On November 28, 2010, the Irish government finally announced a loan bailout package agreement amounting to 85 billion EUR to rescue its banks. The details of the package reveal that the government will chip in 17.5 billion EUR of the total amount while the rest will be funded externally, using loans from the U.K., Denmark, and Sweden. The agreement also stated that Ireland will be given an additional year to make sure that it is able to trim its budget deficit to just 3%.
You’d think that the news would trigger a wide-reaching case of risk appetite in the markets, similar to what happened when Greece received a bailout earlier this year. However, things were quite different this time around, as Ireland’s bailout package did very little to calm the markets. In spite of the new developments, EUR/USD found itself dropping to new lows on Monday, just a few pips under the 1.3100 handle.
You’ll notice that when Greece accepted a bailout, the immediate response was a drop of almost 60 percent on its two-year bonds. On the other hand, yields on Ireland’s bonds, only fell by a measly 4 percent.
Why is this significant?
Determining bond yields is very similar to how your local bank charges interest on its loans. When banks loan out money, they try to make sure that the interest they charge is representative of the risk they take. If the risk is high, then they must be compensated with higher interest payments. And when the risk the bank takes is low, then asking for lower interest payments is okay, because the borrower will most likely be able to pay.
Yes, there are still some risks involved with Ireland’s own rescue package. There’s a chance that the package may be too small and there’s a possibility that interest rates on its loans may still be too high for Ireland to pay.
But what really has the markets worried is the risk of contagion. Think about it. Why would investors celebrate the “rescue” of one country when Spain, Italy, and Portugal are on the verge of getting bailed out as well?
If you need proof that the lack of confidence is beginning to spread, look no further than Italy! Just this Monday, Italy held a bond auction that, on the surface, looked to be successful. Italy was able to auction off about 6.8 billion EUR worth of debt.
But take a closer look and you’ll see all is not well. The bonds were sold with interest rates 0.50% higher than just a month ago! The fact that investors need more incentive (in the form of higher interest rates) to loan money to Italy is a clear sign that markets are beginning to feel concerned for it, too.
With all these debt concerns, worries about the euro zone breaking up are beginning to surface again. Could it be that the EU has dug its own grave by bailing out Ireland and, even prior to that, Greece??
Hotshots from the European Commission have clarified time and again that disintegration won’t happen because the costs associated with it are ridiculously high. But you can’t blame some market participants for thinking so given that threats of debt contagion are becoming as real as ever.
This was what I was talking about a few months ago, when the EU and the IMF provided Greece with an excuse to pass on its debt. Now with Ireland following suit, it seems like the loophole is big enough for a few more debt-ridden euro zone members to go through.