Financial market reaction to Ireland’s four-year budget strategy, out later this month, and its 2011 budget, due in December, will be crucial in determining whether the country seeks an EU-IMF bailout—an increasingly likely prospect. The EU is discussing currently a possible bailout for Ireland. This week, senior European officials laid the groundwork for a bailout of Ireland that could reach €100 billion. Investors have been shunning Irish sovereign bonds since late October. The government's borrowing costs hit record highs as concerns increased about its ability to reduce its large fiscal deficit. Several euro-zone countries urged Ireland to adopt an aid package.
The Irish government says it has been holding talks on how to provide stability for its banks and finances but denies a state rescue is needed to stop its problems spilling into other countries. The government has not applied for a bailout for several reasons: It does not need to refinance its debt until into 2011, it's reluctant to relinquish its national sovereignty over fiscal policy, and officials fear that such a move would discourage foreign investment—a key driver of the economy since the 1990s. However, some EU officials are concerned that Ireland's resistance could cause the crisis to spread to other countries such as Portugal and Spain, southern Europe’s largest country. This would greatly strain Europe's rescue capacity and pose a severe threat to the euro's survival. The yield on Portuguese and Spanish bonds have also increased sharply over recent months as investors sold off bonds.
If Ireland has to tap the emergency EU-IMF stabilisation fund—as appears increasingly likely. After the euro-zone bailout of Greece in May, the currency union established a bailout mechanism made up of €60 billion of loans financed by the EU's own budget, €440 billion worth of loan guarantees from other euro-zone countries and up to €250 billion from the IMF.
A bailout for Ireland would have damaging long-term implications for its economy. The EU would like to Ireland to increase its corporate taxes from 12.5%, the lowest in the EU. The country will lose a key draw for foreign firms. Also, a positive market reaction is not guaranteed, because the government has already sharply tightened fiscal policy over the last two years. The outlook for Ireland’s expected return to the bond market in July looks unfavourable. The probability of Irish sovereign bond yields falling substantially is deteriorating. The government will have to provide massive reassurance to investors in the next couple of months that it is committed to drastically improving public finances. Nevertheless, the political consensus is faltering, which is adding to investors' concerns.
Disclosure: no positions