14 January 2013

Stefan Gerlach: Ireland - from crisis to recovery

Ireland experienced a massive housing bubble, whether measured in terms of prices, credit or the scale of construction activity within the economy. Unfortunately, this appears to have been one of the worst boom-bust cycles on record. The exceptional size of the shock is of course the main reason why it is so difficult to overcome.

The bursting of the bubble had devastating effects on public finances and forced the Government to ask for external assistance. Two factors account for the sharp increase in debt.

First, the socialisation of banks’ severe loan losses – in the first instance through the September 2008 guarantee and later through the unwillingness of our programme partners to consider burde- sharing with unguaranteed senior bondholders – resulted in a very large infusion of public funds to restore their solvency.

To date, the Irish State has injected €64 billion into the banking system, or approximately 40 per cent of 2012 GDP. The second factor is fiscal policy. A stylised fact of many housing booms is that rapid growth of revenues makes the Government’s fiscal position appear much stronger than it is. Governments frequently respond by raising spending and reducing their reliance on revenue from non-property sources, while rapid nominal GDP growth erodes the debt-to-GDP ratio. Ireland was no different; although public spending was well constrained in the 1990s, eventually in the 2000s spending surged, driven by pay rates and social benefits. At the same time, tax rates were reduced, while the debt-to-GDP ratio fell from 100 per cent in 1991 to about 25 per cent in 2007. Particularly unfortunate was the decision to permit strong increases in current spending which were dependent on windfall revenues, rather than other, more permanent, sources of revenues. Consequently, when tax revenues collapsed as the boom turned to bust with a vengeance, a large gap between Government expenditure and revenue rapidly developed.

Following the burst of the bubble, the Irish Government has taken a number of actions to  stabilise the banking system and strengthen public finances in order to support recovery.

The initial policy response in September 2008 took the form of a general guarantee of the liabilities of the banking system. The initial guarantee covered a broad range of liabilities including some existing subordinated debt and covered bonds, and amounting to almost 2½ times GDP. Following the initial guarantee, new debt and deposits continued to be guaranteed on a second scheme which has been rolled forward on a six-monthly basis. This is still in force, but it is probably no longer necessary, and will likely be discontinued in the near future. 

With debt markets in the fall of 2010 becoming unwilling to fund the Irish Government, it faced the choice of either  closing the massive budget deficit literally overnight, or spreading the necessary correction over a longer period of time by asking for a financial assistance programme from the Troika. Adopting the programme has allowed the fiscal restructuring to be done in a much more deliberate and targeted way than otherwise would have been possible. This has increased the likelihood that the improvement will be both structural and lasting in nature, and that as a result the Irish Government will be able to access debt markets on a sustainable basis from this year onwards. That said, the sheer size of the necessary correction has meant that both revenues and spending levels have had to be adjusted sharply.

The fiscal consolidation programme adopted by the Irish Government has been front loaded and, between 2008 and 2013, has entailed measures equal to almost 18 per cent of GDP. The size of this adjustment is second only to that of Greece. Since the total adjustment  necessary by 2015 has been estimated at €34 billion (or 21 per cent of GDP), it follows that the lion’s share of that, about 85 per cent, has already been done. Broadly, one third of the adjustment comes from the revenue side and two thirds from the spending side. Among the  measures taken to increase revenues are an income levy, changes to social insurance, the introduction of a health levy, changes to tax credits and bands, increase in excise duties, a 2 percentage point increase in the VAT and the introduction of a property tax in 2013. On the spending side, current savings achieved to date include paybill reductions, covering pay rates and headcount, a public sector pension levy, and reductions in social welfare rates. Despite these significant adjustments, however, the budget deficit remains very large. The most recent forecasts suggest that the deficit in 2012 will be somewhat below 8 per cent of GDP. Although this is less than the target of 8.6 per cent, public debt is continuing to  accumulate rapidly and is expected to peak in 2013 at 121 per cent of GDP.

Improving debt sustainability by breaking the sovereign-bank link would enhance the prospects of a full return to debt markets at the end of the programme. There are two essential aspects of debt sustainability: first, the level of the debt-to-GDP ratio, and second the rate at which it is increasing. The level of the debt-to-GDP ratio is high at about 120 per cent. The safety margin is therefore minimal: any unexpected increase in the ratio risks triggering worsening market sentiment about the Irish Sovereign. Furthermore, slower  economic growth in Ireland would reduce tax revenues and have a direct effect on the  evolution of the debt-to-GDP ratio. While the ratio is expected to decline slowly after peaking in 2013, forecasts are highly sensitive to nominal GDP growth, which is critically influenced by nominal GDP growth in the euro area and other main trading partners.

Since debt dynamics depend on the difference between the nominal interest rate and nominal GDP growth, the debt-to-GDP ratio is also sensitive to the interest rate on the public debt, which depends on market confidence. If financial markets believe that the Government will not have any problem rolling over its debt in future years, interest rates will be lower and it will be easier for the Government to service the debt. Conversely, market concerns about debt sustainability will raise interest rates, making it more difficult for the Government to  borrow in the markets.

In response to the crisis, the Irish Government has taken a large number of measures to reform the financial sector, strengthen public finances and return the economy to growth. The  first of these measures were adopted already in 2008. Since 2010 they have been part of an assistance programme agreed with our European partners and the IMF. In this period, the Irish authorities have delivered on all of their commitments and made good progress on restructuring the economy. While the economic freefall has now stopped, economic performance has been weaker than  anticipated when the programme was agreed, largely because the external environment has been much more challenging than expected. Overall, economic conditions are still fragile. With the ending of the programme later this year, the Irish Government will be relying again on funding from the private debt markets. The stock of public debt is very large, the level of mortgage arrears is still high and banks are not yet profitable. The safety margin is therefore  small. Improving debt sustainability would greatly enhance the prospects of a successful exit.

Full speech

© BIS - Bank for International Settlements