Access to new credit crucial for turnaround

ECONOMICS:The sweet spot for debt holders is coming to an end, and we will soon see a reversal of the interest rate benefits enjoyed by households, writes DERMOT O'LEARY

IN THE midst of the worst period in Ireland’s economic history, it might seem like a pretty silly and, indeed, depressing question to ask, but could the situation have turned out any worse since the recession began almost two years ago?

Two developments spring to mind. First, the drop in consumer prices has allowed the decline in household incomes due to pay-cuts and job losses to be offset somewhat in real terms. With the majority of spending categories now showing price declines, no one can argue with the view that the vast majority of households are benefiting from the deflationary environment.

Second, households with debt have benefited enormously from the drop in interest rates over the past 18 months. The cumulative effect has been enormous.

After a pretty embarrassing false start from the European Central Bank (ECB) when it raised interest rates in July 2008, the bank embarked on an eight-month stint when it cut its base interest rate to the current record low of 1 per cent.

Most, but not all, of these cuts were, originally at least, passed on to customers by the domestic Irish banks.

This decision to slash interest rates was taken for the euro area as a whole, but the countries that benefit most from rate reductions are those with the largest holdings of private debt. Within this, those countries with the largest proportion of floating rate debt benefit disproportionately. Ireland fits both descriptions.

Take households as an example. Irish household debt stands at about 170 per cent of disposable income, relative to about 100 per cent in Germany and France. Most of this household debt is made up of mortgages, and more than 80 per cent of that is variable, much higher than the European average.

The benefits of the interest rate reductions differ from household to household, depending on whether they have a fixed, variable or tracker rate attached to their mortgage, and the extent to which their bank has passed on the ECB rate cuts to the standard variable rate – or, more recently, increased its margins.

However, we can calculate the cumulative effect from Central Bank statistics. In December 2007, households faced annual interest payments of about €10 billion. In December 2009, the debt was pretty much unchanged but the annual interest cost on that debt had fallen more than 40 per cent to a little over €5.5 billion.

Put another way, households, in total, received a 4 per cent fillip to their household income due to the fall in interest rates over the past two years.

The answer to the question posed at the beginning, therefore, seems to be yes on both counts: were it not for these two developments, real household income and spending trends could have turned out even worse.

Households will probably continue to benefit from falling prices, but the same cannot be said about interest costs. With the recent decision by Permanent TSB to increase mortgage interest rates for its standard variable rate customers, the reality has dawned that the period of exceptionally low borrowing costs is coming to an end. The reason cited for the increase is the high cost of funding.

Unfortunately, this is not a problem exclusive to Permanent TSB.

While it may leave a sour taste in the mouths of taxpayers who have provided an extraordinary level of support to the banking system recently, it is simply not sustainable for any business to be paying out more on its cost of sales than the sales themselves.

With this situation now a reality among Irish mortgage lenders, it is difficult to imagine how the others can avoid a similar course of action.

The ECB doesn’t seem in any rush to raise interest rates, and recent Greek-related turbulence may push out the timing of any rate increases but, with rates pretty much close to zero, interest rates are still likely to be higher at the end of the year than they are now.

In summary, the sweet spot for debt holders in Ireland is coming to an end, and we will soon see a reversal of the interest rate benefits enjoyed by households recently.

Most forecasters, including ourselves, believe the economy will emerge from recession in the second half of this year, led by improvement in global conditions feeding through to higher demand for Irish exports. At the same time, though, we are likely to see interest rates start to climb.

Could this be the trigger for a double-dip in Ireland, as higher borrowing costs choke off the prospect of an improvement in the domestic economy? The answer is that it depends.

One must distinguish between the cost of money and the availability of it. There have been significant benefits to households, and indeed businesses, who are existing debtholders, because the cost of that debt has been reduced. But in terms of economic activity, it is new lending that will drive an economic rebound. The more households and businesses that can get access to new credit at what are still historically low rates, the more houses will be bought and the more businesses set up.

The race, it seems, is on. Can the policies being adopted to return the banking system here to health, including, of course, Nama, improve the availability of funds, thus offsetting the impact of rising rates? This must be done in an environment of a shrinking number of players, as evidenced by the recent decision by Halifax to withdraw from the Irish market. Given that a return to growth in the economy depends on the availability of credit, the answer is that they must.

Dermot O’Leary is chief economist with Goodbody Stockbrokers