Central Bank warns on impact of low inflation, city housing shortages

Thursday 12 June 2014 23.33
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Central Bank publishes its latest Macro-Financial Review
Central Bank publishes its latest Macro-Financial Review
Central Bank says an unexpected decline in the inflation rate will increase the debt ratio
Central Bank says an unexpected decline in the inflation rate will increase the debt ratio

The Central Bank has warned of the risks to state and private sector finances from a prolonged period of low inflation. 

The Central Bank's latest Macro-Financial Review also highlights a very large re-financing requirement for commercial banks in the first quarter of next year.

A survey of property professionals for the review finds 92% expect national property prices to rise, while none of the respondents expect a fall.  

Last year the comparable figures were 38% expecting prices to rise, while 41% expected prices to fall.

While the economy is forecast to grow in real terms by 2% of GDP this year and 3.2% of GDP next year, and employment is rising at a faster rate than previously forecast, the Central Bank warns of continuing imbalances in the economy.

This includes high levels of non-performing bank loans, still high levels of unemployment, and very high levels of public and private indebtedness.

The bank said that fiscal consolidation is expected to hold back domestic demand this year and next year, but to a lesser degree than in previous years. 

It also warned that failure to hit fiscal targets, especially on the deficit, or failure to stick to EU fiscal rules could "undermine investor confidence and would not support financial stability".

Warning on deflation

In a special "box" on low inflation and Government debt sustainability, the Central Bank stated that an unexpected decline in the inflation rate will increase the debt ratio. 

The expected rate of inflation in the euro area is the ECB's target of 2%, but the IMF has forecast euro area inflation will remain below that level until at least 2019. The report warned that this could trigger a vicious circle, with a rising debt ratio leading creditors to charge higher nominal interest rates, which in turn reduce inflation and increase real interest rates further, putting further upward pressure on debt ratios.

The Central Bank pointed out that in all euro area states except Malta, Portugal and Luxembourg, inflation is below expectations, with ten countries experiencing inflation half a percentage point or more below expectations, implying a corresponding increase in real interest rates in these countries.  

The bank warned of the "potential for a large cumulative effect if, as forecast, inflation remains low until at least 2019".

On the banking sector, the Central Bank said that non-performing loans are the biggest challenge to the industry, with impairment rates among SME and Commercial Real Estate (CRE) borrowers noticeably higher than for residential mortgages.  

Together SME and CRE loans account for 36% of total outstanding lending, but 56% of total non-performing loans by value.

The banks face a substantial refinancing period over the next year and a half, with some €18.2 billion in bonds due for redemption. €15 billion of this is market issued debt, while a further €3 billion is in "Own Use Bank Bonds". 

Just over half of all the refinancing falls due in the first quarter of 2015, when €9.8 billion falls due.  This is shortly after the results of the Europe wide banks stress tests will be known.

Today's report pointed to the challenging conditions in the credit union sector, where almost half of the country's 390 credit unions face some sort of lending restrictions. While assets have remained broadly stable at €13.9 billion, lending has fallen by 13% to €4.3 billion.

The fall in lending has had a direct negative impact on the interest income the credit unions can earn.  This, along with falling investment returns and rising operating costs, is likely to continue for the rest of the year.  

The average dividend paid to members in the sector was less than 1%. Continued low dividends may impact on the ability of credit unions to expand or even maintain their current funding base.  

Average loan arrears at the end of last year were 19%, broadly unchanged from a year earlier. It also noted that the number of credit unions in the country has declined by 14 since the publication of the Credit Union Commission report in 2012.

Commercial property among economy's bright spots

Today's report shows that one part of the Irish economy showing a notable upswing in activity - commercial property. Last year saw the largest investment spend in commercial property since 2007 - €1.8 billion. There were 57 commercial property transactions last year, compared with 35 in 2012.  In the first quarter of this year alone, there have been 37 transactions, with a value of €940m.

The take-up (letting and sales activity) in the Dublin office market increased by 25% last year to over 170,000 square metres.  In the first quarter of this year, 63,000 square metres of Dublin office space transactions have been signed - the highest level for more than a decade. 

The vacancy rate for Dublin offices is 13.9% - the lowest level since the third quarter of 2008.  The Central Bank warned that a growing scarcity of offices could have negative consequences for competitiveness, and may hinder efforts to attract multinational firms.

The rise of Real Estate Investment Trusts (REITS) since their introduction in Budget 2013 is highlighted in today's report. The Central Bank said they can help in the deleveraging of commercial banks and NAMA, and be a route to market for the collateral underlying non-performing loans. 

But it warned that as the Irish REIT market is still in its infancy and is relatively illiquid, the withdrawal of a few large investors has the potential to have a large negative impact on it.

The Central Bank said that while attracting finance from abroad is a positive development in terms of aiding market recovery, it warns that the swift pace at which these investors often enter and exit markets leaves the Irish property market exposed to sudden adverse changes in investor sentiment. 

Warning on Dublin housing supply 

A protracted delay in addressing localised housing shortages, especially in Dublin, has the potential to put prices on an unsustainable path again, the Central Bank also warned today.

House prices have begun to recover over the past two years and while they remain 48% below their 2007 peak in Dublin, house prices in the city rose 17.7% year-on-year in April compared to a 1.3% increase elsewhere in the country. 

The Central Bank said supply shortages were an important factor in recent house price increases, with just 8,000 new units built last year compared to an average annual output of about 33,000 since 1970.

"By their nature, they take time to address and, accordingly, should be a priority for policy, if imbalance in the housing market is not once again to become a potential source of financial instability," it cautioned. 

"A protracted delay in addressing these shortages has the potential to put house prices on an unsustainable path. Forward-looking indicators such as commencements notices do not give the impression that an increase in the supply of new builds is likely any time soon," it added.

The Government said last month that while the property crash had left an overhang of stock in many parts of the country, it recognised that there were particular concerns about housing supply in Dublin. 

In a policy document aimed at helping bring about a sustainable recovery in the construction sector, it said local authorities in Dublin were already working to identify housing developments capable of being delivered in the short-term.