Ireland
Selected Issues
Author: International Monetary Fund
Publication Date:
10 Sep 2012
eISBN:
9781475510461
Language:
English
Keywords:
ISCR; CR; firm; saving; lending; mortgage lending; debt burden; IMF staff calculation; households' consumption-saving decision; consumption-balance sheet nexus; Disposable income; Household consumption; Financial statements; Consumption; household debt
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The Selected Issues paper describes the nexus between household wealth, saving, and consumption, and provides estimates for the medium-term path of household saving and consumption. The paper also discusses to what extent the credit market frictions are holding back Ireland's economic recovery. Under current macroeconomic assumptions, the savings rate is expected to decline. Households have rapidly accumulated debt during boom times, and incomes and asset values have declined severely during the crisis. The Executive Board welcomes the country’s efforts toward economic recovery.

Abstract

The Selected Issues paper describes the nexus between household wealth, saving, and consumption, and provides estimates for the medium-term path of household saving and consumption. The paper also discusses to what extent the credit market frictions are holding back Ireland's economic recovery. Under current macroeconomic assumptions, the savings rate is expected to decline. Households have rapidly accumulated debt during boom times, and incomes and asset values have declined severely during the crisis. The Executive Board welcomes the country’s efforts toward economic recovery.

I. Household Consumption, Wealth, and Saving1

A. Introduction

1. Household consumption is a key component of domestic demand which has yet to recover. Household consumption constitutes about half of Ireland’s GDP and about 65 percent of domestic demand. Real private consumption growth averaging about 7 percent in 2005–07 contributed to the boom in this period. However, from its peak in the fourth quarter of 2007, real private consumption fell 14.6 percent by the first quarter of 2012, making a substantial contribution to the 9.4 percent decline in GDP in that period. As of the first quarter of 2012, private consumption continues to decline at a pace of 2.2 percent year-on-year, which dampens the prospects for a broad-based recovery of domestic demand.

2. Household consumption and investment patterns during the boom were enabled by accumulating high debt. Figure 1 shows the increase in households’ net borrowing (“liabilities transactions”) during the boom which funded a large increase in household capital formation, mostly related to real estate such as newly built housing and home improvements. As credit conditions further eased in the mid-2000s, and as households’ confidence was boosted by their rising net wealth, additional borrowing allowed households to reduce their saving rate and allocate a larger share of their disposable income towards consumption. As consequence, many households’ balance sheets became riddled with debt.

Figure 1:
Figure 1:

A Credit-Fuelled Boom and Its Unwinding

(billions of euro)

Citation: IMF Staff Country Reports 2012, 265; 10.5089/9781475510461.002.A001

Sources: CBI; and IMF staff calculations.

3. Despite a rise in household saving in recent years, debt burdens remain high. With the end of the property boom in 2007–08, lending slowed sharply. Figure 2 shows how slowing household lending coincided with sharp falls in household net wealth from the collapse in house prices. In response, households started to save a larger portion of their income. The resulting decline in consumption reinforced the fall in disposable incomes which started with the collapse of the construction sector and was later accelerated by fiscal consolidation among other factors. As a result of falling incomes, households achieved only modest reductions in debt relative to income by 2012 despite nominal debt reductions from higher savings.

Figure 2:
Figure 2:

The Turn of the Credit Cycle

(Billions of 2002 euros)

Citation: IMF Staff Country Reports 2012, 265; 10.5089/9781475510461.002.A001

Sources: CBI; CSO; and IMF staff calculations.

4. The sizable overhang of household debt is expected to be a drag on the recovery of consumption over the medium term. This paper describes the nexus between household wealth, saving, and consumption and provides estimates for the medium-term path of household saving and consumption. Under current macroeconomic assumptions, the savings rate is expected to decline gradually from 14 percent in 2011 to 12 percent by 2017. During the same period, household debt would decline from about 210 percent to 185 percent of disposable income. Alternative scenarios show how an accelerated speed of deleveraging could in part become self-defeating as lower demand depresses growth and incomes, whereas slower deleveraging could support growth but requires additional new lending.

B. The Consumption-Balance Sheet Nexus

5. The extent of households’ indebtedness distinguishes Ireland from comparators. During the last decade, households’ debt-to-income and leverage (debt-to-assets) ratios deteriorated markedly: households rapidly accumulated debt during boom times whereas household incomes and asset values declined severely during the crisis. The amplitude of debt accumulation and, subsequently, of income and house price declines has been more pronounced than in comparator countries where strong house expansions were also followed by a correction (Figures 3 and 4). As debt overhangs are known to take time to work off, households’ consumption-saving decisions may be affected in a more lasting manner.

Figure 3.
Figure 3.

Household Debt to Gross Disposable Income

(percent)

Citation: IMF Staff Country Reports 2012, 265; 10.5089/9781475510461.002.A001

Sources: OECD; and IMF staff calculations.
Figure 4.
Figure 4.

Household Leverage Ratio 1/

(percent)

Citation: IMF Staff Country Reports 2012, 265; 10.5089/9781475510461.002.A001

Sources: OECD; and IMF staff calculations1/ Households’ liabilities over households’ financial and housing assets.

6. The lending and balance sheet channels can create self-reinforcing cycles between borrowing and demand (Figure 5). Financial intermediation lifts the intertemporal budget constraint of the real channel and allows households to borrow against future income for the purpose of consumption and investment (“lending channel”). Higher consumption and investment in turn nourish incomes and asset values, enhancing households’ ability to service their debt. This flow-based framework is complemented by the “balance sheet channel” that takes into account asset prices and wealth. By removing financial constraints, the lending channel lifts asset prices which in turn eases access to lending through higher collateral values and a lower propensity to save if agents treat the gain in wealth as being permanent. However, these effects also work in reverse as a vicious circle, with declining asset values leading to a sharp fall in lending and demand, feeding back into falling incomes and asset prices. In analogy to the financial accelerator described by Bernanke and Gertler (1989), the balance sheet channel can lead to overborrowing and act procyclically.

Figure 5.
Figure 5.

Analytical Framework

Citation: IMF Staff Country Reports 2012, 265; 10.5089/9781475510461.002.A001

Source: IMF staff.

7. The procyclical dynamics of the lending and balance sheet channels can make household’s deleveraging more costly and protracted:

  • Figures 6 and 7 exemplify the lending channel: In the crisis, growth collapsed and the savings rate jumped as banks stopped lending and households cut consumption and investment to free resources for repaying their loans (Figure 6). This switch in income allocation triggered a contraction of demand and incomes which initially outpaced the reduction in debt. Only once growth—driven by external demand—slowly recovered, did households’ debt-to-income ratio start to decline (Figure 7).

  • Figures 8 and 9 illustrate the balance sheet channel: Mortgage lending boosted the value of housing assets which dominate households’ balance sheets and led to a broad-based increase in perceived net wealth (Figure 8). Valuation gains from higher house prices masked the associated increase in mortgage indebtedness, so households’ debt-to-asset ratio rose only slowly until the crisis brought a sharp correction in house prices (Figure 9).

Figure 6:
Figure 6:

Household Borrowing, Saving, and Growth

(Billions of euros)

Citation: IMF Staff Country Reports 2012, 265; 10.5089/9781475510461.002.A001

Sources: CBI; Haver Analytics; and IMF staff calculations.
Figure 7:
Figure 7:

Decline in Income Versus Reduction in Debt

(2008 Q4=100)

Citation: IMF Staff Country Reports 2012, 265; 10.5089/9781475510461.002.A001

Sources: CBI, and IMF staff calculations.
Figure 8:
Figure 8:

Composition of Household Net Wealth

(Billions of 2002 euros)

Citation: IMF Staff Country Reports 2012, 265; 10.5089/9781475510461.002.A001

Source: CBI.1/ Excluding insurance technical reserves and mortgage debt2/ Housing assets minus mortgage debt.3/ Four quarter rolling sum.
Figure 9:
Figure 9:

Changes to Household Assets and Leverage

(Billions of euros)

Citation: IMF Staff Country Reports 2012, 265; 10.5089/9781475510461.002.A001

Source: CBI.

C. The Outlook for Household Saving and Consumption

8. Irish households currently devote a large portion of their income towards debt repayment. At 14 percent, Irelands’ households feature one of the highest savings rates in Europe in 2011.2 Figure 10 shows that liabilities transactions—mainly debt repayment given the lack of new lending—amount to about 6 percent of disposable income, the highest ratio among selected European countries, and constitute the principal use of savings.

Figure 10:
Figure 10:

Decomposition of Household Savings, 2011

(percent of Gross Disposable Income)

Citation: IMF Staff Country Reports 2012, 265; 10.5089/9781475510461.002.A001

Sources: CBI; ECB; Haver Analytics; and IMF staff calculations.

9. Econometric evidence suggests that the savings rate will decline only gradually over time. Table 1 presents results from a panel regression of determinants of the savings rate in nine countries over 1980–2010.3 Regressions (1) and (2) use detrended levels of the explanatory variables to ensure stationarity, similar to IMF (2011). Regressions (3) and (4) use first differences of these variables.

Table 1:

Panel Regression of the Household Savings Rate

(1980-2010)

article image
Sources: OECD, WEO, CBI, IMF staff estimates.

Approximated as housing assets minus household liabilities.

Notes: Dependent variable is household savings rate. Sample includes Canada, France, Germany, Italy, Japan, Spain, United Kingdom for 1980-2010 where available. Robust t-statistics in brackets marked with * (significant at 10 percent level), ** (significant at 5 percent level) or *** (significant at 1 percent level). All variables demeaned and detrended. Fiscal balance for Ireland excludes bank support.

10. Out-of-sample predictions based on regressions (2) and (4) show only a slow decline in savings. These predictions are broadly consistent with staff’s WEO forecast under which the savings rate will decline from 13.2 percent in 2012 to 12.0 percent in 2017 (Figure 11). Disaggregating the contributions to the forecast highlights the significance of Ricardian effects whereby households relax savings when the government cuts the fiscal deficit (and vice versa); this effect is consistently found in the empirical literature.4 Using the coefficient for the fiscal balance as proxy for this Ricardian offset, the ongoing fiscal consolidation in Ireland will contribute most to the estimated reduction in the household savings rate. The reduction in household liabilities or net wealth has a small yet significant contribution, likely a reflection of the common difficulty of estimating the balance sheet effect from empirical data.5 The decline in unemployment and the increase in the dependency rate play minor roles.

Figure 11:
Figure 11:

Household Saving Rate Forecast

(percent)

Citation: IMF Staff Country Reports 2012, 265; 10.5089/9781475510461.002.A001

Source: IMF staff estimates.

11. Under the current forecast, households would reduce debt gradually from about 210 percent of disposable income to 185 percent by 2017. Building on the forecast of the savings rate, the debt path is calculated based on the IMF desk forecast for a muted recovery of disposable incomes at below GDP growth. Further, the debt path assumes that households use about half of their savings to retire debt, and new lending growth remains moderate, increasing from 1.6 percent of GDP in 2012 to 5.3 percent by 2017.6 Reflecting the positive feedback loops described above, the resulting debt path slopes down gradually, being comparable to the pace of debt reduction observed in other mortgage-driven housing bubbles (Figure 12).

Figure 12:
Figure 12:

Household Debt Around the Cycle Peak

(Debt to disposable income in percent)

Citation: IMF Staff Country Reports 2012, 265; 10.5089/9781475510461.002.A001

Sources: OECD; Haver Analytics; national statistics; and IMF staff calculations.

12. Alternative scenarios for the savings rate hinge on availability of new lending to avoid that the growth feedback outweighs households’ deleveraging efforts. Based on a simple multiplier-based macroeconomic model, Figure 13 illustrates growth and debt paths under alternative scenarios for the savings rate. A higher savings rate, associated with a stronger desire of households to deleverage, would dampen growth and incomes, thus resulting in only a marginally accelerated reduction in households’ debt-to-income ratio relative to the baseline scenario. On the opposite side, a 4 percentage point lower savings rate could lift growth temporarily by about 1 percent while the household debt-to-income decline is marginally slower. Such a scenario of slower deleveraging would require higher volumes of new lending for consumption purposes by about €2-3 billion per year. In addition, it is likely that the current outlook for house prices—which is based on a bottoming out of the real estate market during 2013—requires a higher level of mortgage lending than is currently observed.

Figure 13.
Figure 13.

Growth and Debt Under Different Scenarios

Citation: IMF Staff Country Reports 2012, 265; 10.5089/9781475510461.002.A001

Source: IMF staff projections.

D. Conclusion

13. Irish households are undergoing a protracted recovery from a typical yet exceptionally large credit-driven boom-bust cycle. During the expansion, households took on a substantial load of debt which, after incomes declined and asset prices corrected, turned out to be excessive. In response to overstretched balance sheets, households allocated a larger portion of their diminished income towards savings to rebuild their net worth, mainly by reducing debt. Thus, the credit boom in the Irish household sector resembles other credit-driven boom-bust cycles in which high leverage prompts a rise in saving rather than countercyclical dissaving at the turn of the cycle, resulting in a positive feedback loop that deepens the recession, accelerates the fall in asset prices, and weakens the recovery.

14. As the debt overhang will take time to unwind, household consumption is expected to remain subdued in the medium term. Empirical estimates suggest that household’s preference for saving will taper off, in particular in response to a tighter fiscal stance and under the assumption of sufficient mortgage lending to normalize the real estate market. Informed by empirical estimates, the savings rate is forecasted to decline gradually from 14 percent currently to about 12 percent in 2017. Given the desk forecast for 0.2 percent of annual average real growth in disposable income during 2012–17, consumption is expected to grow at 0.7 percent per year in real terms on average. At the same time, the savings rate remains sufficiently high to sustain a steady decline in household debt burden over time.

References

  • Bernanke, Ben S., and Mark Gertler (1989). “Agency Costs, Net Worth, and Business Fluctuations,” American Economic Review, vol. 79 (March), pp. 14–31.

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  • DeBonis, Riccardo, and Andrea Silvestrini (2012). “The Effects of Financial and Real Wealth on Consumption: New Evidence from OECD Countries,” Applied Financial Economics, vol. 22 (5), pp. 409–425.

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  • Durkan, Joseph, and Niall O’Hanlon (2012). “The Savings Rate During Recession,” ESRI Quarterly Economic Commentary (Research Notes), Summer 2012.

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  • Hüfner, Felix, and Isabelle Koske (2010). “Explaining Household Savings Rates in G7 Countries,” OECD Economics Department Working Papers No. 754.

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  • IMF (2011). “What Drives the U.K.’s Household Savings Rate?” IMF Country Report No. 11/221.

  • Salotti, Simone (2010). “Global Imbalances and Household Savings: The Role of Wealth,” The Social Science Journal, vol. 47 (January), pp. 21–44.

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1

All policy recommendations in this paper are staff views in the context of the 2012 Article IV consultation with Ireland. They are distinct from the policy discussions for Ireland’s EU-IMF supported program.

1

This paper was prepared by Jochen Andritzky. The analysis benefitted greatly from comments and data provided by the Irish authorities. Vizhdan Boranova provided excellent research assistance.

2

The saving rate used for forecasting is based on CSO data for household disposable income and savings and therefore differs from quarterly Institutional Sector Accounts (see ESRI 2012).

3

The panel is comprised of annual data for Canada, France, Germany, Ireland, Italy, Japan, Spain, the United States, and the United Kingdom.

4

For an overview of typical determinants used in other empirical studies, see Hüfner and Koske (2010).

5

See Salotti (2010) and DeBonis and Silvestrini (2012) for studies focusing on the wealth effect.

6

No reduction of debt from bankruptcy proceedings or loan modifications is assumed.

Same Series

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Cover IMF Staff Country Reports
Ireland: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 2012: Issue 265
Publisher:
International Monetary Fund
ISBN:
9781475510461
ISSN:
1934-7685
Pages:
74
DOI:
https://doi.org/10.5089/9781475510461.002

A Credit-Fuelled Boom and Its Unwinding

(billions of euro)

The Turn of the Credit Cycle

(Billions of 2002 euros)

Household Debt to Gross Disposable Income

(percent)

Household Leverage Ratio 1/

(percent)

Analytical Framework

Household Borrowing, Saving, and Growth

(Billions of euros)

Decline in Income Versus Reduction in Debt

(2008 Q4=100)

Composition of Household Net Wealth

(Billions of 2002 euros)

Changes to Household Assets and Leverage

(Billions of euros)

Decomposition of Household Savings, 2011

(percent of Gross Disposable Income)

Household Saving Rate Forecast

(percent)

Household Debt Around the Cycle Peak

(Debt to disposable income in percent)

Growth and Debt Under Different Scenarios