Eurozone restructuring inevitable after Irish bailout

The restructuring of the eurozone and its debt is inevitable, as today’s Irish bailout details have shown. The questions now are which areas, how much and when.

If debt is a promise to borrow a sum and repay it with interest, the eurozone has clearly discarded its pledges. On their own, massive spending cuts will hit the eurozone’s revenues and reduce its capacity for payment, as Ireland has proved.

Under current market conditions, Greece, Ireland, Portugal and Spain are unlikely to pay back lenders in full, especially as they and their troubled institutions owe them multiples of their own GDP.

As a result, debt restructuring has already started. As authorities bailed out Ireland, Anglo Irish Bank agreed a voluntary debt swap with its lenders. In certain areas, the swap reduced Anglo Irish’s repayments by 80%.

Under the terms of Ireland’s bailout announced today, junior lenders to Irish banks are due to take more pain. According to Reuters, senior bondholders are ringfenced – as are lenders to the Irish government. But it is questionable whether such deals will be sustainable, given the magnitude of debt outstanding.

Agreeing voluntary debt swaps may hurt pension funds and banks, which may have to cut their pension offers and lending to their customers. But willing action now could be far better than the alternative. (article continues below)

The European Financial Stability Fund (EFSF), Europe’s bailout authority, is offering investors such attractive terms that they are fleeing the debt of potential bailout recipients.

For investors who see Greece, Ireland, Portugal and Spain as a bombed-out opportunity, the EFSF is a much better way of playing it.

If you can invest in AAA-rated bailout debt from the EFSF, guaranteed by powerful nations like Germany, why invest in the bonds of potential bailout recipients?

Haircuts would the polite way of phrasing it – “off with their heads” would be more appropriate

The EFSF gives investors the chance to cast a no-brainer vote in favour of bailouts and a fiscal union for the eurozone, where the budgets and debt of peripheral nations are centrally controlled.

Following events in Greece and Ireland, a bailout of Portugal now looks almost unstoppable. Spain is looming round the corner. To avoid an austerity death spiral, the EFSF and the IMF are unlikely to agree to repay both their lenders and their banks’ lenders in full. They will instead agree discounted repayments that will cause the minimum of contagion.

At that stage, whether the discounts are voluntary will make little difference. Bonds will be herded into a foot-and-mouth-style abattoir and slaughtered. Haircuts would the polite way of phrasing it – “off with their heads” would be more appropriate.

If the Greek and Irish model is used, the bailout of Spain will be the size of the Troubled Asset Relief Programme after the Lehman bankruptcy. It seems doubtful the international community will be able to pay for this without a large-scale debt restructuring.

If the restructuring required is on a Lehman scale, institutions accepting discounts would sell stocks and debt worldwide. Traders and shorter-term investors would follow. Corporate earnings may not dip catastrophically – the world could avoid a double-dip recession – but the market’s rating of them would decline.

Lenders to the EFSF and the IMF, by contrast, are unlikely to be affected. Authorities are unlikely to encourage lenders to bailout mechanisms by offering them discounted repayments. In the case of EFSF, repayment is guaranteed by the eurozone. Any discounts would be visited on eurozone governments, not lenders.

After the flood, the rainbow would be a federal eurozone bond market, which could cover all members, including Italy, France and Germany. The only question would be whether eurozone citizens would tolerate central control over their budgets and, by extension, the euro system itself.