Economic Analysis

Economic Analysis


The following articles have been prepared to highlight some of the key national and international business and economic developments of note that may be useful for students in their exam preparation. They have been written by Dr Ali Ugur, Economist and Head of Tax & Accounting, Banking & Payments Federation Ireland. Further articles will be added on a regular basis.

January 2017 Brexit: FAQs
March 2016 Negative interest rate policies from central banks
March 2016 Housing supply shortages to continue in the short run and likely to maintain pressure on availability and rents
March 2016 Brexit: What Happens Next and Possible Effects

Brexit: FAQs.

The UK has voted to leave the EU following a referendum on 23 June 2016. Even though the implications of the UK leaving the EU are not clear yet from an economic perspective, there are some certainties around the process.

Does it mean that the UK has left the EU after the referendum?

The rules for exiting the EU are set out in Article 50 of the Treaty on European Union and, in order to leave the EU, the UK will need to invoke this Article.

When will Article 50 be triggered?

The British Prime Minister, Theresa May, announced her intention to trigger Article 50 no later than the end of March 2017. However, recently the UK’s High Court ruled that the Government will need Parliamentary approval before serving formal notice, though this position is now subject to an appeal to the Supreme Court by the UK Government.

What happens after triggering of Article 50?

Once initiated, an Article 50 notice will bring the UK’s membership of the EU to an end after two years, unless all the other member states agree to extend this period. So this means that, although negotiating an exit, the UK will remain a full member of the EU for at least two years after the notice is served and will continue to be bound by exactly the same obligations as all the other member states during this time.

What form of agreement will replace the UK’s EU membership?

It is likely that negotiations on the UK’s future relationship with the EU, including the terms of trade, would take place in parallel with the exit negotiations. Possible templates or models for a withdrawal agreement include the following:

  • European Economic Area (EEA) membership such as in the case of Norway. This would provide the UK with full access to the single market in return for a financial contribution to the EU budget and an acceptance of the majority of EU law including free movement of people. The UK would be exempt from EU rules on agriculture, fisheries, justice and home affairs; however, they would have no say over how the rules of the single market are created.
  • Bilateral or joint agreements such as in the case of Switzerland. Under this model the UK would be a member of the European Free Trade Association but not the EEA. Access to the EU market would be governed by a series of bilateral or joint agreements which would cover some but not all areas of trade. The UK would also make a financial contribution but smaller than that of an EEA member. In general, it would not have a duty to apply EU laws but it would have to implement some EU regulations to enable trade. Free movement of people would also apply.
  • Customs union such as in the case of Turkey. If the UK opted for an agreement similar to Turkey, it would have a customs union with the EU, meaning no tariffs (taxes or duties on imports and exports) or quotas on industrial goods exported to EU countries. It would however have to apply the EU’s external tariff on goods imported from outside the EU. The customs union does not apply to agricultural goods or services.
  • Full exit from the EU to become a third country under the rules of the World Trade Organisation (WTO). This is often referred to as a ‘hard’ Brexit. The WTO sets rules for international trade that apply to all members, there is no free movement or financial contribution, or no obligation to apply EU laws although traded goods would still have to meet EU standards and some tariffs would be in place on trade with the EU. Trade in services would be restricted.

While these are existing templates, it should be noted that they have been created after years of negotiations and bilateral agreements. For example, a full or hard exit from the EU for the UK means negotiating more than 30 trade deals at the same time with non-EU countries as existing trade relationships with non-EU countries are currently done via the EU.

Impact on the Irish Economy

Ireland has significant trade links with the UK economy with the UK accounting for nearly 16 per cent of all Irish exports and 30% of imports. Any negative economic impact of a UK exit on its economy will indirectly affect the Irish economy through exports and imports. However, the most significant challenge at the moment is uncertainty.

We have already seen the initial effects on Irish exports to the UK due to the volatility of and depreciation in the value of sterling. In addition Ireland relies heavily on the UK for the supply of its energy requirements and the effects through this channel could be more significant.

Are there any estimates of the potential impact on the Irish Economy?

Recently the Economic and Social Research Institute (ESRI) and the Department of Finance undertook research on the potential macroeconomic impact of Brexit on the Irish economy.

This research shows the potential negative impact of Brexit modelled under three different scenarios:

  • a Norwegian type arrangement (EEA)
  • a Swiss type free trade agreement (EFTA) and
  • a more drastic departure from current arrangements where the UK and EU interact on the basis of WTO rules.

Looking at the effect ten years after a UK exit, research shows that a WTO scenario results in Irish GDP being 3.8% below what it otherwise would have been in a no-Brexit scenario; with most of the impact occurring in the first five years. This most severe scenario indicates that the Irish economy will be more severely impacted than the UK economy.

Which sectors are most likely to be negatively effected?

The Irish economy remains heavily reliant on the UK as a trade partner with the UK market accounting for around 16% of all Irish exports and 30% of Irish imports, in recent years.

At a sectoral level, recent research by the Department of Finance shows that a number of mainly domestic manufacturing sectors are highly exposed to trade with the UK. Exports of agri-food products to the UK account for 41% of total food exported from Ireland and traditional manufacturing which includes sectors like textiles and clothing that rely on the UK for more than one third of all exports of the sector.

The same research shows that certain services sectors such as tourism and hospitality will also be challenged mainly due to the sharp depreciation of sterling against the euro, which makes Ireland relatively more expensive for British visitors to stay and to purchase goods and services. The tourism sector in Ireland is highly dependent on the UK market with 3.5 million overseas trips to Ireland from the UK and spending in the region of nearly €1 billion here in 2015.

Are there any opportunities for Ireland?

In addition to direct effects on trade, it is clear that foreign direct investment (FDI) both in the UK and from the UK will be affected during the negotiations stage and after full Brexit. Given the significance of FDI to the Irish economy, Brexit might present a potential opportunity for Ireland to attract additional FDI, either by attracting new investment that might otherwise have been destined for the UK or by attracting some of the FDI that is currently in the UK but that might relocate to remain within the EU.

Financial services is an important contributor to the UK economy and FDI in this sector plays an important role with many foreign financial services companies located in the UK, mainly in the City of London. It is unclear as to what would happen in relation to the location decision of companies currently located in the City of London because these companies can serve the European Economic Area countries using the UK as a base through passporting ; an option they may not have after trade negotiations between the EU and the UK conclude.

Ireland already has a significant presence of international financial services companies and, along with other financial services centres in the EU such as Frankfurt and Paris, is seen as an important location for attracting activities of mainly foreign firms currently carried out in the UK should they decide to leave London due to Brexit.

Negative interest rate policies from central banks.

An interest rate is commonly known as a rate which is charged or paid for the use of money.

In basic terms, it is the cost of borrowing money or the return received on saving money in a bank/other financial institution or invested on an asset like a government bond.

There are different types of interest rates used in the financial markets such as deposit rate, loan rate, mortgage rate, interbank rate and government bond rate.

In general, interest rates are positive, which means that at the end of a borrowing term a borrower has to pay back an additional amount to the creditor, in addition to the amount borrowed. The same also applies to savings where a financial institution has to pay back to the depositor an extra amount at the end of a savings term in addition to the original amount placed on deposit.

Central bank monetary policy is one of the most significant factors impacting on these different interest rates in the market through the use of tools such as official discount rate or refinancing operations by central banks. Generally, central banks use interest rates in order to achieve low inflation and stable growth.

Negative interest policy rates have been an extremely rare phenomenon. Recently a number of major central banks in Europe, including the European Central Bank (ECB), the Danish National Bank, the Swedish Riksbankand the Swiss National Bank have pushed key short-term policy rates into negative territory.

The Bank of Japan has taken similar action.  For example, the ECB currently applies a negative 0.3 percent rate, meaning that when banks deposit money at the central bank overnight, they pay for this.

With negative interest policy rates by the central banks, nominal yields on some government bonds at short maturities have also fallen below zero, such as in Denmark, Germany, the Netherlands and Switzerland. In Ireland for example, government bonds issued by the NTMA for two-year duration are trading at a negative yield at the moment.

Rising demand and limited supply of highly-rated sovereign bonds could bring their yields well below that rate. In addition, these bonds became more attractive as they can be used as collateral in repurchase agreements with the central banks.

Policy Rates of Countries with Negative Policy Rates (%), 2009-2016
Policy rates

Source: Citibank Research 

Reasons for Negative Interest Policy Rates

A crucial question can therefore be asked as to why some central banks are using negative interest rate policy?

Economists argue that the main reason behind negative interest rates is the ongoing lower-than-expected inflation rates in most developed economies with a growing threat of deflation.

Central banks in developed economies generally target an inflation rate of around 2 per cent per annum.  However, at the moment, most of these developed economies are experiencing either negative or zero inflation.

It is argued that, with negative policy rates, banks will be discouraged from holding excess reserves at central banks and increase lending, as well as also pushing savings rate down, which will in turn increase economic activity and hence inflation.

A second reason is the fact that some central banks have to keep their currency within a band around a peg. When their currency starts appreciating against a relevant peg, rather than using conventional foreign exchange intervention tools, central banks started lowering policy rates.

An example of this is the Danish National Bank which has to keep its currency around a band against the euro. The main reason behind acting against currency appreciation can be seen as the desire to keep export prices lower and to encourage further exports by developed economies.

A third reason given is to encourage lending by making it costly for banks to hold excess reserves at their central banks. However, it has to be noted that not all commercial banks deposits at the central banks attract a negative interest rate.

For example, Bank of Japan only initially imposes a negative deposit rate for banks on less than 5 per cent of the total bank reserves. On the other hand, in the Eurozone the negative policy rate is imposed on all excess reserves (around €650bn currently).

Obviously these measures can have an effect on bank profitability as banks have to pay for excess reserves in the central banks as well as the fact that they cannot fully pass on the cost of negative rates to depositors.

Is there a lower limit to negative interest policy rates?

It was assumed by many that negative nominal interest policy rates were not feasible as participants in the market would switch to cash which offers a nominal zero interest rate (excluding cost of cash storing, security etc.). However, recent international experience suggests that negative interest rates can be a viable monetary tool.

Recent developments in financial markets and the greater risks to the global growth outlook raise the likelihood of more and deeper policy rate cuts across a range of countries.

Many economists believe that there are further risks to global growth in 2016 with the possibility of a global recession. The debate is now around how long the negative policy rates can continue and how much further they can go down given the likelihood that a (more) negative policy rate in one country will be followed by reciprocal actions elsewhere.

Housing supply shortages to continue in the short run and likely to maintain pressure on availability and rents.

Price developments have been a major focus of attention in public discourse around housing issues over the past couple of years in Ireland given the fact that Irish house prices have dropped significantly since their peak back in 2007. Recently however one of the most important challenges in the residential property market is shortage of housing supply.

Irish household formation rates, which are an important factor in determining future housing demand and hence housing completions, are likely to be higher than European averages due to factors such as a much lower median age of population, the highest birth rate in the EU and a much higher, but falling, average  household size. The general consensus amongst housing market stakeholders is that there is a medium to long-term requirement to build approximately 25,000 housing units per annum nationally and around 7,000 units in Dublin.

The rate of housing completions since 2010 has been well below what would be needed to match the ongoing demographic pressures. According to CSO Census 2011 figures, the number of households in Dublin increased by over 90,000 between 2006 and 2011, but only around 50,000 housing units were built during the same period. Some of this “under-supply” was met by the absorption of existing stock recently; this source of supply has already come under pressure in the Dublin area.

housing_shortages

The latest data from the Department of the Environment, Community and Local Government show that 12,666 housing units were completed in 2015, an increase of around 15% compared to 2014 completions. Nearly 48% of housing units built in 2015 were self builds and only 2,891 units were built in Dublin during the same period.

Another useful indicator of housing supply is commencements, where a developer must notify the local authority if a project is to commence in a particular month. Looking at commencements figures we see that in 2015 there was a 5% increase in commencements nationwide, compared to 2014 (8,093 vs. 7,717). However, detailed data show that nearly 40% of these commencements are for one-off builds and only 38% are in the boundaries of Dublin local authorities. Looking at historic commencements data we can expect to see around 12,500-13,000 units to be completed nationally in 2016.

In addition to this, the mismatch between current demand plus additional pent-up demand and the supply of new homes has put significant upward pressure on rental accommodation availability as well as rent levels in 2015, particularly in Dublin. The lack of supply of suitable housing units, together with increased demand for rental accommodation, are posing major challenges for first-time buyers in particular and are creating real pressure on rents. A significant increase in housebuilding activity and in the number of residential units otherwise available for purchase and for rent will be required to alleviate these pressures.

Brexit: What Happens Next and Possible Effects.

The UK Government reached a deal with the EU in February on a “new settlement” and has confirmed that it will hold its referendum on whether to stay in or leave the EU on 23 June 2016. The new deal between the EU and the UK is around four main areas; economic governance, sovereignty, migration and access to welfare and competitiveness.

In summary the new deal confirms existing opt outs of the UK on euro, Schengen (the Schengen Agreement abolished the EU’s internal borders, enabling passport-free movement across much of the bloc), and security and justice, and establishes opt-outs in relation to any further political integration of the EU. In addition it also provides rights for UK financial services to keep its own authorities within the banking union and somehow differentiated treatment within the single rule book (the single rulebook aims to provide a single set of harmonised prudential rules which institutions throughout the EU must respect).

It is possible for an EU member state to leave the EU since 2009 with the approval of the Lisbon Treaty. Exit of a member state can be done unilaterally, i.e. without the need for an agreement from other member states. The process starts with the notification of the country wishing to leave the EU in order to establish a withdrawal agreement and the timeframe is two years after the notification of the leaving member state.

This means that in the event that the UK votes to leave the EU, there will be a two year time limit for departure during which time existing EU legislation will continue to apply to the UK where relevant. There are provisions in EU legislation to increase this time limit if necessary.

Withdrawal Agreement

Possible templates for a withdrawal agreement, in the case of a UK exit from the EU, include European Economic Area (EEA) membership such as in the case of Norway, bilateral agreements such as in the case of Switzerland, customs union such as in the case of Turkey or full exit from the EU to become a third country under the rules of the World Trade Organisation.

While these are existing templates it should be noted that these templates have been created after years of negotiations and bilateral agreements. If for example the UK were to leave the EU, it would need to negotiate more than 30 trade deals at the same time with non-EU countries as existing trade relationships with non-EU countries are currently done via the EU.

Possible Impact

In addition to direct effects on trade, it is clear that foreign direct investment (FDI) both in the UK and from the UK will be affected in the case of a UK exit from the EU. Financial services is an important contributor to the UK economy and FDI in this sector plays an important role with many foreign financial services companies located in the UK, mainly in the City of London. It is unclear as to what would happen in relation to the location decision of companies currently located in the City of London, whether to stay in the UK or leave to locate to another EU member state.

Ireland has significant trade links with the UK economy and any negative economic impact of a possible UK exit on the UK economy will indirectly affect the Irish economy through exports and imports. In addition Ireland relies heavily on the UK for the supply of its energy requirements and the effects through this channel can be more significant.

For the first time within the EU, there is a serious prospect that a member state may leave. The impact of this exit will depend on the withdrawal agreement, the content of which is not clear at this stage.  But it is agreed by many commentators that there may be negative effects on the UK economy as well as on UK’s main trading partners, such as Ireland, in the short term.