Thursday, 23 August 2007

Why the Irish economy is paying for its property dependency

The Irish economy is heading for a fall. While an overheated global economy, rising interest rates and a sub-prime lending crisis may cause problems in all parts of the world, to see where the biggest damage may be done you have to go to Dublin. The Celtic Tiger economy, galloping away year after year with no monetary brakes, is the one most likely to fall off a cliff. If the worst happens, its membership of the euro will bear part of the blame.
The Irish stock market already recognises the deteriorating economic reality. While London has dropped 8% from its recent highs, Dublin lost a massive 15% from the peak of 10,041 set in February. By August 1, the Iseq index was down at 8,407. There’s no market in the developed world with losses that matched this.

How housebuilding propped up the Irish economy

So what is the fear that has so spooked investors in the emerald isle? In a word, property. The Irish economy has become over the past eight years a large geared bet on the profits to be made by building of tens of thousands of new homes, financed by low eurozone interest rates.

Around 90,000 homes were built in Ireland last year, compared with 200,000 in the UK which has 15 times the population. This year, with prices already falling, another 70,000 homes will have to find buyers. The entire Irish economy is dependent on property. It accounts for 15% of economic output, 17% of tax revenues, and most worryingly of all, 64% of bank lending. On a recent trip there I was amazed to see how much of the countryside had disappeared beneath bricks and mortar.
Formerly tiny villages had bulked up to become twice or three times their size, with many homes having been constructed in the last few years. They may have gone too far. Fully 15% of Irish property is empty.

Despite this, the country has the highest rate of house building in the EU, per head of population. By OECD definitions housing starts are 26% above sustainable levels. House prices have risen by 270% since 1996, but are now almost static. Rents, which indicate the underlying level of demand for property, have fallen since 2000, though now prices have moved well beyond the reach of most first time buyers, they are starting to pick up again.

Ireland suffers the ill-effects of the eurozone experiment

However, it isn’t just about property alone. Ireland is one of the far-flung corners of the eurozone, and its runaway economy represents an experiment not dissimilar to that run by the Russian operatives of the Chernobyl who ran it towards meltdown to “see what would happen.” Ireland was already a frisky economy when it joined the eurozone in 1999. GDP growth averaged 9%, four times the OECD average, in the previous four years, and inflation was well above the eurozone average. Until very recently, membership of the currency area has done nothing to slow it. GDP growth was still racing along at 7.5% in the first quarter of 2007 a full eight years after joining, and inflation rose from 2% at the time of accession to 4.5% in the year to July. That is more than twice the 1.9% eurozone average.

In a fully monetarily-independent economy, such as Britain, the U.S. or Japan, the central bank will spot inflationary dangers and head them off with interest rate rises. The familiar cycle of raised rates, more expensive credit, heftier mortgage payments and curbed consumer spending normally does the trick. The idea is to diagnose quickly, and impose the medicine in small doses.

The eurozone has 317m consumers in 13 countries and the European Central Bank has to set right across the area one single interest rate which is somehow ‘right’ for the inflationary conditions prevailing there. Like a pair of standard issue prison trousers, the ECB’s interest rate policies are either going to be too tight or too loose for each of the countries that have to wear them. Not surprisingly, the weighting is likely to be towards the needs of the larger economies. The interests of the Irish Republic, population 4.2m (smaller than that of Berlin), are never going to be at the top of the agenda. Matters closer to home mean the ECB was keeping rates low to help the stodgy economies of France and Germany, where growth was weak and needed nurturing.

So the ECB has actually been very slow to act from an Irish perspective. Only in 2005, after a decade-long Irish housing splurge, did the ECB start to raise rates.
Of course that was nothing to do with noticing what was happening in Ireland. It was because inflationary dangers were now raising their heads in the larger economies.
Eight quarter point rises have seen them reach 4%, with economists predicting a 4.5% cyclical peak. Likewise, when Ireland actually needs rates to fall (which it may do now and in six months almost certainly will), you can be sure that the ECB will still be raising them to stem inflationary worries in core eurozone members.
This illustrates the frictions in the eurozone adjustment mechanism. Instead of interest rates, the EU relies on movement of capital and labour between eurozone members to even out the imbalances in economic growth. Capital, in a single currency zone, moves easily enough to where potential return is greatest. Labour, though, is notoriously sticky.
When the German economy was growing slowly in 2002, and had high unemployment, eurozone theory suggested that jobless Germans would seek out vacancies in Ireland. They didn’t. Indeed it had to wait for Poland’s accession to the EU in May 2004 for a wave of economic migrants from within the eurozone to reach Ireland. These days, if you ask for a pint of Guinness in a bar anywhere in Ireland, you are as likely to be served by a Pole, Lithuanian or Latvian as you are by an Irishman.

So what happens next? There are some apocalyptic voices out there. Professor Morgan Kelly of University College Dublin, who studied adjustments to housing bubbles across a number of different economies, reckons that Irish house prices may lose 70% of their gains, though that would take a number of years to occur.

But it doesn’t need to be this bad to hurt. For banks, estate agents, builders and building materials firms a collapse in house sales volumes would do the job just as well. Asking prices will of course initially be sticky, just as they were in Spain and the U.S., before sellers readjust their expectations.

Certainly affordability is under extreme pressure. Despite recent moves to help first-time buyers with zero stamp duty, higher mortgage interest relief and extended payment terms, Bank of Ireland reckons that the average new mortgage absorbs 38% of borrowers’ incomes. Given that three quarters of mortgage and consumer debt in Ireland is at floating interest rates, every rise in rates is going to hurt.

The consequences for Ireland could be severe. Though the economy has only once ever experienced an annual house price fall in 30 years, that may turn out to be the norm for the next few years. It can hardly be otherwise.

Though we have yet to discover if there is any corollary in Ireland to the dodgy mortgage lending practices in the U.S., we can be sure that falling property prices will uncover them. Now is definitely not the time to own Irish shares.

By Nick Louth
This article first appeared in MoneyWeek