Volatile currency swings and huge debt could yet derail us
DESPITE all the algorithms, alphas, betas and the rest, by which financial markets make their impenetrable way, currency movements remain a mystery. Which is a pity, because never in our economic history has the mystery mattered more.
There was 1991, of course, when sterling’s forced exit from the European currency system provoked a run on the Irish pound and the Central Bank used up all its reserves in the ultimately doomed attempt to maintain the Irish currency’s value.
But at least one knew that crisis would come to an end, one way or the other. There is now no Irish pound to defend, although if things were to go really badly, there could be a run on Irish government loans, pushing up interest rates and making the replacement of debt due for repayment more expensive and difficult.
This danger was referred to in the most intriguing publication of last week – the government’s “National Risk Assessment” – another part of the analysisfest created by the crisis. It tries hard to avoid frightening the horses but careful reading makes it scary enough.
It says the risks to Ireland’s longterm debt sustainability relate mostly to changes to the economic outlook; primarily the growth prospects of key trading partners and the impact of changes on the international trading environment.
Brexit is the biggest threat to the economic outlook and the trading environment, which is where the currency comes in. The mystery of currency movements means there is no reliable answer the question of whether sterling will reach parity with the euro, or where it will go at all.
On the other hand, it is often fairly clear why past movements took place, as well as the impact they had on economies. This is already the case with sterling’s recent fall. A new Economic Letter from analysts at the Central Bank sees significant effects last year – and much has happened since then.
The main effect was on consumer prices. The paper finds that the low rate of Irish inflation in 2016 was largely due to the weakness in sterling after the vote to leave the EU.
Not surprisingly, changes in the euro-sterling exchange rate have a bigger impact on Irish prices than shifts in other currencies. The trend seems to be accelerating, with inflation in the euro area reaching 1.4pc, while prices in Ireland fell by 0.2pc in the 12 months to July.
The ECB may soon cut back on the flow of new money designed to avoid deflation, and even begin to increase interest rates if core inflation, which excludes energy, goes much above one per cent.
That would be unwelcome news for a heavily indebted government and private sector such as Ireland’s; increasing the already high “real interest rate” which compares the actual rate with inflation. But as always with this economy the textbook is of little use, as two recent pieces of data show.
Retail sales figures show that, excluding cars, purchases rose 7pc in the 12 months to July. The 6pc fall in car sales is being attributed to cheaper UK imports; a striking example of how the customer’s gain can be a retailer or producer’s loss and a microcosm of possible future trends.
Firms supplying the home market will benefit from what could be a consumer boom. Already, the sales of household goods are rising at a double digit pace.
The Japanese deflation ogre, where people postponed purchases in the belief that prices would fall further, does not appear to operate in Ireland. Perhaps that is not too surprising either.
It helps that real incomes are rising faster than real interest rates. Average earnings rose by 2pc in the first half of this year compared with 2016. Irish households are spending more and simultaneously reducing their debt.
Not as quickly as they were, admittedly. The small 0.1pc increase in loans in the 12 months to July was the first since the financial crisis began. Adjusted for loan sales and securitisations (the measure I prefer since seeing how much the unadjusted figures disguised the banking crisis), household loans are still falling, although the 1.8pc drop was the lowest since 2009.
Most of that fall was in home loans, where mortgages are still coming to an end faster than new ones are taken out, even though the gap is narrowing. Other loans increased by 3.2pc and there was a €700m a rise in consumer debt in the year to end-July.
Despite that, Irish households still have €8bn more in the bank than they have borrowings – an €80bn swing since 2008 (although total debt remains high by international standards).
The situation is exactly the opposite on the other side of the Irish Sea – or indeed the Irish border. UK inflation is running at 2.6pc but average earnings are growing by just 1pc; one of the steepest falls in real incomes on record.
Consumers have responded by increasing their already substantial borrowings. Retail sales have been the main support of the UK economy in the past year but that cannot continue indefinitely.
Like much to do with Brexit, the full political and economic ramifications have still to be felt.
With surplus cash in their pockets, Irish consumers – the most important part of the economy – may continue to bolster this economy for some time. That is going to make management of the pre-Brexit environment even more difficult.
We may not be able to make credible predictions about sterling future course but we know why it is weak. Markets fear the effects of a hard Brexit. The more probable that looks, the weaker the currency may become.
Irish real incomes will increase and personal spending may continue to grow. By the same token, company profits will be squeezed, with investment and employment the casualties. Policy will be pulled in opposing directions.
Business has been promised assistance, presumably in the shape of grants and tax breaks for marketing and product development, but it will take more than that.
One lesson from the 2000’s was that Ireland needs policies to counter the effects of inappropriate real interest and currency rates. Despite all the talk, that lesson has not been put into practice, but it is needed more than ever.
Some of the windfall gains for consumers from sterling’s weakness should be transferred to the threatened sectors of the economy, which means agri-business, exporters and the government itself, in the form of faster reduction of its uncomfortably high debt.
There is much debate among economists about the effects of currency movements on actual trade and output, with evidence that in today’s world, the impact on prices is immediate but changes to the volume of exports and imports are slow and perhaps even negligible over the long term.
If true, that would be a long-term comfort for Ireland as it faces into a world with a volatile and uncertain real exchange rate but there is a clear and present danger that volatile and uncertain politics may do near-irreparable damage in the short run.