No more celtic tiger

tauringhuang.

Aug 11th 2008
From the Economist Intelligence Unit ViewsWire

Trouble for Ireland's economy, in particular for its financial-services industry


Strong growth in domestic and internationally traded services up to 2007 supported a robust expansion in Ireland's financial services industry. However, with negative GDP growth forecast for this year and in 2009, continued turmoil in the world's financial markets and strains in the international banking system, the outlook for both the domestic and the foreign-oriented sides of the industry is less than rosy.

Lending squeeze
Demand for loans will continue to weaken in the next few years. Mortgage borrowing, corporate investment and, to a lesser extent, personal consumption are all expected to be considerably lower, as the economy slows and the property market undergoes a correction. Despite this decline in demand, though, it is possible that ongoing difficulties in the banking sector, either domestically or internationally, could hinder the ability of financial institutions to supply even these lower levels of credit.

Domestic private-sector credit growth accelerated rapidly from 2003 until the end of 2005, when it peaked at 30%. This was driven to a considerable extent by a phenomenal expansion in mortgage lending and borrowing by companies in the property sector. Growth in the stock of mortgage lending has declined steeply (and smoothly) since early 2006, far from the peak of almost 35% year on year to a rate of growth below 10% by the middle of 2008.

The other major element of household credit—credit for non-housing purposes—has also experienced considerable growth in recent years, but it remains modest (the restraint of consumers is illustrated by private consumption as a percentage of GDP falling over the past 15 years). Mainly owing to high levels of mortgage borrowing, household debt (as a proportion of national income) has risen rapidly in recent years and is now among the highest among the OECD economies. In combination with the high proportion of those borrowing at variable rates, Ireland is more sensitive to changes in interest rates than any other euro area country.

Housing slump
In the decade up to 2006 residential property prices in Ireland rose more rapidly than in any other developed economy. Strong demand partly explains this: incomes, employment and population all grew robustly. The increase in the supply of new housing was just as phenomenal—the number of annual housing completions in 2006 was almost five times that of the early 1990s, which compares with static output in the euro area and in the UK. However, when supply and demand fundamentals are considered in tandem, the enormous increase in prices was unjustified.

Consequently, the country's property market is now going sharply into reverse. Prices have been falling for 18 months and excess supply makes further declines all but inevitable. In the event of an even sharper correction than is currently predicted, the main lenders would probably suffer badly. Although Ireland's banks have been highly profitable over a long period and are thus well capitalised, they are hugely exposed to the domestic property market. The international credit crisis, should it continue, could cause serious financing problems for the banks, adding to concerns about their balance sheets.

One of the variables to keep a close eye on is the extent of foreclosures in the coming years. Thus far, there has been little sign of widespread non-performing loans, but if the rate of repossession of properties by banks accelerates, the resale of these repossessed properties into a falling market would further depress prices. This could result in the recession being deeper and longer than anticipated.

Banking bother
In terms of competition in the banking system, only modest intensification is expected in the short to medium term. Concerns about the lack of competition in the sector have been regularly highlighted by both the Competition Authority and the Irish Financial Services and Regulatory Authority, despite the arrival of overseas players in the savings, mortgage and business markets. The result is that costs to businesses (in particular) will remain high, with overdraft rates, for instance, above those of other euro area countries.

One development that has the potential to shake up the market would be the takeover of one or both of the main clearing banks, Bank of Ireland and Allied Irish Bank, by a larger European institution. Although such a development has long been on the cards—as expectations of consolidation in European banking grew following the launch of the euro in 1999—the collapse in these banks' share price since mid-2007 and their related over-exposure to the falling Irish property market may make them more vulnerable to a takeover.

Structural limitations
Ireland's equity culture has developed in recent years, yet its importance for corporate financing is likely to remain limited. Many of the reasons for this are structural. The limited size of the economy means that Irish firms are mostly small or medium-sized, and as the indigenous equity market is neither particularly deep nor wide, there is a tendency for those firms that do reach a critical mass to list on foreign markets. The launch of the euro has also taken its toll, as euro area markets have integrated, lessening the attraction of smaller exchanges.

For similar reasons, the Irish corporate bond market is underdeveloped. The creation of a market for corporate bonds in 2003 has resulted in an expansion of this form of company financing, but growth will also be restricted. The market for government bonds has suffered illiquidity problems in recent years, as public debt has fallen to low absolute levels (as a percentage of GDP it is among the lowest in the OECD).

However, a rapid move into deficit by the government will see the need for significant new issuance. Although this may slightly reduce the small premium investors demand for holding Irish government debt, it will be more than offset if the recent widening in yield spreads over the euro area benchmark bond (the ten-year German bund) persists or widens.