Abstract
Hit by loan-losses from a bursting property bubble, the Irish banks were brought to near-collapse, contributing to one of the worst economic downturns of the global crisis. The sharp fall in nominal and real interest rates and the removal of exchange risk from foreign borrowing after euro membership played a part in these events. At the same time, several other countries have got into similar trouble, both recently and in decades gone by, so there is no guarantee that staying out of the eurozone would have prevented something comparable from happening. And the euro provided an anchor as the crisis broke.
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Notes
This refers to the change in the net foreign assets of the banks as reported by the Central Bank of Ireland. Much of the inflow was through locally controlled banks. Overall net capital inflows were smaller. This refers to the change in the net foreign assets of the banks as reported by the Central Bank of Ireland. Much of the inflow was through locally controlled banks. Overall net capital inflows were smaller.
Real rates dipped strongly into negative territory in the early years of the Euro as the initial weakness of the euro against sterling and the US dollar added disproportionately to Irish inflation (Honohan and Lane, 2003).
There have been criticisms of monetary policy decision making in Ireland in previous exchange rate regimes, including the Sterling Link (Honohan and Ó Gráda, 1998) and the ERM (Honohan and Conroy, 1994).
Preliminary indications are that the largest block of prospective loan losses relates to lending for property development.
For a more comprehensive account, see Honohan (2009).
For a more detailed account of the demographic and other dimensions to residential property ownership and rental patterns through the crisis, see Bergin et al. (2009).
Fearing excessively rapid economic growth, the Central Bank worked to maintain interest rates high for as long as possible before the euro came in; but from September 1998 Irish short-term rates began to converge quickly towards deutschemark levels.
Supply response should, of course, in time fully offset this capitalization effect for standard houses built on marginal land – for example far from a city centre.
Even such papers as Stevenson (2008) whose abstract mentions that ‘in recent years, prices have largely been in line with fundamentals’, turns out to be referring to changes in house prices between 2000 and 2003. To be sure, almost all commentators, at least before the Autumn of 2007, while asserting overvaluation in house prices, failed to foresee how severe the consequences would be for the banking system and the economy at large.
One indicator often looked at for housing is the rent-to-price ratio. As documented by Alan Ahearne in a Newspaper article (Sunday Independent, 5 August 2007), based on industry data, rent-to-price ratios for residential property, having been stable around 9% from 1980 to 1997, plummeted over the following decade to 3%. Of course some of this fall reflected the changed interest rate environment.
The reversal was a response to an interruption in the upswing of property prices.
Cf. Barham (2004); Rae and Van den Noord (2006). Ironically, the policy of enhancing tax incentives for property investment was driven by the high prices. There was a perception that affordability of housing for first-time buyers could be improved by an increase in the stock of housing, encouraged by tax incentives.
Other institutional features which may have accelerated the bubble's growth were the widespread use of variable rate mortgages (Doyle, 2009) and the fact that pre-payment of mortgage debt was generally possible.
It has been suggested that the formal division between the two organizations hampered the response to the crisis, though a memorandum of understanding guaranteed full access to needed information from both sides, and it remains to be convincingly shown that a more integrated institutional arrangement would have worked better. It is not thought, for example, that there were any communication difficulties in relation to the activation of lender of last resort facilities.
For example, from May 2006, 100% loan-to-value mortgages were risk-weighted at 60% instead of 50% in the Basel 1 capital requirements framework.
Though, as a referee has observed, the use of heavier instruments would have run against prevailing central banking orthodoxy and ‘would have put any dissenting central banker under heavy criticism’. Furthermore, the ability of the Irish regulator to restrict credit offered by foreign banks would have been limited.
After some international pressure, the guarantee was also offered to the main non-Irish controlled retail banks in respect of their Irish business, but not to others, such as DePfa.
Basing their analysis on credit default swaps (CDS) spreads, IMF (2009a) presented an estimate of financial restructuring costs for Ireland of 13.9% of GDP. In March 2009, based on projections of loan losses, Standard and Poor's provided an estimate of ‘gross fiscal costs’ of about 11% of GDP. The book value of the equity capital of the guaranteed banks at end-2008 stood at less than €25 billion.
As examples, Shiller points to the exaggerated belief in the potential of Internet technology to generate growth and profits on a sustained basis as an important example of ‘new era’ thinking which fuelled the dot.com bubble of the late 1990s. He also notes the role of the radio and other electrical inventions around the turn of the 19th century, resulting in the stock market bubble that peaked in June 1901, and the role of the motor car and related technologies as the basis of the ‘new era’ meme driving the US bubble of the late 1920s.
This is not to exclude the facilitating role of the prolonged period of low interest rates and plentiful liquidity that helped fuel the bubble, and whose persistence owed a lot to policymakers’ failure to recognize that low inflation of goods prices did not guarantee avoidance of an asset price bubble (despite the warnings of such authors as Borio and Lowe, 2002).
This parallels the removal of a warning sign on wage competitiveness, which deteriorated sharply in the 2000s. As shown by Honohan and Leddin (2006), the former tendency for deviations in wage competitiveness to correct themselves (error correction model), detectable in previous data, was no longer evident after EMU began. The regime once again tolerated a larger movement away from equilibrium before warning signals sounded.
The enlargement of the EU also meant that the boom could continue longer than otherwise, fuelled as it was by strong inward migration.
That the banks were headquartered in the eurozone – and thus had access to the ECB for liquidity may also have eased access to international financing on a huge scale – though the explosion in international capital flows in the mid-2000s suggests that bank access to foreign borrowing would not have been too difficult.
Spreads on short-term paper were much lower throughout.
Some of this lending was to banks in the offshore financial centre International Financial Services Centre, which have little domestic business.
Our discussion cannot hope to touch on all of the small European countries affected by the crisis. The examples chosen are sufficient to make the point at issue.
Indeed, many other famous foreign-borrowing-financed booms from Chile in early 1980s through Thailand in 1998 could be taken as examples.
Almost every country has its story to tell in the current crisis, and some are still hard to assign robustly to crisis or non-crisis categories.
As in Ireland, procyclical fiscal policy also fuelled the boom. For this and other key descriptive facts about the Latvian boom, see IMF (2009c).
The largest bank in Latvia at present is Sweden's Swedbank, which in early 2009 was reporting 14% loss rate on its loan book in Latvia. The second largest bank, Parex, suffered a crippling run in the period September to November 2008 and was nationalized. A partial freeze on deposit withdrawals was imposed in early December 2008. Latvia already had a severe banking crisis in 1994, involving the loss of about 40% of the system's assets (Fleming and Talley, 1996).
Despite the regressions of Haiss et al. (2009) – which show no tendency of Transition countries with a higher share of foreign bank ownership to rely more on foreign currency lending – it is clear that the origin of denominating lending in lowest-interest currencies was an innovation of Austrian banks (Tzanninis, 2005; IMF, 2009b; Brown et al., 2009).
The total Latvian package from multilaterals and bilaterals comes to about €7 billion or about one-third of GDP; the Iceland package came to over 100% of GDP (IMF, 2008b, 2009c).
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Honohan, P. Euro Membership and Bank Stability – Friends or Foes? Lessons from Ireland. Comp Econ Stud 52, 133–157 (2010). https://doi.org/10.1057/ces.2010.5
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DOI: https://doi.org/10.1057/ces.2010.5