The IMF released their report on Ireland yesterday, here are some of the bullet points of the report.
- Given our serious imbalances Ireland was especially vulnerable to the recent global shocks. Specifically, over reliance on construction, financial intermediation, and this was coupled with a loss of competitiveness. Our expected drop cumulative drop in GDP of 13.5% to 2010 is the largest amongst advanced economies.
- The decline in wages will need to be sustained to help redress our cost disadvantage.
- Rapid progress on bank restructuring is critical. Authorities have taken important steps towards stabilization through the blanket guarantee. ECB is providing vital liquidity.
- NAMA is potentially the right mechanism, but it requires realistic assessments.
- Fiscal consolidation has begun and must be sustained. A continued commitment is required to address sensitive expenditures including the public wage bill and the scope of social welfare programmes.
1. The Context
The problems in Ireland reflect the unwinding of critical imbalances, easy credit fostered a property bubble, bank exposure to property soared as did the use of wholesale funding (sic: too much leverage!).
The Eurozone has provided a safety net as we avoided currency pressures, that, matched with access to ECB financing has been fundamental to the countries ongoing survival. As Ireland cannot devalue currency then we must continue to further reduce wages to restore competitiveness and growth prospects.
The Irish authorities have moved with resolve to counter shocks, that must continue (IMF pat on the back to Irish Government). Determined execution of plans is required.
We need to decisively restore the financial sector. Sustained fiscal consolidation underpinned by rules and accountability within which politically sensitive trade off’s can be made. There must also be pragmatic policy initiatives in the face of acute policy dilemmas, e.g.: Supporting banks increases the financial burden but addressing the deficit maintains market confidence.
Expenditure reduction is superior to raising taxes but if done wrong can hurt the most vulnerable.
2. Economic Outlook
Economic contraction began in 2008 and accelerated rapidly (GDP having grown 6% in 2007). The fall in construction activity will contribute to higher unemployment. The decline in exports is being partly matched by a decline in imports, but decreased exports will increase unemployment which is expected to reach 15.5% in 2010. Consumption is likely to drop sharply.
Authorities agree risks remain significant, a combination of slowing growth, financial sector stress, and the state of the public finances, we remain vulnerable to external shocks. Irish banks exposed to US and UK financial markets could face further losses. Global deleveraging could cause a sizeable capital outflow from Ireland by foreign banks who will move credit provision to their home countries. Ireland’s individual de-leveraging is not likely to be internationally noteworthy unless losses are far greater than expected.
The bleak short term outlook is in part a return to mean after the Celtic tiger years and as we move away from over reliance on construction and financial intermediation services. Inflation is falling, but our prices look set to decline quicker than the rest of the EU, while deflation is not a threat, we will pay higher real interest rates and this will dampen the next economic cycle. Fiscal offset is not feasible.
In the past wage moderation supported the economy, but labour costs rose and output growth declined. A key factor in this was generous wage increases in the public sector. Our international market shares are in (and have been in) decline. Weakening sterling against Euro is also a factor.
Foreign direct investment has fallen rapidly, in recent years Ireland has become the most expensive location in the Eurozone (with the possible exception of Luxembourg). Competition for FDI is high, this will make it harder to attract (sic: the IDA will have a job in getting the kind of investment into Ireland that they did in the 80’s etc. that helped fuel the Celtic Tiger).
CGER methodology shows that our actual exchange rate is 20% above its long term average, eurozone entry at a favourable rate allowed several years of competitive strength.
Authorities in Ireland believe that nominal wage cuts point to our inherent labour market flexibility, there is also the resilience of our pharma/chemical exports. The competition authority should be used to support the process of price and wage adjustment.
4. Managing financial sector stress
These have been revealed in the sharp decline in Irish bank share prices relative to the overall index, there are three key points: firstly, domestic loan portfolio is concentrated in residential mortgages, construction, development land loans and commercial property. The sharp property correction is at the heart of the bank losses. Some banks also have foreign lending exposure.
Secondly, interest margins were low by international standards (been saying that here! and for some time!), margins have been under pressure with the sharp decline in lending rates. In the past profitability came from large volumes, reliance on wholesale funding increased (reflected in loan:deposit ratio).
Thirdly, the state guarantee to depositors and creditors and stabilization via capital injections have been an important stabilizing factor. The authorities ongoing extensive support has been vital to the maintenance of stability. The Guarantee was 200% of GDP an amount much larger than in other countries. Re-capitalisations are in line with those in other countries. NAMA is a significant step in the process of bank restructuring.
5. Bank Restructuring
Estimates of losses vary but are likely to be sizeable. IMF believe they could be €35bn to the end of 2010, the focus is on restructuring property development loans which has been rightly viewed as being at the heart of the banking stress. Losses may go beyond development loans and NAMA should be ready for that.
Making NAMA a reality is pivotal, more capital injections are likely, if well managed the NAMA assets may produce recovery value to compensate for the initial outlay. NAMA’s success is key for a safe exit from the government guarantee which may be drawn out if not aggressively managed.
A key aspect of this is the prices at which assets are bought. This is a challenge but if the price is too low then the upside can be shared, either with shareholders or the state depending on who takes the haircut, or the state can gain via shares. There are options. An industry wide levy may be considered to help support NAMA.
Two strategic economic uncertainties lie ahead. Firstly, if banks are not totally ‘cleaned up’ their return to normal function will be delayed, thus NAMA should not be restricted to development loans. Secondly, employment deterioration is a warning of other areas that may be affected.
The authorities noted these considerations in their ongoing deliberation of NAMA, piecemeal efforts could delay a return to health (Japanese experiences noted).
Nationalisation may become necessary, but should be seen as complimentary to NAMA. It may be the only option for a critically illiquid bank. There have been numerous examples of this (Japan, Sweden, US). If this happens shareholders are fully diluted (wiped out) to protect the tax payer, bad assets are removed but issue of pricing is removed. Nationalised institutions could be merged.
Authorities prefer private ownership of banks in order to keep market pricing alive. They disagree with the IMF view that pricing would be easier to assess under national ownership. They are concerned about negative sentiment regarding the integrity of the banks. A clear exit strategy would be necessary.
6. Supporting measures
Other supportive measures must be created, firstly a framework for bank resolution. Secondly enhancements to supervision.
A broader tool kit will allow for faster and less disruptive resolution of banks. Authorities are open to looking at a special bank resolution scheme (as exists in the UK when they adopted one in order to nationalise northern rock).
There are several supervisory and regulatory initiatives, from additional staff, and by the amalgamation of agencies. Authorities want to work towards identifying risks earlier. There will be a ‘related party’ disclosure requirement.
7. Achieving fiscal credibility.
Before the crisis hit the public finances had serious issues. Income taxes were lowered, expenditure grew (fastest of the OECD economies). Property revenues masked the structural deficit.
Gaining control over public finances is key, it will only work if confidence exists that a strong government reorientation is under way, if not the downturn could get worse. Government services must get more efficient, the tax base must be broadened while not impacting on labour costs.
Authorities have taken significant steps in revenue measures (c. 1% of GDP), the bulk comes from an income levy. Expenditure savings (c. 1% of GDP) via a public sector pension levy. The goal is to reach <3% deficit by 2013.
Thus far the focus has been on taxation, in particular middle and upper income earners, this has protected the most vulnerable in society, it also helps return taxation to normal levels. The next goal must be to focus on expenditure. The IMF thinks stronger expenditure consolidation must take place. Financing needs remain substantial in the near term, the NPRF has about €15bn in it and state has c. €25bn in cash (having issued €12bn in bonds YTD).
8. Consolidation strategies
The evidence is clear, fiscal adjustment must focus on expenditure cuts, in particular that of publi expenditure, the IMF and State both agree that spending cuts rather than increased taxation are better sustained.
Social welfare must better target the vulnerable, authorities recognise that it must move away from universalism to one that relies on targeting and incentives. Testing child benefit is under discussion. Earned income tax credits for working families is another, and changing the price basket benefits are weighed against. A more nuanced minimum wage would help competitiveness.
Despite recent reductions in the public sector wage bill further cuts are likely to be inevitable. Public sector pay lies above private sector pay in most areas. The ESRI in 2006 showed that the premium was c. 20%. International comparisons confirm this. Consolidation on a further scale is not possible without further reduction to the wage bill.
A review of public service employment is necessary. From 2000 to 2008 total employment grew at 3% while public service employment grew at 3.7%, in health and education the figures are even higher. Greater efforts to obtain value for money are vital.
Broadening the tax base is a key challenge, there is mortgage interest relief with no ongoing property taxation. The proposed ideas would require robust institutional support. Done correctly fiscal rule can create the basis for public commitment to fiscal prudence.
9. Staff appraisal
Ireland is in the midst of an unprecedented economic correction which match the most severe in post WW2 history.
Risks remain significant, market sentiment has improved and lowered spreads on Irish sovereign debt, public and private sector wages are decreasing which will aid competitiveness.
On the two most important fronts the authorities have moved in the right direction, firstly in the proposed establishment of NAMA which will remove distressed assets from the banks, and in their multi-year plan to control the fiscal deficit.
The task ahead is formidable, determined execution is required. Clear objectives, benchmarks and transparency are required.
Regarding NAMA, risk sharing structures should be considered to address the well known pricing problem. Pricing can slow down the transfer to the troubled bank, risk sharing can create better incentives for managing the assets, they also guard against the risk the taxpayer undertakes, so that they don’t bear a disproportionate burden of the cost of cleaning up the banks.
NAMA must have a flexible design, an early focus on development property may be right, but other asset classes may need to be considered, without this banks might remain hobbled.
Where a bank is economically insolvent the only real option is temporary nationalization. If that were the case price transfers would be less of an issue, it could also be used as a step towards mergers and sectoral restructuring. The nationalized bank would need transparency, commercial objectives, and be under the same regulatory/supervisory regime as private banks. A clear exit strategy would be required.
Accompanying the crisis management there are several important supporting measures required: A broader tool kit for banking intervention. Better identification, observation, and surveillance of systemic risks in the making, related party lending, and macro-prudential regulation.
The authorities have laid out an ambitious fiscal consolidation plan, the first part focused on taxation, the next part must focus on spending cuts. Steps must be taken to ensure the plan is executed, but several principles should apply:
1. More targeting of the vulnerable and greater reliance on incentives for efficient use of public resources.
2. Further ratcheting down of the public pay structure and employment levels.
3. Broadening the tax base