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Is the continuing boom in borrowing unsafe? asks Eunan King
Credit has been growing at a double digit pace in this country since 1994. In 1997 and 1998 growth has been in excess of 20 percent. Mortgage credit grew broadly in line and has been the focus of much attention because house prices have risen sharply in these years. The OECD and the Central Bank as well as numerous commentators have warned of the risks of this situation. The UK experience of a decade ago, when house prices ballooned and then collapsed, informs much of the debate.

Yet there are good reasons for believing the developments of recent years in Ireland will prove not to be a bubble but a necessary part of a transition to higher incomes, wealth and asset prices. Important demographic changes are an integral part of this process. There is a bulge in the population which is now aged between 15 and 24. Average family size has declined rapidly since the 1980s. Fewer 15-24 year olds are emigrating. There is a strong inflow of 25-44 year old migrants or returning emigrants. The reduced birth rate is associated with a big rise in women returning to the labour force. A favourable tax and interest rate environment and this demographic evolution provide the basis of a self-feeding growth process.

This process requires considerable investment in accommodation, infrastructure and in companies supplying a range of goods and services demanded by a rising population with increased discretionary spending power. Of the order of 45,000 new houses per annum will be required between now and 2006. The requirement would be higher were net immigration to be maintained at last year’s pace.

At current house prices and levels of borrowing, 45,000 new house completions per annum would imply that credit should continue to rise at almost a 20 percent pace until 2006. Rapid credit growth is not indicative of an impending recession unless it gives rise to an imbalance between demand and supply. The last four years provide scant evidence of such imbalances in the market for goods and services in the Irish economy.

The rise in house prices is seen by some as evidence of an asset price bubble which has the potential to cause recession if it bursts. The UK and Japan are recent examples of this phenomenon. Worries about “unsafe” lending practices have been expressed, notably by the Governor of the Central Bank.Whatever about anecdotal stories at the individual level, there is little publicly available evidence in the aggregate data from lending institution of such practices. In the 1994-8 period GNP, at current prices, rose by 48 percent in Ireland. The average house price, new and second hand, on Department of Environment data, rose 82 percent, while the average loan rose by 71 percent. The loan to value ratio has thus fallen from 69 percent in 1994 to 63 percent in 1998. This is a source of comfort to lenders.

In the case of first time buyers, most vulnerable to a setback to house prices, Irish Permanent data show the loan to value ratio at 74 in 1998 compared to 89 in the UK (1997 data). Only 33 percent of Irish Permanent’s first time buyers borrowed in excess of 90 percent of the price in 1998. This compared to 73 percent in the UK in 1988, close to the peak of the bubble. Since mortgage lenders in the Irish market are fully appraised of the losses on UK loan books in the early 1990s, commercial self interest would seem to account for the favourable aggregate position of loan books.

“Unsafe lending practices” are often judged relative to traditional multiples of gross income which it was judged prudent to lend. However, implicit in such multiples are interest rate levels and income tax levels. The bottom line measure of affordability is the income remaining after mortgage repayments. It may be estimated from DoE data that the loan as a multiple of average income, based on principal income only, has risen from 1.7 in 1994 to 2.2 in 1998. However, interest rates are on a lower trajectory than when Ireland operated its independent currency. Moreover, borrowers can fix their repayments for years ahead, since deep capital markets now allow them access to much longer term fixed rate mortgages than in the past. Moreover tax rates are being reduced as Ireland’s budgetary position improves, thus raising the income available for repayments at unchanged gross incomes. Previously accepted income multiples may be conservative given low bond yields (low fixed rate mortgages) and falling taxes.

If the rise in asset prices is set to continue it is perhaps the rise in US asset prices which provides the more relevant analogy for Ireland. Some years ago Mr Greenspan expressed misgivings about the levels of “irrational exuberance” implied by the US equity market, then trading at about 6,000 on the Dow. Currently, while still conscious of the potential adverse effects of fall in the Dow, he spends more time analysing how increased technologically-induced productivity has reduced unit labour costs and raised profitability. In turn, this is fuelling investment growth thereby raising growth potential. The Dow hovers around 11,000.

While productivity is difficult to measure with confidence it appears to be growing strongly in Ireland, especially in recent years. The likely reason for this is the much improved educational content of the workforce as new entrants replace retirees with much lower levels of education on average.

As productivity rises, profits and share prices rise. Other assets such as property must rise in tandem. In this situation, countries with a separate currency would experience an appreciation of the exchange rate, as Germany experienced in much of the post war era. In Ireland in the Eurozone the currency won’t rise so asset prices have all the more to do. It doesn’t mean it’s a bubble. It may just be a rational reflection of greater productivity.

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