Tuesday 11 December 2018

Italy, Trump and Brexit mean the perfect storm is brewing

Are the Government and the banking system prepared for the growing risk of slump Ireland, asks Dan O'Brien

Threat: Will Trump take further measures against the EU? Photo: AP
Threat: Will Trump take further measures against the EU? Photo: AP
Dan O'Brien

Dan O'Brien

Ireland is a very open economy dependent on three major markets: the euro area, the US and the UK (in that order). All three now pose big risks.

The reigniting of the euro crisis has, predictably, taken place in the weakest country in the single currency zone: Italy. Its new government, formed by two populist parties, has made commitments which will push the country's already-teetering public finances toward the edge. Even if the coming crisis can be contained, it could have a significant impact on the Irish economy if the euro-area economy slumps, just as happened during the Greek phase of the crisis.

Continental Europe is Ireland's largest trading partner. The US is now in second place, having overtaken Britain in recent years. At the end of last week, Donald Trump hit some goods imported into the US from Europe with taxes. These breach World Trade Organisation rules. As had been flagged, the EU, which conducts trade policy for all member countries, hit back. If Trump takes further measures against Europe, as he has promised, the EU will hit back again. If the cycle continues, it will be only a matter of time before Irish goods exports to the US, worth €33bn last year, are affected.

As if these clouds were not bad enough, there is Brexit. If a deal can be reached, involving a transition period beyond March of next year, then there is little to worry about - in the medium term at least. But if the talks break down and the UK exits without a deal, trade will be disrupted - probably severely - from March 30, 2019.

The chances of the eurozone crisis, a transatlantic trade war or Brexit (or some mix of the three) hitting the Irish economy are high and rising. After more than half a decade of recovery, how well prepared are the two weakest actors - the State and the banks - to withstand a slowdown?

Consider the Government first. Despite six years of solid economic growth, it has failed to get its finances back into the black. Unlike almost half of the 28 EU member countries in which governments are taking in more than they are spending - the prudent position to be taking during an upturn - Ireland's public finances are still in deficit.

That means that the deficit would quickly move into the danger zone if the economy went into recession. With public debt per person standing at €42,000 (by way of comparison, the Italian state owes €37,000 for each resident of that country) there is not much room for manoeuvre. While it is positive that the Finance Minister has recently indicated a reluctance to spend as much as the budgetary rules allow him to get away with, the failure to move into a strong surplus during the long upturn means that austerity will return in short order in the event of the economy slumping.

If there was anything positive coming out of the flare-up in the eurozone over the past week and more it has been the absence of contagion to Ireland, so far. Unlike Portugal and Greece, euro area countries that were bailed out along with Ireland, investors did not sell off Irish government bonds last week. That brings hope Ireland is no longer viewed as a Club Med country. That might mean more leeway if the sort of crisis in the eurozone experienced from early 2010 to the middle of 2012 hits again.

What about the banks?

Like the State, they could be better positioned to enter a downturn. Around one-tenth of the loans they have outstanding are non-performing. That is already a high level, and recessions invariably mean more individuals and businesses being unable to repay their loans. The Irish banking system collapsed a decade ago because too many of its loans - mostly in commercial property - turned bad.

It has been some time since commentators have talked about banks' balance sheets. I know it can be a bit dull on a Sunday morning, but given how badly everyone was affected by the banking crisis, a plain-English explainer may be useful given the high risk of turbulence ahead.

Atop the hierarchy of blame for the property bubble and crash sit bankers. That is because in the five years up to 2008 they sucked in money from wherever they could get it and then lent it out recklessly - mostly to people and businesses to buy property.

One source of cash was the bonds which became so controversial after the collapse. In the early 2000s Irish banks started issuing IOUs in large quantities, mostly to foreigners. Not content with lending out the money Irish residents deposited with them - the traditional means for banks to fund their loans - Irish- headquartered banks had borrowed €130bn by issuing bonds by the time the crash came.

The good news from the restructuring of the banking system since then is that the banks collectively have gone back to their more conservative old ways, and very few new bonds have been issued. The same group of banks had just €20bn of such bonds outstanding as of April (these figures, and those cited below, come from the Central Bank of Ireland).

This will be particularly beneficial if contagion from Italy spreads. A big weakness of bonds for banks is that, unlike most deposits, they need to be repaid on agreed dates. Usually banks simply sell new ones to pay back the bonds falling due. But in times of financial distress, banks have to offer higher interests rates (which erode profits) or can't sell their bonds at all.

The decline in the use of bonds, along with dependence on flighty foreign deposits, means that the banks' aggregate total liabilities are now considerably less than half what they were a decade ago. Much more of the liability side of the balance sheet is accounted for by traditional deposits - of Irish individuals, companies and other financial institutions - which are less likely to be withdrawn at the first sign of trouble.

The asset side of banks' balance sheet has also shrunk as dramatically (total assets and total liabilities must, by accounting definition, be equal). There are multiple reasons for this. First, banks have been giving out far fewer new loans than before the crisis. Second, repayments of loans have exceeded new loans (though that is finally changing in the important mortgage segment). Finally, the banks have been selling off chunks of their loan books, usually to what are often described as "vulture funds".

All this means that the banks have drastically less money out on loan than a decade ago. And the deleveraging has been particularly stark in the sectors that got into most trouble during the crash.

What the Central Bank describes as companies in "Real Estate, Land and Development Activities" had more than €100bn in loans at the peak. As of the end of last year, that was down to €14bn. The shrinking in lending has been even more dramatic among builders. Construction companies had just €764m out in loans as of December 31 last year. At the peak, they owed €10bn.

In sum, the banks have much less out in loans now and the quality of those loans is less likely to turn bad in an externally caused recession than was the case a decade ago when a domestic bubble was the main reason for slump.

To conclude, consider the connection between the banks and the State.

Banks' holding of the bonds of their own governments has been described as a "doom loop", as it connects the fate of the former to the latter. Currently, the Irish- headquartered banks hold €15bn of Irish government debt on their books. This is much higher than pre-crisis levels and poses a vulnerability if Italy goes Greek and a wave of defaults threatens to engulf Europe.

But because the banks are much smaller, another banking crisis would be less damaging than when they were bloated and blew up a decade ago. That may provide a modicum of comfort as the conditions for a perfect economic storm brew on the horizon.   

Sunday Independent

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