DBRS Downgrades Ireland to A (high) Negative Trend on Higher Fiscal Costs

DBRS Inc. (DBRS) has today downgraded the Republic of Ireland’s Long-Term Local Currency and Long-Term Foreign Currency ratings from AA to A (high), and placed a Negative trend on the ratings. This concludes DRBS’s Under Review with Negative Implications assigned on 5 October 2010.

The reasons for the two-notch downgrade are: (1) the larger-than-expected fiscal costs of bank recapitalisations since our last assessment in July 2010, which have driven up public debt levels, and (2) a weaker growth outlook. DBRS will maintain the Negative trend until there is greater clarity that Ireland’s banking system has stabilised and that the European policy response to tensions in the financial markets is sufficient to restore investor confidence and support Ireland’s recovery.

Ireland’s structural strengths and strong policy response to the financial crisis continue to support the ratings. The Government has taken extraordinary steps to put public finances on a sustainable path, increasing taxes and cutting spending by EUR 8 billion (5.0% of GDP) in 2009 and EUR 4 billion (2.5% of GDP) in 2010. Taxation receipts and expenditures in 2010, not including bank recapitalisations, are in line to meet the targets set out by the Department of Finance in December 2009.

Complementing this, the 2011 budget incorporates an additional EUR 6 billion in spending cuts and tax increases, aiming to reduce the general government deficit from an estimated 11.6% of GDP in 2010 (31.9% of GDP including bank recapitalisations) to 9.4% in 2011. The government’s four-year budgetary consolidation plan envisages a further EUR 9 billion in fiscal savings in order to reduce the deficit below 3% of GDP by 2014.

The EUR 85 billion IMF-EU financial support program announced in late November, which includes a EUR 17.5 billion commitment from the Irish government, will help cover Ireland’s public financing needs over the next three years and provide additional capital support to the Irish banking system. This more secure source of funding should give Ireland more time to consolidate public finances and restructure the banking system.

Notwithstanding the near term challenges, the ratings are supported by Ireland’s strong long-term growth prospects. Ireland is a highly open economy with a flexible labour market, a young and educated workforce and a pro-business environment. Due in part to sizeable competitiveness gains over the last two years, Ireland is quickly unwinding external imbalances and the export sector is well-positioned to support the recovery. The current account is expected to move from a deficit of 5.6% of GDP in 2008 into a small surplus next year, while exports will likely grow over 6% in 2010.

However, the fiscal cost of recapitalising Ireland’s banking system has significantly increased since DBRS’s previous assessment in July 2010. The Central Bank of Ireland announced on September 30, 2010 that up-front recapitalisation costs of the financial sector would be at least EUR 45 billion (29% of GDP), up from a previous estimate of EUR 33 billion. As part of the IMF-EU program, an additional EUR 8 billion in capital – on top of the EUR 45 billion – will be made available to the banks in order to raise core tier one capital ratios to at least 12%. This is above the 8% ratio required by the Central Bank of Ireland in September 2010. To the extent that this commitment is drawn upon, the additional capital will come from government resources and, therefore, will not increase gross general government debt. In the event capital ratios fall below 10.5%, the IMF-EU program set up a EUR 25 billion contingency capital fund.

Weaker-than-expected growth has pushed public debt ratios to levels higher than previously anticipated. The government now estimates average annual GDP growth of 2.75% from 2011 to 2014, below the previous estimate of 4.0%. While DBRS believes the revised growth forecast presents a plausible scenario, the balance of risks is to the downside. This is due to fiscal consolidation, on-going private sector de-leveraging, weak labour market conditions and uncertainty regarding the strength of external demand.

Under the Department of Finance’s growth and fiscal assumptions, gross general government debt is projected to increase from 94.2% of GDP in 2010 to 102.5% in 2013 before declining to 100.0% in 2014. This incorporates the gradual unwinding of the Government’s cash resources, which the NTMA estimates will total almost EUR 16 billion (10% of GDP) at year-end 2010. However, weaker nominal growth or further recapitalisation costs could push the debt ratios even higher.

It is important to note that these projections exclude NAMA bonds (estimated to reach 22% of GDP in 2011), which DBRS treats as contingent liabilities of the government.

Investor sentiment has also been negatively affected by uncertainty over European Union policy toward bondholders. Whether or not private holders of Ireland’s and other Euro area member countries’ securities will be forced to bear the burden of future sovereign debt restructuring has led to a sharp deterioration in confidence. Greater clarity on this policy could help calm the markets, and by extension, the timing of Ireland’s recovery.

DBRS could move the trends to Stable if the government demonstrates progress on reducing the deficit and restructuring the banking sector. On the other hand, DBRS is likely to downgrade the ratings if: (1) budgetary consolidation is not carried out in line with the principles of the government’s four year plan or recapitalisation costs greatly exceed current estimates, (2) growth significantly underperforms or (3) instability in other parts of the euro zone undermines investor confidence, weakening Ireland’s recovery.

Notes:
All figures are in Euros (EUR) unless otherwise noted.

The applicable methodology is Rating Sovereign Governments, which can be found on our website under Methodologies.

The sources of information used for this rating include The Republic of Ireland’s National Recovery Plan 2011-2014, the Budget 2011 issued by the Department of Finance and the EU/IMF Programme of Financial Support for Ireland dated 1 December 2010. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

Lead Analyst: Michael Heydt
Rating Committee Chair: Alan G. Reid

Initial Rating Date: 21 July 2010
Most Recent Rating Update: 5 October 2010

For additional information on this rating please refer to the linking document located below.