Irish Economy: Riding For A Fall?

Nick Louth - Mon 13 Aug, 2007

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...

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.

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.

However, it isn’t just about property alone. Ireland is
one 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.

Nick Louth is a regular contributor to the Financial
Times, Investors Chronicle and MSN website

Regards

Nick Louth
For The Daily Reckoning 

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