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Ireland's political and cultural magazine
24June 2015
T
HREE recent events, distinct as they may
appear, point to a singular shared risk faced
by the Irish economy, a risk that is only now
being addressed in our policy papers and in
the mainstream media.
First, over the course of May, European financial
markets have posted surprising rises in Government
and corporate bond-yields amidst falling liquidity,
widening spreads and increased volatility.
Second, both the IMF and the Irish Government
have recognised a simple fact: once interest rates
revert back to their ‘normal’ path, things will get test-
ing for the Irish economy.
And third, the Irish Government has quietly admit-
ted that the fabled arrears solutions to our household
debt crisis are not working.
Deep below the lazy gaze of Irish analysts, these
risks are connected to the very same source: the mas-
sive debt overhang that sits on the back of our
struggling economy.
Take the first set of news. The problem of spiking
yields and blowing up trading platforms in the Euro-
pean bond markets was so pronounced in May, that
the ECB had to rush in with a bold promise to acceler-
ate its quantitative-easing purchases of Government
paper to avoid an even bigger squeeze during the
summer. All in, between January and the end of May,
euro-area government-bond yields rose by some
basis points, the cost of non-financial corporate bor-
rowings rose by around basis points, and banks’
bond yields were up basis point. This is against a
background of declining interbank rates (-month
Euribor is down basis points) and massive buying
up of bonds by the ECB.
In one recent survey completed by Euromoney
before the May bond-market meltdown almost out
of institutional investors expressed deep concerns
over evaporating market liquidity (higher costs of ,
and longer time to complete, trades) in the sovereign-
bond markets. In another survey, completed late in
the first quarter (Q) by Bank of America-Mer-
rill Lynch, % of large fund managers said that
European and US stocks and bonds are currently over-
valued – the largest proportion since the survey began
back in .
In the US the current consensus expectation is that
the Federal Reserve will start hiking rates in Q .
In Europe, the same is expected around Q . And
recently, both estimates have been adjusted closer,
despite mixed macroeconomic data coming from the
economies on the ground. If the process of rates nor-
malisation coincides with continued liquidity
problems in the bondmarkets, we may witness both
evaporation of demand for new government debt
issues and a simultaneous increase in the cost of fund-
ing for banks, companies and the Governments alike.
Which brings us to the second point – the role of
interest rates in this economy.
In its recent Stability Programme Update (SPU) filed
with the EU Commission, the Department of Finance
provided a handy estimate of the impact of a % rise
in the ECB key rate. The estimates – done by the ESRI
Ireland is at risk
from higher bond
yields, normalising
(ie rising )
interest rates
and unresolved
household mortgage
arrears
Choppy nancial
waters ahead
Constantin Gurdgiev
OPINION
INTERLOPER
June 2015 25
The total number of mortgages in arrears stood at
145,949 accounts, amounting to a total debt of €29.8bn
or 18% of the total lending for house purchase
”
– show that in a rise in the ECB rate to % from
the current .% will likely cost this economy .%
of our GDP in , rising to .% in and .
By , the effect could amount to losses of around
.% of GDP.
This increase would bring ECB rates to just over
/rd of the historical pre-crisis-period average –
hardly a major ‘normalisation’ of the rates. Which
means that such a hike will be just the start of a rather
protracted journey that is likely to see rates rising
closer to -. percent.
But here is a kicker, the ESRI exercise does not
account fully for the realities on the ground.
In addition to the ECB rate itself, several other fac-
tors matter when we consider the impact of
interest-rate normalisation on the real economy. Take
for example the cost of funds in the interbank mar-
kets. Average months Euribor – the prime rate at
which highest-rated euro-area banks borrow from
each other - averaged .% for the period -
. Today the rate sits at .%. This means rates
normalisation will squeeze banks’ profits. If the euro
area, on average, were to hike loans in line with ECB
increases, while maintaining current -month aver-
age lending margins, the rate charged on corporate
year-and-over loans in excess of € million would
jump from the current .% to .%.
It turns out that due to our dysfunctional banking
system, Irish retail rates carry a heftier premium than
euro-area average rates, as illustrated in Chart 1. This
of course simply amplifies the impact of any change in
the ECB base rate on Ireland’s economy.
The reason for this is the pesky issue of Irish banks’
profitability – a matter that is distinct from the aver-
age euro-area banking-sector performance due to the
massive non-performing-loan burden and the legacy
of losses carried by our banking institutions. Accord-
ing to the latest IMF assessment published in late
April, the Irish banking system is the second worst-
performing in the euro area after the Greek when it
comes to current levels of non-performing loans. In
today’s terms, this means that the average lending
margin charged by the banks in excess of ECB policy
rate is .% for house purchase loans, .% for
loans of under €m to Irish companies with a fix of
one year and over, and .% for loans of over €m to
the same companies. This means that a hike in the
ECB rate to % will imply a rise in the interest rates
charged by the banks ranging from .% for house-
holds loans, to .% for smaller corporate loans and
to .% for corporate loans in excess of €m.
Chart 2 highlights what we can expect in terms of
rate movements in response to the ECB hiking its base
Chart 1: Key retail Interest Rates – Difference to ECB Rate
Chart 2: Key Interest Rates before and after 1 percentage point
hike in ECB Rate
Source: Author’s own calculation based on data from ECB, Euribor and the Central Bank
5.50
4.50
Euro Area: Companies
3.50
2.50
1.50
0.50
-0.50
Jan 2004 Jan 2005 Jan 2006 Jan 2007 Jan 2008 Jan 2009 Jan 2010 Jan 2011 Jan 2012 Jan 2014 Jan 2015Jan 2013
Euribor: 12mo
Ireland: House Purchases
Ireland: Companies
Jan 2003
8.00
7. 0 0
6.00
5.00
4.00
3.00
2.00
1.00
0.00
ECB rate
Current rates
Ireland
Euro Area:
Companies, 1-5 yrs
> 1m
Euribor, 12mo New loans for
house purchases
Companies, loans
<1m over 1 year fix
Companies, loans
>1m over 1 year fix
Source: Author’s own calculation based on data from ECB, Euribor and the Central Bank
ECB rate increase scenario reflects current 12mo average margins
Increase in ECB rate of 1%, current margins
26June 2015
rate from the current .% to %.
No one – not the ESRI, not the Central Bank, not
any other state body – knows what effect such
increases may have on mortgage arrears, but it is safe
to say that households and companies currently expe-
riencing difficulties repaying their loans will see these
problems magnified. As will households and compa-
nies that are servicing their debts, but are on the
margin of slipping into arrears.
While the ESRI-led analysis does enlighten us about
the effects of higher rates on tax revenues and state
deficits, it does little to provide any certainty as to
what happens with consumer demand (linked to
credit), property investment and development (both
critically dependent on the cost of funding), as well as
the impact of higher rates on enterprise formation,
and survivorship, rates.
In addition, higher rates across the euro area are
likely to imply a higher value for the euro relative to
our major trading partners’ currencies. Which is not
going to help our exporters. Multinational companies
trading through Ireland are relatively immune to this
effect, as most of their trade is priced internally and a
stronger euro can be offset by accounting and other
means. But for SMEs exporting, every percentage
point increase in the value of the euro spells lower
sales and lower profits.
Across the euro area, there many ways higher rates
can drain growth momentum in the economy.
But in Ireland’s case, these pathways are almost all
invariably adversely affected by the debt overhang
carried by households and the corporate sector. Cur-
rent total debt, registered in Irish financial
institutions as being extended to Irish households and
resident enterprises stands at just over €.bn.
And that is before we take into the account our Gov-
ernment debt, as illustrated in Chart 3.
A percentage point increase in
retail rates would see some €.bn
worth of corporate and household
incomes going to finance existing
loans - an amount that is well in
excess of the €.bn increase in
personal consumption recorded in
compared to , and whch is
% of the total increase in Ireland’s
GNP over the same period. Add to
that added Government debt costs
which will rise, over the years, to
some €.bn annually.
What is not considered in the anal-
ysis is that at the same time the rising
cost of credit is likely to depress the
value of households’ collateral, as
property prices are linked to credit-
market conditions. This implies that
during the rising-interest-rates cycle,
banks may face the added risk of lower recovery from
home sales.
The effect of this would be negligible, if things were
relatively normal in Irish mortgages markets. But
they hardly are.
OPINION Constantin Gurdgiev
At the end of Q , the total number of mortgages in arrears stood at ,
accounts, amounting to a total debt of €.bn or % of the total lending for house
purchases. , accounts amounting to €.bn of additional debt were restruc-
tured and are not in arrears. Roughly three quarters of the restructured mortgages
involve ‘solutions’ that are probably resulting in higher debt over the lifetime of the
restructured mortgage than before the restructuring. We cannot tell with any degree of
accuracy as to how sensitive these restructured mortgages are to interest-rate changes,
but arrears cases will be much harder to resolve in the period of rising rates than the
cases so far worked out through the system.
You’d guess that the ESRI and the Department of Finance would have done some
homework on all of the above factors. But you would be wrong. There is no case-specific
risk analysis relating to interest-rate changes performed. Perhaps one of the reasons
why most analysts have been dismissing the specific risks of interest rate increases is
due to the lack of data and models for such detailed stress-testing.
Another reason is the false sense of security.
Take the US case. Its economy is now in mature recovery, based on
the most recent survey of economic forecasters by the BlackRock
Investment Institute. But the underlying weaknesses in growth remain,
prompting repeated revisions of analysts’ expectations as to the timing
of the Federal Reserve rates hikes. Still, the Fed is now clearly signalling
an upcoming rate hike.
The Fed is pursuing a much broader mandate than the ECB - a man-
date that includes the target of full employment. This is harder to meet
than the ECB’s singular objective of targeting inflation.
While European inflation is low, it is not as low as one imagines. Strip-
ping out energy costs - helped by low oil prices - inflation in the Euro
area was estimated to be at .% in April . The prices of gas, heat-
ing-oil and fuels for transport shave . percentage points off the
headline inflation figure. Although .% is still a far cry from the ‘close
to but below %’ target, for every % increase in energy prices, the
HICP (Harmonised Index of Consumer Prices) metric watched by the
ECB will rise approximately . percentage points. So far, in April
, energy prices are down .% year-on-year - the shallowest rate
of decline in five months. Month on month prices rose . percentage points.
Sooner or later interest rates will have to rise. In the US explicit Fed policy is that such
increases will take place after the real economy recovers sufficiently to withstand such a
shock. In the euro area, there is no such policy in place. That is dangerous for Ireland. •
Chart 3: Total real economic debt (1millions)
Source: Author’s own calculation based on data from CSO and the Central Bank
Total of Household debt, Secutitised Household debt, Corporate debt and Gross Government debt
600,000
500,000
400,000
300,000
200,000
100,000
0
Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1Q3Q3Q3Q3Q3Q3Q3Q3Q3Q3Q3Q3
2003 2004 2005 2006 2007 2008 2009
2003-2008 average
2010 2011 2012 2013 2014 2015
In 2017 a rise in the
ECB rate to 1% from
the current 0.05%
will probably cost this
economy 2.1% of our GDP
in 2017, rising to 2.4% in
2018 and 2019. By 2020,
the effect could amount
to losses of around 2.5%
of GDP
“
