The Central Bank Rules Finance

How the revived Central Bank has assumed a dominant role in the Irish economy in conflict with the Department of Finance. The Irish economy has now embarked on the type of stop-go merry go-round which plagued the British economy during the 195Os and 1960s. When Fianna Fail returned to office in 1977, it set itself the target of re-establishing business confidence. In this it was singularly successful - for nothing succeeds like excess.

In the ensuing wave of euphoria, the public went on a spending spree as if there were to be no settling day. If money was not immediately available to finance consumers' insatiable appetite for spending, there were always the banks. Bank managers were in a receptive mood during 1978. The Central Bank had set a 20 per cent guideline for the increase in private sector credit through 1978. By the end of August, most of this growth had already been exhausted. As the Central Bank put it then, "The unexpectedly rapid growth in consumption expenditure this year has undoubtedly been fuelled by the increase in bank lending."

The evidence of this trend was everywhere to be seen. Soaring land and house prices; new washing machines and colour televisions bought on the never-never. It was President Hoover's dream come true: a car in every garage and a chicken in every pot. In the year to mid-August 1978 alone, personal lending increased by 45 per cent. The bulge in lending had become so great that the Central Bank was forced to abandon its 1978 guideline at the beginning of October. Instead, it introduced an interim guideline of 10 per cent for the six months which ended in March 1979. Although the Central Bank had lost the first round of its battle with the commercial banks over credit creation, it remained unbowed although bloodied.

While the European Monetary System had been mooted during July 1978, it was not until December that Ireland elected to join the new exchange rate system, even though Britain had indicated that it would be remaining outside. The interim guideline of 10 per cent was no more successful than its predecessor. In the six months to the end of last March, private sector credit increased by 15 per cent.

The Central Bank was not in reality able to control the growth in credit while the sterling link persisted even though it could control domestic credit creation by the Irish commercial banks" The existence of a unified money market meant that even when a customer was refused a loan by his Irish bank, he simply borrowed the money in London, circumventing the Central Bank altogether. A leading banker admits, "When the Irish banks ran out of funds or when British interest rates looked good, the private sector here could always arrange facilities with London and this they did." Much of the cash flowing into the country in recent years can be attributed to this practice, especially when times were good. The Central Bank was virtually powerless to control this trend.

The second factor limiting the Central Bank's effectiveness was its oftrepeated role as "accommodating" whatever levels of real growth and price increase were existent in the economy. It did not want to be seen as acting in a manner which would impede the achievement of a high growth rate. But up to 1978, the scale of credit growth had never been as intimitating. Ireland's membership of the EMS and the severance of the one-for-one parity at the end of March presented the Central Bank with an unrepeatable opportunity to assert its authority. This it seized gratefully.

The Central Bank's hand had been strengthened immeasurably by the introduction of exchange controls on flows of capital to Britain. After the Brussels European Council meeting last December, when it became clear that Britain would be remaining outside the EMS, the Irish authorities lost no time in launching the new controls. They came into effect on December 18, just two weeks after the Brussels summit.

In essence, the exchange controls then introduced severed the unity of the British and Irish capital markets. Irish residents could no longer buy British shares. Only £500 in foreign currency could be taken out of the country by personal travellers. British bank accounts held by Irish residents had to be closed. But of fundamental importance was the fact that the exchange controls were administered by the Central Bank itself.

The introduction of exchange controls made it considerably more difficult for Irish residents - personal or corporate - to circumvent the Central Bank's credit guidelines. The Irish financial sector was closed off from Britain, virtually at a stroke. But if the Irish Central Bank had acquired new powers as a result of the break with Britain, new responsibilities had also been thrust upon it. The Central Bank was now the guardian of the country's external reserves and the exchange rate in a very real sense. Independence exacts a high price. Burdened with the task of protecting the infant Irish currency, and by implication, protecting the reserves, The Central Bank was in no mood to permit excessive credit growth to persist during 1979. It simply could not alford to do so.

Excessive domestic credit creation would leak into imports. The balance of payments deficit would deteriorate and the country's bank balance with the rest of the world - the external reserves - would begin to fall. This the Central Bank was not prepared to contemplate. It was essential that the Irish pound's participation in the EMS was smooth. Otherwise, pressure on the newly-independent currency might be impossible to head off.

The Central Bank reacted sharply and unexpectedly. While the Central Bank cannot adequately control the money supply itself, it can dictate its counterpart - the level of domestic credit creation. Using its recently developed econometric model, the Bank estimated that the demand for money would rise by about 15 per cent this year, more or less in line with the growth in nominal Gross National Product, which comprises real economic growth and inflation.

"The indicated increase in private sector credit which emerged was some percentage points less than the 18 per cent decided upon", Central Bank Governor Mr. Charles Murray said recently. The additional three percentage points were included to allow for the repatriation of credit following the introduction of exchange controls and the break in the link with sterling.

The 18 per cent guideline - 20 per cent for the productive private sector and 10 per cent for personal credit growth - was introduced at the end of March. But the bankers received a nasty shock. The guideline was backdated to mid-February, even though the interim guideline did not expire until the end of March. In the intervening period, the banks - particularly the "Big Four" Associated Banks - had been granting permissions for loans and creating credit without knowledge of the new guidelines. Nor did they anticipate the new - and necessary - get tough policy adopted by the Bank.

At the time the guidelines were introduced, the Associated Banks estimate that interest on outstanding_ loans would bump up credit by 8 per cent at the end of the financial year in March; earmarked loans for projects backed by the Industrial Development Authority would swallow up a further 6 per cent of new credit, while the adjustment for the seasonally low credit benchmark in February would add a further 1 per cent to credit creation during the year. In short, by the time the credit guidelines were introduced, there was precious little room for new credit creation - for the rest of the credit year.

There would, of course, be "repayments of existing loans amounting to several hundred million pounds which are available for further lending" as the Central Bank's governor had recently stated. But then the lightning struck. As many Irish firms repatriated their borrowings following the break with sterling at the end of March, they began to call upon the loan permissions granted by the banks in balmier days. The granting of loan permissions is somewhat akin to overbooking air flights: it is undertaken on the basis that not everyone will turn up. But, denied access to Britain on the old terms, they did turn up, looking for their loan agreements to be honoured.

While debts were repatriated, so were assets. But the crucial problem faced by the banks was that they did not end up in the same place. Much of the repatriated cash found itself into the safe haven of the building societies' coffers, while the demand for loans went to the banks. In other words, the banks did not find themselves with sufficient deposits to counteract the increased demand for loans.The Associated Banks thus found themselves in difficulty, virtually from the start of the new credit year. Meetings were held with the Central Bank, but the guideline remained at 18 per cent.

Officials at the Central Bank were having their own difficulties. Maintaining the Irish pound at its prearranged level within the EMS structure required support, and the reserves fell. In the nature of things, the fall in external reserves - they declined by £320 million in the first nine months of the year - would have caused a contraction in the liquidity of the banking system, and thus in its ability to create new credit.

This requires some elaboration. The Associated Banks were required to keep 13 per cent of their resources in a highly liquid form - cash or call money. Essentially, this is a precautionary move designed to ensure that customers asking for cash for their cheques are sure of getting their money. In addition, though, the Banks were required to maintain a further 30 per cent in government securities. In total they could freely lend only £57 of every £100 deposited. Once their liquidity contracted, their ability to create new credit contracted also. These liquidity ratios have recently been revised downwards to 10 per cent and 25 per cent respectively. But this is a technical move which does not ease credit in the slightest.

This is what happened. The Associated Banks ran short of liquidity. To support their lending, they were forced to purchase new liquidity from the Central Bank. The Bank charged them penal rates for rediscounting their government paper. Until recently, the banking system's indebtedness to the Central Bank was running close to £400 million. The rates charged by the Bank ran up to 20 per cent. This hit the Associated Banks' profitability. The recent introduction of the liquidity ratios allows the banks to run down their indebtedness with the Central Bank by selling the surplus securities to it. This boosts profitability. It is the anomalous side effect of the Central Bank financing government borrowing which it cogently argues is excessive at present.

But unless the Central Bank has been prepared to neutralise the effects of the externally-induced liquidity

drain on the banking system by supplying additional liquidity, it is doubtful if the Associated Banks could even have expanded credit by the 18 per cent permitted. The Bank itself does not accept that there has been as much credit switching as the Associated Banks themselves have suggested. "While precise data are not available, such information as the Bank has to hand indicates that other credit switching has not been significant", Mr. Murray said recently.

In the real economy, things were not going according to plan as 1979 progressed. Growth was much lower than the 61/2 per cent originally anticipated by the Government. Inflation was again accelerating. For various reasons - among them the effects of the postal dispute - the public sector borrowing requirement was increasing rather than falling. The Exchequer borrowing requirement had initially been estimated at £779 million in the budget, equivalent to an estimated 10 1/2 per cent of GNP. Recent forecasts put it in the range of £900 million to £950 million, or more than 13 per cent of GNP. The public sector was not demonstrating the discipline which the Government was attemping to foist on the rest of the economy.

A leading monetary economist, Dr. Antoin Murphy of Trinity College, argues that it is pointless to enforce a tight squeeze on credit in the productive private sector, while the public sector's appetite for funds continues to grow unchecked. A second development which pushed up the demand for private sector credit is the extent of re-stocking, particularly in agriculture. Following the large cattle disposals of the previous three years, stocks had to be replenished during 1979, and together with the long hard winter, farmers' demand for credit increased sharply.

The only concession which the Associated Banks had wrung from the Central Bank in their abortive meetings following the introduction of the 18 per cent guideline was that the Bank would review the situation if the economic outlook changed. However, when the Bank came to review its guidelines recently the pressure on the reserves and the swelling of the Government's borrowing requirement convinced them that "all the signs point in the direction of more rather than less restraint" (Central Bank's emphasis). The Bank's governor points out "The Central Bank has nevertheless - and not without misgivings - decided against a reduction of the guideline."

With considerable credit increases for 1979 already built into the banking system before the guidelines were announced, there had to be a crunch as the Associated Banks attempted to adjust to the slower rate of domestic credit creation. They retrenched, and the money supply actually declined during August (although its annual growth rate still topped 32 per cent). The guidelines' impact has grown more onerous as the year progresses. As a result of a survey of its members, the Confederation of Irish Industry concludes that "with inflation running at 13 per cent, many manufacturing firms are unable to borrow sufficient working capital to maintain the existing level of output".

It adds, "the situation clearly becomes much more difficult for firms which want to expand. This requires an even higher level of borrowing. If some firms have difficulty in maintaining the existing level of output because of credit restrictions, it is obvious that many more firms are constrained from growing".

Is the Bank's tight credIt policy then in conflict with the Government's objective of seeking high output and employment growth? This question elicits an emphatic no from the Tanaiste and Minister for Finance, Mr. George Colley. "The implementation of the guidelines is causing some problems, but they are not major. It is not our object to close down any businesses", he says. While there has been "no massive degree of hardship", the Tanaiste says that "because the guidelines were disregarded, there may be a cutback towards the end of the present credit year. "

If the productive element of the private sector is in difficulty, then the personal borrower has effectively been cut off from new credit. This has hit those seeking bridging loans particularly hard, especially since the time-lag between the granting and the receiving of a mortgage has increased sharply during 1979. In an effort to take the pressure off house purchasers and farmers, the Tanaiste announced in October that additional funds would be made available to the Agricultural Credit Corporation, while the Trustee Savings Banks were allowed to disburse a further £10 million in bridging loans.

One source of easement from the present difficulties does exist. Domestic bank lending denominated in foreign currencies and based on capital inflows is exempt from the 18 per cent guideline. But Irish companies appear markedly reluctant to undertake foreign borrowing, even though interest rates among our EMS partners are lower than those prevailing in Ireland. The Associated Banks have been actively courting firms to engage in such borrowings, but Irish companies are afraid of the exchange risk - despite the fact that the Irish pound's value is firmly pegged to other EMS currencies. At present the CII is attempting to convince the Government to underwrite the exchange rate risk.

The outlook for the future is bleak. Credit will remain tight during 1980, and a tough new guideline on domestic credit creation can be expected from the Central Bank when the present indicator expires in mid-February. In order to defend the reserves and the exchange rate, the Central Bank simply has no choice but to pursue such a policy. Interest rates will remain high in nominal terms. This is unavoidable in view of the general upward pressure of world interest rates and the size of Ireland's 1979 balance of payments deficit. In real terms - adjusted for inflation - interest rates are nothing near as high as they appear.

The restrictive stance in credit policy is likely to be paralleled by a greater degree of restraint in other sectors of the economy. If Ireland's credit rating is to remain high internationally, the Government must attempt to curb the 1980 Exchequer borrowing requirement. It tried this year and failed. Next year, it must succeed.