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House prices, debt and uneven recovery: What are the biggest risks to the Irish economy according to the Central Bank?

“A clearer path to recovery” has become visible in recent months.

Image: Sasko Lazarov

LAST NOVEMBER, TOWARDS the end of what would be the second of three national lockdowns, the Central Bank of Ireland detailed the “extraordinary shock” that the pandemic had delivered to the Irish economy.

In its second and final Financial Stability Review (FSR) of a remarkable year, the bank said “the main risks” to the stability of the financial system at the time stemmed “from the possibility of further pandemic-related disruption”.

This was despite the “progress” on vaccine development around that time.

One lengthy lockdown period and 1.9 million administered jabs later, the Central Bank’s first FSR of 2021, published this morning, paints a slightly brighter picture.

Yet, from where the Central Bank is standing, significant risks remain.

What are they and in what position is the financial system to deal with them?

The recovery path

A lot has changed in the intervening months. 

“A clearer path to recovery” has become visible in the interim thanks to the expansion of the vaccination programme, the Central Bank said today.

“Uncertainty and downside risks” have been “reduced” relative to the November Review because of the roll-out.

But speaking to reporters today, Gabriel Makhlouf, Governor of the Central Bank of Ireland, said, “The recovery may be bumpy and uneven, as some sectors in Ireland thrive while others continue to struggle with the effects of the restrictions.”

Moreover, he said there is the potential for a more “widespread setback” to the recovery from “challenges related to the vaccine roll-out” and the spread of Covid-19 variants.

In other words, we’re not out of the woods yet.

The Central Bank isn’t ruling out the possibility that restrictions might have to be tightened once again if the virus situation changes.

Against that backdrop, today’s FSR reiterates that the macroeconomic outlook remains uncertain.

With large swathes of businesses still being propped up by government supports, the upcoming tapering of those pandemic-era measures “could test the viability of the most distressed firms as well as the incomes of households employed in the most affected sectors,” according to the Central Bank.

In particular, the property sector could be further tested.

Irish commercial real estate values and rents “weakened considerably throughout 2020 and into 2021″ and are likely to fall further if there is any “prolonged disruption” arising from more restrictions.

Meanwhile, the report highlights “the potential for a widening of the mismatch between housing demand and supply” as a result of the pandemic.

This could put even more upward pressure on prices in the near term, the bank warned.

The banks

Last year, Ireland’s banks were among the most cautious lenders in Europe when it came to dealing with the impact of the pandemic.

In fact, recent analysis by Mazars suggested that AIB and Bank of Ireland were the most proactive European banks in setting aside money to cover a potential wave of Covid-related loan losses arising from defaults.

Those provisions coupled with Central Bank rules around the amount of capital that Irish banks have to hold onto to support loans allowed the banks to “absorb losses rather than amplify the shock”.

Demand for credit declined in 2020 and overall bank lending to Irish residents fell by €7 billion as a result.

Here’s where the trouble could lie, according to the Central Bank.

Although the supply of credit has been bolstered by government and ECB intervention over the past year, “a collective contraction in the supply of credit” or a ‘credit crunch’ could hamper the recovery.

“A range of structural changes within the financial system in Ireland” — including the recent decisions by Ulster Bank and KBC to exit the market —  could “have near-term consequences for the supply of credit to the real economy” in the Central Bank’s view.

Similarly, a prolonged period of economic disruption as a result of fresh public health restrictions could reduce risk appetites for Irish banks, which might make them less willing to lend to businesses in certain sectors of the economy.

“Such credit dynamics could potentially exacerbate the uneven impact of the shock across the domestic economy,” according to the Central Bank.

International developments

Moving away from the domestic, Ireland’s financial system remains susceptible to a host of global risks, among them changes in the global trade and tax environments.

As a small open economy, Ireland is particularly susceptible to risks to the global recovery, the Central Bank cautioned today.

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Irish exports have performed famously during the pandemic but increased trade tensions and the bedding in of the new post-Brexit trade relationship between the UK and Europe could hamper the recovery.

Meanwhile, proposed changes to the global taxation regime for corporations “could have a disproportionate effect on Irish tax revenues given the increased role of corporation taxes within Ireland’s tax base”.

It’s unclear how the proposals “will translate into a new operating environment for multinational firms”, Makhlouf said today.

“But it seems prudent for the government to begin planning for a world in which corporation tax revenues are lower in the future.”

Global financial market risks

“Sharp” changes of fortune in global financial markets could also transmit to the Irish financial system, the Central Bank warned.

Since the onset of the pandemic, central banks across the world have worked to maintain loose financing conditions by keeping interest rates low and launching enormous bond-buying initiatives like the European Central Bank’s €1.85 trillion Pandemic Emergency Purchase Programme.

This has helped to keep down borrowing costs for governments and businesses alike.

The flip side of the coin is that debt levels have risen and lower bond yields mean lower returns for investors, many of whom have turned to riskier punts in their hunt for returns.

Since the last FSR, the Central Bank said today that there is “evidence of increased risk-taking in financial markets”.

This has created the potential for sudden ‘corrections’, which could be transmitted to the Irish financial system.

Somewhat ominously, the Central Bank suggests that by some metrics, global risk has “reached levels seen before the bursting of the dot-com bubble in 2001″.

The report highlights “a series of isolated events” including the scandal around the collapse of US finance firm Archegos Capital in March and the “Gamestop episode in January”.

Although the contagion from Archegos’ downfall was largely contained to some of its more unlucky institutional backers like Credit Suisse (which lost nearly $5 billion in the debacle), it was an object lesson in how hidden risks can suddenly become visible.

“While not systemic in isolation, these episodes highlight vulnerabilities in financial markets, including through the build-up of leverage,” the Central Bank said.

“A sudden market correction could lead to a deterioration in global financial conditions with adverse consequences for the economic recovery, particularly in Ireland.”

 

 

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