A Latvian solution to an Irish problem?
By pursuing the right policies, Ireland can change the narrative of inevitable default, writes John Looby
The list of domestic and international commentators arguing that some form of Irish debt default is inevitable has been growing by the day. Whether making a moral case – Irish tax-payers should not be responsible for the debts of private banks or a practical one – Irish tax-payers will prove unable to shoulder the likely debt burden now faced, such commentary has led to an increasingly settled consensus in recent weeks. This consensus view is often adorned by the alleged comfort offered by the post-default experiences of Argentina, Russia or Kazakhstan and is often expressed in a tone of growing impatience with the continuing failure of the Irish authorities to bow to the inevitable. I disagree.
The global financial crisis has impacted across different economies with varying degrees of severity. While countries such as China, Canada and Australia have been relatively unscathed, the previously booming Baltic region has been especially hard hit. Latvian GDP, for example, contracted by almost 25% in 2008-09, the unemployment rate rose from under 5% to over 17% and the government budget deficit for 2009 (under unchanged policies) was sent ballooning towards 18% of GDP.
Heightened doubts about the sustainability of the currency peg to the euro in the face of the global crisis sparked a collapse in investor confidence, a flight of capital, a sudden contraction in credit and a sharp rise in the cost of government and bank borrowing. In effect, Latvia was engulfed by a cycle of vicious negativity which sent its economy into freefall.
The overwhelming consensus by the spring of 2009 was that devaluation and debt default was inevitable. Unable to access the debt markets, the Latvian authorities were forced to seek the external support of the IMF, the EU and their near Nordic neighbours and a package of loans was approved by the ECOFIN council in January 2009. Facing a continuing cycle of negativity, the inevitable devaluation and debt default was expected to follow and the yield (interest rate) on the Latvian (euro-denominated) government bond maturing in March 2018, soared to almost 12% by March 2009.
With the continuing support of the international community however, the Latvian authorities have implemented a range of policies which have restored the government finances to a credibly sustainable path. The consensus narrative of devaluation and default has come unstuck. There has been no break in the currency peg to the euro. There has been no debt default. Fuelled by restored competitiveness, Latvian exports are booming and the economy is growing again. Confidence and capital have returned and the yield (interest rate) on the March 2018 government bond is now touching 5%. The inevitable of 18 months ago has turned out to be avoidable.
Some of the key policies implemented were:
• A 20% cut in the average public sector salary in the 2009 budget followed by a further 5% reduction in the 2010 budget
• A reduction in the number of government agencies from 76 to 39
• A reduction in the number of hospitals from 59 to 42
• An increase in the main VAT rate from 18% to 21%
These and other measures have combined to put the Latvian government budget deficit on a sustainable path of below 10% of GDP in 2009, below 8.5% of GDP in 2010, below 6% of GDP in 2011 and below 3% of GDP in 2012.
Despite the extraordinary difficulties of recent years, Latvia has chosen to make the decisions to underpin its longstanding policy of becoming a credible member of the euro zone in 2014. The short-term attractions of a populist refusal to restore its government finances to a credibly sustainable path have been eschewed in favour of the long-term benefits of participating fully in the evolving European project.
The message for Ireland is clear. Debt default need not be the inevitable outcome of being engulfed in a cycle of vicious negativity and economic freefall. Economic recovery can be embarked upon without taking an existential risk with our banking system and currency. Our policy-makers are not powerless in battling a widely expected inevitable slide into an experimental unknown.
By pursuing policies which return our government finances to a credibly sustainable path, the Irish authorities can follow the example of our Latvian neighbours and change the narrative of inevitable debt default into one of restored credibility and renewed prosperity. It need not be the case that we are locked into a static, vicious cycle of fiscal austerity, begetting low growth, begetting an intractable deficit and yet more austerity, which can only be broken by a dramatic default.
A dynamic, virtuous alternative of fiscal credibility combining with regained cost competitiveness, begetting rising exports/revenue/confidence, begetting recovering growth and a narrowing deficit can be the path that Ireland follows. Indeed the consistently improving trend in exports, output and exchequer returns over recent months, culminating in the better than forecast out-turn for 2010, suggests that this process may possibly be already under way. Despite the turmoil of recent times the choice remains ours to make this a compelling certainty. There is nothing inevitable about our current predicament. We should look to Latvia.
John Looby is an Investment Manager at Setanta Asset Management.