Sharon Donnery: Risks and resilience in uncertain times
Address by Ms Sharon Donnery, Deputy Governor of the Central Bank of Ireland, to the Institute
of International and European Affairs, Dublin, 8 March 2019.
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Good afternoon, it is a pleasure to address the Institute of International and European Affairs.
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The ebbs and flows of a country's economic and financial fortunes are not always predictable.
In Ireland, even less so.
While, sometimes, there are patterns or regularities for such events - they are not always a
perfect indicator of what's to come.
Uncertainty always accompanies predictions.
When Seamus Heaney died in 2013, the Economist magazine published an obituary
remembering him, with the by-line 'a shy soul'. They noted that "during his years studying to be a
schoolteacher in the 1960s, he used the pen-name "Incertus", meaning "uncertain".....
Yet there is little that is hesitant in his poems."
There are plenty who may think there's no poetry in economics, but economics, like any field,
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can learn from the greats in others.
A central theme of my remarks today is uncertainty.
Ireland today faces considerable uncertainty. Put simply, the Irish macrofinancial environment
could change significantly over the short and medium term.
The UK leaving the EU is not the only risk. The international economic environment has
deteriorated, yet the domestic economy is currently robust.
So, we find ourselves in the interesting position of assessing a potential slowdown in the external
international environment, the UK departing the EU, while also worrying about potential
overheating from a domestic perspective.
Plotting a course through such an environment, with the potential for a wide range of future
outcomes, is indeed challenging.
While we can state with certainty that we have greatly expanded and strengthened our toolkit to
deal with various risks, it is important that we maintain a sense of humility about what we can
forecast and, more to the point, what we can control.
Yet like Heaney, despite the uncertainty we face - we cannot be shy, hesitant or complacent in
our words, not least in our actions and policies.
Today, I would like to discuss the economic outlook, both for Ireland and critically, the
international environment. Then, I will elaborate on some of the risks that Ireland faces. I will finish
by giving some thoughts on what policy can do when facing these very different risks.
The economic environment and outlook
Given I have the opportunity to speak to the IIEA and given the timeliness of this speech following
the announcement of yesterday's monetary policy measures, I will begin by focusing on the euro
area and global economic outlook.
Just yesterday, I returned from a meeting of the Governing Council of the European Central
Bank. A key concern of the Council was uncertainty. Specifically, the persistence of uncertainties
related to geopolitical factors and the threat of protectionism appear to be leaving marks on
economic sentiment. On account of this, the risks surrounding the euro area growth outlook are
still tilted to the downside.
Incoming data have continued to be weak, in particular in the manufacturing sector, reflecting the
slowdown in external demand compounded by some country and sector-specific factors. The
impact of these factors is turning out to be somewhat longer-lasting, which suggests that the
near-term growth outlook will be weaker than previously anticipated.
This assessment is broadly reflected in the March 2019 ECB staff macroeconomic projections
for the euro area. These projections foresee annual real GDP increasing by 1.1% in 2019, 1.6%
in 2020 and 1.5% in 2021.
Compared with the December 2018 Eurosystem staff macroeconomic projections, the outlook
for real GDP growth has been revised down substantially in 2019 and slightly in 2020.
Ireland's trade and financial openness is a fundamental structural characteristic of the economy.
This is most evident from the familiar multinational brands headquartered here. The Irish
economy is highly integrated with the international economy, both in terms of trade and with
global financial markets, and particularly with regard to cross-border capital flows.
Over recent decades, Ireland has benefited very positively from developments in the global
economy and the move toward high value, low volume trade. This has provided many benefits in
terms of revenue and employment. For example, multinationals are estimated to account for 22
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per cent of total employment. However, this means structural shocks emanating from abroad
can have an important bearing on the performance of the economy. These can include changes
in global trade or international taxation regimes. Indeed, the structure of Ireland's economy
means that it can even be affected by idiosyncratic shocks facing individual sectors or firms
operating here.
Whilst providing many positives, this openness therefore also increases the propensity - and
sensitivity - of the Irish economy to global shocks - be they structural shocks I just described, or
cyclical - driven by the global economic cycle or by developments in global financial conditions
for example.
This is evident in the data. The Irish macrofinancial environment has been more volatile than its
European peers in the past. Cross-country volatility of a range of macrofinancial variables since
1980 - including house prices, GDP, household income, employment, and credit, for example -
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illustrates this.
In summary, there are big benefits for Ireland being a highly globalised economy. But these
benefits also bring risks. And the risks need to be managed appropriately.
Turning to home, a range of indicators we monitor and analyse show that the economy grew
robustly in 2018.
The strength of activity has been supported by strong growth in employment. This has, in turn,
stimulated incomes and supported consumer spending. We have also seen an acceleration of
investment in the economy, for example in building and construction.
Taking a slightly longer-term perspective, the strong recovery since 2013 has yielded several
important benefits.
One of the most clearly tangible places we can all see this, is in the number of people in work.
Nearly 420,000 additional people have found employment since the low point of 2012. Nearly 2.3
million people are currently in employment, exceeding the peak of 2007. Crucially, growth in
employment has been broad based across different sectors of the economy. For example,
construction employment accounted for 1 in 9 jobs in 2007. Today, it makes up just 1 in every 16.
The improvement in labour market conditions has also been felt across different regions.
We've also seen the overall size of the labour force grow. More people, particularly older people,
are participating in the work force. Net inward migration has also resumed. In the year to April
2018, it amounted to 34,000 people. This is equivalent to 1.4 per cent of the labour force. This is
a clear signal of the strength of domestic economic activity.
Looking ahead, our central forecasts assume that the UK parliament will ratify a withdrawal
agreement and that a transition period will come into effect until the end of 2020.
Based on this key assumption, the outlook for the Irish economy over the coming years remains
broadly positive.
However, we expect that a tightening of conditions in the labour market and bottlenecks in the
housing market will contribute to a moderation in growth. This moderation also reflects the less
favourable international economic environment I discussed earlier, with prospects for growth in
our main trading partners less positive than previously anticipated.
We now expect GDP growth this year of 4.4 per cent. Our forecasts suggest this will moderate
to 3.6 per cent next year. Underlying domestic demand, a measure that gives a more accurate
picture of economic activity, is forecast at 4.1 per cent this year, moderating to 3.3 per cent in
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2020.
We expect further growth in employment in 2019 and 2020, of the order of 2.2 per cent this year
and 1.7 per cent next year. Given our forecasts for labour force growth, this implies that the
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unemployment rate will drop to 4.9 per cent this year and 4.7 per cent next year.
So, our central forecasts indicate that the current economic prospects for the Irish economy are
quite robust.
Risks from inside and out
Risks however are prevalent from both inside and out.
However, it is important that we are not complacent in thinking that the UK's departure from the
EU is the only risk to the Irish economic outlook. The international outlook is uncertain. And
should we avoid a disorderly UK exit, and the dent to Irish economic growth that comes with it, a
continued fast growing economy is only desirable as long as growth is sustainable.
Events could result in outcomes well beyond what we expect from our current central forecasts.
In the current circumstances, much of the uncertainty arises from the lack of clarity regarding our
future relationship with the UK. From the spectrum of potential outcomes, a no-deal disorderly
departure represents a worst-case scenario for Ireland. The abrupt ending of cooperation
agreements would have material and immediate economic implications.
In our latest Quarterly Bulletin, using our economic modelling tools, we examined the possible
macroeconomic implications of a sudden and disorderly Brexit. Given the unprecedented nature
of a 'no deal' scenario, quantification is highly uncertain and this exercise represents a scenario
analysis and not a forecast - it considers what could happen under certain assumptions, not
necessarily what is most likely to happen.
With a disorderly departure, significant additional frictions and costs would arise. These result
not just from the introduction of new trading arrangements, but from a breakdown in some of the
arrangements that make trade possible. For example, regulatory and customs issues, border
infrastructure issues and legal uncertainties. People are likely to feel this in their everyday lives.
This would be likely to have immediately damaging consequences for trade and the functioning of
supply chains for production, distribution and retailing.
Models and forecasting tools can be used to estimate the impact of long-run changes to trade
arrangements. However, they are less suited for predicting the short-run effects and potential
disruption arising from a breakdown in those arrangements. The scale of disruption would also
be influenced by the ability of firms and retailers to respond and adjust. Policy responses or
mitigating actions would also help to ameliorate the situation. Nevertheless, it is clear that a no
deal scenario would have very severe and immediate disruptive effects, which would permeate
almost all areas of economic activity.
Certain sectors would be disproportionately affected, particularly agriculture and food. Border
regions for example, would also be heavily affected.
We calculate that a disorderly Brexit could reduce the growth rate of the Irish economy by four
percentage points in the first year, albeit this figure is subject to much uncertainty.
However, as a result of domestic demand and the strong non-UK multinational sector, our
assessment is that there would still be some positive growth in output over the coming years -
even under a no-deal scenario. This would be materially lower than in the central forecast I
outlined earlier - and would be closer to one per cent growth in both years.
A fast-growing economy is desirable as long as growth is sustainable. However, sometimes the
economy can grow too fast and overheat. This happens when an economy reaches the limits of
its capacity to meet demand from individuals, firms and government. One element of this is the
concept of "full employment", which occurs when almost everyone who wants to work has a job.
When this happens, there is very little available slack. In other words, the amount of unused
resources, or spare capacity in the economy - is very limited or non-existent.
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The problem with overheating is that it tends to result in a harmful downturn. Temporary surges
create dynamics that are difficult to reverse. For example, wages can rise quickly to
unsustainable levels.
Overheating can make households and firms over-optimistic about their future income
prospects, and lead them to take on too much debt. If this future income fails to materialise,
readjusting to a sustainable growth path can be painful. The result can be bankruptcies, job
losses, wage reductions and cuts to public services.
I mentioned earlier that our central forecast suggests some moderation in growth over the
coming years. However, despite this, we still see labour market conditions tightening further.
Surveying a range of indicators reveals mixed evidence as to the extent of current overheating
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pressures. Investment in the real economy remains well below its previous peak. Overall credit
growth is subdued as households continue to reduce their debts. The modified current account
of the balance of payments - an important indicator of imbalance -recorded a small surplus in
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the most recent data.
While these measures are not indicative of significant overheating pressures currently, past
episodes demonstrate that the position can change quickly. As the economy moves closer to full
employment, there is a need to guard against the risk that economic conditions give rise to
overheating dynamics. To date, the tightening of the labour market has not been accompanied by
significant evidence of strong wage or price pressures. However, further increases in aggregate
demand may lead to overheating in the economy.
Financial system resilience and macroprudential policy
So, we find ourselves in the interesting position of considering a potential slowdown in the
international environment and the UK leaving the EU. And at the same time, also worrying about
potential overheating from a domestic perspective. The potential for a wide range of future
outcomes, and associated uncertainty, is indeed challenging.
To guard against these risks, we need to build resilience.
Resilience in households, resilience in businesses, resilience in the public finances and
resilience in the financial system.
This is important to withstand future downturns. If buffers are built up during the good times,
policy can react during a downturn. Counter-cyclical policy therefore offers a way to moderate
the effects of downturns, supporting demand in the economy when necessary. However, the
ability to implement counter-cyclical policy relies crucially on taking advantage of positive growth
periods to build the buffers.
Given our continued strong growth right now, reducing Ireland's high debt to safer levels should
remain a priority - both in order to protect the public finances in the face of risks and to lay the
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foundations for sustainable future growth. Ireland's debt-to-GNI ratio remains elevated and
above 100 per cent. Reducing the debt burden is vital to future-proofing the economy to weather
possible shocks.
The unpredictability of corporate tax revenues in recent years points to the dangers of relying on
what might prove to be a partly transitory surge in revenues to fund lasting spending
commitments. In recent years, the public finances have benefited from an exceptional growth in
corporation tax revenue. They have also benefited from savings on national debt interest
payments due to the low interest rate environment internationally. Since 2015, revenue from
corporation tax has consistently outperformed the Department of Finance's forecasts by an
average of almost €1.4 billion per annum. Saving, rather than spending, such windfalls would
help to mitigate against potential overheating and allow the build up of buffers which can be used
in the event of future downturns.
So, just as fiscal buffers can be used to absorb shocks to the economy, the financial system
also needs to have such buffers. Without these, the financial system may react in a way that
further deepens the economic stress faced by households and firms in a downturn, by curtailing
the supply of credit for example. Indeed, the costs of the financial system having insufficient
buffers to absorb shocks became painfully obvious in the crisis.
The Central Bank's mission is to serve the public interest by safeguarding monetary and financial
stability and by working to ensure that the financial system operates in the best interests of
consumers and the wider economy.
An essential outcome of this mission is strengthening the resilience of the financial system. This
is one of our five strategic priorities of our Strategic Plan 2019-2021. Our aim is to ensure that
we at the Central Bank can, and do, play our part in strengthening the resilience of the system as
a whole, building on what has been achieved since the financial crisis.
So what has changed for the domestically relevant banking system since the crisis in terms of its
resilience to deal with negative shocks?
At a headline level, three things come to mind:
1. Its capital position (relative to risk-weighted assets) has improved almost threefold relative to
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2007.
2. Reliance on short-term wholesale funding from international capital markets has reduced.
The share of customer deposit funding has increased from less than half to around four
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fifths.
3. Funding costs have fallen and, despite recent market volatility, have remained contained.
This suggests that counterparties' view of the creditworthiness of Irish banks has not
changed, which in itself is a reflection of the financial resilience of the core of the banking
system.
And what of the role of policy generally, and the Central Bank in particular, in promoting resilience
and safeguarding financial stability?
Changes to the international regulatory and supervisory architecture have played a part in
restoring confidence and promoting resilience in the financial system. We have also done much
work in preparing the financial system for the UK's departure from the EU.
I spoke on Tuesday to central bank experts from across the EU who were visiting the Central
Bank of Ireland. There I highlighted some of the contingency planning we have undertaken. In
particular, I explained how the Irish market is unique in the area of securities settlement. In simple
terms, when shares in a stock or other securities - like government or corporate bonds - are
bought and sold, they are settled at a central securities depository or CSD. Securities settlement
systems provide the institutional and technical infrastructure that allows trading to happen. Due
to the fact that Ireland has no domestic infrastructure and utilises a number of settlement
systems located across Europe, following the departure of the UK from the EU the current
arrangements are not sustainable.
Therefore, the Central Bank in conjunction with the Department of Finance has engaged
extensively with European counterparts to mitigate against the potential disruption from this
immediate cliff edge risk. I am happy to report that it has been largely mitigated - notably with the
European Commission's decision to grant temporary equivalence to the UK's legal and
supervisory arrangements for CSDs until 29 March 2021. The Central Bank will continue to liaise
with the relevant stakeholders to ensure a long-term solution is implemented on time.
I am happy to discuss more on Brexit in the following Q&A but for the remainder of my remarks
today, I will pay particular attention to how our macroprudential policy framework aims to
strengthen resilience to withstand adverse macroeconomic shocks.
Earlier in my remarks I discussed how as a small, open economy, Ireland is not only exposed to
risks from within but also from the external environment. It is vital that a small and highly
globalised economy like Ireland is proactive in using macroprudential policy to mitigate systemic
risk and build resilience. Our macroprudential framework and toolkit builds resilience in the
system against different risk factors, and complements the firm-specific resilience that is the
focus of micro-prudential regulation and supervision.
To date the Central Bank has activated a number of tools which, to a greater or lesser extent,
aim to enhance the resilience of the system.
The Other Systemically Important Institutions (O-SII) buffer looks to build additional resilience
for institutions whose failure would have a bigger impact on the economy and the financial
system. The O-SII framework was introduced in Ireland in 2015 when two institutions were
identified as systemically important, with a buffer of 1.5 per cent phased-in between 1 July
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2019 and 1 July 2021. Our latest review identified six Irish authorised institutions as O-SIIs.
Promoting resilience in the banking sector, for example, is the primary rationale underlying
our policy stance for the countercyclical capital buffer (CCyB), which we announced last
year. We introduced the CCyB because a number of indicators suggested a sustained
trajectory towards a gradual build-up of cyclical systemic risk. Our aim is to mitigate against
a negative reaction of bank lending to the real economy in any future downturn or period of
systemic stress.
Increasing bank and borrower resilience, so as they are more able to withstand the impact of
negative shocks, is one of the objectives behind the mortgage measures.
Each of the macroprudential policy interventions that the Central Bank takes has the objective of
protecting financial stability by targeting different elements of systemic risk. Individual
macroprudential tools have different objectives, operate through different transmission channels
and look to address different sources of systemic risk.
I began my remarks by discussing how the Irish economy is very integrated with the international
economy both in terms of trade and with global financial markets. I also highlighted the
vulnerabilities that this entails. It is important banks hold sufficient structural buffers as well as
cyclical buffers to guard against the higher levels of macroeconomic risk Ireland faces.
Having buffers means capital depletion does not lead to instability in financial markets. This
makes a tightening of credit conditions less likely.
Resilience in the banking system should be locked in through the more active use of capital
buffers. This is important given the higher levels of risk intrinsic to a small highly globalised
economy. It also allows the system to withstand both unexpected negative developments and the
ebb and flow of financing conditions.
Conclusion
To conclude, the wide range of possible future paths means building resilience is not only
desirable, it is necessary.
Incertae - uncertainty - will always be a feature of the system, and therefore, we need to be
humble about the extent to which we can forecast and predict, while being aggressive in building
defences against potential risks.
The government, firms, households and financial sector participants should be cognisant of the
range of potential outcomes and the risks contained within.
The Central Bank has particular powers, and will use them to safeguard monetary and financial
stability and to ensure that the financial system operates in the best interests of consumers and
the wider economy.
This is how we best serve the public interest.
Thank you, I look forward to the discussion.
Underlying domestic demand is a measure of spending in the Irish economy. It excludes trade in aircraft by
aircraft leasing companies and imports of R&D related to intellectual property imports from headline investment.
This measure more accurately reflects economic activity within the domestic economy than standard measures
such as GDP and GNP.
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Central Bank of Ireland: Quarterly Bulletin 1 (2019)
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Conefrey, T, O'Reilly, G and Walsh, G: ' The Macroeconomic Implications of a Disorderly Brexit', Central Bank of
Ireland, Box B Quarterly Bulletin No.1 (2019)
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Central Bank of Ireland: Explainer - What does overheating in the economy mean?
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Underlying investment refers to overall investment excluding intangible assets and aircraft.
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Central Bank of Ireland: Quarterly Financial Accounts
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Source: Central Statistics Office - Current Account Balance for Ireland 2007 - 2017
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Capital here refers to common equity capital less intangibles and deferred tax assets as a proxy over time for
CET1.
13
Sibley, Ed: Safety and soundness - Strategic priorities for the next three years, BPFI Risk Management &
Supervisory Conference (January 2019)
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Central Bank of Ireland: Identification of Other Systemically Important Institutions in Ireland and Announcement
of Associated Buffers (12 November 2018)