populism – as the default risk premium of bank bonds rise, so too does the default risk of financing all government debt by proxy.

Fianna Fáil Minister for Finance, Brian Lenihan’s response to the plan is haphazard at best. He claims that defaulting on bank debts will raise the cost of debt for the Irish state, which is just wrong.

The impression that you get from public dialogue in Ireland is that international investors who lend to the Irish government are emotional, irrational people who are doing us a favour by purchasing bonds. If such people exist, luckily they are only in a minority.

Although capital is scarce and the market for government bonds in Europe is saturated, removing the government guarantee for bank liabilities would not push up the cost. If some investors were irrationally chilled to the prospect of lending to Irish institutions, they would miss out on a profitable opportunity. The fundamentals of Ireland’s economy and its government would still be exactly the same.

These are the determinants of the price and demand for Irish debt. Investors are not foolish and do not spend billions of euro based on impressions or heuristics. If only the same could be said for the Irish government.

© The Free Marketeer 2009

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