Baccardax: The Wrong Irish Referendum

If stock markets are about poetry (and certainly more tragedy than comedy these days) bond markets are a lot more about prose. So it’s easy to see the iron in the fact that the finances of the nation of poets is coming under real and sustained pressure not from what’s happened in its equity markets, but rather its debt.

The former Celtic Tiger has clearly fallen on hard times of late, and is expected to contract by at least 5 percent this year, the most of any euro zone member state. Major names in it banking sector have been nationalized, and investors anticipate further government intervention before the rot is completely stopped.

To wit, Finance Minister Brian Lenhian will pump another 7 billion euros ($ 9 billion) directly into Allied Irish Banks and Bank of Ireland and may throw lifelines to the EBS Building Society, Irish Life & Permanent and the Irish Nationwide Building Society. The state is also on the hook for a 400-billion-euro backstop to bank bonds and depositors promised last year.

Against this backdrop, the British Broadcasting Corporation is reporting that Ireland is considering bringing forward its (second) referendum on acceptance of the Lisbon Treaty, which is essentially a vote on closer European Union integration, from October to June.

If you ask me, the government seems to be focused on the wrong referendum. They should be looking to the bond markets -- which are effectively a daily referendum on the state of a nation’s financial affairs. At present, the votes are in, and the result isn’t good.

Traders of credit default swaps (derivatives that act as insurance against a country or a company failing to pay its debts) are trading at record highs this week, effectively ranking the risk of default for Ireland (which still holds a triple-A rating) as roughly equal to that of the Philippines, a deep-junk rated B1.

Ireland’s woes have ignited further investor concern about the health of euro zone members Greece and Spain, pushing the spread (or the extra yield investors demand to hold that debt instead of German government bunds) to record levels of 127.5 basis points and 281 basis points respectively. Simultaneously, yields on short-dated German governments bonds, the so-called schatz, have touched records lows of 130 basis points and investors pile into the safest fixed-income product on the continent.

Is the Irish default scenario overdone? Probably, at least for the moment. Even though its growth (and therefore its tax base) has been built on the surreal sand of international financial services and property, and its debt to GDP ratio will probably touch 54 percent by the end of the year, it still enjoys the full financial support of its euro zone brethren, has a relatively low level of government debt when compared to countries like Italy, Greece or, indeed Japan.

But, sticking with the prose theme, you can’t ignore the fact that Ireland’s not a currency issuer, and it can’t devalue the euro to “start-over” as many nations used to do in the past. Its efforts to reflate will increase borrowing -- and borrowing costs -- for years to come, potentially creating a debt trap where current service payments cannot be met but current GDP growth. Japan is facing down the barrel of that gun right, now. But it need not default on yen-denominated debt. It prints its own cash (or more accurately, credits the accounts of its own banks). Ireland can’t do this. Nor can Spain, Greece Italy or any other member of the single currency.

At present, Irish voters seem to be looking to the short-term support of the euro zone (or, more simply, German taxpayers) with an estimated 51 percent now in favor of supporting a treaty they rejected 8 months ago.

The longer-term implications of extracting an economy from the protracted crisis amid the shackles of the single currency seem too painful for the poets to contemplate at this point. But the more straight-forward prose seems to have turned the books ahead a few hundred pages to the final chapter.

And let’s face it, the bond market has been right on this sort of thing before.