Wednesday 28 September 2016

Heavy traffic ahead on our road to recovery

Our economic fortunes are now more closely tied to Bilbao than to Beijing

Published 24/01/2016 | 02:30

Traders on the floor of the New York Stock Exchange. Photo: Michael Nagle/Bloomberg
Traders on the floor of the New York Stock Exchange. Photo: Michael Nagle/Bloomberg

A small trading economy, and Ireland fits the description, cannot escape when things take a nosedive internationally. There are growing fears that this is happening, with agencies like the European Commission, the IMF and the OECD revising their economic forecasts downwards.

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Worries about demand, especially in China, have been pushing commodity prices ever lower and now the stock markets have taken fright. Despite Friday's recovery, share prices are well down on the major exchanges for the first three weeks of January. The mood is gloomy enough to have persuaded European Central Bank president Mario Draghi to promise a further relaxation of eurozone monetary policy should the slowdown deepen, and the Bank of England seems afraid to follow the US Federal Reserve in raising interest rates anytime soon.

The speed of recovery in Ireland has been exceptional. Growth in world trade has faltered, forecasts for almost all major economies have been scaled back, and the Davos conference has been hearing some very bearish presentations. The pessimists could be wrong and there is always a chance that the stock market weakness will prove to be another puff of smoke.

The late American economist Paul Samuelson remarked once that "the stock market has forecast nine of the last five recessions" and the current dip could be another false call. There was a hiccup last summer and it passed, adding to the plentiful evidence that short-run movements in stock markets do not always reflect, much less predict, underlying changes in real economic prospects.

The key concern should not be stock markets, but rather the performance of the international economy and the prospects for Ireland's main trading partners. The pessimists fear a recession in China and poor performance in some large developing countries, including oil exporters and those with heavy debts in appreciating dollars. But Ireland is not heavily exposed to these economies - around 83pc of Irish merchandise exports go to Europe and North America. According to the CSO's trade statistics, Switzerland is three times more important as a destination for exporters than China, which takes only about 2pc of the total, not much more than Northern Ireland. A recession in Switzerland, or Belgium, matters much more than anything that might happen in China.

If the external environment worsens enough in 2016 to create a slowdown here, the chances are that the problems will, once again, emerge in Europe. The Chinese slowdown is in any event neither unexpected nor particularly severe. The economy expanded by about 6pc last year, down from the double-digit rates of a few years back but hardly at panic stations. Cheaper oil and raw materials, partly a result of lower Chinese demand, is anyway an unambiguous bonus to a country which must import these same items.

There are legitimate worries, not new either, about excess credit creation in China and the state of its banking system, but there are unresolved banking problems much closer to home. The economic under-performance in the eurozone since 2008 has a lot to do with the continuing failure to address the scale of the banking bust. Numerous major European banks remain seriously undercapitalised, including the biggest, Germany's Deutsche Bank. The proof is in the share prices, which value several of them well below book value. This means that the markets are more sceptical about the value of their loan books than are the regulators. This problem, a result of can-kicking for eight years by the ECB and European politicians, has re-surfaced in acute form in Italy.

Four minor Italian banks were re-capitalised last November in a manoeuvre which imposed losses on smaller creditors. These included people who thought they held protected deposits but had actually been sold (or mis-sold) bonds exposed to haircuts. More significantly, some of the major banks have serious problems with non-performing loans. Italy should never have joined the common currency back in 1999 and has seen the worst economic performance of the major participants. There was no credit bubble but the stagnant economy has achieved the same effect: very poor loan quality and sinking share prices for banks, which want the Italian government to take the problem off their hands with a Nama-style bad bank. The over-indebted government is reluctant to oblige without European support (not forthcoming) and there is a stand-off.

A government has still to be formed in Spain over a month after the election, the recently-formed Portuguese government looks fragile and both these heavily-indebted countries are struggling to sustain what little growth momentum emerged last year. Both have ongoing banking headaches. Greece has yet to bed down its third bailout agreement and its banks were damaged by the ECB-enforced closure in July.

The ECB's latest disappointment is the continuing failure to achieve the target 2pc per annum inflation rate. Prices were flat across the eurozone in 2015 and ECB economists had been hoping for 1pc in 2016 and 1.6pc for 2017. These numbers now look unattainable and the cumulative under-shoot since 2012 will be approaching 5pc by the end of this year, an unwelcome addition to the real burden of debt.

If the 2pc inflation target had been delivered the more indebted countries would have enjoyed some gentle debt relief. Instead the ECB is likely to under-shoot its own chosen target all the way through 2017, which means for five years in a row and the eurozone is well on the way to a full decade of growth under-performance, even relative to the unimpressive record in the UK and the USA.

So even if the fears about China are over-blown, and if stock market wobbles can be ignored, there are reasons to be nervous about the prospects for Ireland's major trading partners in Europe.

If a big country like Italy or Spain gets into trouble during 2016, there could be a full dress re-run of the eurozone crisis, with deposit outflows from the weaker banking systems and sell-offs in the vulnerable sovereign bond markets.

The next government needs to draw a line under our own banking debacle, if I interpret correctly an IMF assessment released last week. "In the mortgage segment (bad loan) resolution is complicated by weak cooperation between borrowers and lenders, lengthy legal proceedings, and limited (but increasing) utilisation of personal insolvency arrangements.

As a result, the stock of mortgage accounts in deep arrears (over 720 days) continues to increase, reaching 55pc of past-due loans (over 90 days) in mid-2015 from 49pc at end-2014. About half of the (developer) loans are still non-performing, despite promising trends in restructurings and write downs."

The ever-helpful IMF are insufficiently blunt in their pronouncements. They are saying that some of the banks' assets are not worth quite as much as the banks (and the government) are hoping. Provisions against non-performing loans made in previous years are already being added back to produce 'profits', and this may be premature according to the IMF or, as we say in Ireland, a bit previous. The banks are also burdened with some performing assets, namely tracker mortgages, which are likely to lose money for some years yet. It is not prudent to show these loans at full value. Serious politics resumes after the election.

Sunday Independent

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