Opening Statement by Tom O’Connell, Assistant Director General, to the Joint Oireachtas Committee on Enterprise, Trade and Employment

29 July 2009 Speech

Good morning Chairman and members of the Joint Committee. Thank you for the invitation to speak with you today. I am accompanied by John Flynn, Head of Economic Analysis and Research.

Economic Background

I would like to begin by commenting on the performance and prospects for the economy. In common with other countries, the pace of deterioration in economic activity has worsened since last autumn, the point at which the turmoil in global financial markets developed into a full-blown crisis. Given the highly open nature of the economy and the character of economic growth in the years preceding 2007, Ireland was both exposed and vulnerable to the global financial and economic shocks that have emerged. These vulnerabilities included an over-reliance of the economy on the construction sector, large bank exposures to that sector and a substantial reliance by the domestic banking sector on wholesale funding. History shows us that downturns in economic activity that are preceded by problems in the banking sector tend to be more severe than those caused by other factors. This is proving to be the case both here and abroad.

Between last autumn and this spring, deteriorating financial market conditions and intense strains on the financial sector led to sharp declines in global economic sentiment. This prompted a sharp retrenchment on the part of households and firms. In Ireland, this was reflected in consumers reining back spending even further and firms responding to the changed economic environment by cutting production and acting quickly to lower costs. With exports weakening, and a fiscal stimulus not possible, this has accelerated the fall-off in demand and has been reflected in a very sharp rise in unemployment.

Our expectation now is that GDP will contract by 8.3 per cent this year. Next year, the fall in output is likely to be around 3 per cent for the year as a whole with some gradual recovery emerging later in the year but unlikely to take hold until 2011. The contraction in activity has already led to a significant rise in unemployment, which will not begin to reverse until the recovery gains some momentum. Reflecting this, unemployment is forecast to average around 13 per cent this year and 15 per cent in 2010. One consequence of the downturn in growth has been a sharp turnaround in inflation. The consumer price index is forecast to fall by around 4 per cent this year and to be broadly flat next year (the HICP index, which does not include mortgage interest payments, is projected to fall by close to 1½ per cent this year with a further modest fall in 2010).

As has been stated by the Governor at the recent launch of the Central Bank’s Annual Report, we are confronted by significant challenges on three fronts - financial, fiscal and in the field of competitiveness.

To address problems in the financial area we have seen a number of actions:

  • a state guarantee for bank liabilities was introduced to stabilise the funding situation;
  • the main domestic banks were recapitalised in order to ensure their viability, to support the supply of credit to the economy, and to address market participants’ requirements for banks to maintain higher core Tier 1 capital ratios; and
  • legislation for the establishment of the National Asset Management Agency (NAMA) is imminent to help address the problem of non-performing assets.

On the fiscal side, we are all aware of the deterioration in the public finances arising from high rates of increase in public spending and the erosion of windfall taxes deriving from the property sector. The Government has agreed with the European Commission to correct our Excessive Deficit position by 2013 and it is crucial that these targets are met. The Government’s introduction of a public sector pension levy and the Supplementary Budget are steps that have been taken to this end. Bringing the public finances back into balance is necessary to restore macroeconomic stability and to ensure international confidence in the economy on which, as a small open economy, we are so dependent.

With regard to competitiveness in recent years, economy-wide productivity gains have been very modest and labour and other cost increases have been relatively high compared with our main trading partners. This has led to a substantial erosion of the country’s competitiveness. This deterioration is now being addressed and many firms have taken action to reduce their costs, with a view to regaining competitiveness and protecting output and employment. While this has undoubtedly been painful, it nevertheless reflects encouraging evidence of the flexibility that is needed if the economy is to maintain the maximum possible number of jobs in the short term while placing Ireland in a favourable position to benefit from an eventual recovery in world demand. This type of flexibility must embrace all parts of the economy – both exposed and sheltered sectors.

Over the past two decades, Ireland has demonstrated a strong ability to exploit its advantages - in the form of flexible markets, a competitive economy and a highly-skilled and educated labour force - to generate growth. In more recent times, these strengths have come to be masked by other factors. However, there is much evidence that Ireland still retains a relatively flexible and adaptable economy, which, allied to our skills base and the capacity for a rebound in productivity growth, holds out the prospect of a return to a potential growth rate of 2-3 per cent once we come through the current difficult patch. However, our ability to realise this potential will be very much dependent on how we deal with the significant challenges that we currently face.

Credit and Financing Developments

I would like to turn now to what is happening in the area of credit and the financing of business, the main focus of your Committee’s work at this time.

It might be useful at first to reflect on the broad financial context over the past decade. At the turn of the millennium, Ireland was experiencing strong economic growth as our living standards converged towards those of our advanced European neighbours. At that stage, exports continued to be a strong driver of growth. Employment and population were both increasing strongly. With the adoption of the euro, Ireland faced quite low interest rates by historical standards. The increased affordability of borrowing, and improving incomes enabled the private sector to assume somewhat higher borrowings for investment and consumption purposes.

However, private-sector credit (which includes lending to households, non-financial corporations and non-bank financial institutions) experienced very rapid increases over recent years, averaging 23 per cent per annum between 2002 and 2007. Irish households were the third most indebted in the EU in 2007 with household financial liabilities amounting to 198 per cent of disposable income, although some decline in indebtedness was recorded in 2008. In the first half of 2009, household borrowings from banks have declined by around 1.5 per cent.

The rapid increase in credit and indebtedness of Irish households and NFCs during the early part of the decade, particularly when viewed against the experience of other EU member states, suggested that some degree of deleveraging to reduce the debt burden was likely. Looking at the broader picture of the household sector’s balance sheet, aggregate financial assets remain higher than their liabilities, although the difference is narrowing, and the value of their non-financial assets, mostly property, has significantly declined over the past two years. Of course, within the broad household sector, there is likely to be a wide diversity of experience with younger households having significant borrowings, mainly related to housing, and older households tending to be in a stronger net financial asset position.

During the first five months of 2009, credit outstanding to households fell by €3 billion, mostly as a result of a fall in consumer credit with mortgage lending remaining relatively static. Over the same period, allowing for write-downs, there has been a modest decline in lending to NFCs.

Sectoral Evolution of Credit

Turning to sectoral developments, most of the increase in private sector credit, particularly from 2006, has been property-related – split relatively evenly between residential mortgages and real estate and construction activities. Lending to the real estate and construction sectors grew rapidly since the turn of the decade, reaching approximately two thirds of total NFC lending in Q2 2007. While the outstanding amount of total NFC lending has declined in more recent months, the proportion accounted for by property related lending has remained relatively static.

The extent of the dominance of property-related lending is highlighted in the credit data for the years 2002-2007. These data show property-related NFC lending increasing at 43 per cent per annum over the period, whereas NFC lending for non-property related activities increased at a much lower, but still significant rate of 12.5 per cent per annum.

Recent Credit Developments

Regarding more recent trends, the pace of growth in outstanding credit to NFCs has slowed markedly over the past year. The annual rate of increase of lending to both the property- related and other NFC sectors peaked in 2006, when the rate of increase in credit for the sector as a whole, reached a high of 39 per cent. The rate of growth has moderated sharply since, to an increase of just 2.1 per cent in Q1 2009. Lending to specific sectors such as manufacturing, wholesale/retail trade and hotels and restaurants peaked at a later date around the middle of 2008 and has also been declining since.

Both the supply of, and the demand for, credit has been weak for all NFCs given the present difficult economic conditions. The financial market turmoil that has persisted for some time has led to a challenging funding position for banks across the globe, including in Ireland. This, together with pressure on their capital positions has acted to inhibit banks’ capacity to supply credit. Irish results of the euro-area Bank Lending Survey in recent quarters reports some tightening of credit standards by banks as well as falling demand for loans by NFCs.

Regarding funding, total bank deposits have been volatile since autumn 2008. On average for the first five months of 2009, total deposits are 8 per cent lower than in the same period 2008. With domestic deposits just 3 per cent lower, there has been a more significant fall in non-resident deposits. Banks are also reporting tighter margins as competition for deposits increases. There is also an increasing tendency for banks to retain funds raised through deposits and other sources, in order to strengthen their balance sheets in the face of rising losses on existing credit arrangements. These funds are, therefore, not available for on-lending to the real economy.

The stresses in wholesale inter-bank markets have eased gradually over time assisted by the actions of the Eurosystem in providing significant amounts of liquidity through both short-term and longer term refinancing operations. Irish resident credit institutions have been able to avail of this liquidity, as have all other credit institutions operating in the euro area.

The impact of both supply and demand factors on outstanding credit growth is one issue highlighted in the recently published Mazars report regarding credit availability to SMEs, commissioned by the Department of Finance. The results of this survey are broadly in line with the credit data compiled by the Central Bank. However, it is difficult to make comparisons at sectoral level, because of coverage and definitional issues, and because larger corporations were not included in the Mazars survey. The main messages from the two sources are:

  • Total SME lending has remained fairly static for the past year or so;
  • The data would indicate that existing credit facilities are being re-negotiated;
  • Most SME loan applications are for working capital or cash-flow purposes;
  • Rejection rates of loan application quoted by SMEs are somewhat higher than the banks’ reported rejection rates especially for very small business, but some of the difference may be due to differing perceptions of what constitutes a substantive loan application;
  • Not surprisingly, the quality of the SME loan book was found to have deteriorated significantly;
  • The two main Irish banks are conforming to the terms of the Government re-capitalisation programme with regard to lending to SMEs and first-time buyers. Foreign banks, both here and elsewhere, as reports indicated, are tending to focus on primarily on promoting credit flows in their home markets.

Interest Rate Developments and Pass-through

Overall, interest rates on loans to NFCs have been reduced by more than the cuts in ECB interest rates since the beginning of the rate-cutting cycle in October 2008. However, the interest rate pass-through on loans of less than €1 million - taken as a proxy for SME loans- has been less than for larger loans. One potential explanation for this phenomenon is that historically larger margins on loans to smaller firms tend to be observed in a downturn, as they are perceived to be riskier by banks. ECB rate cuts were more or less fully passed through to households over the period, particularly for new mortgages. Existing mortgage holders also benefitted due to the high proportion of mortgages whose interest rate is legally tied to ECB rates, and for which banks are contractually obliged to pass on ECB rate cuts to customers in full.

Interest rates on deposits with agreed maturity initially did not pass on cuts in official ECB rates, due to competition for funds between banks, especially in an environment of higher interbank rates. However, since January interest rate reductions have been passed through to customers with agreed maturity and notice deposits. Recently, banks have been constrained in reducing deposit rates further in response to ECB rate cuts due to their already low level.

In summary, credit flows to businesses and households are currently broadly flat – with new loans extended more or less corresponding to repayments on outstanding loans. As we have indicated, there are both supply and demand factors at play in this. We are now available, Chairman, to try to answer any questions that you and the Committee members might have.