Why the Irish debt crisis matters

Ireland's sovereign debt crisis was almost entirely caused by its blanket guarantee of the banking sector.

Before the financial crisis, the sector was over-leveraged, over-sized, and fueled the country's bubble economy and bubble real estate sector. When the economy and housing market collpased, Irish banks were left with steep losses. In response, Ireland bailed out its banks and guaranteed all of their unsecured senior debt.

The bailout puts Ireland's budget deficit at over 30 percent of GDP and the public debt as high as 176 percent of GDP, said Jacob Kirkegaard, a research fellow at the Peterson Institute for International Economics (PIIE), citing Eurostat data. The public debt-to-GDP figure compares to only 39 percent for Britain, which has the second highest liability from bailing out the banking sector.

If Ireland did not have bank bailout liabilities, its budget deficit would be about 10 percent of GDP and the public debt about 60 percent of GDP. While those numbers are not great, they're certainly not in crisis territory.

However, Kirkegaard said if Irish banks were allowed to collapse, the Irish economy may go down with it and trigger a global banking crisis.

From this perspective, Ireland's public finances and economy is in terrible shape and the banking sector has just masked it until now. The scenario of 10 percent deficit and 60 percent public debt, then, is unrealistic.

The global banking exposure to Ireland is also much higher compared to Greece. Using Bank for International Settlements (BIS) data, Kirkegaard/PIIE estimated the exposure to be $500-billion, which is more than three times the exposure to Greek debt.

So even an isolated Irish economic collapse -- meaning it won't trigger other sovereign debt and economic crisis, which is a generous assumption -- would be quite dangerous to the banks that hold their debt and the countries that must bail those banks out.

German and British banks combined for over half of the exposure. The United States is the third highest after Germany and Britain. Therefore, the European Central Bank (because of German influence), the U.K., and the International Monetary Fund (IMF) -- because of U.S. influence -- all have incentives to bail out Ireland.

The U.K. chancellor, in fact, said Britain wants to be a good neighbor and promised to lend billions of sterling pounds to Ireland, perhaps even independent of the IMF or ECB bailouts.

Kirkegaard said it's a foregone conclusion that Ireland will receive aid; the only question is what kind and on what conditions.

Ireland has so far refused to request any European, IMF, or U.K. aid.

Kirkegaard said this was predictable as the Irish play a game of chicken to receive better terms. Secretly, Ireland may be hoping for its sovereign debt woes to spread to countries like Spain, he said.

If that happens, Europe would be desperate for Ireland to accept a bailout and likely give the country generous terms.

The Irish want to keep their low corporate income tax rate of 12.5 percent. Even better, they could retain fiscal sovereignty if the aid goes to the banks only and not to the government.

Email Hao Li at hao.li@ibtimes.com

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