How Many Irish bonds can QE buy?

The ECB’s expanded  QE is due to start in March and a figure of €12bn is often reported in terms of the amount of Irish sovereign debt that the Central bank can buy. The case is not that clear-cut , however,  and the limit may be only €9bn from June.

Bonds purchased in any EA  country  under QE are subject to a number of restrictions. The first limits the share  of the total each country can buy. In Ireland that means about 1.7% of  the €60bn per month  QE target, which includes private and  EU supranationals as well as government debt. The second limits central bank buying to 25% of any issue. A third puts a  33% ceiling  on the amount of   any issuer’s debt that can be held . The latter only makes sense relative to the 25% limit if existing central bank holdings are included .

Indeed,the ECB does already own some sovereign debt, purchased under the Securities Market Program (SMP) , which stands at €144bn having fallen from over €200bn (via bonds maturing). We do not know the  current breakdown of that holding by country but the ECB did publish that data as at end-2012. At  that time €14bn of Irish government debt  had been purchased, 6.5% of the then total, which implies about €9bn today, assuming redemptions were broadly proportional over the past two years.

The Irish Central Bank also owns government debt stemming from the Anglo Promissory note. Part of that was repaid  in 2012 via the issuance of €3.5bn  of the 5.4% 2025 bond. The Bank announced it had sold a portion of that in 2013 but presumably still owns around €3bn of that issue. In addition, the Central bank received €25bn in long term bonds as part of the Promissory note deal in 2013   and again has sold a small amount, leaving €24.5bn.

Another QE stipulation is that  only bonds with a maturity  between 2 and 30 years are eligible, which in Ireland’s  case gives a current figure of €86bn. That implies  €8.5bn of central bank holdings are within that range ( including €5.5bn of the Prom note bonds) which alongside the €9bn SMP figure gives €17.5bn or 20% of the total at issue. The issue limit therefore leaves only 13% open to further purchase, which is just under €11bn

Finance Minister Noonan stated that the Central bank had ‘ample room ‘ to purchase Irish debt. However, the situation changes in mid-year as  €3bn of the Prom note bonds redeem in June 2045 (i.e. would then fall within the 30 year limit), so  from then on the CB’s eligible  holdings rise to €20.5bn or 23% of the total, implying less than €9bn could be added.

Some SMP holdings will mature over the next 18 months and the Central bank will sell some of its Prom note bonds, so giving some room for additional QE, The NTMA will also issue new debt (perhaps another €11bn this year) which  will qualify as long as it is over 2 years so raising the remaining limit for the Central bank rule. Perhaps not quite as ‘ample’ then as some think, in the short term and with more moving parts.

 

ECB to buy Government debt but limited risk sharing

The ECB today decided to buy sovereign debt, a decision  which, although widely anticipated, had the immediate effect of weakening the euro further on the FX markets and  giving a further fillip to government bonds, which were already at record yield lows in many cases. Equities too rallied although it remains to be seen  when the dust settles how much of the ECB policy change  was already priced in to markets.

Mario Draghi gave two reasons for the move. First, inflation has been weaker than expected and inflation expectations have fallen further, which could in turn have a negative impact on wage and price developments particularly given the level of spare capacity in the euro zone.Second, the existing monetary policy measures in place have not had much of an impact and in that context it was announced that the interest rate on the long term loans available to banks (the TLTRO) will be reduced from 0.15% to 0.05% , an implicit admission that the take-up has been disappointing.

The ECB is also currently buying private sector debt (covered bonds and asset backed securities) in the secondary market  but again the impact has been limited, with only €35bn purchased to date. Consequently the ECB decided to significantly expand the programme to include public sector debt (Government and European Institutions), although some in the council were still of a mind to wait and see how inflation develops in the coming months. The expanded QE programme will now amount to €60bn per month, starting in March and continuing until September 2016,with the prospect of extending it further until there is a ‘a sustained adjustment in the path of inflation which is consistent with our aim of achieving inflation rates below, but close to, 2% over the medium term’. The minimum purchased will therefore be €1,080bn and the final figure may be well above that .

One area of market debate ahead of the decision was the issue of risk sharing-  the ECB had shared the risk of the Securities Market Programme ( a previous and limited excursion into the sovereign debt market)  but there was some opposition to this in terms of QE, notably from Germany. In the event 12% of the purchases will be European institutional debt and all the risk of that will be shared, with the ECB also purchasing another 8% of debt on its own books. Consequently 80% of bonds purchased will be at the risk  of national central banks, implying over 90% of bonds excluding the European institutional debt.

Another question was which sovereign  bonds to buy and the ECB decided to allocate purchases by using the capital key ( each national bank’s contribution to the ECB’s capital). Euro countries provide only 70%  of the later so one assumes that the share will be adjusted pro rata for the euro members.  This would give Germany a figure of 25.6%, France 20.2%, Italy 17.5% and Ireland 1.7%.Clearly, then, purchases of German, French and Italian debt will dominate. If one assumes that €50bn of the monthly purchase is sovereign debt (the rest private sector and European Institutions) the figure for Ireland would be €0.8bn against over €12bn for Germany. The respective debt markets are very different in size though so it is more meaningful to estimate how much of the market would be owned by central banks after 18 months and that gives some interesting results; the central bank would hold 19% of Portugal’s debt, over 14% in Germany, some 13% in Ireland but less than 9% in Italy.  Indeed, in some of the smaller EA  countries with little debt the scheme would imply less than half the debt left in private hands,  and so the ECB announced certain limits, including 30% of the issuer as a maximum.

What  impact will it have on the real economy? When asked, Draghi put forward three  effects. The scheme  is a very significant move for the ECB and hence may boost inflation expectations. Second it will lower funding costs further and hence  may stimulate credit growth and spending. Third it will strengthen the ECB’s forward guidance on interest rates. He did not add it has already resulted in a currency depreciation. Will it work? QE in the UK and the US certainly seemed to boost equity markets and growth did pick up, although core inflation in both economies is still below respective central bank inflation targets. Draghi himself does not seem too hopeful – he responded  to a question about the risks of hyper-inflation when central banks print money by pointing out that  that inflation has not taken off elsewhere in the wake of QE. This begs the obvious question as to its usefulness as a tool in generating inflation in the EA, such is the weakness of domestic demand, but the ECB is clearly desperate to try everything in an envoronmnet when an alternative, expanding fiscal  policy, is deemed verboten.

Falling Prices versus Deflation

Consumer prices in Ireland fell by 0.3% in the year to December, providing a welcome boost to the real income of Irish households. Prices also fell across the euro area, declining by an average 0.2%  Good news then, one might think, so consumers may well be puzzled by the reaction of policy makers, with the ECB announcing its intention to take further action in order to raise prices and boost the  euro  inflation rate  towards 2% per annum, citing the risk of deflation as the catalyst for the move. Why are falling prices deemed a bad thing when central banks have spent most of the last fifty years worrying about the problems caused by rising prices?

Not everyone is convinced that deflation currently exists in Europe because the concept involves the notion of a persistent fall in prices rather than a short term period of negative inflation. This in turn depends on what is causing prices to fall – is it in response to a supply shock such as a rise in oil production (which some economists have termed ‘good deflation’) or as a consequence of falling demand (‘bad deflation’.) Looking at the Irish CPI it is clear that a key factor is the sharp decline in global commodity  prices , which started in earnest over the summer months and has resulted in declining food prices ( down 2.7% in the year to December) and energy costs ( down 5.5%). The latter has further to fall and largely for that reason most forecasts  envisage the annual inflation rate staying negative in Ireland and across the euro area for at least the first half of 2015.

If one excludes energy and unprocessed food Irish prices rose, albeit by a modest 0.5%, and this points to the case  against the prospect of deflation – energy prices will not fall for ever and so the deflationary impact on the CPI will eventually fade. Goods prices account for less than  half of the Irish CPI (45%) and the price of services is still rising ( up 1.7% or 2.8% excluding mortgages) so a sustained fall in  the CPI would probably in turn require a prolonged and heavy  fall in wages. Ireland has seen a  modest fall in wages on one measure (the micro data at industry level) but not on another (the aggregate wage figure used in the national accounts)  while wage growth is positive on average across the euro area.

The performance of  euro equity markets would also suggest that deflation is not a base case,  and the ECB concurs, although stressing that the risks have risen. Modern experience of deflation is limited to Japan but prices also fell steadily during the Great Depression in the US and elsewhere, which has contributed to the association of falling prices with very negative developments in the real economy. The argument partly focuses on expectations , with households and firms postponing consumption and investment in anticipation of lower prices  next year. Deflation will also  affect real interest rates as nominal rates for most borrowers are bounded at or close to zero, implying real rates will rise if the price level falls. This would increase savings and reduce consumption and investment.Similarly, if nominal prices and incomes fall the real burden of household and government debt rises, a particular concern given the current scale of outstanding debt.

The expectations element in deflation has made central banks, including the ECB, very keen to monitor the private sector’s view on future prices. That can be hard to gauge (surveys tend to be strongly influenced by the recent trend) which makes market-based measures ( inflation swaps or derived from nominal versus real bond  yields)  popular as they can be monitored in real time. On that basis the US market is expecting inflation  to average around 1.5% a year for rhe next decade while the ECB’s favourite measure suggests euro investors expect inflation in 5-years time to also average around 1.5% over the following 5 years.

Evidence, then, that inflation is expected to be low and certainly below  the 2% level many central banks view as optimal, but not that there is a widespread belief that inflation will stay negative for a long time. This low inflation outlook is not a scenario which implies strong growth in nominal wages but certainly one in which short periods of falling prices is a positive rather than a negative.

 

The 2014 Budget outturn was very different to that envisaged when delivered

Ireland’s Budget for the following calendar year is now presented in early October, which increases the probability of forecast errors. Such errors are a feature of any fiscal projections but are notable in the Irish context; the median difference between the  forecast Exchequer balance and the outturn over the past fifteen years is €2.5bn. This is not to put any blame on the Department of Finance or to suggest any inherent bias ( the  sample is evenly split between overshoots and undershoots relative to target), but rather to highlight that errors are highly likely in an economy as volatile and open as that of Ireland, and that unexpected events can and often do materialize.

Take the 2014 budget. The fiscal projections were predicated on real economic growth of 2% , including a pick up in consumer spending and a very modest contribution from the external sector, with exports forecast to grow by 1.9%. It now seems likely that the economy grew by 5% last year , with exports growing at a double digit pace. Moreover, consumer spending growth was probably less than 1% while inflation has been much lower than forecast, although the labour market has been much firmer, with the unemployment rate averaging around 11.5% against the projected 12.4%.

The Budget arithmetic had anyway changed by the beginning of the calendar year, with debt service costs  then seen to be €400mn lower than initially envisaged and revenue boosted by  the full amount of receipts from the sale of the national lottery (instead of half).As a result of these factors and other changes the projected 2014  Exchequer deficit was revised down in April to €8.7bn from the original Budget target of €9.6bn

It also became clear early in the year that tax receipts were running ahead of profile and that trend continued over the course of 2014, with a final outturn €1.2bn above target; tax revenue grew by 9.2% instead of the envisaged 6%. All tax headings came in above expectations with the exception of the Local Property Tax , including a  €400mn overshoot in VAT, €234mn from Corporation tax and  in excess of €200mn from Stamp duty, including monies from the pension levy.

That tax oveshoot would have resulted in a deficit below €7.5bn, all else equal, but in the event  the Government chose to use some of the largesse to increase spending. That decision was taken relatively late in the year as expenditure has been on or below target for much of 2014, but  at end- December  emerged €840mn or 2% above profile. Most of this additional outlay went on Health, which begs the question as to the realism of the original target spend for that Department.

As a consequence the Exchequer deficit for 2014 emerged at €8.2bn, above what might have been achieved but well below the original target of €9.6bn and  the lowest deficit since 2007. The NTMA funded the shortfall by borrowing a broadly similar amount and used existing cash balances (i.e. previous overfunding) to repay €8.2bn to the IMF.

So one might say it turned out all right in the end but somewhat different from that envisaged when the Budget was originally delivered, an all too common experience for the Irish exchequer and one which implies it would be fruitless for Ireland to try and fine-tune economic growth via fiscal policy, even if that were possible given euro rules. On final point: the Government is now using the Irish semi-state companies (particularly the utilities) in a more aggressive way to raise revenue, with dividends  received amounting to €475mn in 2014, against €264mn in 2013 and €112mn in 2012. The ESB alone ( and therefore its customers) have  has contributed €840mn since 2008.

ECB -where to from here?

The ECB’s mandate is to deliver price stability, which the Bank itself initially defined as an annual inflation rate below 2%. Clearly there was no thought given to the risks of deflation with such an asymmetric target and the definition was subsequently tweaked to the current ‘below but close to 2%’. Euro area inflation fell below 2% in early 2013 and below 1% a year ago, with the latest ECB staff forecast projecting very low inflation for at least another two years. Moreover , the forecast was predicated on oil prices averaging $86 a barrel next year , which now looks high given that Brent is currently trading under $70.

There are ‘long and variable’ time lags with monetary policy, so one could argue that the current low inflation rate (the flash figure for November was 0.3%) reflects policy decisions made some time ago-remember the ECB actually tightened policy in 2011. Against that backdrop the recent press conference by ECB President Draghi was remarkable in many ways, not least because he had promised ‘immediate action’ on inflation in a speech in the latter part of November.

In the event the only change of note was in the language surrounding an expansion of the ECB’s balance sheet, which had been  ‘expected‘ to reach the level seen in early 2012 but now measures are ‘intended’ to achieve that level. That would entail an increase of about €1,000bn and clearly there is no agreement within the ECB to promote that as a target. Indeed, Draghi stated that there was not unanimity among the 6-member Executive Board on the announced change in wording, limited as it was.

Draghi had previously played down disagreements within the Governing Council but here seemed willing to place them out in the open, emphasising at one point that previous decisions had been taken  by majority. The obvious divisions  on further policy action made for an uncomfortable conference, however, with Draghi having to again indicate the need for more time to assess the situation despite more forecast downgrades and the blatant contradiction between that  approach and his earlier promise of ‘immediate action’

The upshot is that the Governing Council will reassess the situation ‘early next year’  including the size of the balance sheet. That will be affected by the existing bond buying programme (albeit the figure to date is just €22.5bn) and the outcome of the second targeted long term loan operation (the TLTRO). The latter saw a low uptake for the first tranche (€82bn) and there is a wide range of expectations with regard to the one upcoming, while there will be some offsetting downward pressure on the balance sheet via repayment of previous long term lending to the banks.

The euro rallied during the conference, which was attributed to disappointment about a  QE announcement, although that remains  the market’s general expectation. For others, including this writer, it remains less than a certainty that the ECB will eventually buy sovereign debt, and if it does it is not at all clear how much of an impact it will have on economic activity and inflation, leaving aside the impact it has already had on asset prices. A lot of uncertainty then, and one wonders if the next few months will see further resignations from the ECB Council given the fundamental disagreements on the next steps for monetary policy.

Dublin House Prices: Bubble or not?

The CSO recently released the latest Irish house price data, for October, revealing that residential property prices excluding Dublin  are picking up at an accelerating pace; prices rose by 4.8% over the past three months, bringing the annual increase in October to 8.7%, an inflation rate last seen in early 2007. Yet prices are still only 12% up from the lows recorded eighteen months ago and  so few would consider that the market over the bulk of the country is overheating, particularly as national prices still look far from overvalued relative to affordability, incomes or rent.

The price trend in Dublin is very different. Prices there have risen by 46% from the lows recorded in the summer of 2012 and are now 38% below the levels seen in early 2007, a peak now generally considered the height of a Bubble. That term is now reappearing in the context of commentary on the residential property market in the capital and it does arguably satisfy some of the usual criteria employed to categorise a Bubble. One is rapid price appreciation and that is certainly the case ;  the annual increase in October was 24.2%, a pace rarely seen and then only back in 1997 and 1998, in the run-up to euro membership. Moreover, the pace of price inflation has accelerated this year and  the past three months has seen a 9.3% rise, or over 42% at an annualized rate. Expectations of further price gains is also a common feature of asset Bubbles and that also appears to be present; a recent Daft.ie survey showed respondents expect Dublin prices to rise by an average 12% over the next year, up from 6% twelve  months ago, even though  only 15% believe housing in the Capital is still good value (the  value figure for housing ex Dublin is 50%).

Price expectation is an important determinant of  the actual house price trend , notably in terms of the user cost of housing ( the total cost of buying a home with a mortgage, including the mortgage rate, maintenance, depreciation and any tax breaks). That user cost is now negative, particularly so in Dublin, because the expected capital appreciation from buying a home exceeds the other costs, including the mortgage rate.

Bubbles are also often associated with leverage and Dublin fails the Bubble test on that measure as credit is clearly not a driver, or at least credit from the main Irish mortgage lenders. Data from the Banking and Payments Federation Ireland (formally the IBF) showed that the number of new mortgages for house purchase  in Ireland amounted to 5763 in the third quarter, against total property transactions of 11,257 as reported in the Property Price register, so 51% of transactions were funded by Irish mortgages, a proportion that has risen through the year ( from 46% in q1) but is still well below the 80%-85% one associates with more normal market conditions.

A final Bubble test is whether  asset prices make sense relative to fundamentals and here there is often room for debate (witness the range of views on US equity markets and Euro bond yields). In terms of housing one metric is to compare prices with  private rents , as the latter represents the amount consumers are willing to pay for the utility housing provides . Rents nationally, as reported by the CSO, have been rising now for four years, by a cumulative 21%, and have picked up momentum again in recent months after a sluggish period earlier in the year, increasing by 2.5% in the  three months to October. The CSO does not provide a regional breakdown but Daft.ie does , and their figures broadly track the official data. The website shows  strong double digit growth in Dublin rents (around an annual 15% of late, with growth elsewhere at less than half that pace)  and provides detailed rental figures across housing size and type. For example , a 3-bedroom house  in Dublin currently rents at an average €1,518 per month, or €18,216 a year. In theory, the price of any house, discounted at an appropriate rate, should give a present value equal to the rent. If we use the average new mortgage rate as our discount rate ( 3.25%, as quoted by the Central bank) that  Dublin rent implies a house price of €560,000. The Central bank data has been criticized and is going to be revised so an alternative would be to use the standard variable mortgage rate of around 4.25%. On that basis the house price would be  €430,000.

How much is the average price of a house in Dublin? Our own estimates, based on updating the Irish Permanent index (no longer published) with the CSO index gives an actual  figure around €300,000, which is broadly consistent with the average asking price of €325,000 quoted by Daft.ie. The median price of Dublin property transacted  in q3 on the Property Price register was under €280,000 so the implication is that prices in the capital are still not excessive relative to rents, despite the recent pace of price appreciation.The latter reflects ,in part, a recovery from over- sold territory but nonetheless ticks a few Bubble boxes, but not all.

Are current euro sovereign yields irrational?

The Irish Government issued a 15-year bond recently at a yield of 2.49% and the 10-year benchmark is trading at under 1.6%, a far cry from the double digit levels seen in the latter just a few years ago. Sovereign yields across the euro area have plunged of course ; 10-year yields in Italy are down at 2.3%, Spain is trading at 2.1% while Portugal is just over 3%.The perceived risk of default  over the next five years has clearly changed dramatically and judging by Credit Default Spreads is now around 10% for Italy, 17% for Portugal and less than 5% for Ireland.

German yields are lower still and bund yields can be considered the nearest thing to a risk-free rate in the euro area. Consequently, a 10-year bund rate of just 0.8% implies that the market expects short term  euro interest rates to stay low for a long time and then to rise only slowly; the implied 5-year forward yield in five years time is under 1.5%.Interest rates are also extremely low in other currencies but higher than bunds, with the US 10-year yield at 2.34% and the UK  trading at 2.1%. The 5-year forward rates also tell a  very different story- the US implied yield is just over 3% , with the UK at 2.8%.So the bund curve indicates  that investors expect inflation to stay low for a long time and not to threaten the ECB’s 2% target. This , in turn, indicates an expectation that growth will remain weak in Germany, with the prospect of  secular stagnation clearly seen by many investors  as more than just an academic debating point.

That scenario  may or may not materialize but it would appear to be a plausible rationale for the current level of bund yields. The problem is , though, that such a scenario would be very negative for other euro zone economies, particularly those with extremely high debt burdens and needing an internal devaluation to become more competitive within the zone. A prolonged period of very low nominal GDP growth, possibly with price deflation, would severely damage fiscal capacity and via the denominator put further pressure on already stretched debt ratios; Italy’s ratio in q2 of this year  was 134% , for example, with Portugal at 129%.Indeed, Italy’s GDP is already falling steadily and in real terms is back to the level recorded in early 2000.

Buyers of peripheral euro sovereign bonds can point to Draghi’s ‘whatever it takes’ mantra and  it would seem that the market views full-blown QE (i.e. buying sovereign debt)  by the ECB as inevitable and that somehow this will save the day. The Governing Council is clearly split on the issue, however, and some opposed the current plan to buy Asset Backed securities which explains why Draghi is at pains to add the qualification ‘within our mandate’ to his statement that there is unanimous support for additional non-standard policy measures.- clearly some members feel that the ECB could be acting ultra vires. So QE is not inevitable but if it did emerge (through a majority vote perhaps) it is still problematical relative to experience elsewhere. The banking system in Europe  is the main source of credit, unlike the US where the disintermediation of banks is the norm, so QE may not have much impact. Moreover Central banks in the US, the UK and Japan have bought their own sovereign bonds but the ECB has no sovereign bonds to buy- it would have to choose among the sovereign bonds of the 19 member states. How would it proceed if it chose a €1,000bn target- would it buy in proportion to the country weights within the euro area, or target higher yields? The former would imply the purchase of large amounts of  bunds and say only €12bn of Irish bonds. In addition the ECB would be buying at extremely low yields ( elevated prices) so adding a high degree of market risk to the credit risk inherent in QE.

More fundamentally, transferring ownership of some sovereign debt from one group of investors to another (in this case the ECB) does nothing to change the debt burden unless of course one believes that the ECB will effectively tear up the bonds or hold to maturity and then pass the proceeds back to the respective governments. One doubts if that would be acceptable to the Germanic school within the Governing Council, at least on any scale that would make much difference to high debt countries, but such concerns do not seem to weigh much on investors at the moment.

Odd Timing for Proposed Irish Mortage Restrictions

Interest rates are extraordinarily low in many parts of the world; the ECB refinancing rate is 0.05%, in the US the equivalent is less than 0.25% and in the UK the Bank rate is 0.5%.Rates are expected to rise next year in both the UK and the US but the respective central banks have made it clear that any increases are likely to be moderate and that  the cost of borrowing may well settle at levels below previous cyclical highs. In the euro area the economic  outlook is bleaker and most observers expect rates to remain at current levels for a number of years. This low-rate environment carries potential risks for asset bubbles and excessive credit growth so central banks have embraced the idea of macro-prudential tools i.e. measures that can be implemented to protect against systemic financial instability. The housing market is often seen as a specific stability risk and a number of countries have introduced restrictions on mortgage lending, the latest being the UK, where only 15% of new mortgages can be above a Loan to Income (LTI) ratio of 4.5.

The Irish Central bank has now entered  macro-prudential territory with proposals on mortgage lending designed to ‘increase the resilience of the banking and household sectors to financial shocks’ .Like the Bank of England there is a restriction relating to LTI, but in the Irish case the limit is lower , at 3,5, although 20% of lending can be above that limit. In addition, the Bank is also proposing restrictions in terms of loan to value (LTV ) with only 15% of lending allowed above an LTV of 80%. For Buy -to Let loans the LTV limit is 70% with only 10% of lending above that. The LTI restrictions only apply to principal dwelling homes (PDH).

The Bank refers to international evidence supporting the view that LTI restrictions can slow mortgage lending growth and ‘reduce the potential for a housing bubble to emerge‘ although the impact on house prices is less clear, with the Bank of England claiming that there is ‘some evidence of a modest and lagged effect on house price growth’. The latter conclusion is not surprising as credit is only one variable in most house price models, with income, interest rate, the user cost of housing and price expectations also playing important roles. The Central Bank also notes that LTV restrictions are more important after a crash, in limiting losses for the lender.

The proposals have generated debate, of course, with some welcoming the move as important in dampening house price inflation (despite the caveat noted above) while other have argued it will hit  the First Time buyer (FTB) particularly hard and dampen housing supply.Indeed, the LTV limit would appear to be binding now, with 44% of new PDH lending  last year above 80%, while only 7% of lending was above 4.5 LTI, with 77% at 3.5 or below.

Another issue is the timing of the proposals. House prices in Dublin have certainly risen sharply of late and are now over 40% above the cycle low but outside the capital prices have recovered by just 9% and most observers, including the Central Bank and the ESRI, still conclude that prices are not excessive relative to fundamentals such as income or rents. A greater puzzle on timing relates to the credit cycle, given that the restrictions are designed to directly impact lending.The stock of outstanding mortgage debt in Ireland has been falling now for five years and the latest figure, for September, showed a 3.1% annual decline. New mortgage lending for house purchase is picking up but amounted to  just €1.3bn in the first half of 2014 and is still being swamped by redemptions and early repayments. Ireland is therefore hardly swimming in new mortgage lending so restrictions at this time seems premature, particularly as the secondary aim of the moves is to ‘dampen pro-cyclical dynamics between property lending and housing prices’ . That might suggest that restrictions would be better served if actually adjusted for the cycle, with  the LTI limit  reduced if credit growth is deemed too rapid and  the LTV limit reduced if house prices are deemed in excess of fundamentals.

The proposals may indeed dampen  future housing cycles but also have broader societal implications. The Government  was not consulted  and is now reported to be considering some form of mortgage insurance scheme to help FTBs secure a higher LTV.The Governor of the Central Bank in a recent speech also  appeared to be more comfortable  than indicated in the proposal document with the idea of  FTB insurance although with the caveat that who provides the insurance is important. Insurance protects the lender , not the borrower of course, and has to be paid for.A broader conclusion from the Governor’s speech may be that  the proposals will see further modification before implementation, or a longer lead-in time. As it stands the restrictions do have significant implications for  young Irish households, with a longer period of saving in store and therefore a later age for home ownership, at least for some.

Irish petrol prices under downward pressure

Spending on energy accounts for over 10% of the average Irish household budget and the volatility of energy costs is often a significant factor in the swings evident in the  overall inflation rate. The past year has seen a much more stable picture,  however, and in September energy prices were 1.7% below the same month in 2013.  Spending on petrol  and diesel accounts for over half the total energy spend and prices there have also fallen , by some 4% over the past year. The price of petrol at the pump has also eased over the past few months and currently averages around €1.50 a litre, from  €1.57 in July. Further falls are likely in the near term  in the absence of a significant fall in the euro, to perhaps  around €1.47,  given the events unfolding in the oil and gasoline markets.

Tax accounts for around 55% of Irish petrol prices but the recent Budget left fuel alone, following a series of tax increases since 2009, amounting to over 20 cent per litre. Apart from the Exchequer, the price of petrol is largely determined by three factors; the price of crude oil, the value of the euro against the dollar and refinery margins. The global demand for crude is rising but at a slower pace than most expected  -the International Energy Agency has just revised down its forecast for this year and next-reflecting sluggish world growth and a steady decline in the amount of oil required to produce a given unit of output;oil provided 46% of world energy needs in 1973 but only 31% today..The biggest recent  change in the global oil market has come from the supply side, however, with a large increase in non-OPEC production; in the past year non-OPEC supply has increased by over 2 million barrels per day  and in the near term increased production from that source is expected to more than offset any likely increase in overall  global demand. A big factor in that change is the increase in output from the US (in part reflecting the impact of oil from Shale sands) with production there currently challenging Saudi Arabia for the title of largest world producer.

The price of Brent Blend, the European crude benchmark, has fallen by 22% over the past three months, to around $85 a barrel in the face of these demand and supply changes. The euro has also fallen against the dollar over the same period but the decline there has been much  less pronounced, at around 7%, so in euro terms crude oil is now some 15% cheaper than it was in mid-July. In the medium term the price of crude will determine the price of refined products, including petrol, but in the shorter term the margin that a refinery can make  by ‘Cracking’ the barrel of crude (the ‘Crack spread’) can vary, depending on local demand conditions and the degree of excess capacity in the industry. Crack spreads in Europe have been higher in recent months than they were a year ago  but the wholesale price of gasoline has fallen sharply of late and now broadly reflects that of the fall in crude.

A 15% fall in the wholesale price of petrol  over recent months would therefore imply a 7% fall in prices at the pump from the mid July level  (given  over half the price is tax) which would leave average prices around €1.47 a litre. Price will vary around this, of, course, given local supply and demand conditions but most areas should see some price declines, although the demand for petrol is now rising again nationally, which may also influence retail margins. The main risk to that outcome relates to the euro, which has regained some ground of late but still looks vulnerable given the economic backdrop .

 

gi

Irish Budget could now add up to €1bn in stimulus to economy

In April, the Irish Government expected that another round of tax increases and spending reductions would be required to get the 2015 Budget deficit below the 3% target set by the EU, with €2bn seen as the adjustment figure. That would have taken the cumulative adjustment to €32bn since the initial retrenchment started in 2008 but in the event it now appears that such is the transformed economic outlook that the 2015 Budget ( to be delivered on Tuesday Oct 14) will now provide a stimulus to the economy, which may amount to up to €1bn, depending on how much leeway the Minister for Finance chooses relative to the 3% target.

A key factor behind this remarkable change in the budgetary position is the performance of the economy over the first half of 2014. That has prompted the Department of Finance to revise up its real growth forecast for this year and next; 4.7% growth is now envisaged in 2014, from an initial 2%, with the economy forecast to expand by 3.6% in 2015. Nominal GDP is also now seen as being much higher than originally  projected, with  a figure  of €193bn  forecast by the Department , an extraordinary  €19bn above that forecast six months ago. A stronger economy implies a lower cash deficit, via reduced welfare spending and higher tax receipts, with a higher nominal GDP figure also helping to lower the fiscal and debt ratios.

It has been apparent for some time that this year’s deficit would be much lower than initially forecast and the Government’s ‘Estimates of Receipts and Expenditure’, published last night, predicts a 2014 General Government deficit (GGD) of  €6.9bn, which is €1.2bn below that envisaged in April. The deficit ratio is also much lower, at 3.7% of GDP instead of 4.8%. In fact that outturn, if it materializes, would be a little worse than some had expected; revenue is projected to come in €1.8bn ahead of the April forecast, including a €1bn overshoot in tax receipts, but spending is now forecast to be €800mn above the initial target, including over €500mn in voted expenditure, perhaps indicating that the current Health overspend will not be corrected.

Voted  current spending is projected to fall in 2015, by €1.3bn from the 2014 outturn, but again this hides a significant change in plan, as next year’s figure is almost €1bn above that envisaged last April . As a consequence the GGD  in 2015 is only €0.5bn below that projected in April, coming in at €4.7bn. This is 2.4% of forecast GDP and hence well below the 3% target, although had the initial spending plans been adhered to the deficit would be substantially  below 2%.

The figures are on an unchanged policy basis and so the Minister has significant leeway now to raise spending and give some tax relief, with the scale of any largess dependent on his final target. In addition, he may announce some ‘savings’, so increasing the scope for a potential stimulus, including lower debt interest on foot of some repayment of the IMF loan, refinanced at cheaper market rates. That might amount to say €300mn. so reducing the pre-Budget deficit further, to €4.4bn. Consequently a final target of say, , €5.4bn,, or 2.8% of GDP, would imply a spending and tax package of around €1bn, not counting any tax buoyancy on foot of the stimulus  or positive impact on GDP.

The global economic outlook looks cloudier than it did a few months ago , with the euro area particularly weak, which adds a greater degree of uncertainty than usual to any fiscal forecast. The Minister may  err on the side of caution and go for a lower forecast deficit but the difference now is that he has far more options than envisaged earlier in the year and certainly far more than in recent budgets. A deficit of 2.8% would also mean a strong primary surplus (the budget balance less interest payments).