As in other economies, housing and finance have been the two sectors of the Irish economy most seriously affected by the global crisis. The health of the whole financial system has been seriously questioned. Irish banks were highly leveraged on property, and collapsing property values have put further pressure on the banking system.
While some mistakes are inevitable during crises, the Irish government made fundamental errors in handling the financial deterioration. For example, late last September it introduced a Bank Guarantee Scheme whose primary aim was to allay fears that the deposits at Irish banks would not have sufficient assets to cover them. This scheme was introduced as a fait accompli with sketchy information given. Throughout the crisis, poor communication of information has hindered effective policymaking.
It looks like the Government has agreed to guarantee the liabilities of approximately €400 billion (over two times annual GDP) and charge a small fee – €1 billion over the two years of the scheme – for doing so. Unlike other international schemes, this was a blanket guarantee covering all liabilities. Six Irish institutions were covered with no attempt to distinguish the relative probabilities of each bank calling in the guarantee. Since then, it has become very clear that there are large risk imbalances associated with each bank’s covered liabilities.
This guarantee scheme is similar to pension guarantee schemes (see Marcus, 1987). It represented a (very) cheap option being sold by the Irish government on behalf of taxpayers to make up for the inability of Irish banks to cover their liabilities due to insufficient assets (loans heavily immersed in property).
No attempt was made to avoid adverse selection. All banks were covered, with no distinction made as to the relative risk of each bank and the likelihood of their subsequently exercising the option.
Moreover, there does not seem to be any attempt to control the moral hazard of those banks insured by the scheme. The government has been very slow to control the activities of the banks and their management. Information only appears to be forthcoming when further government support is required.
Some would go further and argue that the information set that the guarantee scheme was based on was cloudy at the very least and potentially incorrect where the valuation of the banks assets could not be truly ascertained. One could argue that poor information evolution is common in crises, but this does not excuse the weak attempts at extracting relevant and correct information from the banks.
At the time of the guarantee scheme, it was suggested that Irish banks were healthy because they had assets of €480 billion that exceeded liabilities. However, these assets are heavily sourced from property loans, which calls into question the state of the banks that are heavily dependent on commercial and residential real estate.
Mismanaged support for mismanaged banks
Irish financial institutions have received support under the guise of the government providing support to institutions of systemic importance. But for such a small economy it seems a strange interpretation of the term – there are six of them (and given the fact that they do not consider themselves to be systemic given their behaviour and how they provide information to the government). It is also becoming very clear that some of their assets are really bad with little value and a large proportion declining rapidly. It may be time to be stricter in determining to whom the government provides support.
After the guarantee scheme, the Irish government introduced a recapitalisation scheme in December tosupport three banks. By mid-January, it was decided that the recapitalisation scheme for one of the banks covered, Anglo Irish Banks, was insufficient and it was nationalised. There is a major information deficit here – banks required recapitalisation just a just short time after being recapitalised. There is also a corporate governance problem for the banks. In the first instance, it suggests imprudent decision-making, and, in more recent times, it seems to be more about personal survival than facing the problems facing the banks.
Given many banks’ lack of capital, there has recently been a debate on whether temporary nationalisation is required or whether their assets will be taken over by the government at some appropriate value. The government has chosen the latter approach and set up the National Assets Management Agency, whose function is to buy the assets (at the suggested value of €80-90 billion) of distressed banks.
This is a very high-risk strategy. It strongly depends on getting correct valuations, and these property-related assets are falling in value with no sign that they have reached bottom. It is also highly dependent on the correct information being given to the National Assets Management Agency. Given what we have seen of the banking sector in recent months, there would be very little evidence of this.
Note I mentioned that a debate has taken place. Although not everyone is in agreement with the decisions now being made, it is an improvement on how government has been responding to the financial crisis in its early days. Previously, there were either straight denial or attempts to bully the decision-making process.
Dysfunctional property market
Property is a main driver of the financial crisis. Overall the property market – both residential and commercial real estate – can be considered highly dysfunctional. For example, consider residential property – average prices increased by 270% in the ten years through June 2006. This boom made those involved very prominent in terms of wealth creation and decision making in the economy. Since its peak in February 2007, the market has fallen by approximately 20%, although fortunately this decline has been reasonably staggered with price movements of around 1% per month. However, very few would forecast that the market has reached its trough.
The dysfunctional property market was supported and facilitated by policies and activities of both Government and the banking sector. Government directly benefited from the transaction stamp duty and capital gains from price appreciations. Moreover, policies supported the property sector as an important source of economic growth. Banks’ growth and profitability soared (one of the most well-known is Anglo Irish Bank, which increased almost 10-fold in market capitalisation from 2000 to 2007), and their property loan portfolio was identified as the main source of their successes. Also, Government through the regulatory bodies (mainly the Irish regulator) had a soft supervisory stance that involved weak surveillance and monitoring of the banks’ property based loan portfolio.
We are still at an early stage of working through the unravelling of the dysfunctional property market. At present, there appears to be little pressure being put by government on both banks and developers to ensure that the property loan books realise their maximum value.
The Irish subprime problem
Just like the US, many would blame the financial leverage associated with the housing sector. And we even had our own subprime market, although it is distinct from the US version (and we did not have our financial firms investing heavily in these products in secondary markets). The Irish subprime problem, unlike the US, did not originate from providing loans to individuals to purchase single units with poor credit. Rather, it involved providing loans to property developers to build multi-unit blocks. So in primary markets, there were a small number of players borrowing relatively large amounts.
However the Irish subprime makret has many of the characteristics of its US counterpart – borrowers’ underinvestigated credit histories, poor supervision of the process, and high debt-to-assets ratios. It was the size of these loans that led to them being very high-risk given what underpinned the value of the multi-units.
Stock market performance
Turning to equities, the Irish equity market has performed dismally, driven by the large declines in financial firms who historically dominated the market. Year on year, the market fell by 66% in 2008, following a decline of 26% in 2007, and thus far in 2009 the market has continued to decline, down by 6% at the end of the first quarter. This is in stark contrast to earlier in the decade when the market outperformed many international counterparts (Cotter, 2004).
From this smaller aggregate market, the influence of bank stocks has fallen from almost 40% of total market capitalisation at the start of 2008 to less than 10% in 2009.
Worryingly, the market is showing all the signs of being uncompetitive, and it already had a very small base characterised by thin trading. Today, there are very few promising features with almost non-existent primary market activity, much-reduced turnover, and a dwindling number of listed firms. Regardless of the recognition that many of these features are a result of the global financial crisis, questions about the future of the market are becoming increasingly prominent.
Bond market performance
The Irish bond market is now under much closer scrutiny, given the Government’s requirement to raise new finance through debt issues. The analysis has been mixed, but there may be more hope starting to emerge in terms of the economy’s credit worthiness and its ability to obtain further funding.
Whilst serious concerns have been raised about the spreads between Irish bonds compared to their Euro counterparts (Irish bond yields were almost twice German yields), this spread appears to be narrowing. The credit default swap spreads have also narrowed.
Of equal concern is the reduction in credit rating from AAA from leading agencies. To counteract this, the Department of Finance and the Government’s asset and liability management agency, NTMA, are pressing the flesh in European markets in an attempt to minimise the bad publicity relating to Ireland’s poor credit worthiness. The NTMA has successfully been able to issue new bonds on a number of occasions in 2009, although with weak demand and low associated coverage.
Overall the ability of the Irish Government to raise finance through debt issuance appears to be improving as time progresses.
Macroeconomic indicators and the overall picture
There is no doubt that the Irish economy has taken a large hit from the global financial crisis. Many of the economic indicators have worsened considerably – forecasts suggest that things will get worse before they get better.
Economic activity has collapsed – the economy is expected to decline by over 9% in 2009 (the steepest in the Eurozone). This follows a contraction of almost 5% in 2008.
The state of the economy is understandable, as it is a textbook small open economy. Ireland became quite uncompetitive in export markets at the start of this decade, through uncompetitive salaries and trading in strong currency markets (its two largest markets are the US and the UK). This lack of competitiveness has, if anything, increased in recent times with the appreciation of the euro against both the pound and the dollar. Trading in the euro has been criticised in this context, but there is general agreement that the systematic external pressures from membership of the Eurozone will help to develop and enforce economic policies in the long-term that benefit the economy.
During the boom, policy makers lost their focus on the importance of export markets as domestic demand soared with the property bubble. It is now very clear, and worrying, that Ireland may not be able to exploit its position as a small open economy when world economic growth takes off again, especially given the forecasts for our input costs and the currencies in which we trade.
On a daily basis, the population are feeling the human costs of the Irish crisis – unemployment rose gradually from 4.5% to 6.1% during 2008 but it has recently soared and more than doubled to 13.2% by last month. The forecasts suggest that it will continue to rise –with almost 1 in 5 out of work next year.
Public finances (that were driven by the property boom) have become extremely unhealthy. The most optimistic forecasts project budgetary deficits in excess of 10% of the economy’s GDP. This has tied the hands of policy makers trying to boost government expenditure and domestic demand.
Moreover, our very healthy debt situation from a couple of years ago has understandably deteriorated considerably as the Government continues to borrow to finance its activities. Ireland’s debt-to-GDP has risen and is expected to double by then end of 2009 with a further deterioration expected in 2010.
However, Ireland does have a national pension fund (sovereign wealth fund) that was financed whilst we experienced our strong growth. The use of this pension fund is critical to support our ailing economy. I hope it will not be used to finance the bail out of our banking and property sectors.
All these indicators have led many to question the wriggle room the Irish economy has in trying to kick-start the economy. Given the very poor public finances, the increased debt is not being earmarked to bolster the economy. In addition, increasing taxes with reduced government expenditure could imply that, even with increased international demand, we are unable to get the economy growing when the world economy starts to rebound.
What Ireland does have are positive characteristics that were in place since before the crisis (e.g. low corporation taxes and an educated, English-speaking workforce) (Honohan and Walsh, 2002). Hopefully they will help attract new engines of growth.
Overall, the Irish economy has suffered extensively from the financial crisis. Whilst we are not near the end of the cries, there is some evidence that the poor state of the economy will start to improve.
Author’s note: Thanks to Karl Whelan.
Cotter, John (2004), “Viability of the Irish Equity Market”, Irish Banking Review, Summer, 42-54.
Honohan, Patrick and Brendan Walsh (2002). “Catching Up With the Leaders: The Irish Hare,” Brookings Papers on Economic Activity, (1):1-77.
Marcus, Alan (1987), “Corporate Pension Policy and the Value of PBGC Insurance”, in Bodie, Z, Shoven, J, and Wise, D (eds), Issues in Pension Economics, University of Chicago Press, Chicago, 49-76.