Stefan Gerlach: Ireland - from crisis to recovery
Address by Mr Stefan Gerlach, Deputy Governor of the Central Bank of Ireland, at the Berlin
Finance Lecture, a joint initiative of Deutsche Bank Research and the Departments of
Mathematics and Economics of Humboldt University, Berlin, 14 January 2013.
* * *
I am grateful to John Flynn, Carina Harte, Rebecca Stuart and Laura Weymes for help in preparing these
remarks.
1. Introduction
I am very pleased to be in Berlin today and to speak on economic developments in Ireland in
recent years in this distinguished lecture series.
As you know, the Irish economy underwent a disastrous boom-bust cycle in the last decade.
Following the bursting of the bubble in 2007/8, the economy entered a period of almost
free-fall. In response to the crisis, the Irish authorities have been working conscientiously on
stabilising and returning the economy to growth. That process started immediately after the
bubble burst and a number of important policy measures were taken in 2008 and 2009.
Initially, the focus was on ensuring that the banking system continued to function and on
restoring fiscal soundness. However, despite significant measures in both the banking and
fiscal areas, serious concerns persisted about Ireland's financial balance sheet. In the fall of
2010, a few weeks after the Deauville statement that suggested that private sector investors
could experience losses on their holdings of sovereign debt, confidence in the Irish sovereign
collapsed.1 This forced the Irish Government to seek external financial assistance from the
ECB, the European Commission and the IMF, the "Troika".
Access to official funding under the programme has been very helpful and has enabled the
Government to pursue the reform process that had already started. As readers of the
Troika's quarterly reviews of Ireland's progress during the programme will know, policy
implementation has been strong and the authorities have delivered on all the commitments
they have entered into.2
Although domestic demand continues to shrink, this is being offset by growth in net external
demand and as a result overall Irish economic activity has been broadly stable and there are
a few signs that a modest recovery could potentially take hold this year. While real GDP
growth has been very weak, it was positive in both 2011 and 2012, and is forecasted to
increase to a little over 1 per cent in 2013. Similarly, house prices, which have been falling
since 2007, were broadly flat in the second half of 2012 although there is no expectation of a
significant increase. Finally, unemployment has started to fall, but the improvement, from a
peak of 15 per cent in early 2012 to 14.6 per cent by year end, is small and partially due to
net emigration.
For a small and very open economy such as ours, domestic economic conditions are
critically influenced by the external economic environment. Unfortunately, this has been
extremely challenging in recent years and considerably worse than was forecasted when the
programme was agreed in 2010. In particular, the euro area has experienced serious
economic and financial tensions with GDP forecasts frequently being revised downwards. A
shift towards fiscal consolidation, although essential in most countries and urgent in some,
and the necessary process of bank deleveraging in Europe have not helped recovery in
Ireland. While the overall direction of the policy response within Europe to the crisis has been
appropriate, the pace of change has been uneven and this has generated a high level of
uncertainty which has not been beneficial.
The Government has made a good start in re-entering debt markets, but the market is
conscious that economic conditions remain fragile and the stock of public debt is very high at
120 per cent of GDP (or almost 150 per cent of GNP, which may be a more relevant
measure in the case of Ireland). There is therefore little, if any, safety margin and even a
small adverse shock to market confidence in the Irish Sovereign could complicate the exit
from the programme. A successful exit, on the other hand, would be a very positive
development not just for Ireland but also for Europe more broadly. Actions that would help
reduce the sovereign-bank link and that would improve debt sustainability could greatly
enhance Irish prospects of exiting the programme on schedule.
But I am getting ahead of myself. Given that the assistance programme is scheduled to end
late this year, this is a good time to take a look at the Irish Government's progress in
resolving the crisis and take stock of where we stand. To organise the material, I have
decided to structure the discussion in three parts. First, I will discuss the crisis itself, its
causes and consequences for the Irish economy. Next I will review the main policy measures
adopted by the Irish authorities in response to the crisis. Finally, I will review what the most
pressing challenges are this year.
2. The crisis
Ireland experienced a massive housing bubble, whether measured in terms of prices, credit
or the scale of construction activity within the economy. Unfortunately, this appears to have
been one of the worst boom-bust cycles on record.3 The exceptional size of the shock is of
course the main reason why it is so difficult to overcome.
The bubble took the form of a very large increase in residential and commercial property
prices which rose almost four-fold between 1997 and 2007. Like many other bubbles, it
started from strong growth, which in Ireland's case began around 1990 and largely resulted
from greater economic integration with Europe. During the 1990s, growth was underpinned
by fundamentals, as exceptional export performance was accompanied by moderate wage
and price inflation and healthy public finances. The expansion was aided by EU structural
funds of up to 3 per cent of GDP per annum. Of course, the large fall in Irish interest rates as
part of the move to Monetary Union also exerted a powerful force. For instance, mortgage
rates fell from over 11.5 per cent in 1990 to lows of close to 3.5 per cent in 2005.
In the early 2000s, however, as the economy approached full employment and technological
constraints began to bind, the nature of the boom changed from one that reflected strong
fundamentals to one that was fuelled by excessive credit expansion. Strong economic growth
and lower interest rates led to an increase in both the demand for and price of housing and
rapid growth in credit. Both domestic and foreign-owned banks with branches or subsidiaries
in Ireland participated in this expansion, lending heavily to developers and retail mortgage
borrowers. As a result, the fraction of non-financial private-sector lending that went to the
property sector - that is, mortgages and lending for commercial property - rose from
60 per cent in 2000 to 80 per cent in 2007.4 The boom was not just a price bubble, but
involved a huge expansion in lending and construction activity.
We now know that this explosion in lending reflected an astounding neglect of credit risk by
lenders. Primary responsibility for the soundness of individual institutions rests squarely with
the management of the financial firms themselves. However, it is clear that ineffective
regulation and supervision - both at the level of the individual firm and on a system-wide
basis - also played a role.5 While Ireland's problems were homemade, it is natural also to
ask how Irish banks financed this rapid increase in lending. The data show that the bulk of it
was financed by wholesale funding from abroad. One wonders what led to this surge in
lending. Did foreign lenders to banks not understand how dangerously unbalanced the Irish
economy was becoming and that credit risks were rising? Or did they assume that if the
property bubble burst, they would be able to get out in time or that they would be bailed out?
Whatever the explanation, the Irish property bubble was aggravated by the apparent
willingness of foreign financial institutions to fund reckless lending in Ireland.
Housing prices peaked already in 2007, but any hope of a soft landing vanished the following
year. The banks' heavy reliance on cross-border wholesale funding and concerns about the
scale of their losses as a result of the collapse in property markets help explain why they
began to find it increasingly difficult to attract longer-term funding through early-2008, and
meant that they were particularly affected by increased fears of counterparty risk as markets
froze following the collapse of Lehman Brothers in September 2008.
From then the process has followed a familiar pattern: with the economy weakening, market
sentiment worsening and banks unwilling to lend, demand for property declined and the fall
in house prices accelerated. As a consequence, construction, which during the boom had
grown to over one-fifth of the Irish economy, collapsed significantly weakening aggregate
demand and employment. The end result has been a vicious circle of continuous and sharp
falls in property prices, bank lending and aggregate demand, and rising loan losses and
unemployment which has now lasted more than five years. A few statistics tell the facts:
between 2007 and 2012 GNP fell by 11 per cent in real terms and 20 per cent in nominal
terms, while domestic spending fell by almost 25 per cent in real terms and almost
30 per cent in nominal terms.
The bursting of the bubble had devastating effects on public finances and forced the
Government to ask for external assistance. Two factors account for the sharp increase in
debt.
First, the socialisation of banks' severe loan losses - in the first instance through the
September 2008 guarantee and later through the unwillingness of our programme partners to
consider burden sharing with unguaranteed senior bondholders - resulted in a very large
infusion of public funds to restore their solvency.6
To date, the Irish State has injected
€64 billion into the banking system, or approximately 40 per cent of 2012 GDP.7
The second factor is fiscal policy. A stylised fact of many housing booms is that rapid growth
of revenues makes the Government's fiscal position appear much stronger than it is.
Governments frequently respond by raising spending and reducing their reliance on revenue
from non-property sources, while rapid nominal GDP growth erodes the debt-to-GDP ratio.
Ireland was no different; although public spending was well constrained in the 1990s,
eventually in the 2000s spending surged, driven by pay rates and social benefits. At the
same time tax rates were reduced, while the debt-to-GDP ratio fell from 100 per cent in 1991
to about 25 per cent in 2007.8 Particularly unfortunate was the decision to permit strong
increases in current spending which were dependent on windfall revenues, rather than other,
more permanent, sources of revenues. Consequently, when tax revenues collapsed as the
boom turned to bust with a vengeance, a large gap between Government expenditure and
revenue rapidly developed.
3. Policy responses
Following the burst of the bubble, the Irish Government has taken a number of actions to
stabilise the banking system and strengthen public finances in order to support recovery. Let
me focus on some of the most important.
3.1 Stabilising the banking system
The initial policy response in September 2008 took the form of a general guarantee of the
liabilities of the banking system.9
The initial guarantee covered a broad range of liabilities
including some existing subordinated debt and covered bonds, and amounting to almost
21⁄2 times GDP.10 Following the initial guarantee, new debt and deposits continued to be
guaranteed on a second scheme which has been rolled forward on a six-monthly basis. This
is still in force, but it is probably no longer necessary, and will likely be discontinued in the
near future.
As I have noted, during the pre-crisis credit expansion, banks became increasingly reliant on
shorter-term wholesale funding. The guarantee was introduced in the belief that the main
problem facing the banks was merely difficulties attracting funding following the collapse of
Lehman Brothers. That the system faced a solvency problem was not recognised at the time.
However, as doubts emerged about the solvency of the banks in light of increased property
losses and the ability of the Sovereign to backstop such a large guarantee, the Irish banking
system suffered a massive withdrawal of funding. Over time, Irish banks were shut out of
almost all debt markets, while a flight of retail and, particularly, corporate deposits also
occurred. To fund the resulting liquidity deficit and ensure the Irish banking system's ability to
function, the ECB has provided an unprecedented level of liquidity support.
As the property market continued to decline it became clearer that the banking system
needed capital to remain solvent. The initial step to recapitalise banks in December 2008
marked the beginning of a series of injections over the following years, as estimates of the
capital needs were made in a highly uncertain environment characterised by systematic loan
underwriting errors, inadequate management information and intrinsic uncertainties about
borrowers' ability to repay loans in negative equity. An initial independent assessment of the
banks covered by the guarantee was already undertaken in 2008. Based on the results, the
Government decided to recapitalise the banking system and to nationalise Anglo-Irish Bank
in early-2009. By June of that year, the Government had injected €10 billion into the three
major banks. Despite already receiving a 4 billion injection, by the end of 2009, it was clear
that Anglo-Irish Bank would have a further capital shortfall; this was met, following
discussions and approval by the European Commission, by a "Promissory Note".11
In 2009 the Government established the National Asset Management Agency with the
objective of removing commercial property and development loans from banks' balance
sheets. In total, NAMA purchased loans with a face value of €73 billion at an average
discount of 57 per cent. The transfers of loans to NAMA crystallised losses and led to a need
to inject further capital into the banks. Estimates of losses, both NAMA and non-NAMA
related, were conducted in 2010 with further capital being injected, leading to an increase in
the Promissory Note.
These initial recapitalisations took place as Government finances were deteriorating
significantly due to the collapse in economic activity, limiting the capacity to over-capitalise
the banks. A major objective of the programme, especially of the funders, was to remove this
constraint. However, as the programme did not envisage burden sharing with senior bank
creditors and the additional capital was added to Government debt, issues of debt
sustainability persisted. Nonetheless, the assistance provided by programme partners
allowed a more ambitious approach to be taken than previously, with strong external
validation and greater transparency built-in as features of the exercise. Using loan-by-loan
data and a systematic data verification process, BlackRock Solutions conducted a bottom-up
multi-year loan-loss forecasting exercise, applying parameters estimated from emerging
patterns of loan delinquency. Compared to previous estimates, this exercise involved higher
percentage capital ratios; higher three-year loan loss projections; a buffer for loan-losses
beyond the three-year horizon; and costs associated with deleveraging non-core assets. The
result, announced in March 2011, was a further required capital figure of €24 billion.12
3.2 Strengthening public finances
The collapse of the bubble had a disastrous effect on the Government's finances. With the
budget deficit spiking to 31 per cent of GDP in 2010 (if banking support costs of 20.2 per cent
per cent of GDP are included) and public debt rising very rapidly from 2007 onward, the Irish
Government has taken a number of measures to strengthen public finances. Austerity is
never popular but, as evidenced by the pre-programme actions of the Government, it was
recognised at an early stage that there was no alternative to this policy. With debt markets in
the fall of 2010 becoming unwilling to fund the Irish Government, it faced the choice of either
closing the massive budget deficit literally overnight, or spreading the necessary correction
over a longer period of time by asking for a financial assistance programme from the Troika.
Adopting the programme has allowed the fiscal restructuring to be done in a much more
deliberate and targeted way than otherwise would have been possible. This has increased
the likelihood that the improvement will be both structural and lasting in nature, and that as a
result the Irish Government will be able to access debt markets on a sustainable basis from
this year onwards. That said, the sheer size of the necessary correction has meant that both
revenues and spending levels have had to be adjusted sharply.
The fiscal consolidation programme adopted by the Irish Government has been front loaded
and, between 2008 and 2013, has entailed measures equal to almost 18 per cent of GDP.13
The size of this adjustment is second only to that of Greece. Since the total adjustment
necessary by 2015 has been estimated at €34 billion (or 21 per cent of GDP), it follows that
the lion's share of that, about 85 per cent, has already been done. Broadly, one third of the
adjustment comes from the revenue side and two thirds from the spending side. Among the
measures taken to increase revenues are an income levy, changes to social insurance, the
introduction of a health levy, changes to tax credits and bands, increase in excise duties, a
2 percentage point increase in the VAT and the introduction of a property tax in 2013. On the
spending side, current savings achieved to date include paybill reductions, covering pay
rates and headcount, a public sector pension levy, and reductions in social welfare rates.
Despite these significant adjustments, however, the budget deficit remains very large. The
most recent forecasts suggest that the deficit in 2012 will be somewhat below 8 per cent of
GDP. Although this is less than the target of 8.6 per cent, public debt is continuing to
accumulate rapidly and is expected to peak in 2013 at 121 per cent of GDP.
4. The current situation
But while many measures have been taken by the Irish authorities to overcome the crisis and
to prepare for the exit from the programme, concerns remain. Two are readily apparent. The
first arises from the high level of mortgage arrears; the second is the risk to sovereign debt
sustainability arising from the high debt-to-GDP ratio.
4.1 Mortgage arrears
As a consequence of the crisis, mortgage arrears have risen sharply, with some
15.1 per cent of mortgages now in arrears for more than 90 days. A key determinant of
mortgage arrears is the unemployment rate which stands at just under 15 per cent, three
times the level at the start of 2007. Mortgage borrowers who become unemployed may rely
on savings to meet debt repayments for some period of time. However, the long-term
unemployment rate has increased more than six-fold, with the effect that large numbers of
people have experienced sharply reduced incomes for more than a year, raising arrears
rates. For the banking sector, the combination of mortgage arrears and negative equity is
major determinant of loss rates. While borrowers that become unemployed and therefore are
unable to service their mortgages but who are not in negative equity can in principle sell their
houses and repay the loans, those that are in negative equity cannot.
Moreover, it is difficult for banks to assess the repayment capacity of distressed borrowers.
Some borrowers may be experiencing temporary financial difficulties, from which they will
recover relatively quickly. These borrowers may need some breathing space until they, for
instance, find a new job. Other borrowers may be experiencing a permanent decline in
income, and require a more extensive modification of their mortgages, while others still may
never be able to service their debts and banks may have to pursue the route of
repossession. These difficulties faced by banks in distinguishing between types of borrowers,
together with the fact that it is costly to modify mortgages for borrowers that in fact would
have been able to service them, have arguably caused banks to be slow to tackle the
problem of mortgage arrears.
Unfortunately, the delay in doing so and in resolving the uncertainty faced by households and
banks alike has had detrimental effects on the economy. Uncertainty about the future makes
households save more, dampening consumption spending and preventing the economy from
returning to growth. The prospect of a large number of repossessed properties being placed
on the market in the near future has made households hesitate to purchase property now.
For banks, uncertainty about the potential for future mortgage losses has made it difficult to
attract sufficient deposits and market funding, requiring them to rely on the eurosystem for
funding. Combined, these factors in turn impact banks' ability and willingness to lend, with
further negative knock-on effects on the real economy.
A further source of uncertainty arises from the new Personal Insolvency Bill, agreed with the
Troika, that will come into law in 2013. It will reduce the bankruptcy period from 12 years to
3 years, establish an insolvency service to help people manage their debt and create three
non-judicial voluntary debt settlement procedures. Although these procedures are untested,
they should speed up the resolution of arrears, and will be an important part of the solution
for managing private-sector indebtedness.
4.2 Fiscal sustainability
Improving debt sustainability by breaking the sovereign-bank link would enhance the
prospects of a full return to debt markets at the end of the programme. There are two
essential aspects of debt sustainability: first, the level of the debt-to-GDP ratio, and second
the rate at which it is increasing. The level of the debt-to-GDP ratio is high at about
120 per cent. The safety margin is therefore minimal: any unexpected increase in the ratio
risks triggering worsening market sentiment about the Irish Sovereign. Furthermore, slower
economic growth in Ireland would reduce tax revenues and have a direct effect on the
evolution of the debt-to-GDP ratio. While the ratio is expected to decline slowly after peaking
in 2013, forecasts are highly sensitive to nominal GDP growth, which is critically influenced
by nominal GDP growth in the euro area and other main trading partners.
Since debt dynamics depend on the difference between the nominal interest rate and
nominal GDP growth, the debt-to-GDP ratio is also sensitive to the interest rate on the public
debt, which depends on market confidence. If financial markets believe that the Government
will not have any problem rolling over its debt in future years, interest rates will be lower and
it will be easier for the Government to service the debt. Conversely, market concerns about
debt sustainability will raise interest rates, making it more difficult for the Government to
borrow in the markets.14 Hence, expectations are self-fulfilling, permitting both a good and a
bad equilibrium.
To facilitate a smooth exit from the programme, it is therefore important that financial market
concerns about the future debt service burden of the Irish Sovereign are allayed. Continued
sound implementation of the programme is crucial, while developments at the European level
can also be helpful. I have already noted the importance of economic developments in
Europe to Ireland's growth. In addition, European policy announcements can also have a
significant impact on market confidence and the Irish Sovereign's ability to re-enter the
markets.
In this regard, markets responded positively to the 29 June EU Summit statement and the
announcement of the ECB's programme of Outright Monetary Transactions.15 Irish Sovereign
yields declined sharply, facilitating limited bond issues since then. However, these positive
developments depend crucially on market sentiment, which can change rapidly. Any new
development leading to a reassessment of euro area risk by financial markets could result in
an abrupt reversal of the recent declines in yields.
The 29 June EU Summit announcement of the potential future use of the ESM to recapitalise
banks following the establishment of banking union could reduce the total nominal level of
debt. However, the timeframe for implementation of the ESM and uncertainty about the
amount of banking-related public debt that would be eligible, were the ESM to be applied
retrospectively, are unclear. For Ireland, greater certainty on this issue could provide support
for successfully exiting the programme in 2013.
The announcement also included a reference to examining the situation of the Irish financial
sector. This has raised expectations of a possible reprofiling of the Promissory Notes, on
which the Government makes an annual payment of €3.1 billion, or 2 per cent of GDP.
Agreement that results in a more favourable time profile of payments would improve the
Government's fiscal position and greatly enhance its ability to regain full access to the
markets.
5. Conclusions
Ireland has undergone a disastrous boom-bust cycle in the last the decade. Following the
burst of the bubble, the Irish economy experienced an exceptionally severe contraction and
massive bank losses. Lower revenues and large capital injections in the banking system
have led the debt-to-GDP ratio to rise from 25 per cent to about 120 per cent since 2007.
In response to the crisis, the Irish Government has taken a large number of measures to
reform the financial sector, strengthen public finances and return the economy to growth. The
first of these measures were adopted already in 2008. Since 2010 they have been part of an
assistance programme agreed with our European partners and the IMF. In this period, the
Irish authorities have delivered on all of their commitments and made good progress on
restructuring the economy.
While the economic freefall has now stopped, economic performance has been weaker than
anticipated when the programme was agreed, largely because the external environment has
been much more challenging than expected. Overall, economic conditions are still fragile.
With the ending of the programme later this year, the Irish Government will be relying again
on funding from the private debt markets. The stock of public debt is very large, the level of
mortgage arrears is still high and banks are not yet profitable. The safety margin is therefore
small. Improving debt sustainability would greatly enhance the prospects of a successful exit.