World-Beating Bonds Mask Irish Bailout Exit Hurdles: Euro Credit

Ireland’s dash to the bailout exit door is turning into more of a stagger than a sprint.

Labor unions representing government-paid workers staged their biggest revolt after five years of spending reductions and tax increases. They voted last week against salary cuts and longer working hours aimed at saving 1 billion euros ($1.3 billion) a year and narrowing the third-biggest budget shortfall in the euro region. Prime Minister Enda Kenny is trying to find a way to break the impasse.

“The rejection of the pay deal serves as a reminder of the banana skins that still exist in reducing budget deficits to sustainable levels,” said Dermot O’Leary, an economist at Goodbody Stockbrokers, adding Ireland still remains “odds-on” to become the first country to exit a rescue program.

Renewed confidence in the country’s ability to pay its debts helped Irish bonds return 7 percent in dollar terms this year, the world’s best performers based on 26 indexes compiled by Bloomberg and the European Federation of Financial Analysts Societies. The yield on Ireland’s 10-year bonds fell 60 basis points this month to 3.62 percent today.

Austerity Hit

The pushback in Ireland reflects a wider debate across the euro region on the merits of cutting deficits so quickly. European Commission President Jose Barroso said this week that austerity had “reached its limits in many aspects.”

Until now, Ireland has soaked it up without the widespread opposition and civil unrest seen in Greece, the first recipient of international aid and where voters deserted the two main political groups. In Portugal, which is seeking to follow Ireland in exiting its bailout program, protesters gathered in cities on March 2 as the government raises taxes.

Kenny, who turned 62 yesterday, took power two years ago following his Fine Gael party’s best election result since Irish independence from the U.K. in 1922. Kenny told lawmakers two days ago that the government has asked a mediator to see if there’s a basis for reopening talks with the unions. He expects an answer within two weeks, he said.

“Increased political risk may well become a variable that investors will have to assess,” said Ryan McGrath, a Dublin-based analyst at Cantor Fitzgerald LP. “Noise surrounding the public pay deal may have some limited impact on bond yields, but a lot will depend on how the government handles the issue in the coming weeks.”

Cutting Effect

Kenny’s coalition is three-quarters of the way through 33.4 billion euros of budget savings, equivalent to about a fifth of the economy, planned through 2015. The underlying fiscal deficit is on track to narrow to 7.4 percent of gross domestic product this year from 11.5 percent in 2009, the government forecasts.

Reassured by European Central Bank President Mario Draghi’s pledge last year to do whatever it takes to defend the euro, investors are rewarding Ireland and paving the way toward exiting the November 2010 bailout by the end of the year.

The drop in Ireland’s 10-year bond yields narrowed the extra cost of borrowing over German bunds to 2.38 percentage points from a high of 11.5 percentage points in July 2011. The yield on two-year Irish notes was 0.94 percent today, the least since Bloomberg began compiling the data in 2003.

The absence of any serious resistance to deficit cutting ended a week ago when the most powerful labor group, SIPTU, rejected government proposals to reduce salaries for some of the best-paid public workers by at least 5.5 percent.

Next Move

Now, Kenny has to decide on his next move. So far, he has said little beyond expressing disappointment with the result and maintaining savings still have to be found.

One option is to push through a unilateral, across-the-board 7 percent pay cut for all public workers the government had threatened before the deal was rejected. That risks triggering a “mutually destructive” row, Jack O’Connor, head of SIPTU, told broadcaster RTE two days ago.

Complicating matters is the position of the Labour Party, the junior coalition party that traditionally draws support from the unions. Labour’s support among voters has slumped since the 2011 election, polls show, testing its willingness to force through more cuts for workers who have seen earnings drop an average 14 percent over the past five years.

As yet, investors have paid little attention to the rejection of the pay deal. In a sale of 500 million euros of Treasury bills two days after the union vote, the average yield dropped to 0.195 percent from 0.24 percent a month earlier.

No Standoff

In part, that may reflect a belief that the government will avoid confrontation by cutting a deal with the unions.

While Kenny has committed to 3.1 billion euros of further austerity measures next year, he may have scope to do less as the deficit narrows faster than estimated. The shortfall last year was 7.6 percent, compared with the 8.6 percent target set by the European Union, International Monetary Fund and ECB, the European Commission said this week.

Already, the government has pushed back a plan to introduce water charges next year. Welfare Minister Joan Burton, a member of the Labour Party, said in a speech last week that the limits of austerity had been reached.

“Any unilateral legislation for cuts would be a politically risky move so I would expect there will be a consensual solution to this,” said Philip O’Sullivan, an economist at NCB Stockbrokers in Dublin. “There will be sense of realism on both sides.”