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Recently released Irish GDP data emphasise Ireland’s ‘dual economy’ structure
Underlying growth rate around 6% in 2015; likely to slow to 3.5% this year
Precise impact of Brexit on Irish economy will remain unclear for some time
Weaker GBP and uncertainty likely to slow activity and income growth
Public finances close to balance in 2016
Drop in Debt/GDP ratio below 79% exaggerates extent of recent improvement
Outlook and ECB purchases supportive of Irish bonds, but rich in absolute terms
Low funding need in 2017 & 2018
Irish bond traded more or less stable in ASW spread terms since the second half of last year with two notable exceptions. In the run-up to the Irish general election (Feb2016) and the British EU-referendum (June2016), Irish ASW-spreads widened. Underpinning strong sentiment on EMU bond markets and Irish bonds in particular was the immediate market reaction after the adverse outcomes of both events. Investors used the spike higher in ASW spreads, to “buy the dip” (see graph 1), backed by strong underlying growth, improving public finances and of course the ECB’s public sector purchase programme. We hold our view that at current levels, EMU government bonds remain expensive. From a relative point of view, Ireland reconnected with the EMU “semi-core” (Belgium/France/Slovakia). The 10-yr yield differential between Belgium and Ireland for example trades on average around 20-30 bps since the end of last year.
Under its Public Sector Purchases Programme, the ECB bought €13.25B Irish bonds up until the end of June. The weighted average maturity of the ECB’s current Irish bond portfolio is 9.38 years. Since the ECB stepped up monthly asset purchases from €60B/month to€80B/month in April, the average monthly volume of Irish government bond purchases increased as well, from €0.77B/month to €1.09B/month. If the ECB continues its PSPP-programme as planned until the end of March 2017, its Irish bond portfolio will be €23.1B. However, we expect a slowing down of Irish public sector purchases because of the “issuer limit” (33%) which refers to the maximum share of an issuer’s outstanding securities that the ECB is prepared to buy. It’s a means to safeguard market functioning of price formation as well as to mitigate the risk of the ECB becoming a dominant creditor of euro area government. In the Irish case, the ECB becomes close to hitting this limit because of the central bank’s Irish bond portfolio stemming from before the start of PSPP. The ECB already bought Irish bonds under the SMP-programme and also the restructuring of the Irish promissory notes is also taken into account. If the ECB slows its purchases, this should in theory trigger some ASW spread widening, but we don’t expect such moves to last long in the current “buy the dip” market.
This year, NTMA expects to raise €6-10B of long term bonds, €5.6B of which has already been issued via a combination of a new syndicated 10-yr benchmark deal (1% May2026) and three regular tap auctions. The Exchequer had around €8.5B of cash and other liquid assets at the end of June 2016 and aims to raise this to around €10B at the end of the year. That would imply that Ireland actually is already fully funded for 2017. Next year’s funding need will likely be around the tune of €10B, consisting of one bond redemption (€6.4B 5.5% Oct2017) and an Exchequer deficit of around €3B deficit. Also in 2018, the Irish funding need is expected to remain low with only one redemption (€9.25B Oct2018). These are favourable conditions to start preparing for the next “funding cliff” in the 2019-2020 period when a mix of Irish bonds and bilateral loans come due (see graph).
In 2014-2015, the Irish Treasury used cash proceeds they built up and reduced short term (2015-2020), expensive, outstanding IMF debt by approximately €18B to less than €5B (redeeming between 2021 and 2023). Those IMF repayments significantly improved the Irish maturity profile, together with loan extensions by EFSM and EFSF. Following decisions by the Council and the EFSF board of governors in June 2013, the average maturity of EFSM and EFSF loans to Ireland was extended by 7 years. The first principal repayments are due in 2029 for the EFSF loan and 2027 for the EFSM loan. The agreed maturity extension is already effective for EFSF loans whereas, for EFSM loans, the potential maturity extension will be determined at a later stage as the loans approach their original maturity dates. The NTMA is expecting not to refinance any of the EFSM loans before 2027. These changes to the amount and profile of official borrowing outstanding further enhance an already favourable cost and maturity profile for Irish sovereign debt.
In February, Fitch upgraded the Irish A- rating (positive outlook) to A (stable outlook). Fitch justified the upgrade by an improvement in debt dynamics, reflecting the combination of strong growth and a return to a primary budget surplus. In May, Moody’s followed the example by raising the Irish rating to A3 from Baa1 with a positive outlook. Moody’s also cited the rapid improvement of the government’s public finances as well as the political deal reached following the elections. S&P, the third big rating agency, rates Ireland at A+ (stable outlook). This year’s remaining scheduled reviews for Ireland take place on September 16 (Moody’s) and December 1 (S&P).
Any consideration of the outlook for the Irish economy and the effects this might have on the Irish Government bond market needs to begin by discussing the possible implications of two important recent developments. The first of these is the recent publication of statistics showing the Irish GDP increased by a staggering 26.3% in 2015, while the second relates to the prospective impact on the Irish economy of the UK referendum vote to leave the EU. Consequently, this section of the credit study examines these two issues in some detail before considering trends in the public finances and the longer term outlook for the Irish economy.
New official statistics released in mid-July present revised estimates of Irish economic growth which show an astonishing upward revision to GDP growth for 2015 from a provisional figure of 7.8% to an extraordinary 26.3%. It should be emphasised that this revision is statistical in the sense that previous estimates of jobs growth of 2.6% and an increase in tax revenues of 10.5% in 2015 remain unaltered. So, these numbers don’t fundamentally alter the economic reality experienced by most Irish business and households during 2015. Nor do they materially change the resources available to Irish society although they have some implications for fiscal metrics.
These revisions should be seen primarily as a step change in that the measured size of Irish economic activity increased dramatically in 2015, but the rate at which it grows in the future is unlikely to be permanently boosted. However, the measured growth rate could become even more volatile than in the past. The recent dramatic revisions primarily reflect reclassifications and relocations of the activities of a handful of multinational companies that are very large by Irish standards. Consequently, this materially alters the size of Irish economic activity as measured by standard International National Accounting practices although the underlying impacts on activity and employment are likely to be comparatively small.
The causes of the revisions aren’t entirely clear-cut. For reasons of confidentiality in relation to companies providing details of their activities in Ireland to the Central Statistics Office, public information on the precise reasons for the sharp upward revision to Ireland’s capital stock is quite limited. It is believed that the relocation of a number of companies in sectors such as aircraft leasing and medical devices played some role, but a notably more important element appears to be a reclassification/relocation of items on one or two companies’ Irish balance sheet as capital assets. This in turn translated into the inclusion of such items as part of Ireland’s capital stock.
These alterations materially increase the recorded size of the 'balance sheet' of the Irish economy. The new official estimates show the productive capital stock of the Irish economy increased from about €700 billion in 2014 to around €1050 billion in 2015—an enormous change in view of the fact that the capital stock usually changes incrementally to reflect the gap between Gross Capital Formation and Depreciation, which came to just €7 billion in 2014. In the wake of these new estimates, Ireland’s capital stock increased from about 325% of Irish GDP in 2014 to around 410% of GDP in 2015. The annual output associated with this much higher capital stock was scaled up sharply for 2015, resulting in the 26.3% rise in GDP reported in mid-July.
While a much larger capital stock suggests scope for persistently larger Irish economic output in the future, it doesn’t necessarily imply a persistently faster pace of growth. Indeed, an important consequence of the markedly larger capital stock is the prospect that potentially significant fluctuations in the provision for depreciation could lead to the possibility of markedly greater volatility in National Accounts data in the future as the scale and nature of companies and activities such as those incorporated in the new 2015 GDP data won’t necessarily mirror the contours of the remainder of the Irish economy. In this context, graph 4 highlights the sharp divergence between annual growth in 2015 as measured by changes in Ireland’s Gross Domestic Product and Net National Product. Both indicators show a broadly similar trend for the past twenty years putting into stark contrast how exceptional the 2015 growth estimates are. Incidentally, the 6.5% increase in NNP in 2015 is consistent with the broad swathe of other indicators in emphasising that the underlying pace of increase in Irish economic activity remains extremely robust.
While we think there may be a marginally negative impact on 2016 growth numbers from last year’s outsized increase, our forecasts for the Irish economy reflect a view that the 2015 outturn was exceptional in nature and won’t have any consistent impact on prospective growth rates for future years. An alternative way of looking at the forecast numbers presented at the end of this note is to suggest that they are intended to relate to the underlying trends in the Irish economy.
While the latest revisions to Irish GDP data alter the statistical picture rather than the underlying economic reality, the outlook for the Irish economy has been materially affected by the recent UK vote to leave the EU. ‘Brexit’ can be expected to have a significant negative effect on the Irish economic outlook. However, the precise nature, extent and timeframe in which this impact is felt remains unclear at this time. As the UK’s departure from the EU is an unprecedented event, all estimates of its likely scale of impact on the Irish economy have to be seen as broadly indicative in nature. Our best guess is that a reasonably orderly exit process from the EU by the UK could subtract about 2% cumulatively from Irish GDP growth over a period of two to three years. While Brexit is not a ‘big bang’ event and, as such, seems unlikely to threaten a sudden stop in Irish economic activity, some significant effects on the Irish economy are likely to be seen through the second half of 2016, with the bulk of the impact felt before the end of 2017.
Our expectations in regard to Brexit’s potential impact on the Irish economy primarily reflects the speedy and substantial reaction of foreign exchange markets to the UK referendum vote and the implications of this reaction for Irish exports. It also takes into consideration the nature and extent of economic and cultural ties between the two countries that makes the UK decision closer to a ‘domestic’ rather than a foreign development. The associated domestic focus on Brexit within Ireland means its repercussions are likely to feed through to sentiment and business decision-making reasonably quickly. In this regard, graph 2 below hints at links between Sterling’s fortunes on FX markets and the performance of the Irish jobs market.
We expect the primary impact of Brexit on Irish economic growth prospects to be seen in a slower pace of export growth. Exports to the UK amount to some 20% of Irish GDP. Reflecting both the direct effect from Brexit on Irish exports to the UK, a smaller impact from some spill-over weakness in other European markets and the reported weakness of exports in early 2016, we expect a sharp slowdown in the pace of export growth. We also think that Brexit-related uncertainty will weigh on Irish investment. However, strong underlying momentum in areas such as construction should significantly cushion the Brexit blow.
While we envisage a significant adverse impact in the next year or two, we don’t expect a sea-change in Irish economic conditions as a result of the Brexit vote. For this reason, we don’t anticipate any dramatic alteration of the conditions facing the average Irish consumer in the near term. Indeed, at the margin, cheaper UK imports will boost household purchasing power. However, in time Brexit will have some adverse impact on Ireland’s public finances and expectations of reduced scope for favourable fiscal measures together with an element of increased caution on the part of consumers will weigh on household spending.
The overall impact on the Irish economy of the prospective departure of the UK from the EU will be clearly negative but, within a wide range of effects, there should be a number of positive consequences in specific areas. As there is likely some redirection of Foreign Direct Investment from the UK into other EU countries, Ireland is well positioned to attract some element of activity related to companies looking to retain a presence in the EU. The scale and timing of such investment flows is extremely uncertain and will be significantly influenced by the precise nature of the relationship the UK forges with the EU after its departure. For this reason, we have made the possibly strong assumption that there is no boost to Irish economic activity in the next two to three years from any Brexit relocations into this country.
We previously envisaged a growth rate of about 5% for 2015, but the UK vote together with soft Q1 data and the possibility of some slight correction of last year’s outsized growth figure have prompted us to downgrade our forecast of GDP growth for this year to 4%. We have also pared back our GDP forecast for 2017 to around 3% from 3.7% previously and reduced our forecast for 2018 by 0.5% to 2.8% on Brexit effects. The somewhat slower pace of growth envisaged through the remainder of 2016 has led us to revise our forecast for jobs growth to 2% in both 2016 and 2017 (previously 2.6%). As a result, we have amended our unemployment estimates to an average jobless rate of 7.8% for this year from 7.5% previously and to 7.2% for 2017 from 6.7% previously. Alongside these impacts, we now see Irish inflation at 0.0% (previously 0.2%) and 0.5% for 2017 (previously 1.3%).
While we must emphasize the degree of uncertainty in the current environment, we think these projections adequately capture the nature and extent of downside risks to Irish economic growth which have crystallized in the wake of the UK referendum vote. Our sense is that these new estimates encompass a substantial adverse impact from Brexit that could be slower to materialize or may be less pronounced than these forecasts envisage. In this context, our estimates of the cumulative hit to Irish GDP over the three year period 2016-2018 entail a larger impact than envisaged by the IMF which estimated an impact on Irish GDP ranging from 0.7% to 1.8%.
In assessing the outlook for the Irish economy in coming years, it is also important that we consider the adverse impact of ‘Brexit’ in the context of the exceptional momentum of the Irish economy over the past couple of years. Our current GDP forecast for 2016 is still likely to be sufficiently strong to make Ireland the fastest growing economy in the EU for the third year running while our estimates for 2017 and 2018 would still be about twice the average pace of growth likely in the EU over this period.
Furthermore, as a counterpoint to Brexit, there are some risks in the opposite direction that domestic economic activity could move onto a stronger trajectory than we currently envisage. For example, it is widely estimated that the current pace of homebuilding in Ireland is between 13k and 17k short of the number of units necessary to balance demand and supply. Our projections envisage only a modest step-up in housing output in the next couple of years. If there were to be significant changes in the regulatory, planning or funding environment that facilitated an expansion in supply amounting to an additional 15k homes, that would be sufficient to boost Irish GDP by 1.5%. A new housing plan announced by the Irish Government in late July is unlikely to have an immediate impact of this magnitude but does represent a source of material upside risks to our forecasts.
A clear but controlled easing in property price inflation and a marked decline in transaction levels are the two key features of the Irish residential property market through the first half of 2016. While healthy Irish economic conditions continue to be the main influence on property price trends, the picture is significantly complicated by a shortfall in residential supply and the influence of CBI credit constraints. We expect a gradual easing in the pace of annual price inflation to continue to around 5% by the end of this year. As monthly price changes were choppy through 2015, the slowdown in the year on year increases through the remainder of this year is unlikely to be a smooth process.
While most studies envisage some adverse impact on Irish GDP from Brexit, the magnitudes envisaged suggest Irish economic growth should remain solidly positive through the next couple of years. With the possibility of some additional immigration-related demand for housing and the prospect of borrowing costs remaining lower for longer in the Euro area, there are likely to be some positive influences related to Brexit on the Irish housing market to partly compensate for the broader negative impact on the Irish economy. Similarly, while the commercial market may be adversely affected by a Brexit related slowdown in the Irish economy, a notable offset could be an influx of FDI that hitherto would have been located in the UK. Again, it is not possible to quantify the scale of this relocation effect at this point but it seem likely to have a material impact on conditions in the Irish commercial property market in coming years
The turnaround in Ireland’s public finances is set to continue and a deficit of less than 1% of GDP, which seems attainable this year, represents further significant progress towards a balanced budget. The projected improvement compared to the 2015 deficit of 1.8% of GDP is flattered by the statistical treatment of a share conversion that boosted the 2015 outturn by €1700 million (0.8% of GDP). The Irish Government converted preference shares in AIB into AIB and this was deemed to be (deficit boosting) capital spending rather than, as had been generally expected, a (deficit neutral) financial transaction.
The drop in the underlying deficit from 3.8% of GDP in 2014 to 1% of GDP in 2015 primarily reflects buoyant exchequer tax receipts (+10.5%) which were €3.3 billion or 1.5% of GDP above target. This provided leeway for a supplementary increase in public spending of about €1.5 billion in 2015 as well as delivering a below target outturn for the end year deficit. Exchequer debt servicing costs were €7.1 billion, roughly €500 million lower than in 2014 reflecting the early repayment of IMF loans and their replacement with lower cost market funding.
Exchequer returns data for the first six months of 2016 show a continuing trend improvement in Ireland’s public finances consistent with strong positive momentum in economic activity through the first half of the year. The overall trend in tax revenues remains very strong but we envisage some easing in the pace of growth through the balance of the year. Corporation tax receipts remain the most notable source of buoyancy in taxes and, encouragingly, the increased level of multinational activities revealed by the recent revision to GDP data suggest a likelihood that this trend will continue. With half-year returns indicating that public spending remains on a sustainable trajectory, we expect this year’s budget target of a deficit of just below 1% of GDP can be met or slightly bettered.
The sustained improvement in the Ireland’s fiscal position has allowed the stance of government policy to change from implementing severe austerity measures to imparting a modest stimulus to activity. The associated step-up in public spending and easing in taxation should spread the upturn more broadly on both a geographic and sectoral basis. While we expect some pull-back in the extent of concessions possible in the upcoming budgets, the manner in which the concept of ‘fiscal space’ means this may not influence the parameters around Budget 2017. As a result, the upcoming Budget is likely to include adjustments that add about 0.3% to GDP in 2017.
Although recent revisions to GDP data don’t directly impinge on the economic circumstances of the average Irish firm or consumer, they have potentially important implications for Budget policy. By altering the measured size of the Irish economy, they influence important fiscal ratios such as debt/GDP, reducing end-2015 outturn below 79% of GDP from the previously estimated 94% of GDP. Their impact on the deficit/GDP ratio is more modest, cutting the 2015 General Government Balance to 1.8% of GDP from 2.3% previously. However, larger Irish GDP also suggests the prospect of an increased Irish contribution to the EU budget that could run to €300-400 million in coming years although this impact is more than offset by increased tax revenues associated with the higher GDP number.
More importantly, the scale of recent revisions to Irish GDP figures mean technical considerations such as Ireland’s potential growth rate, the associated output gap and, more importantly from a practical and political perspective, measures such as the structural budget balance and fiscal space are rendered virtually meaningless (even if there were always major problems with the mechanical nature of such calculations for an economy of the structure of Ireland).
The February 2016 Irish general election did not produce a clear-cut outcome. The outgoing coalition government of Fine Gael (centre right) and Labour (centre left) was expected to lose its overall majority but the scale of losses was much heavier than expected.
After discussions lasting several weeks, a minority Government took office in early May in the 158 member Dáil (the principal chamber of the Irish parliament). The new Government comprises 50 members of Fine Gael, the largest party, and 8 independents with whom a programme for Government has been agreed. The minority Government is underpinned through an arrangement with Fianna Fáil, the second largest party comprising 50 deputies, not to vote against the Government on confidence motions or public spending bills. There is no strong ideological gap or major economic policy difference between the two largest parties. There is a strong historical difference as they emerged from opposing sides of a civil war that followed independence in 1922.
While the current situation is very unusual in Irish politics, it has a precedent as during an economic crisis in the 1980s, the then Fine Gael opposition agreed to support economic reforms introduced by a minority Fianna Fáil government. That arrangement lasted nearly two years. Importantly, while the outgoing Government parties suffered heavy losses, these were not the result of the emergence of any radical party as, for example, happened in Greece. Indeed, Sinn Féin, far and away the most radical of the larger parties, made fewer gains than expected.
There is little prospect of any radical shift in the stance of Irish economic policy in the foreseeable future and the operation of EU fiscal rules, coupled with an acute awareness of the importance of market sentiment to the sustainability of the public finances should further underpin budgetary discipline. That said, the populist tone evident in politics in a range of other countries is likely to have some influence on the thrust of spending and taxation decisions in coming years, with an increased focus on measures that directly support household spending power as well as increasing outlays to improve the health services and infrastructure.
One important consequence of market confidence in the sustained improvement in the Irish public finances and, more importantly, the Government bond purchasing programme of the ECB is a further narrowing in Irish Government bond spreads over Germany even in the aftermath of the UK referendum result.
The medium term outlook for the Irish economy has been clouded somewhat by recent dramatic developments in relation to growth statistics for 2015 and the prospective departure of the UK from the EU. As discussed above, these influences suggest the prospect of increased volatility in Irish economic conditions but in both instances, even assessments that may err on the side of caution suggest the Irish economy can continue to sustain a notably faster pace of economic growth than most other European economies. If we ignore the 2015 data and focus instead on the preceding 20 years, a period encompassing both boom and bust, the annual average increase in GDP was 4.6%, the same rate as the 40 year average.
The latest Census data underline the potential to sustain above average growth into the future. Ireland’s population rose by 0.7% on average each year between 2011 and 2016. This demographic trajectory suggests scope for a potentially faster pace of Irish economic growth in coming years than had been envisaged. We tentatively estimate that the potential growth rate for the period up to 2020 might now be around 4% rather than our previous figure of just over 3% (this revised figure abstracts from any implications of the notably larger capital stock revealed in recent GDP data).
These data also emphasize that Ireland remains set on a notably different demographic path than most other EU countries. As table 1 below indicates, Ireland’s pace of population increase is notably faster than the EU average even though Ireland has experienced a net migration outflow through the past five years. The ‘natural’ rate of increase reflects clearly different trends in both the birth rate and death rate stemming from a notably younger population profile and contrasts starkly with a negative natural change across the EU as a whole in 2016. With today’s data suggesting the strong likelihood of a return to net inward migration into Ireland of late, Ireland’s population path looks notably more balanced than that of many EU countries.
This non-exhaustive information is based on short-term forecasts for expected developments in the economy and financial markets. KBC Bank cannot guarantee that these forecasts will materialize and cannot be held liable in any way for direct or consequential loss arising from any use of this document or its content. The document is not intended as personalised investment advice and does not constitute a recommendation to buy, sell or hold investments described herein. Although information has been obtained from and is based upon sources KBC believes to be reliable, KBC does not guarantee the accuracy of this information, which may be incomplete or condensed. All opinions and estimates constitute a judgment as of the date of the report and are subject to change without notice.