End of Irish Europe Love Affair May Hurt Bonds

Ireland is falling out of love with Europe, and the consequences may be costly.

The country is preparing to vote for a fifth time in 11 years on a European Union treaty. Unlike previous referendums, an Irish rejection of the euro region’s latest financial agreement wouldn’t veto the deal for the rest of Europe. For Ireland, it may spell rising bond yields, tougher access to money and questions over its euro status.

“Although Ireland remains a pro-euro country, the love affair with Europe has definitely suffered in recent years,” said Frank Oeland Hansen, a senior economist at Danske Bank A/S from Copenhagen. “The referendum may cause some negative sentiment for Irish sovereign risk in terms of question marks over Ireland’s long-term position in the euro and how the government hopes to return to the bond market.”

The specter of the vote is looming over markets just as investors had become more sanguine about Ireland’s prospects of reviving its crippled economy and avoiding a second bailout by the EU and International Monetary Fund.

Before Prime Minister Enda Kenny announced the referendum on Feb. 28, the yield on Ireland’s 2020 bond, its benchmark, had dropped to 6.81 percent, less than half the euro-era high of 13.8 percent on July 18. It has since risen to 6.97 percent, 535 basis points more than German debt of similar maturity. No date has yet been set for the vote.

“I would expect uncertainty to seep into the Irish sovereign,” said Cathal O’Leary, head of fixed income at NCB Stockbrokers in Dublin. “The run it has been on for the past three months may come to a halt.”

No Exit

Finance Minister Michael Noonan said in December a vote on the so-called fiscal compact agreed by EU leaders would effectively be a ballot on euro membership. Opponents of the treaty dispute that view, and since the vote was announced, the government has stepped back from euro-exit rhetoric. The vote will give the Irish a chance to reaffirm commitment to the euro, Deputy Prime Minister Eamon Gilmore said.

“Irish people understand the importance of the euro,” Gilmore said in a Feb. 29 interview. “As a small very open economy dependent on trade and foreign direct investment, the issue of confidence in the country and confidence in the currency that we hold is hugely important.”

Irish voters rejected changes to Europe’s governing treaty in 2001 and 2008, before reruns passed the proposals. The Irish veto held up the rules coming into force. This time, just 12 of the 17 euro countries must back the financial treaty, which sets new budget rules and broadens a bailout fund, to take effect.

Storm in Guinness

“Ireland’s decision to hold a referendum will most likely end up as a storm in a pint of Guinness than a major stumbling block in the path of the successful implementation,” said Simon Smith, chief economist at foreign-exchange broker FXPro Group Ltd. in London. “Ireland has a history of creating a fuss but then falling into line with such referenda.”

Irish voters may be concerned about the implications of rejecting the treaty, two surveys published yesterday signaled. The polls, commissioned by the Sunday Business Post and the Sunday Independent newspapers, show the “yes” side has a lead of about 20 percentage points as the campaign opened.

The polling figures only include people who expressed a preference. Previous unsuccessful campaigns have seen support for European treaties erode as the vote neared.

Default Swaps

The euro has weakened since the Irish announcement on Feb. 28. The cost of insuring against Ireland defaulting for five years rose 15 basis points to 595, according to prices from data provider CMA. That implies a 40 percent probability of Ireland failing to meet its obligations within five years.

An Irish rejection in the plebiscite may deprive the country of possible future aid once the euro area’s permanent bailout fund goes into operation. While the nation’s 67.5 billion-euro ($89.5 billion) international rescue in 2010 means the state is fully funded through 2013, the government is aiming for a full return to credit markets next year.

“The negotiation of any additional support at the end of the existing program could be seriously compromised, which might result in significantly higher cost of funding for the Irish economy,” Royal Bank of Scotland Plc economists, including Nick Matthews, said in an e-mail on Feb. 28. “The negotiating power vis-à-vis other European and international creditors will be significantly undermined by a refusal to ratify the compact.”

Austerity Focus

To be sure, an Irish rejection may not be pain free for politicians elsewhere in the region because it may focus European voters on the pain of austerity measures. The compact requires nations to virtually eliminate structural deficits, creates an “automatic correction mechanism” and enshrines the new measures in national law.

The treaty also provides for tighter control of tax and spending by governments that overstep the bloc’s deficit limit of 3 percent of gross domestic product. Francois Hollande, the Socialist candidate in France’s presidential election, has said he may seek to renegotiate the compact should he defeat Nicolas Sarkozy in April and May voting.

“There is likely widespread public disapproval of the fiscal straightjacket, not just in Ireland, but across Europe,” said Ciaran O’Hagan, head of euro-area rate strategy at Societe Generale SA in Paris. “So an Irish ‘no,’ unlike how events unfolded in Greece, will find widespread support.”

The implications for Ireland may be greater, as the nation struggles to escape its worst recession in modern history and seeks European help to reduce the burden of banking debt.

“It is clear that ratification can go ahead without support from Ireland,” said Dermot O’Leary, an economist at Goodbody Stockbrokers in Dublin. “A ‘no’ vote by Ireland would certainly leave the country isolated in the euro-area.”

To contact the reporter on this story: Dara Doyle in Dublin at ddoyle1@bloomberg.net

To contact the editor responsible for this story: Tim Quinson at tquinson@bloomberg.net

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