Renewed policy commitment in the euro area to address the dysfunctional monetary transmission mechanism in non-core Member States has helped to ease sovereign stress and significantly reduce the risk premium on Irish sovereign bonds. However, low domestic growth and high public debt continue to drive sovereign risk.
Possible domestic triggers for a heightening of sovereign risk include unforeseen increases in the capital needs of the banking sector and, more significantly, any slowdown in economic growth that undermines the sustainability of public debt. Potential international triggers include external growth shocks, euro area sovereign defaults and a failure to sever the link between sovereign debt and banking debt.
Sovereign risk premia rose sharply for Italy and Spain during the first half of the year amid an increase in banking-sector strains in Spain and fears of contagion to Italy. As noted in the Overview, recent policy commitments have alleviated some market stress.
Irish banks have limited direct exposures to other vulnerable euro area countries but the Irish economy remains indirectly exposed to foreign default risk. Any future default by a euro area country would likely trigger contagion, leading to an abrupt revision of sovereign risk premia and an escalation of redenomination risk.
Irish sovereign bond spreads narrowed by almost a full percentage point after euro area leaders agreed in June to permit the European Stability Mechanism, the euro area's
permanent rescue fund, to recapitalise banks directly. Nevertheless, Irish sovereign risk remains acutely sensitive to future domestic economic growth and debt sustainability.
While Ireland has so far met the fiscal targets set in 2010 as conditions for receiving financial support from the EU and IMF, an inability to meet future budget targets or a prolonged contraction in growth would threaten fiscal recovery and heighten sovereign risk. With public debt converging only gradually towards a trajectory where the debt-to-GDP ratio reduces over time, there is limited capacity to provide a discretionary fiscal buffer in the face of an unforeseen shock. The projected debt-to-GDP ratio remains highly sensitive to both positive and negative shocks to GDP growth .
Any unforeseen increase in the size of the contingent fiscal liability of the domestic banking system, stemming for instance from explicit Government guarantees of bank liabilities, continues to represent a sovereign risk. Explicit Government guarantees to the domestic banking sector have declined during the past four years, with bank-liability guarantees excluding deposits (under the government's Eligible Liabilities Guarantees scheme) falling from €375 billion in 2008 to €78 billion in
September 2012 (48 per cent of GDP).
Debt issued by the National Asset Management Agency and used by domestic banks as collateral to raise funding from the ECB receives Government guarantees equalling 18 per cent of GDP, while Government support to the banking sector in the form of promissory notes represents a liability of 19 per cent of GDP.
While these guarantees are explicit, the extent of other contingent fiscal liabilities remains uncertain, such as those stemming from the restructuring of, or further losses incurred by, domestic credit institutions given the State's large equity stake in the banks. Credit institution losses could conceivably rise in the short term following the implementation of the new personal insolvency legislation. However, this legislation is an important part of the solution for managing private-sector indebtedness and promoting long-term growth.
Possible domestic triggers for a heightening of sovereign risk include unforeseen increases in the capital needs of the banking sector and, more significantly, any slowdown in economic growth that undermines the sustainability of public debt. Potential international triggers include external growth shocks, euro area sovereign defaults and a failure to sever the link between sovereign debt and banking debt.
Sovereign risk premia rose sharply for Italy and Spain during the first half of the year amid an increase in banking-sector strains in Spain and fears of contagion to Italy. As noted in the Overview, recent policy commitments have alleviated some market stress.
Irish banks have limited direct exposures to other vulnerable euro area countries but the Irish economy remains indirectly exposed to foreign default risk. Any future default by a euro area country would likely trigger contagion, leading to an abrupt revision of sovereign risk premia and an escalation of redenomination risk.
Irish sovereign bond spreads narrowed by almost a full percentage point after euro area leaders agreed in June to permit the European Stability Mechanism, the euro area's
permanent rescue fund, to recapitalise banks directly. Nevertheless, Irish sovereign risk remains acutely sensitive to future domestic economic growth and debt sustainability.
While Ireland has so far met the fiscal targets set in 2010 as conditions for receiving financial support from the EU and IMF, an inability to meet future budget targets or a prolonged contraction in growth would threaten fiscal recovery and heighten sovereign risk. With public debt converging only gradually towards a trajectory where the debt-to-GDP ratio reduces over time, there is limited capacity to provide a discretionary fiscal buffer in the face of an unforeseen shock. The projected debt-to-GDP ratio remains highly sensitive to both positive and negative shocks to GDP growth .
Any unforeseen increase in the size of the contingent fiscal liability of the domestic banking system, stemming for instance from explicit Government guarantees of bank liabilities, continues to represent a sovereign risk. Explicit Government guarantees to the domestic banking sector have declined during the past four years, with bank-liability guarantees excluding deposits (under the government's Eligible Liabilities Guarantees scheme) falling from €375 billion in 2008 to €78 billion in
September 2012 (48 per cent of GDP).
While these guarantees are explicit, the extent of other contingent fiscal liabilities remains uncertain, such as those stemming from the restructuring of, or further losses incurred by, domestic credit institutions given the State's large equity stake in the banks. Credit institution losses could conceivably rise in the short term following the implementation of the new personal insolvency legislation. However, this legislation is an important part of the solution for managing private-sector indebtedness and promoting long-term growth.
