Ireland is a Hedge Fund (or Noddy Does Sovereign Economics)

I'm pretty comfortable looking at the balance sheet of most forms of enterprises, assessing risk profiles of contingent liabilities and so on. But I haven't had to start doing this in the context of a whole country until the Irish government's recent staggering decision to guarantee all the senior creditors of its banking system.

I suspect I would have been better prepared for this sort of analysis if I had paid more attention to Economics 101. While a whole country's revenue account is a simple enough concept (Taxes in, then public expenditure, infrastructure capex and debt service out), what does the balance sheet look like? In particular, how do you put values on the assets to determine if the country is solvent or not in the conventional sense? I suppose it looks a bit like this:

Assets
Land (& natural resources therein)
Labour's inclination to show up in the office/factory/hospital/school every day
Infrastructure Capital (housing, buildings and machinery etc)
Goodwill, IP, or "Entrepreneurial Capacity"

Liabilities
National Debt
Capitalised future social security obligations
Other liabilities (like guarantees)
"Stockholders' equity"

Where Stockholders are citizens and their "equity" is some capitalised measure of the quality of life or GDP/head. If this horrible simplification offends any economists, know that I am just pouring it out of the top of my head to allow some focus on the impact of the guarantee, and for that I apologise.

Some figures:

As at December 2006, the last date for which I could get hold of the Irish complete financial accounts, the National Debt was EUR38bn. Contingent liabilities, or guarantees of state sponsored vehicles' debt, stood at EUR3.3bn. On the revenue account side, tax and other income was EUR46bn roughly matching public and capex spending of EUR46bn. GDP was around EUR180bn at purchasing power parity, though who knows how you capitalise this for balance sheet value.

Broadly then, the Irish action adds a EUR400bn contingent liability (being the deposit and wholesale funding base of the banks it has guaranteed) to a EUR38bn national debt of a country with a EUR180bn GDP. However you cut it, those are scary figures; this is like a hedge fund embarking on a lemon strategy and rolling the dice.

By implementing the guarantee for two years, Ireland has effectively written a put option on the value of its banking sector's assets to the holders of the liabilities. (Long time readers must have known this was coming). The assets stand at some EUR460bn, so the put option is 13% out of the money. If the banking sector's revenue account is flat over the next two years (ie the forward on the assets is flat), then a crude estimate of the value of the put option at 20% volatility is around EUR24bn which should appear as a contingent liability on the balance sheet above if mark to market rules applied. Crudely therefore, this is the sort of state acquisition of banking sector equity which we should expect to see if the Irish citizenry are to be appropriately compensated for their assumption of private sector risk. No surprise then that the Finance Bill notes that

"The (finance) Minister may subscribe for, take an allotment of or purchase shares and any other securities in a credit institution or subsidiary to which financial support is provided under this section on such terms as the Minister sees fit."

Expect a crude, unreasonable transfer of value from present shareholders to debtholders, which will be an affront to the whole concept of "equity" for the political expedient of restoring confidence. Failing institutions should be allowed either fail or survive, we need to take our lumps, bear the consequences and move on.

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Edit: if this looks scary I strongly recommend you do NOT try and do a similar back of the envelope analysis for Iceland.