Euro Membership & Bank StabilityFriends Or Foes?

Lessons From Ireland

Patrick Honohan

Professor, Department of Economics and

Institute for International Integration Studies

Trinity College Dublin

Prepared for the 15th Dubrovnik Economic Conference, 26-27 June, 2009

The question

• Ireland was doing exceptionally well before joining EMU

• Then everything started to go wrong

• Especially the credit boom, fuelled by easy money – low interest, no FX risk

• And Ireland has ended up with [one of] the worst busts in the global crisis

• So is there something specially risky about euro membership for banking?

0

2

4

6

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18

60 65 70 75 80 85 90 95 00 05

Unemployment rate

Employment in nonAg as % Population

0

5

10

15

20

25

30

35

40

45

50

1961 1971 1986 1991 2001 2007

Net migration 1930-2007 (000s)

-80

-60

-40

-20

0

20

40

60

80

30 40 50 60 70 80 90 00

Growth in living standards

-1

0

1

2

3

4

5

6

7

8

75/70 80/75 85/80 90/85 95/90 00/95 06/00

% p

er a

nnum

GNP/PopGNDI Adj ToT/PopPersonal Cons/Pop

After 2000 – shift to property/construction bubble

Biggest price bubble: driven by a “new era” myth (Shiller)Supported by sense that Tiger was unstoppableRationalized by sharp drop in interest rates with €By 2004 prices exceeded any equilibrium model

And not just price: construction2006: 15% of houses empty% labour force in construction jumps from 7% to 13%

Funded by bank borrowing from abroadLTVs rise and rise

A rogue bank grows from 3% to 18% of marketdestabilizing others

Real interest rates 1983-2007deflated by 4-quarter future inflation

-5

0

5

10

15

20

83 85 87 89 91 93 95 97 99 01 03 05 07

Irish Real New House Prices 1970-2008

0.5

1

1.5

2

2.5

3

3.5

4

1970 1980 1990 2000 2010

Inde

x, 1

970=

1

Employment in construction

as % of total employment, 1990-2008 (April)

5

6

7

8

9

10

11

12

13

14

90 95 00 05

Net international position of Irish credit institutions

1999q1-2009q1

0

10

20

30

40

50

60

70

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

% G

DP

LTV rates -- all loans

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2004 2005 2006 2007

100% LTV

95-99% LTV

91-95% LTV

81-90% LTV

71-80% LTV

<70% LTV

LTV rates -- first time buyers

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2004 2005 2006 2007

100% LTV

95-99% LTV

91-95% LTV

81-90% LTV

71-80% LTV

<70% LTV

Ireland: Mortgage loans by initial loan-to-value ratio 2004-7

Irish Life and Permanent Growth 1999-2008

-30

-10

10

30

50

70

90

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

%

0

10

2030

40

50

6070

80

90

€ bi

llion

Total assets realgrowth rate %

Total assets (RHS,€bn)

Anglo Irish Bank Growth 1999-2008

0

10

2030

40

50

6070

80

90

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

%

0

20

40

60

80

100

120

€ bi

llion

Total assets realgrowth rate %

Total assets (RHS,€bn)

Allied Irish Banks AIB Growth 1999-2008

-20

-10

0

10

20

30

40

50

60

70

80

90

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

%

0

20

40

60

80

100

120

140

160

180

200

€ bi

llion

Total assets real growth rate %

Total assets (RHS, €bn)

Bank of Ireland Growth 1999-2008

-10

0

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20

30

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60

70

80

90

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

%

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100

120

140

160

180

200

€ bi

llion

Irish Nationwide BS Growth 1999-2008

-30

-10

10

30

50

70

90

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

%

0

2

4

6

8

10

12

14

16

18

€ bi

llion

Total assets realgrowth rate %

Total assets (RHS,€bn)

Educational BS Growth 2001-2008

-10

0

10

20

30

40

50

60

70

80

90

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

%

0

5

10

15

20

25

€ bi

llion

Total assets realgrowth rate %

Total assets (RHS,€bn)

Growth rates of Irish banks, 1999-2008

The collapse and after -- banks

3rd bank fails in September 2008—others fear runGovt gives extensive guarantee believing problem just caused by

unjustified international lender concerns -- liquidity

Management abuses revealed (small beer but reputationally damaging)3rd bank nationalized (Jan 15th 2009)

Foreign borrowing not rolled overreplaced with central bank lending

AMC announced

0

20

40

60

80

100

120

140

End 2006 End 2007 End 2008

€ b

illio

n

Irish Credit Institutions Borrowing from Central Bank

The collapse and after – rest of economy

Govt revenue collapses (had become super-dependent on property—related and other boom-dependent sources

Fiscal prospects (including bank rescue costs) cause Govt borrowing spreads to balloon out to 284 bps (end-March)

Tough fiscal response cuts public sector pay, but deficit for 2009 still 11 %

GDP fall peak-to-trough expected to be 15% (9% fall this year)

Ireland: Credit Supply and Demand -- Enterprises(Change from previous quarter)

1

1.5

2

2.5

3

3.5

4

2003Jan 2005Jan 2007Jan 2009Jan

Supply (standards)

Demand

Ireland: Credit demand & Supply -- House purchase (change from previous quarter)

1

1.5

2

2.5

3

3.5

4

2003Jan 2005Jan 2007Jan 2009Jan

Supply (standards)

Demand

More demand, easier supply

More demand, easier supply

Less demand, tighter supply

Less demand, tighter supply

Ireland: Credit supply and demand, Jan 2003-Apr 2009

(Change from previous quarter; “3” = no change)

Enterprises Households

0

1

2

3

4

5

6

2007Jan 2008Jan 2009Jan

%

Irish Prime highest

Irish Prime lowest

ECB

Irish bank prime lending rates 2007-2009

Proof by contradiction: Other countries

In

Irelandcrisis

Portugalno crisis

Out

LatviaFixed peg - crisis

IcelandNot pegged - crisis

Latvia

The mythPost-socialist convergence, EU membership, EMU glidepath2005-7: GDP growth @ 11%; house price growth @ 60%

Incredible factsDouble-digit inflation despite 15-year currency peg90% FX-denominated loans

Supporting actorsForeign banks (60%)

The crash: One bank failed, largest bank (Swedbank) says 14% loss rateRescue package about 30% GDPGDP falling faster than anywhere else

Iceland

The mythNothing to do with euroBelief in industrial/financial conglomerate model

Incredible factsBanking sector liabilities c.10 times GDP1/3 to 2/3 of balance sheet outside Iceland

Supporting actorsEEA single banking passportPolitical/business nexus

The crash: All three big banks failed and nationalizedDeposit insurance scheme failsFX market suspended, currency collapseGDP falls 10% this year but may bounce back fasterRescue package > 100% GDP

Portugal

No “new era” myth

Incredible factsSmall boom after euro membership (attributed to post

euro-entry optimism and low interest rates

Shallow recession 2002-3

Subsequent continued stagnation – no convergence in living standards

Conclusion: € neither necessary nor sufficient

Euro did have a causal role in Ireland storyLow interest ratesContext for unremarked huge bank borrowing

But background of global credit bubble was a fertile environment for “new era” mythsLulled regulators worldwide into false securityLatvia, Iceland and others “caught” their own indigenous mythsIf it hadn’t been euro, it might have been something else

Any big environment change is risky – even if it promises stability

Financial markets did not punish excesses as in the pastAnd policy antennae had not been retuned (also on wages)That is a mistake that will not be made again