Wednesday 26 October 2016

Little hope of recovery if ECB uses us as a poster child for deleveraging

Published 11/03/2014 | 02:30

Prof Morgan Kelly: warning
Prof Morgan Kelly: warning

Karl Marx wasn't a friend to bankers. In volume 3, chapter 33 of the monumental book 'Capital', Marx wrote that "the credit system, which has its focal point in the allegedly national banks and the big money-lenders and usurers that surround them, is one enormous centralisation and gives this class of parasites a fabulous power not only to decimate the industrial capitalists periodically but also to interfere in actual production in the most dangerous manner – and this crew know nothing of production and have nothing at all to do with it".

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UCD's Professor Morgan Kelly echoed Marx in a recent lecture. Prof Kelly's vision is of banks foreclosing on small and medium enterprises on the orders of the European Central Bank (ECB), with declining standards in third-level education damaging the long-run growth prospects of little Ireland.

Prof Kelly is someone we should listen to, someone whose arguments are never haphazard, nor partial.

Prof Kelly's argument runs like this: following a serious asset quality review, which Europe's banks haven't really had so far, the ECB might push for faster, harder and more transparent winding-up arrangements for Irish small and medium-sized enterprises (SMEs). This would be catastrophic for the Irish economy, because most private sector workers are actually SME workers.

So is Prof Kelly correct?

If, and it's a big if, the ECB decides to push hard on our banks and their SME lenders, who have around €58bn of debt in total, with about €33bn of that debt being property related, then in addition to the huge economic shock of many businesses closing, the banks will require more capital to keep going; this might lead to the banks borrowing more from other banks abroad or from the taxpayer to fund themselves.

Remember, these loans can be very complex, with many properties cross-collateralised with large and uncertain effects on the real economy when the loans are foreclosed on. As demand increases, these companies will see increased cash-flow, all being equal, and perhaps many might be able to pay off their loans in a timely way. Without economic growth, these firms will have no access to cash-flow. In other words, the periodic decimation of industrial capitalists Marx talked about would take place.

One place Prof Kelly is wrong is his assumption the Government doesn't care about SMEs. Most of the people who will vote in the next government work in or own SMEs. Initiatives abound to help Irish businesses, particularly export-focused ones, survive and thrive.

Any effort by the ECB to push for foreclosures in the SME sector would cause a political backlash of the same scale or greater than that in October 2008 for the restoration of the medical card for over-70s.

Going back to the effects of a meltdown in the SME sector, we can look at the experience of Iceland to get a sense of what might happen. More than 70pc of all Icelanders work in SMEs. Following the financial crisis of 2008, all three major Icelandic banks collapsed, and SMEs went out of business and into bankruptcy in many cases. Employment dropped 20pc for Icelandic SMEs, while insolvencies jumped by nearly 60pc between 2008 and 2012.

That's probably an outward estimate of what might happen in Ireland should Prof Kelly's vision come true. The Central Bank of Ireland's Fergal McCann and Tara McIndoe-Calder looked at what might determine SME loan default in Ireland, and found the share of defaults falls as firms get larger, and rise as loans get larger relative to assets. So smaller, highly indebted SMEs are fragile, and tend to go under more, depending on the sector they are in.

One thing is absolutely clear: the domestic recovery won't happen if the ECB takes this course of action. So the question would be: why would they do this?

The ECB might want to use Ireland as a signal. Europe's banks do need to deleverage – to reduce the size of their balance sheets. The thinking might go that here we have Ireland, the poster child for fiscal austerity, let's make Ireland the poster child for cleaning out banks' balance sheets, too.

There is no way to test Prof Kelly's hypothesis without seeing how the ECB's asset quality review plays out, and seeing how policy makers react to the results. We can write scenarios composed of 'if-then' statements about the things Prof Kelly says, and see what happens.

The country will focus on SMEs and their likelihood of default now for some time. This is an important topic, and Prof Kelly should be thanked for bringing it to us, as a society, to look carefully at. That's the function of academics at their best: they help us see things differently. OK, Prof Kelly does also tend to terrify us, but you can't have everything.


Irish Independent

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