News Analysis

Monday 22 September 2014

Dr Alan Ahearne: Debt still a huge challenge despite our foreign assets

Published 09/03/2012 | 05:00

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Did you ever wonder where all the money went? We know that the boom here was funded by borrowing from abroad. Bucketloads of cash was channelled through the banks from savers abroad to Irish residents. Just before the crisis hit in 2008, the stock of foreign borrowing by the Irish banks had soared to €110bn. Only four years earlier, the same figure was at €15bn.

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The banks looked abroad for funding because their lending grew so fast that it outpaced growth in domestic deposits. Therefore the funding gap was filled by foreign debt. The banks used these inflows of money from abroad mainly to fund the domestic property market.

The very fact that our banks became so dependent on what turned out to be footloose foreign funding is evidence of a serious failure of banks' management and banking regulation in this country and abroad.

Of course, size matters here. €110bn was a tiny piece of global banking assets and these loans may have slipped under the regulatory radar abroad, but this amount was equivalent to 60pc of Ireland's GDP.

Foreign borrowing by the Irish banking sector is part of this country's total foreign debt, along with foreign borrowing by the Government and some large corporations. Households and small businesses tend to borrow from the Irish banks, not directly from abroad. But the jump in foreign borrowing by the banks contributed to a marked increase in Ireland's total foreign debt over the period 2003-2007.

So what happened to all the money?

The answer to this can be gleaned from another measure of Ireland's financial relationship with the rest of the world, our so-called net external debt. The term "net" is important here because net external debt is calculated by subtracting from our foreign debt the amount of foreign assets owned by Irish residents. Irish households, for instance, own foreign assets such as shares in foreign companies and bonds issued by governments and corporations abroad in their pension funds.

Consider an example in which an Irish resident borrows €1,000 from a foreign bank and uses the funds to buy shares in Microsoft. In that case, Ireland's foreign debt and foreign assets would both increase by that amount, but net external debt would not change.

What's interesting is that Ireland's net external debt increased by €33bn over the period 2003-2007, far less than the €95bn increase in foreign borrowing by our banks. These figures exclude IFSC-based companies, whose activities can distort the data.

Yes, caution is required because the data are volatile, but one interpretation of these developments is that Irish residents must have increased greatly the amount of foreign assets that they own.

It's not difficult to imagine how this could have happened. Ireland is a small open economy, so the typical investment portfolio of an Irish resident is largely composed of foreign assets, especially equities. Farmers and other landowners sold sites to property developers who borrowed the funds from the banks. The proceeds from these transactions were then invested abroad.

In addition, property developers borrowed from Irish banks or used profits from earlier deals to buy properties abroad, as did many households.

The result of this recycling of funds is that Ireland Inc ended up with, as Trinity's Philip Lane put it recently, a balance sheet that is long in foreign equity and property and short in foreign debt.

The Government also got a slice of the action. Through capital gains taxes, stamp duty, and VAT on housing, the Government grabbed a sizeable chunk of the foreign cash that the banks were pumping into the economy. Klaus Regling and Max Watson in their 2010 report on the banking crisis estimate that nearly one euro in every three of tax revenues in 2006 was generated by the property bubble. In 2006 alone, that amounted to €14bn. The cumulative figure over the period 2003-2007 would be a multiple of this.

What did the Government do with its share of the cash that the banks had borrowed from abroad? Some of it went to buy foreign assets, mostly equities, for the State through the National Pensions Reserve Fund. But most of it went to increase spending and cut taxes. During the last decade, average rates of public sector pay jumped by nearly 60pc. Annual spending on social welfare had gone up by €11bn over the course of the boom, while spending on health increased by €10bn. The State spent €9bn in 2008 on capital projects, up from €4bn in 2000. In 2007, as bank borrowing from abroad approached its peak, government current spending surged 13pc.

The government also cut income tax rates, widened tax bands and increased tax credits. These reductions in taxation boosted disposable incomes to levels beyond what our economy could sustain. Our incomes were temporarily topped up by the cash the banks were borrowing from abroad. Yet in the public debate, the link between the cash borrowed by the banks from abroad and the cash in our pockets was rarely made.

We know that the household savings rate plummeted during the bubble, suggesting that the average household used the bulk of the additional disposable income to boost consumption. And since most of what we consume is imported, some of the money borrowed from abroad would have returned overseas as payments to foreign businesses for imported goods and services.

As a result of the banking rescue, a chunk of the banks' borrowings is now part of the national debt. Ireland's foreign assets fared badly during the crisis as stock prices and property values abroad fell, though recent months have seen some recovery. Nonetheless, the amount of foreign assets owned by Irish residents remains large relative to the size of our economy. Our foreign debts are even higher. That's why deleveraging Ireland Inc is a huge ongoing challenge.

Irish Independent

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