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Negative Rates Forever

The ECB seeks to set short term interest rates in the Euro Area via control over the amount of liquidity it supplies to the banking system, as the latter is required to observe a minimum reserve requirement, in turn related to the amount of customer deposits each bank holds. The current requirement is around €140bn in aggregate and currently banks have €3,000bn deposited with the ECB, implying excess liquidity of some €2,900bn. This will generally put downward presure on money market rates but there is a floor, in theory at least, which is the ECB’s Deposit rate, which has been in negative territory for over six years now . It was cut to -0.5% last September and if money market rates fell below that banks could borrow in the market and deposit back to the ECB at -0.5%, so this potential arbitrage will generally keep rates above the Deposit rate.

The scale of excess liquidity is such that rates are very close to that floor, nonetheless, with 3 -month euribor trading at -0.486% in recent days. Indeed one money market reference rate, the euro short term rate or €STR, is trading below the Deposit rate ( at -0.54%) because it includes non-bank borrowers, unlike the conventional euribor rates.

How long will these rates last? That ultimately depends on the ECB’s perception of the inflation outlook, but judging by expectations in the money market it will be years before we see a return to positive short term rates- the market is currently pricing in a 3 month rate of -0.125% in six years time. That may not transpire of course but as it stands it implies that rates are expected to be in negative territory for well over a decade, and not the short time period envisaged by the ECB when when embarking on that policy.

Does it matter? The standard ECB argument is that negative rates are just an extension of low rates and will eventually boost credit growth, economic activity and inflation. However, negative rates have put pressure on EA bank profitability in that they have indeed helped push down borrowing costs for households and businesses but , to date, at least, most banks have been reluctant to cut deposit rates for households by a similar amount, which would take them below zero. The ECB argues that this hit to bank margins can be offset by loan growth but negative rates send a signal to potential borrowers , implying a pretty dismal economic outlook and one not conducive to productive investment spending by the private sector. Of course if one also factors in the impact of the Covid pandemic it is difficult to see an explosion in credit growth any time soon.Not surprising , then, that EA banks trade well below their equivalents in the US in terms of equity valuation, with Irish banks at around 20% of their net asset value.

There are other issues, which will become increasinly pressing if negative rates are here for the long term. The ECB can provide liquidity but can’t direct where that goes and it may simply be used to bid up existing assets such as equities and real estate. Negative rates are also a massive challenge to the long established investment model of pension funds and wealth managers. That model envisaged say a 60-40 split betwen equities ( deemed higher risk) and bonds and cash but what happens to that model when the yield on the lower risk asset is actually negative ( as is the case with many EA government bonds) and where large deposits with a bank can be charged a negative rate. In other words a fund will lose money by holding cash in a bank or by lending it to the Government. This leads to the TINA (There Is No Alternative) case for taking more investment risk so pushing up equity valuations, real estate prices and lowering the yield on high risk corporate debt.

It is hard to see how the ECB can get out of the current situation, although it does seem reluctant to cut the deposit rate again, and the implicaions of negative rates for savers are not palatable. Commercial banks may well start to cut deposit rates into negative territory for household deposits with significant implications for high savings economies such as Ireland, where household deposits and currency exceeds debt by €21bn, and where deposits in Irish headquartered banks are €37bn higher than loans. The cost of borrowing for households is low, of course, and in Ireland that mainly flows into property but that is constrained by mortgage controls, which do not apply to institutional investors..

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Irish Unemployment: 131,000 or over 1 million?

Unemployment in Ireland is officially measured in the quarterly Labour Force Survey(LFS), based on a sample of households, and the numbers in that category have to be both available for work and to be actively seeking it. The Survey also captures total employment, with the sum of those in work and unemployed defined as the labour force.

Prior to the Covid Pandemic and Economic Lockdown the unemployment figure had fallen to a 115,000-120,000 range, with the unemployment rate hitting a cycle low of 4.7% in late 2019. The first quarter of 2020 saw a modest tick up, to 123,000 , and an unemployment rate of 5%, with the universal belief that the following months would see a massive spike , a view reflected in most economic forecasts, which envisaged average unemployment rates of 15%-20% over the year.

The CSO issues a monthly estimate of unemployment, which is often revised based on the LFS when published, and it was a surprise to many that the increase in April and May was very modest ( a rise to 138,000) followed by a fall in June, to 131,000, with the unemployment rate easing back to 5.3% from 5.6%. On the face of it then, these figures are wildly at odds with consensus forecasts.

The CSO does provide an alternative measure, which takes account of those in receipt of the Pandemic Unemployment Payment, and that figure rose to a peak of around 600,000 in early May. However, those recipients do not meet the definition of unemployed as per the LFS so are not captured in the official figure. One option is to assume all are in fact unemployed ( which is unlikely to be the case)and so adding them to the official figure. The CSO use that approach to give an ‘upper bound’ for unemployment , resulting in a total of 695,000 in April and an unemployment rate of 28%.

The numbers in receipt of the PUP have fallen steadily over the past two months, as Lockdown eased, so the upper bound unemployment total in June had fallen to 560,000, with an unemployment rate of 22.5%. Two competing forces will impact that figure from here- the PUP figure will continue to fall as the economy re-opens but some firms wil either not emerge from Lockdown or do so with a reduced workforce, so boosting the official unemployment total.

The Live Register adds an additonal twist . This measures those claiming unemployment Benefit and Assistance and although not the official measure of unemployment ( the cycle low there was 182,000) the trend is used by the CSO to estimate the monthly unemployment figure . Again the Register picked up sharply in April and May ( to 226,000) but fell back again in June, to 221,000. When the PUP figure is added that total rises to 660,000, None of these figures take acount of those on a Wage subsidy scheme , numbering 382,000 in June, so if they are also added we arrrive at a grand total 1,041,822, with a peak of over 1,250,000 in April.

It is highly unlikely that everyone on a wage subsidy and in receipt of the PUP will end up unemployed so the 1 million figure is hopefully not reflective of things to come. At the other end of the scale it is not plausible that all will resume employment as before, so the official unemployment data may well start to tick up over the second half of the year. Nonetheless, estimates of the official unemployment rate for the year now look far too high , and it also may well be the case that unemployment on that definition will keep rising well into 2021, which again is contrary to the consensus .

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Ireland only Euro economy to grow in first quarter.

Most developed economies saw contractions in the first quarter, with the Euro Area (EA) decline at 3.8%. A fall in Irish GDP was also widely expected ( the Department of Finance projected -5.0%), reflecting the lockdown which began in March, although the most recent data had shown quarterly  growth in industrial production,  a substantial gain in employment and  very strong performance from merchandise exports, driven by pharmaceuticals and medical devices. In the event Ireland appears unique in  the EA during the early phase of the Covid pandemic as the only country to record GDP growth, with output rsing by 1.2%. This  left the annual change in GDP at 4.6%,  and although it does not mean that the average figure for the year will also be positive ( the q2 decline in domestic demand is likely to be large) , it does reduce the possibility of a double digit decline, as seen by some forecasters.

In truth a wide range of outcomes is possible given that exports account for 130% of GDP, so dwarfing any impact from consumer spending or domestic investment. The type of  exports produced here by multinationals ( chemicals, pharma, business and computer services) does render them more resilient in the type of lockdown seen globally as a result of the pandemic, although contract or offshore manufacturing (largely in China) adds an additional degree of uncertainty to the export outlook. Indeed, the latter fell in the first quarter so reducing mechandise export growth to an annual 4% from the 12% recorded dometically. Service exports grew by over 10% and the volume growth for exports overall was 5.9% in annual terms, which clearly provides a massive boost to total GDP.

Imports must be captured as domestic demand or as an input into exports and so have no net impact on GDP. In the first quarter merchandise imports were flat but service imports rose by 69%,  driven  by  a very large increase in  the import of intellectual property, by a small number of firms. The corollary was a very strong increase in investment in Intangibles, and the CSO did not provide a figure for this or for spending on mechinery and equipment. We know that overall investment spending rose by 197% to €46bn, and that construction increased by over 8% to €5.6bn, leaving a residual of   over €40bn for Machinery, Equipment and Intangibles , and an annual rise of  286%.

Retail spending fell by 5.5% in the quarter, weighed down by a collapse in car sales,  and so a hefty fall in consumer spending was likely and duly emerged, with a 4.7% decline, taking the annual change also into negative territory at -2.5%. Consumption now accounts for less than a third of GDP however, and so even a fall of that magnitude was not sufficient to generate a negative print for GDP, although modified domestic demand, the CSO’s measure of domestic spending excluding the impact of multinationals on investment, did fall by an annual basis. by 1.2%.

The second quarter may well be different in that the fall in consumption and domestic demand is likely to prove strong enough to override  exports  and a double digit decline in GDP is widely expected , both for Ireland and across the EA. That may be the case  but an offseting factor here  may be a recovery in contract manufacturing exports from China. To reiterate; exports are key.

 

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Euro Governments can run out of money

The euro zone  economy contracted by 3.8% in the first quarter which was much steeper than either the UK (-2%) or the US (-1.2%). Lockdowns are beginning to ease but the percentage fall in GDP could reach double digits in all three  economies in q2, given the collapse in activity seen in April. Budget deficits will automatically rise in such circumstances (tax receipts fall while transfers to the unemployed rise) but governments have also taken discretionary spending measures in order to support incomes, with the result that fiscal deficts are likely to be extremely large- the IMF forecasts an EA deficit of 7.5% of GDP, with the US at double that figure and the UK at 8.3%. The implication is that the discretionary fiscal effort in the EA  is much lower, in large part because the  EU as a body cannot provide much  budgetary support, leaving it up to individual governments to go it alone. Member states have varying degrees of fiscal space and all lack monetary sovereignty i.e. they cannot create money and so in theory could run out of funds to spend.

A ‘ €540bn stimulus package’ has been agreed by the EU but as is often the case with these initiatives the detail is less encouraging. A €100bn package of loans is on offer to support employment across the EU while €200bn of the package turns out to be EIB loans, with that figure deemed possible from €25bn in additional capital from member states. The final €240bn is again in the form of potential loans, this time from the ESM, although as yet no country has requested funds, with a perceived political stigma apparent given the Fund was set up to bail out countries unable to access the bond market.

The frustration of some EU States  with such ‘smoke and mirrors’ has been apparent, notably from Italy and some of its Southern neighbours, with a call for EU grants rather than loans, given the already high level of debt in many countries. The idea of ‘Corona bonds’ was floated , with the EU as a body guaranteeing repayment, but such debt mutualisation is seen as  anathema in some states, including Germany.

The EU does have a Budget of course but its annual spend is of the order of €160bn  which is just 1% of EU GDP. Moreover, Article 310 of the EU Treaty would seem to rule out running a Budget deficit and to date all spending is funded from current resources.

It was a surprise therefore when Chancellor Merkel and President Macron   unveiled a plan for a €500bn ‘Recovery Fund”, with debt issuance by the EU and the sums then distributed as grants. Some hailed this as a “Hamiltonian moment’ referencing the decision by  US Secretary of State Alexander Hamilton in 1790 to convert individual State debt into Federal Government liabilities. Opposition from other EU states has emerged , however, and it remains to be seen how events unfold.

The borrowing proposed under the Plan is modest enough (3% of EU GDP) and appears to be ‘one-off’, implying that bonds would be repaid from EU resources on maturity, rather than funded by fresh bond issuance, as is the norm for individual governments. In that case it is  bringing forward future EU budgetary spending, so other non-covid related  spending would have to  cut or additional resources raised from member states

The ECB has a role to play in that it could buy some of these EU bonds and is of course  already buying some of the debt of member states, although the German constitutional court challenge to the ‘proportionality’ of that policy has raised issues. Indeed some argue that the German willingness to accept some EU borrowing, however limited, is a realisation that  future ECB asset purchasing is problematical. Again it remains to be seen how the Court challenge will play out but ultimately the pandemic has exposed the fact that the EU, as currently set up, has very limited room to provide centralised fiscal support on the scale required in a crisis. That and the  ban on monetary financing leaves each member State dependent on their respective ability to borrow, so the fiscal support provided  is not unlimited as the money can run out.

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Striking contrast between US and Euro Policy response

The consensus view on the economic impact of the Covid pandemic envisages a plunge in economic activity across the global economy in the second quarter of the year, followed by a recovery in the latter part of 2020, with no significant damage to potential growth. This may prove optimistic but also appears  the prevalent view in equity markets, with investors ignoring  data which does point to a very severe hit to output and employment, believing  that short lived. Policy makers have reacted, of course, and we have seen a significant fiscal and monetary response, although that has varied across the globe and the contrast between the US and the Euro area (EA) in that regard is particularly  striking.

On the monetary side the Fed  initially reacted to a scramble for dollar liquidity by pumping trillions of dollars into markets that were effectively seizing up, including the provision of dollars to other central banks across the globe. It then embarked on a broad purchase of assets, ranging far beyond government bonds  and mortgage backed securities,  to include bank loans and even junk rated corporate bonds,  taking the extraordinary step of buying the latter through ETF’s. As a reult the Fed’s balance sheet has grown by over 50% since the turn of the year, currently standing at $6.6 trillion from $4.2 trillion. As a result excess reserves held by commercial banks have doubled in just two months, to $3 trillion, while the money supply (M2) has grown at an annualised 16% pace over the past three months. Monetarists might worry about the implications  for inflation down the line but markets certainly feel it is supportive of asset prices.

Monetary policy has also been supportive in the EA , but the scale of the response is quite different; the ECB’s balance shee has increased too but by only 12%, to €5.3 trillion from €4.7, and the amount of exces liquidity in the system has not greatly changed.  It is also worth noting that interbank rates  have actually risen (3-month euribor rose to -0.16% last week before falling back to -0.22%) implying that all  EA banks are not deemed equal, while it is reported that US banks are pulling back their EA lending.  Of course the ECB is constrained in its response relative to the Fed in that it can provide  short and now longer term loans to banks  but cannot buy unlimited amounts of assets, as its public sector purchases are contrained by the capital key  and issuer limits. It has sought to circumvent the latter with its PEPP scheme, but that is limited to €750bn , at least for now.

On the fiscal side the EU has struggled to find a mechanism to provide support across member states, with the result that each county has sought its own solutions, although the degree of fiscal space available varies greatly. A €540bn package was produced to great fanfare by euro governments, but as with many such announcements the devil is in the detail- in this case €100bn was in the form of employment grants from the European Commission, with the rest in the form of EIB loans and  ESM loans, with the latter unlikely to be taken up. Grants rather than loans became the big issue at the recent EU summit, with headlines emerging about a package amounting to ‘trillions’ but nothing was agreed and it seems that  funds will eventually come out of the EU budget, with the issue of loans versus grants kicked down the road.

In the US the  Federal fiscal response has been quicker and substantially larger, with a series of packages emerging, the largest being €2 trillion. Again one should note that some of this is in the form of loans, albeit guaranteed by the government on attractive terms. That said , the IMF expects the US fiscal deficit to exceed 15% of GDP this year, which is more than double that forecast for the EA. . In any downturn automatic  stabilisers kick in ( tax receipts fall and government transfers rise) so fiscal deficits will increase  anyway in the absence of any discretionary policy action but the difference between the respective US and EA deficits is clearly not just cyclical.

 

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Fiscal support is from taxpayers, not helicopters

The economic impact from  Covid-19 has already been unprecedented in its severity and speed, prompting governments across the globe to offer  extraordinary levels of fiscal support to ameliorate the impact on households and businesses. As a consequence budget deficits will soar, raising the question of how they will be funded. The fact that some of the additional government spending has come in the form of cash payments to households or direct wage support has prompted references to ‘Helicopter money’, although that is to misunderstand the concept and indeed how these deficits will be funded,which as it stands will be from existing and future tax payers  albeit with the caveat that central bank actions can reduce the interest bill.

The term ‘Helicopter money’ was coined in 1969 by Milton Friedman, musing on the impact of  a one-off increase in the money supply, in this case via the drop of €1,000 dollar bills from the sky (it would simpy raise prices he thought). More recently the idea re-emerged  in the noughties as central banks started to worry about deflation and  has also become associated with Modern Monetary Theory or as some call it, the ‘Magic Money Tree’. This contends that money is essentially a fiscal creation and that a government with monetary sovereignty, such as the US or UK,  can fund additional spending by printing money rather than through taxes, albeit in the modern world through the central bank simply crediting a balance in the State’s account at the bank. Note that euro member states do not have monetary sovereignty and the ECB is prohibited from monetary financing.

What is striking  though is that,to date at least, the huge sums that governments have committed to spend are seen to be funded by borrowing. The partial payment of wages by the State, for example, is no different from the payment to recipients of unemployment or other social welfare i.e. it is  a transfer from tax payers, paid out of current tax receipts or from future tax receipts by borrowing.

Consequently, Government debt levels will rise steeply, as in many cases deficit ratios  will balloon to double digit levels, although that depends on the duration and  severity of the recession unfolding before us.  In Ireland’s case the Central Bank (CB) has  recently projected an Exchequer  deficit around €20bn this year, which if broadly right implies a major increase in debt issuance. That had been put at up to €14bn, against €19bn due for redemption because  the NTMA had intended to run down some of its cash balances which amounted to €15bn at the beginning of the year. The implication now  is that a €10bn reduction in cash balances would still require around €30bn in issuance of new debt.

The NTMA have already issued €11bn to date and of course the interest rate on the debt is very low, albeit higher than it was a few months ago, so debt is being redeemed and replaced at a much lower cost, reducing the average interest rate on the outstanding debt, which is now down around 2%. QE is helping of course, which allows the ECB and the (CB) to buy up to a third of any issuance and hold up to a third of debt issued. That means that most of the interest on that QE debt is paid to the CB , boosting its income and hence largely returned to the Exchequer as CB profit.

This is not helicopter money as the bonds at issue will have to be repaid, most likley by  issuing new debt on redemption, which implies QE will be never ending unless economies are strong enough for private investors to buy all of the new debt issued. There is also an additional contraint on QE in the euro area  in that bond buying is broadly proportionate to each member’s population and GDP, which determines the ‘Capital Key’ ( share of the ECB’s capital subscription). In Ireland’s case it is around 1.5%, so Irish government bonds held under QE amount to €34bn out of a total of €2261bn .

The Covid pandemic and resulting economic crisis has prompted the ECB’s new Pandemic Emergency Purchase Programme  (PEPP)  which does  appear to include the capital key constraint but not the issue limit. It is designed to run this year with a size of €750bn  and therefore in theory could buy most or all of a new bond. Ireland might  issue €15bn in a  30 year pandemic bond, for example,   and the ECB could buy say €12bn, with most of the interest therefore paid to the CB. All this helps to reduce interest costs but is not the same as printing money to give to individuals, via bank transfer or from a helicopter.

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V, U or L

The Covid -19 pandemic has taken many lives and threatens many more, prompting an unprecedented policy response across the globe , generally intended to slow the spread of the virus and ‘flatten out the curve’ by reducing the risk of a short term spike in hospitalisations overwhelming the health system. Many economies, although not all,  are in various forms of lockdown and the economic impact will be severe, to an extent impossible to quantify with any degree of certainty, although in some cases data is now emerging which allows economists to make a stab at the impact.

Crucially though, a question which cannot be answered at this stage is how long the hit to economic activity will last. Stock markets have plummeted but the scale of the fall to date implies that investors are betting on a V shaped  recession i.e. a very sharp fall in activity for a couple of quarters, followed by a rapid recovery at least approaching  pre-crisis levels.That also seems to be the consensus view in terms of US analysts, with Goldman Sachs, for example, projecting a 1.5% fall in GDP in the first quarter, followed by a 6% decline in q2 and then a 3% rise in q3 and q4 . That leaves the average fall in  US GDP in 2020 at -3.8%, with a projected rise in the unemployment rate to around 9% from the current 3.6%.

The same  V pattern appears to be underpinning  expectations in the Euro Area (EA), although again the fall in annual GDP is huge. Germany. for example, appears to be  predicating its fiscal response to the crisis on a 5% fall in GDP. The March PMI for the EA (31.4) does provide sime guidance, with the average for the first quarter implying a 0.7% decline in  q1 GDP, followed by  around 2.7% in q2 if the PMI figure averages around 30  over the next few months. A 0.5% decline in q3 followed by a 1.5% bounce in q4 would leave the average fall in  EA GDP in 2020  at 2.5%.

In Ireland’ case the PMI indices do not correlate highly with recorded GDP but in any case we do not have a March reading anyway  so  we have little to go on in estimating the economic impact of the virus on the economy. Assuming a V shaped recession, however, with  heroic assumptions on the scale of very steep falls in non-food domestic spending till June,  yields a €10bn (9% )drop in consumption and a €15bn (8%) drop in modified domestic demand in 2020, assumimg a modest recovery in the latter part of the year.A similar  percentage fall in private sector employment would  push the average unemployment rate up to 12%. The impact on overall GDP largely depends on exports, however, including contract manufacturing, which amounts to some €70bn, with most originating in China. A collapse in that figure could throw up an enormous fall in recorded GDP but again if we assume that V shape for exports as a whole the overall fall in  fall in GDP is around 5%, which would be less than half the slump recorded during the financial crash because it would be short and sharp rather than over two years.

How long the recessions will last depends on the path of the virus and how quickly activity returns to ‘normal’ which are unknowns of course. So a U shaped cycle is certainly possible, with any material recovery in spending and output pushed out from two to say four quarters. That would clearly render the above estimates  very optimistic and pose big choices for governments in terms of fiscal supports designed to be short-lived.

Finally, there is also the prospect that the virus takes much longer to pass through the population and that the return to ‘normal’ patterns of social and economic activity does not occur for  a prolonged period, giving an L shaped cycle i.e. any upturn takes well  over a year to eighteen months to materialise. Clearly that would result in much steeper falls in  equity markets than seen to date, much larger increases in unemployment, massive credit issues and much larger fiscal hits to governments. Of course we have seen unprecedented levels of policy response on the monetary side, designed to pump liquidity into the system and limit the scale of any rise in long term borrowing cost for governments. Media headlines have also highlighted huge fiscal ‘stimulus’ packages but to date most of this relates to State guarantees for bank loans, which may carry fiscal  implications down the line but is effectively monetary in seeking to supply credit to the business sector. Nonetheless, we have also seen governments now also turning to more direct measures , including enhanced unemployment assistance and in some cases, including Ireland, wage support. As yet these massive increases in fiscal deficits are seen to be financed by borrowing rather than money creation, albeit with the resumption of QE in many cases meaning that  the private sector will not be alone in buying the debt.

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Irish GDP grew by 5.5% in 2019 but consumer spending surprisingly weak.

Irish real GDP grew by 5.5% in 2019, a slowdown from the 8.2% recorded the previous year. The nominal value of GDP rose by 7.2% and now stands at €347bn, which is double the level seen in 2012, a surge which has precipitated a huge fall in the Government debt ratio, which probably ended 2019 at 58.6% and hence  below the 60% limit as set out in the EU’s Stability and Growth pact.

The growth outcome was actually  below consensus expectations ( the Central Bank expected 6.1% and the Department of Finance 6.3%) despite a strong 1.8% increase in the final quarter and this was in part due to downward revisons to growth in the earlier part of the year. This included consumer spending, which is now seen to have risen by only 2.8% in 2019 , with the annual change slowing sharply to only 2.0% in the final quarter. Given booming employment and  stronger wage growth the implication is that precautionary savings rose, as also indicated by the growth in household bank deposits. In contrast, Government consumption was revised up and grew by 5.6%, or double that of personal consumption, a rare combination.

In terms of the other components of domestc demand , building and construction grew by 6.8% in 2019, with housebuilding up 18%, but the pace of expansion is slowing, as might be expected given the small starting base of completions. Spending on housing improvements surprisingly fell but spending on non-residential building continued to grow, by 9%. The prevailing uncertainty about Brexit last year also impacted spending by domestic firms on machinery and equipment, which fell by 15%, with the result that what the CSO deem modified capital formation (total investment excluding the impact of multinationals on various components) rose by just 1.3%, which with the sluggish increase in consumer spending meant that modified domestic demand grew by just 3%  from 4.7% in 2018.

That concept is a CSO  construct and the actual GDP  figure as recognised internationally includes all spending on investment, including aircraft leasing and that undertaken by multinationals on R&D (captured as Intangibles), which can be both enormous and extremely volatile relative to the small scale of the underlying Irish economy. In 2019 Intangibles alone rose by over €70bn, or  270% with the result that overall capital formation increased by an extraordinary 94% having fallen by 21% the previous year.On the face of then, Capital Formation now accounts for over 40% of Irish GDP, with consumer spending less than a third, an unusual if not unique configuration.

That Intangibles figure is broadly neutral for GDP  however, as virtually all of it  is captured as a service import , so total imports rose very strongly in 2019, by 35%. Exports continued to perform strongly , rising by over 11%, so massively outperforming the growth in global trade, but the result was a large Balance of Payments deficit of €33bn or 9.5% of GDP. Normally a large deficit like that would imply problems, in that  the  economy is consuming more than it is producing but in Ireland’s case is a useless indicator.

The  economy finished the year strongly according to the GDP data, despite the weak consumer, with the quarterly increase of 1.8% bringing the annual change in q4 to 6.2%. This therfore provides a strong positive carryover into 2020 but there are fresh risks alongside the ongoing possibility of a no-deal Brexit. One is political (it is still unclear if a governmnet will be formed or that an election will be required) but the most pressing now is the economic impact of  COVID-19. That may be domestic ( reduced consumer spending and a supply side hit to output across all sectors) , external ( a global recession ) and/or company specific. The latter tends to be overlooked, but the impact of contract manufacturing on Irish exports is substantial; total merchandise exports in 2019 amounted to €227bn, against €144bn actually shipped from Ireland, with the difference largely deemed to be accounted for by production in China. On that basis the first quarter export figure could be a shock.

 

 

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Mortgage Controls, the ECB and the Irish Housing market

Ireland’s monetary policy is set by the ECB and has had a very significant impact on household income and wealth in Ireland over recent years, as well as a profound effect on the housing market, particularly in relation to house prices and the ownership of the housing stock. Yet little attention is paid to it, in contrast to say Germany where it is heavily criticised and indeed the subject of legal challenge.  Similarly, the Central Bank introduced mortgage controls five years ago ,which again has had a material impact not only on housing but on credit growth, the distribution of wealth in Ireland and indeed on the political landscape, begetting policies designed to mitigate the consequences of these  monetary and macro prudential decisions.

Let’s start  with the controls. The average new mortgage for house purchase peaked in 2008 at €270,000 and then plunged alongside house prices before  bottoming in 2012 at €174,000. Since then it has risen steadily, reaching €233,000 last year, which when related to  rising incomes and the much lower cost of a mortgage indicates that affordability is much improved and in fact is still better than the long run average.

Mortgage controls are designed to limit  household leverage, imposing a LTI limit of 3.5 ( with some exceptions) and the Central Bank acknowledged in 2015 that  one might expect this to dampen house price inflation, credit growth and also negatively impact housing supply. We do not know how the market would have developed in the absence of such controls but the Central Bank  made a stab at answering  in their recent Financial Stability Review , estimating that prices in the period to the first quarter of 2019 would have been around 20% higher, or 4% per annum, with PDH lending substantially higher, by some 40%.The Bank does not show an estimate for housing supply but if prices had been higher completions would presumaly have been stronger, although what is also clear  is that the longer term relationship between house prices and supply has shifted since the crash, in that house building  has been much weaker in response to the actual price changes observed than experienced in the past.

If housing demand exceeds supply prices and/ or rents will increase, with that split being affected by, inter alia, the growth in income for  would be buyers, the cost and availability of credit and the type of buyer in the market. So if mortgage lending would have been higher in the absence of controls  then  some would-be buyers are forced to rent or live at home if that is an option. This has thrown up the odd situation  where the average rent nationally in 2019 was around €1200 per month, while the average monthly payment on a new  FTB 25-year mortgage  was  €1076 i.e. the rental payment could sustain a mortgage of  €254,000 instead of the actual FTB average last year of  €227,000. Landlords are therefore taking on higher credit risk than banks, and the average LTI for  FTBs  is actually only 3.1, which may be too low in an economy where the cost of housebuilding is high and where the  average rental payment  would service a mortgage with an LTI of 3.5 . It also  looks very conservative compared to the UK, where the LTI  cap is  4.5, with a 15% exception on a rolling twelve month basis rather than a calendar year.Rental growth in the UK has also been much weaker than in Ireland.

The type of buyer has also changed. The introduction of mortgage controls  coincided (?) with the ECB’s decision to buy bonds under QE, which alongside negative rates has pushed  Government bond yields into negative territory, including Irish debt out to 10 years. That renders Irish residential rentals yields ( which appear to be above 5%) unusually attractive and so we have had an influx of institutional buyers into the market, which was not a feature of previous cycles. Since the end of 2014  institutional buyers have purchased a quarter of new housing according to the CSO data, rising to 33% last year alone, which is then rented, with housebuilders also now more inclined to pre-sell developments to institutional buyers rather than risk waiting to sell to individuals.

QE is designed to boost investment in assets other than bonds and so will push up house prices, but  at the same time the Central Bank controls have constrained   access to mortgages for households. That not only has implications for owner occupation but also wealth: gross Irish household wealth rose to €947bn in the third quarter of 2019, of which €545bn was in the form of housing, or €412bn net of debt.Wealth in Ireland is therefore disproportionately held in property and so the combination of controls and QE has and will have  broader implications for wealth in Ireland  and its distribution over time.

As to the future, QE is open-ended at present and the market is not priced for a return to positive ECB  rates for years so the yield on bonds is unlikely to rise sharply, thereby maintaining the demand for rental yield. Similarly the Central Bank appears happy with the mortgage controls as they are, albeit showing some concern about the profitability of Irish banks (too low, that is), and if change occurs it may be to move towards a debt service metric- the impact of a fixed  LTI limit on mortgage payments  when rates are 3% would be be very different if rates were 5%.

A demand shock could change everything ( rents fell by over 20% from 2008 to 2010) as indeed could a supply shock. That might be positive (an upside surprise in terms of house completions) but also negative – an extension of rental controls or a rent freeze would reduce the value of the housing stock and it would be a very unusual economic development if that encouraged more completions.

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Spending rather than tax cuts: General Election fiscal proposals

Ireland goes to the polls on February 8th and the main political parties have outlined their fiscal proposals, although some in greater detail than others, at least to date. A universal feature is the pledge to devote substantially more resources to  additional government spending rather than tax cuts, with the promised ratio far higher than was the norm in recent years. The plans are also  predicated on what are in effect pretty conservative projections for economic growth, although of course with no presumption that Ireland will experience a recession, either Brexit related or following a global setback.

For context it is worth noting that 2019 ended with Irish current revenue exceeding current exchequer spending by  €7.9bn, or around €13bn if debt interest is excluded, with a capital deficit of €7.3bn. That implies that if current   revenue rises broadly in line with projected GDP, the current budget surplus will continue to increase, allowing the sitting government the option to raise spending, be it current or capital, and/or to cut taxes, whilst still running an overall budget surplus.

That is exactly the position outlined in early January by the outgoing Government, envisaging €16.6bn in available resources in the five years to 2025, a figure which all the parties have taken as their benchmark. That sum is also consistent with an annual fiscal surplus of just over 1% of  GDP, although it should be noted that what is relevant for EU fiscal rules is the Budget adjusted for the economic cycle (the structural balance) and on that criterion the structural deficit might well be  in deficit and indeed worse than the 0.5% of GDP curently set as Ireland’s  fiscal objective, given that the EU believes that the Irish economy is operating much higher above capacity than seen by the Department of Finance.

That said, it also notable that the forecasts envisage a sharp deceleration in growth, from 3.9% this year to under 3% and then 2.5% by 2025.This is supply rather than demand related; the Department of Finance believes the economy is at full employment and so employment growth is forecast to slow , constrained by the growth of the labour force, with no pool of unemployed workers from which to draw.

On the various fiscal plans, Fine Gael augment the €16.6bn figure modestly to €17.1bn via higher taxes on tobacco and vaping,with additional compliance also assumed to add revenue. From the new figure  €2.8bn is allocated to tax cuts, largely to fund increases in the standard tax band, with  €14.3bn in additional spending, a ratio of over 5 to 1. On spending, €5.6bn is pre-committed (€3bn current and €2.6bn capital)  and the biggest slice of the €8.7bn unallocated is set to go on Health (€3.1bn) . The plan also includes €2bn specifically earmarked for higher  public sector pay.

The Labour Party have also set out a detailed fiscal plan, which envisages bolstering the available resources by €2bn, to €18.6bn, by raising tax receipts via higher stamp duty on shares and commercial property alongside a higher bank levy. Some €3bn of this €18.6bn will be set aside for indexing the personal tax system, implying raising allowances and the standard tax band by around 2% a year, leaving €15.6bn, of which €5.6bn is deemed pre-committed with the remaining €10bn for additional expenditure (€8bn current and €2bn capital).

Fianna Fail have not (as yet) set out a detailed fiscal plan as above but from their manifesto is is clear they are taking the €16,6bn figure as given, although arguing that the €5.6bn deemed as pre-committed by the outgoing adminstration is too low, including an underestimation of demographic pressures. Consequently FF would set aside an additional €1.2bn to also  include unforeseen expenditure, leaving €9.8bn to be allocated overall. FF pledge a 4:1 ratio of spending to tax reductions, with €1.3bn of the unallocated figure  earmarked to fund personal tax cuts, including a lower USC rate and an increase in the standard tax band.

Of course these are all manifesto promises and not all will see the light of day, particularly as the opinion polls suggest that a coalition government is the most likely outcome. Events may also intrude, throwing any fiscal plans off course. Interesting to note, though, the big move by all parties towards higher spending and away from any notion of cutting income tax rates.