Capital Flows

In the midst of the financial crisis of 2008, governments helped to prevent bank runs by guaranteeing bank debts. Yet as sovereign solvency itself becomes an issue, such guarantees quickly lose their value. If Ireland provides a rule of thumb, bank runs can be expected once sovereign credit default swap yields pass 3%. The figure above shows that when Irish government CDS yields first passed 3% in early 2009, foreign deposits fled the country. This happened again in late 2010. Now that Spanish CDS yields have broken the 3% threshold, there is reason to be concerned about the stability of Spanish bank deposits as well. Steil, Swartz: When Irish IOUs are Smouldering Geo-Graphics: Luck of the Irish Hinges on Banks Economist: European Banks Barr: 2011-Year of the Bank Run?

The EU-IMF Irish bailout gives Ireland a window of opportunity to solve its problems, but how large a window is it? Although the €85 billion headline number appears to be very large, at over 50% of Irish GDP, the funds must be benchmarked against what they are being earmarked for. €50 billion is tagged for public finances, which will cover two years of public debt refinancing and deficits. This provides a significant window for Ireland to achieve fiscal improvement. However, the window provided by the €35 billion tagged for banking sector recapitalization is much smaller. Over €34 billion of foreign deposits fled Irish banks in September 2010 alone. Over the past two years, Irish banks’ balance sheets have shrunk by over 9%, while their funding reliance on the European Central Bank has increased from 5% to 9% of total liabilities. This suggests that any Irish bailout plan, to be credible enough for the markets, must ensure that the Irish government ceases adding bank debt to its public debt. That will almost surely involve a restructuring – that is, a significant partial default – on the bank debt. Such a restructuring, however, will raise a slew of new bailout questions, since German, French, British and other European banks holding Irish bank debt may themselves require public assistance to remain acceptably capitalized. Wolf: Why the Irish Crisis Is Such a Huge Test for the Eurozone Economist: Dealing With Bad Banks Eichengreen: Ireland’s Reparations Burden Wolverson: Aftershocks of the Ireland Bailout Geo-Graphics: Bank Burden

The risk of corporate debt is often measured by looking at the spread between its yield and similar ‘risk-free’ government debt. The higher the spread, the greater the risk. However, when government credit comes into question, this spread is no longer suitable as a measure of corporate risk. The spread does, nevertheless, tell a story about relative risk. In Greece, Ireland, and Portugal, a number of sectors have negative corporate spreads, suggesting that firms are either less likely to default than their governments or will have higher recovery rates if they do default. The sector that stands apart as being much riskier than the government is financials. If these governments partially default, the guarantees they have made to the banking system are no longer credible, and the credit losses may be severe. Economist: Ireland's Public Finances Geo-Graphics: Greek Debt Crisis – Apocalypse Later Steil: Don't Blame the Euro for Greece's Woes Oakley, Hope: Greece Rules Out Possibility of Default Ross-Thomas, Lima: Portuguese Budget Deficit Widens 5 Percent as Borrowing Costs Hit Record