Stress test shows economy vulnerable on interest rates

As part of its draft stability programme update, published this week, the Department of Finance included a "sensitivity analysis" to model the effect of changes in world output and interest rates on the Irish economy, a sort of a macro stress-testing exercise.

It found the economy here is considerably more sensitive to changes in interest rates than to changes in global output.

What’s worrying about this finding is that a period of higher interest rates is guaranteed while a contraction in global output, while probable, is not a certainty.

The department’s analysis found that a 1 per cent decline in world output would lower Irish gross domestic product (GDP) by 1 per cent and and push up unemployment by 0.5 per cent over five years relative to a baseline path for the economy.

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However, a 1 per cent hike in the European Central Bank’s main lending rate would have nearly twice the impact on Irish GDP, amounting to a 1.8 per cent drag over five years.

It would also push up unemployment by 0.7 per cent, contract wages by 0.8 per cent and leave Irish exports 2.6 per cent lower than where they might have been.

Competitiveness

The reason for our greater sensitivity to interest rate changes is easily explained. A hike in the ECB's main rate will strengthen the euro with a negative competitiveness effect on Ireland – we've already seen how sterling's Brexit-related depreciation has hurt our trade with the UK.

A second reason, and perhaps the more worrying one, relates to the high level of indebtedness, State and household, that still pertains in the wake of the crash.

The State is still paying €6-€7 billion in interest a year on its national debt even in a era of historically low interest rates, reflecting the mountain of debt accumulated during the crisis.

On a household level, the wave of pain that could be inflicted on mortgage holders from a big upswing in rates is obvious.

All of which goes to show that Ireland’s economy remains acutely vulnerable to international shocks, and that a tight fiscal stance will have to be maintained despite the clamour for tax cuts and spending hikes.