Stefan Gerlach: Ireland's road out of the crisis
Address by Mr Stefan Gerlach, Deputy Governor of the Central Bank of Ireland, to the
ZinsFORUM, Frankfurt am Main, 8 December 2011.
* * *
1. Introductory remarks
Ladies and gentlemen, first I would like to begin by thanking the organisers for the invitation
to speak here at this conference today.
From all the available evidence, it is clear that the global economy is experiencing a period of
unprecedented economic and financial instability. Risks have increased substantially in
recent months. The crisis, and not just here in Europe, has entered a new and dangerous
phase. Against this background, the a priori expectation would have been that a country with
its own considerable banking and fiscal difficulties, and one that was already in an external
assistance programme, would see its situation worsen. However, that is not what has
happened to Ireland. While market sentiment still remains fragile, and even allowing for the
recent reversal in Irish bond yields, there has been an improvement in market perceptions of
the risks associated with the Irish sovereign and the domestic banking sector since the
summer. Notably, Ireland has also received favourable comment in some official circles,
being referred to as an example, and even a role model, in terms of implementing a
programme of adjustment.
While these are welcome developments, they largely reflect the fact that, to date, Ireland is
performing well under the terms of the adjustment programme. This is good, but there are no
grounds for complacency. Ireland is a small and very open economy and, more than most, it
is subject to the fluctuations of the international economy. More immediately, the recent rise
in Irish bond yields is a reminder that market perceptions are volatile and can change quickly.
So, while good progress is being made in returning the economy, the public finances and the
banking system to a sustainable path, much still remains to be done. As it has been to date,
the adjustment must continue to be comprehensive, convincing and transparent if it is to
deliver lasting success.
Having said this, as it is around one year on from Ireland's entry into an external assistance
programme, it is probably timely to give an account of how Ireland is charting a path out of
the crisis and what its progress has been. It will become apparent from this account that
Ireland's adjustment began well before its entry into the EU-IMF programme and that many
of the elements of that programme were already in place before Ireland had to turn to the
Troika. What involvement with the external partners has provided are the invaluable funds
needed both to keep the government and the banks financed and to implement the
programme of fiscal, banking and structural adjustment over a reasonable time frame, as
well as welcome external discipline and oversight.
2. Some background
To begin, it is useful to go back in time and recall a little of Ireland's recent economic history
in order to understand how the country found itself in the difficult situation it has faced in
recent years and to provide a context for explaining the approach taken to managing the
crisis.
For much of the 1970s and 1980s, the Irish economy was a problem economy, characterised
by low growth, high inflation and high and rising public debt. In addition, relative to the EU
average, living standards were low. This period came to an end in the late 1980s, when the
economy, first, stabilised and then was transformed through the second-half of the 1990s on
the back of very rapid output, employment and productivity growth. As can be seen from the
chart (Chart 1), the main engine of growth during this period was the strength of export
growth, which was underpinned by wage restraint. Consequently, after an extended period of
underperformance, the 1990s witnessed rapid economic convergence with Europe while
maintaining macroeconomic stability. As a result, the unemployment rate fell from almost
17 per cent in 1987 to just over 4 per cent by the turn of the millennium, the fiscal balance
moved from a deficit of over 8 per cent of GDP to a surplus of 2.7 per cent and the debt-to
GDP ratio from in excess of 110 per cent to under 40 per cent over the same period.
This period, up to 2000, was the true "Celtic Tiger" era, characterised by buoyant export-led
growth, strong employment growth, moderate wage and price inflation and healthy public
finances. There was no single factor which accounted for the buoyancy and stability of the
economy during this period. Rather, the period saw the coming together of a number of
factors, both long and short-term, which helped to generate strong and stable growth. These
factors included:
 Broad macro policy stability, which was built on the back of successful fiscal
consolidation in the late 1980s;
 A strong focus on improving the economy's external competitiveness through wage
restraint;
 Strong growth in labour supply and a dividend from earlier investment in education;
 A marked increase in inward foreign direct investment;
 Increased infrastructural investment (partly funded by the EU); and
 Micro reforms of labour and product markets.
3. The growth of imbalances
By 2000, economic convergence with Europe had been achieved, full employment had
effectively been reached and there was little spare capacity left in the economy. At that point,
one would have expected growth to slow, moving to the more moderate rates normally seen
in post-convergent economies. While, against the background of the global recession of the
time, Irish economic growth did slow in 2001-02, growth picked up strongly again from 2003
onwards. Notably, however, the sources and composition of growth after 2003 differed
significantly from those of the 1990s. Growth became predominantly driven by domestic
factors and, in particular, by a surge in construction activity, reflecting a boom in housing and
commercial property investment. On the external side, there was a sharp deceleration in the
rate of export growth as compared to the 1990s, reflecting, in turn, a considerable loss of
competitiveness. In addition, there was also a significant slowdown in productivity growth.
This period, from 2003 to 2007, saw the emergence of significant imbalances in the Irish
economy, which were at the root of the problems which emerged later. In summary, there
were three sets of problems:
 An uncontrolled credit-fuelled construction boom which gave rise to an overheated
property market and over-exposed banks;
 On the fiscal side, a tax structure and public expenditure levels which became too
dependent on revenue from cyclically sensitive sources; and
 A trend loss in wage competitiveness, the labour market impact of which was
masked by the transitory strength of parts of the domestic economy.
3.1 The property market and banking
Looking, first, at developments in housing and the construction sector. While both housing
output and house prices grew reasonably strongly over the course of the 1990s, these
developments could largely be justified by both the initial low level of the housing stock and
property values at the start of that decade. As a result, over the course of the 1990s the
housing stock grew from 1.2 million to 1.4 million homes. However, over the following eight
years, the number of homes increased by a further half a million (Whelan 2010), a staggering
36 per cent increase in the stock. As a result, investment in dwellings in Ireland as a share of
GDP rose from being close to the euro area average in the mid-1990s to being more than
double that average a decade later (Chart 2). At this point, the share of construction output in
GDP had also doubled in a decade, rising to around 10 per cent, while construction jobs
accounted for more than one-eighth of total employment.
Despite the remarkable increase in supply, however, Ireland also experienced an
exceptionally strong boom in house prices (Chart 2), reflecting the fact that demand, at that
time, was significantly outstripping even the considerable growth in supply. In nominal terms,
house prices increased by over 300 per cent in the decade between 1996 and 2006, with
average annual growth in the region of 15 per cent over the period. Irish house price inflation
over these years far outstripped that of any other advanced economy, with the rise in house
prices across a selection of other OECD countries for which data is available, averaging
around 6 per cent over the same period.
There were both fundamental and other, less comforting, reasons why Irish house prices
grew so strongly during this period. Strong growth in per capita real disposable incomes and
favourable demographic and household formation trends, boosted by sizeable net
immigration, underpinned some of the increase in demand. However, worryingly, the rise in
even basic valuation measures, such as the ratio of house prices to disposable incomes, was
considerable. There were also other influences at work. The interest rate convergence
process as a result of the move to EMU brought about a sharp fall in nominal short-term
interest rates, with ex-post real interest rates further impacted by the higher rates of Irish
inflation relative to the euro area. Also, there were significant incentives at the micro level, in
terms of favourable tax treatment, which also served to stimulate the demand for property.
For this greatly increased demand for housing and other forms of property to be satisfied,
however, finance had to be provided - and it was, and in extremely large amounts. While
banks had not been central to the financing of the export-led Celtic Tiger period, which was
income-led rather than credit-led, they were central to developments in the housing and
property markets from 2003 onwards. Stimulated by financial market liberalisation and
increased competition in banking, as a result of the entry of some foreign banks into the Irish
market, competition in the mortgage market intensified. This led to a significant easing of
loan conditions, such as maximum loan-to-value ratios and the rigour of creditworthiness
assessments, as well as a narrowing of margins on lending. Against this background, there
was rapid credit expansion throughout the banking sector (Chart 3). While much of this was
related to house purchase, lending for property development also soared.
Given the scale of mortgage lending, it is no surprise to find that this resulted in an
overconcentration of lending to the property sector and increasingly, over time, to property
developers. It was the latter, which was to prove particularly problematic. At the peak of the
boom, lending to the property sector accounted for two-thirds of the total outstanding amount
of lending advanced by domestic Irish banks (Chart 3). This effectively tied the fate of the
Irish banks to the evolution of the market for property and for development land. An
additional problem was that, with growth in credit greatly exceeding growth in the deposit
base, a significant proportion of the funding for this lending came through short-term
wholesale foreign borrowing by Irish banks. While this development occurred in other euro
area countries as well, reflecting the fact that the introduction of the euro facilitated a
significant increase in the availability of cross-border funding, in the case of the Irish banks
the increased reliance on this source of funding was quite dramatic. Between late-2003 and
early-2008, the net external indebtedness of domestic Irish banks had jumped from around
10 per cent to over 60 per cent of GDP.
As noted by Honohan (2010), the later difficulties of the Irish banks, whether in terms of
liquidity or solvency, are directly attributable to their over-lending for land and property
investment during this period and to the fact that much of it was financed through external
borrowing. In summary, both the scale and funding of property related lending between 2003
and 2007 were systemic risks which were very poorly managed and have been a major
subject of official reports into the Irish crisis. The very costly lessons learned from this
episode have informed subsequent decisions with respect to the transformation of financial
supervision and regulation in Ireland in recent years.
3.2 Fiscal issues
In addition to the imbalances which were being created in property and banking, there were
also less visible problems being built up in the fiscal area. There was both a particular and
general aspect to these problems. The particular aspect stemmed from a growing reliance on
revenues generated by the booming housing market. This was not just an Irish phenomenon,
however. In many other countries, during this period, government revenues also benefitted
from surging house prices, financial asset prices or strong growth in the financial services
industry. We are now more aware that these gains are, to a large degree, cyclical, and need
to be viewed as such. However, adjusting for the impact of housing booms or asset bubbles
on tax revenue is not straightforward and is not something that was explicitly corrected for
either in Ireland or elsewhere at that time. By not taking account of this effect, however, the
underlying health of the fiscal position is overstated and its vulnerability to the cycle is
understated.
In Ireland's case, given the scale of the housing boom, this was a significant factor.
Estimates suggest (Addison-Smyth and McQuinn, 2010) that the contribution of residential
property market taxes to total tax revenue doubled to almost 16 per cent between 2002 and
2006 (Chart 4). If one adds revenues from Corporation Profits tax to this, the share of this
group of taxes rises to around 30 per cent of total tax revenue. This would be around 4 times
higher than the share of this same group of taxes two decades earlier. This raises the more
general problem that had been gradually been increasing over time, which was a reduced
reliance for revenue on more stable and reliable sources, such as income tax and VAT, and
a greater reliance on more cyclically sensitive taxes. Growth in the latter had been used to
facilitate a significant narrowing in the income tax base over the longer term and had also
been used to fund relatively strong expenditure growth in the 2000s (Chart 4). The dangers
inherent in this approach were to materialise once the source of these cyclical revenues
dried up.
3.3 Competitiveness
The emergence of imbalances during the boom period was also reflected in a sharp loss of
wage competitiveness. Following EMU entry, some deterioration in competitiveness was
probably inevitable, given that, by then, the economy had reached full employment and had
probably achieved a level a level of competitiveness that was unsustainable. To some extent,
this would have been a natural equilibrating mechanism in a strongly growing economy in a
currency union. However, the scale of the loss of competitiveness which occurred went far
beyond what might have been reasonable (Chart 5). The domestic demand driven nature of
the boom, particularly after 2002, generated a strong boom-fuelled labour market.
Notwithstanding strong inward migration, wage growth moved well ahead of that in trading
partner countries. In turn, export growth slowed and the balance of payments moved rapidly
into deficit (Chart 5), a development reinforced by the sharp increase in the net external
liabilities of the domestic banking system, referred to earlier.
4. The crisis unfolds
As time passed, it became increasingly apparent that the boom was based on unsustainable
drivers. The over-extension of credit had given risen to significant over-investment in
housing, an excessive increase in house prices and a sharp rise in indebtedness. Growth
had come to be increasingly driven by domestic demand, as external competitiveness
deteriorated. There was an evident property price and construction bubble, the banks were
over-exposed to this and there had been an effective loosening of fiscal policy, financed by
an increasing dependence on cyclical tax revenues. This was unsustainable.
A slowdown in activity loomed once the housing cycle began to turn in late 2006, in response
to evident oversupply and the impact of rising interest rates on affordability. In early 2007, the
broader level of economic activity peaked and the bubble started to burst. The adjustment in
the housing market, once it began, was relatively swift and spread quickly to the wider
economy. The effect on the wider economy was, in turn, then aggravated by the outbreak of
global financial market turmoil from mid-2007 onwards. However, with or without this turmoil,
the Irish economy would have undergone a significant downward adjustment. So while the
global recession of 2008/09 undoubtedly amplified the Irish downturn, Ireland's problems
were home-made.
The collapse of the housing market over the following years was at the centre of the
recession and the unwinding of economic imbalances. The level of annual housing output
has fallen by around 90 per cent from peak (Chart 6), with output now little greater than the
estimated depreciation rate of the housing stock. House prices have also collapsed, with the
national average price currently around 45 per cent below peak and still declining (Chart 6).
To give some context, the Japanese house price fall, which began in the early 1990s, is the
only housing market decline across OECD countries which exceeds the Irish one in terms of
depth and duration (Kennedy and McQuinn, 2011).
The recession triggered by the housing crash and amplified by the fall-out from the correction
of the significant imbalances which had been created between 2003 and 2007 has been
extremely severe. While less than the fall in output experienced by the Baltic countries in
2008-09, it is the largest contraction within the OECD area. Chart 7 shows that the fall in
average annual GDP between 2007 and 2010 was just over 10 per cent. With the price level
falling, the fall in nominal GDP, at close to 18 per cent, has been much greater.
Not surprisingly, given the nature of the preceding boom, the contraction in activity has been
greatest on the domestic side of the economy, particularly on the investment side, reflecting
the collapse of construction activity. On an annual average basis, total building and
construction output fell by more than two-thirds between 2007 and 2010 and it is the fall in
this component which has subtracted the most from growth in recent years. Consumption
has also been hard hit. However, exports have performed better than expected, with the
composition of Irish exports proving to be somewhat acyclical during the global trade
downturn of 2008-09.
With the domestic side of the economy being relatively more labour intensive, the downturn
has resulted in a sharp rise in the unemployment rate, which has risen from over 4 per cent
to stand at over 14 per cent at present. Ireland's unemployment rate is now one of the
highest in the OECD and over half of the jobless have been unemployed for over twelve
months. Construction has accounted for close to half of the jobs lost. Large losses have also
occurred in manufacturing and labour intensive services such as retail, hotels and
restaurants. Younger workers without tertiary qualifications have been hardest hit. Mitigating
the rise in the unemployment rate somewhat has been a sharp fall in the rate of labour force
participation and also a rise in net outward migration.
4.1 Fiscal and banking developments
Turning to fiscal developments, the crisis triggered a dramatic shift in the state of the public
finances. Having appeared a model of fiscal probity, running a budget surplus every year,
except for one, between 1997 and 2007, Ireland rapidly moved into sizeable fiscal deficit
from 2008 onwards. While I will deal later with the fiscal implications of the banking crisis, I
would emphasise that a large part of the movement into deficit reflected the fact that the
crisis revealed a weakness in the public finances which was not apparent during the boom
years - the increased reliance on cyclical revenues derived from property related sources.
While a movement into deficit could have been expected given the scale of the collapse in
economic activity, the deterioration in the fiscal position in 2008-09 was driven, in large part,
by a sharp collapse in Exchequer revenues (Chart 8), which fell at almost twice the rate at
which nominal GDP declined. This reflected the fact that a large and growing share of
boomtime tax revenues, which had been boosted by the property bubble, all but vanished during
the downturn.
The most obvious impact of the crisis, however, was on the banks. The sharp correction in
property prices exposed very severe vulnerabilities in the banking sector. Given the scale of
lending during the boom and the heavy exposures to the property sector, and particularly to
property developers, banks found themselves awash with bad or rapidly deteriorating assets,
once the property market began to collapse. During the boom, the Irish banking system had
lent excessively to fund a huge increase in credit, concentrated on the property sector. While
most lending was to Irish residents, Irish banks also lent extensively abroad, though
generally for property-related assets and in markets strongly correlated to Ireland. In effect,
there was little risk diversification. The bulk of the lending advanced during the boom was
secured against property and once the value of the latter began to fall, which it did
dramatically in the case of development land, and with the economy also moving into a
severe recession, a surge in non-performing loans and impairments became inevitable
(Chart 9).
Although Irish banks had little or no exposure to the US sub-prime market, their heavy
reliance on cross-border wholesale funding and concerns about the scale of their likely
losses as a result of the rapidly unfolding collapse in property markets, meant that they were
particularly vulnerable once liquidity began to dry up in global financial markets. However,
concerns in relation to the Irish banks were not confined to liquidity, as evidence of the scale
of their losses emerged (Chart 10) solvency concerns intensified and the Irish banks
experienced a sharp rise in their credit-default swap spreads and a steep fall in their share
prices (OECD 2009). With the growing prospect of their capital being eroded, and in some
cases entirely exhausted, the State was forced to step in to underpin the banking system.
5. Policy responses
The extent of the deterioration in both the fiscal and banking situations required immediate
policy actions and I will now turn to discuss these and talk about the approach taken by the
Irish authorities to, first, respond to, and, then, gradually start to begin to work their way out
of the crisis. In doing this, it will become apparent that much was done before Ireland entered
the EU-IMF programme and that the programme essentially represents a continuation and
deepening of the adjustment strategy that had already been put in place. Crucially, however,
this is now happening within a secure funding environment for the next two years and is
benefitting from the engagement and support of partners.
While the aim has obviously been to unwind the imbalances in the economy and, in
particular, to correct the problems in the fiscal and banking areas, the underlying approach
has increasingly been to recognise the need to reduce both the level of debt in the economy
and also the perceived tail risks associated with that debt, especially in relation to the banks.
The lesson is that reducing uncertainty and risk in this way helps, not only to improve market
perceptions, but also to demonstrate clearly that progress towards a resolution of the
problems is being made. Successfully managing risk perceptions, through convincing and
transparent actions, is crucial in the current market environment.
5.1 Banking
Turning to the policy response on the banking side, the first point to make is that, while policy
actions were taken relatively quickly in response to the emerging crisis in banking, for
reasons outlined in a moment, it took some time to get a clear and credible estimate of the
potential upper limit of the losses of the banking system in a stressed scenario. Up to that
point, despite the scale of the policy actions taken, concerns about uncertainty and risk in
relation to further bank losses dominated assessments of the outlook for both the banking
system and fiscal policy.
A timeline of banking sector developments from September 2008 is shown in Chart 11. As it
shows, the initial response of the Irish Government, in September 2008, to the severe
funding difficulties of the Irish banks and the intense concerns which emerged about the
viability of the Irish banking system was to introduce an extensive guarantee of bank
liabilities for a period of two years. While this guarantee was introduced in highly pressing
and urgent circumstances, as Patrick Honohan (2010) noted in his report on the Irish banking
crisis, "it complicated and narrowed the eventual resolution options for the failing institutions
and increased the State's potential share of the losses". This guarantee was superseded by
a narrower, more time-limited, scheme which has continued to be extended after the expiry
of the original guarantee scheme and still remains in place.
It should be added, at this point in the narrative, that, governed by a detailed legal
framework, the ECB provided ample liquidity to the Irish banking system all through this
period, thereby considerably reducing risks for the domestic banks. During this time, the
Central Bank of Ireland has worked with the ECB to ensure that the necessary liquidity has
been made available to allow the Irish banking sector to continue to function.
Returning to the banking strategy, in practice, it has come to be organised around three
objectives - recapitalise, resize and restructure. The first move to recapitalise banks was in
late 2008, though these injections were small relative to what would come later. To help
stabilise and start to resize the system, it was decided to establish a national asset
management agency (NAMA) to purchase the largest property development-related loans,
removing them from banks' balance sheets. By removing the uncertainty about future losses
on these loans, the intention was that it would leave banks in a stronger position to recover.
The NAMA approach, with a view to breaking even over time, was to buy loans at
marketrelated prices from banks. Given the state of the property market, this implied substantial
haircuts and necessarily entailed crystallising sizeable losses on banks' balance sheets. This
generated a large and transparent recapitalisation need, which was met by the State. While it
was recognised that this would be costly, it gave visibility to the process.
However, there were difficulties. As a result of a requirement to apply competition law, it was
necessary to value and transfer loans individually. This made the transfer process a relatively
lengthy one, which worked against the objective of moving quickly to cleanse balance
sheets. More significantly, an unforeseen consequence was the fact that the average size of
the haircut increased over time, as the typical size of haircut on the later tranches proved
unexpectedly large. As a result, the final recapitalisation need arising from the NAMA
process was greater than the initial indications from the earlier tranches of loan transfers had
suggested. This added to the uncertainty as to the ultimate cost of State support for the
banks and, given that this news emerged as the European sovereign debt crisis itself was
unfolding, it added to pressures on the Irish sovereign at a crucial time in 2010.
Taking everything into account, the total recapitalisation need up to end-2010 was slightly
over €46bn, of which just under €36bn (over one-fifth of 2010 GDP) was gross debt
enhancing. The bulk of this €36bn was accounted for by the cost of recapitalising Anglo Irish
Bank, a bank with catastrophic development-related losses and which had been nationalised
in early 2009. The remaining public capital injections in 2009-10, of just under €11bn, into
the two major domestic banks were recorded as financial investments and were funded from
the National Pension Reserve Fund.
The effect of the sizeable sovereign support for the banks, which impacted significantly on
the 2010 fiscal deficit, allied to the rapid deterioration in the underlying fiscal deficit (Chart
12), led to an extremely sharp rise in the general government debt ratio (Chart 12). This
increased from a relatively low level of 25 per cent of GDP in 2007 to rise to more than
90 per cent of GDP by 2010. The increase in the deficit and debt ratios occurred despite the
fact that considerable fiscal consolidation had already been underway since 2008. In total,
over five fiscal adjustment packages, this amounted to cumulative ex-ante consolidation
measures of the order of almost 10 per cent of GDP. Their impact in improving the fiscal
position, however, was being countered by the effect of the sizeable contraction in economic
activity on the public finances.
By the third quarter of 2010 then, despite significant measures in both the banking and fiscal
areas, concerns remained elevated about Ireland's financial balance sheet. The fiscal deficit
was high, the debt ratio had risen sharply and had reached a level where there were growing
concerns about sustainability, particularly given the perceived uncertainty about the ultimate
costs of bank support and, in particular, about the uncertainty regarding the associated tail
risks. In addition, the economy, particularly the domestic side, was still contracting.
Against the background of the heightening of tensions in European sovereign debt markets,
there were obvious risks in these circumstances. Added to this was the looming deadline of
the expiration of the bank guarantee scheme introduced in September 2008. Irish
government bond yields began to rise and deposits flowed out of the domestic banking
system at an accelerated rate. Crucially, despite a sharp increase in the need for central
bank funding, the Eurosystem continued to fund the growing liquidity deficit, with lending
carried out either through normal Eurosystem operations or directly from the Central Bank of
Ireland.
5.2 EU-IMF programme and banking measures
Pressures continued to mount, however, and an adverse shift in international market
sentiment drove yields on Irish debt in November 2010 to levels that signalled the market
was no longer willing to provide funding to the sovereign at reasonable rates of interest. At
this point, external assistance in the form of recourse to the financing facilities of the EU and
IMF became essential.
Through providing financial support out to end-2013, subject to specific conditionality, the
programme provides time for Ireland to tackle its problems. In terms of conditionality, as I
mentioned earlier, the programme essentially required a continuation and deepening of
existing policies. In particular, the EU-IMF programme endorsed the overall policy approach
to banking, while facilitating a more rapid and far-reaching implementation of this strategy.
The central aim remained to recapitalise, resize and restructure. First, capital was being
injected to reach the newly increased capital standards. Second, an explicit strategy for
downsizing and reorganising the banking sector was to be implemented. Third, the
institutional weaknesses that had become apparent during the banking crisis were to be
addressed.
To ensure that bank balance sheets were strengthened and that deleveraging plans could be
implemented, the Central Bank carried out painstakingly detailed capital and liquidity
assessment reviews of the domestic banks, the results of which were published in
endMarch this year (Chart 13). While a number of previous capital assessment reviews had
been carried out earlier, this one differed in some important respects, with tougher loan loss
assessments, the insertion of an additional capital buffer, strong external validation and
greater transparency, all features of the exercise. A highly conservative approach was taken
to the estimation of loan losses, with an independent loan loss assessment exercise carried
out by internationally recognised experts in this area. These assessments were carried out
on the basis of more granular and demanding information gathering and analysis of the
impaired loan portfolio and financial condition of the banks. In addition