Spain and Ireland ‘thrown to the wolves’ after ECB move

This is a story about how the ECB move affects individuals. As much as I support the ECB rate hike, one has to remember that real people are very much affected by these policy decisions. This is what makes these decisions difficult.

From the Independent Ireland:

By Ben Sills and Fergal O’Brien, Friday July 04 2008

Jose Mauricio Rodriguez Montalvo rents a room from his sister to help her afford her basement flat in Madrid as mortgage costs soar.

”She’s crying over the Euribor,” the 12-month money- market rate used to set Spanish mortgages, Montalvo, 28, said in an interview. ”We’re just praying it won’t keep going up.”

For homeowners in Spain and in Ireland, struggling to stay afloat amid the wreckage of a decade-long real-estate boom, those prayers are going unanswered. The European Central Bank yesterday increased its benchmark rate to 4.25 percent to fight inflation, pushing both economies a step closer to recession.

The two countries are particularly vulnerable to higher lending costs because their housing industries account for about 10 percent of their economies, twice the EU average. Montalvo’s family has seen its monthly mortgage payment leap 50 percent to 2,080 euros since the ECB began raising rates in December 2005.

”They have been thrown to the wolves,” said Stuart Thomson, who helps manage $46 billion in bonds at Resolution Investment Management Ltd. in Glasgow, Scotland. ”It’s much easier to bring inflation lower if you’re willing to have a recession in economies like Spain, Italy and Ireland.”

The Irish economy contracted for the first time in more than a decade in the first quarter. Growth in Spain was the slowest in 13 years in the period, and economists surveyed by Bloomberg News see a 45 percent probability of a recession, or two consecutive quarterly contractions, within the next year.

Balancing Act

The ECB has more than doubled its key rate in less than two years under its mandate to control prices. Euro-region inflation accelerated to 4 percent last month, the fastest in 16 years, on soaring food and oil costs, even with growth slowing.

Trichet yesterday signaled further rate increases weren’t imminent as he strikes a balance between taming inflation and not choking economic growth. Still, while he acknowledged some countries will be harder hit than others by the rate increase, he said the bank must serve the entire euro region just as the Federal Reserve sets policy for all 50 U.S. states.

”If you concentrate on California or Florida, it is not at all like Massachusetts or Alaska,” he said in an interview with Ireland’s RTE radio. ”It is the same in our case and we have to make a judgment what is good for the full body of the 320 million people” in the euro area.

Fraction of Germany

Spain and Ireland make up less than 15 percent of the region’s economy and their economies together are about half the size of Germany’s. Growth in Europe’s biggest economy accelerated in the first quarter to the fastest pace in 12 years and manufacturing was still expanding in June. Spanish industry contracted by the most on record.

Spanish Prime Minister Jose Luis Rodriguez Zapatero has called on the ECB to be “flexible” in setting monetary policy.

The Euribor has risen almost 30 basis points since June 5 when Trichet first signaled higher rates. That made new mortgages more expensive and will make existing ones costlier as 98 percent of Spanish home loans are on a variable rate. The jump in costs has sapped demand for housing.

Home starts in Spain plunged 70 percent in March from a year ago and dropped around 60 percent in Ireland. The slowdown prompted Dublin-based realtor Lisney to lower salaries by 10 percent for its 170 workers. The Irish unit of CB Richard Ellis plans to cut around a 10th of its workforce.

”Transactions have dried up,” said Guy Hollis, managing director of CBRE in Ireland. ”It’s not going to last forever, but we have to be prudent.”

Job Creation

The building boom going bust is tarnishing a decade of gains. Ireland’s economy has grown the most in the euro area since monetary union in 1999, while Spain created more than a third of new jobs in the region.

After years of ”inappropriately low” interest rates, Spain and Ireland are now feeling the ”hangover,” said Alan Ahearne, a lecturer at Ireland’s National University and a former economist at the Fed.

Irish banks including Allied Irish Banks Plc had their 2008 earnings estimates cut by Merrion Stockbrokers yesterday because of expectations for deteriorating credit quality.

The decade-long expansion does leave Spain and Ireland with resources to ease the pain of the slowdown. Zapatero’s government will use a budget surplus of 2.2 percent of gross domestic product to finance 18 billion euros of measures to prevent defaults and aid unemployed construction workers.

Ireland, with the second-lowest government debt in the euro area after Luxembourg, will maintain a 184 billion-euro infrastructure investment plan.

That may not be enough to buffer the hard landing. The Spanish downturn destroyed 75,000 jobs in the first quarter when the unemployment rate jumped the most in three years to almost 10 percent. Ireland’s jobless rate has risen to a nine-year high of 5.4 percent.

”Central banks are paid to cause a recession now and then,” said Fortis Investments Chief Investment Officer William De Vijlder. ”Maybe it’s a shock to put it like that, but that’s reality.” (Bloomberg)

– Ben Sills and Fergal O’Brien