In-depth review: Ireland
25 June 2015
Strong upturn in economic activity as export growth remains impressive.
Key development is improvement in domestic spending.
More balanced recovery supporting job gains and boosting public finances.
By the end of the year, Irish government already fully funded for 2016?
Virtuous circle expected to push debt ratio below 100% by the end of 2016.
Much improved maturity profile following early IMF repayments.
Irish bonds: semi-core status
The bull flattening of the Irish yield curve continued in the first quarter of 2015. This primarily reflected global rather than domestic influences and the Irish yield curve shifted in similar fashion with other EMU yield curves in a move that started early 2014. The main driver was the gradual easing of monetary policy by the ECB that eventually led to an outright Quantitative Easing programme. The Irish yield curve reached its lowest level mid‐April with the 10‐yr yield approaching 0.60%.
However, 2014 also saw a fundamental change in the way investors viewed Irish sovereign debt. Ireland didn’t only leave the EU/IMF bailout programme in 2014, but also left the so‐called “periphery”. Irish bonds moved away from levels near Spain & Italy towards semi‐core Belgium & France. This reassessment has continued in early 2015.
Since mid‐April, the EMU bond market was hit by two sharp corrective repositioning moves (bear steepening). Several small factors triggered the repositioning. First, the one‐ directional investments into longer term maturities were simply prone for a correction. Second, market liquidity was low because of the absence of end investors as yield dropped to absurd levels. Third, European growth perspectives improved and inflation expectations picked up.
Looking forward, we don’t think that Irish yields will return to the record lows of the spring despite continued Central Bank bond purchases. At least until September 2016, the ECB intends to buy €60B bonds/month. In March, April and May, Irish government bond buying averaged €0.743B (total €2.23B). By the end of the buying programme, central bank purchases will total €14.12B, which is around 15% of the Irish bond market. The continued presence of this large buyer, which is also active in the illiquid summer months, supports the bond market and limits short term additional upward potential of EMU yields in the near term. A risk factor to this scenario is the Fed’s normalisation process. This could increase volatility further and put some limited upward pressure on EMU yields and spread products as well. Throughout 2013 that was the case in the run‐up to the Fed’s QE tapering.
We hold our view that from a relative point of view, further outperformance versus Spain & Italy is likely. From an absolute point of view, in common with their counterparts elsewhere in Europe, Irish bonds may have become too expensive.
Improved maturity profile
In 2014, the Irish treasury (NTMA) raised €12B through a mix of regular auctions and two syndications. Thanks to that successful return to the market, NTMA managed to pre‐ fund for the whole 2015! In 2015, NTMA expects to issue €12‐15B of long term bonds, €10.25B of which has been issued so far this year. At the start of the year, the NTMA took advantage of favourable market circumstances to launch a new 7‐yr benchmark (€4B 0.8% Mar2022) and a new 30‐yr benchmark (€4B 2% Feb2045). The latter was the first time ever Ireland launched a bond with such a long tenor.
Given that NTMA was already more than funded for 2015, they used the cash proceeds they built up to repay the lion share of IMF loans from the bailout package, a process which started in 2014. NTMA reduced short term (2015‐ 2020), expensive, outstanding IMF debt by approximately €18B to less than €5B (redeeming between 2021 and 2023). Total interest cost savings could exceed €1.5B over 5 years 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 2016, we expect Ireland’s funding need to be around €10B, consisting of a €8.1B bond redemption (4.6% Apr2016) and an exchequer borrowing budget deficit that we think will be lower than official projections of about €1.8B. NTMA estimates that its cash reserves will be around €12B by the end of the year, so actually Ireland is already fully funded for 2016! Therefore, the NTMA will likely continue to hold an opportunistic approach with raising funding. Also in 2017 and 2018, the funding need is expected to be low, possibly even below €10B, with again only one bond redemption (€6.4B 5.5% Oct2017 & €9.26B 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).
More Rating Upgrades
In early June, S&P raised Ireland’s credit rating by one notch to A+ from A (stable outlook). The upgrade reflects S&P’s view of Ireland’s improved fiscal performance, higher state assets sales, and robust economic performance, which have combined to lead to a quicker decline in net general government debt than S&P earlier previously forecast. Ireland is rated A‐ at Fitch and Baa1 at Moody’s. Also those ratings have a stable outlook. Next Irish reviews are scheduled for August 7 (Fitch), September 9 (Moody’s) and December 4 (S&P).
We share the view of an improving Irish economic and fiscal dynamic that underpinned the recent S&P upgrade. As a result, we expect Moody’s to raise the Irish rating further. Currently it’s the only rating agency not to award Ireland with a rating in the “A” group. Once this upgrade occurs, the investor base for Irish bonds should expand significantly further.
The Irish economy has put in an encouraging performance in the first half of 2015 that suggests an upturn in activity and employment is both strengthening and broadening. While recent trade data point to the persistence of strong export growth, the most notable development of late is increasing evidence from a range of indicators that implies a clear improvement in domestic economic conditions is taking hold.
The upswing now underway is expected to continue and to build further momentum through the balance of 2015 and into 2016. As such, the one to two year outlook for the Irish economy appears increasingly favourable, notwithstanding many uncertainties in the global outlook at present. A virtuous circle is becoming established in which broadly based growth in Irish economic activity is translating into a marked increase in employment, a rebound in property values and a notably healthier trajectory in the public finances. The forecasts presented in table 1 at the end of this document reflect this notably positive dynamic.
Ireland is a textbook example of a ‘small open economy’. Its GDP is just 1.3% of the EU aggregate while the sum of Irish exports and imports amounts to 203% of its GDP. As a result, global developments are an important influence on Irish economic performance. While conditions in the world economy are mixed at present, the particular constellation of circumstances now prevailing in key trading partners is supportive of robust growth in Ireland.
The continuing upswing in the US economy benefits Ireland not only because it is the largest destination for Irish goods exports but also because of its significance as a source of foreign direct investment into Ireland. Similarly, strong domestic demand in the UK has an outsized impact on smaller Irish firms, many of whom see the British market as part of their domestic customer base. It is generally expected that economic conditions in both the US and UK will remain supportive of Irish export growth through the remainder of 2015 and in 2016.
The comparatively tentative stage of the Euro area upswing is exerting some constraining influence on Irish exports. However, associated downward pressure on the exchange rate of the Euro is having a notable positive effect on the competitive position of the Irish economy vis‐à‐vis third markets. With 65% of Irish exports going outside EMU, this is an important counterweight to sluggish demand in the Euro area. The cyclical position of the Euro area economy and the related monetary stance of the European Central Bank also imply borrowing costs facing the Irish Government, as well as firms and households, will remain reasonably subdued for the foreseeable future.
Supportive conditions abroad are providing significant momentum to the Irish economy. In addition, improved competitiveness and a strong pipeline of export augmenting FDI are underpinning exports. Irish exports grew by 12.6% in 2014, the fastest pace since 2000. Recorded export growth has been boosted by ‘contract manufacturing’. In common with most other forecasters, we have assumed a marked easing in the contribution of contract manufacturing to export growth both this year and next. However, this technical influence shouldn’t obscure a more broadly based positive trend. A sharp acceleration of exports in recent monthly trade data allied to the generally supportive environment outlined above, point in the direction of a further strong expansion of Irish exports in 2015 and 2016.
Strong growth in exports and the constraining influence of subdued domestic spending on imports have resulted in a sharp increase in Ireland’s trade surplus and an associated turn in the current account balance from a deficit of 5.7% of GDP in 2008 to a reported surplus of 6.2% of GDP in 2014. While improving domestic demand may boost imports in coming years, we expect the external position to remain a net positive contributor to Irish economic growth in coming years. However, upcoming statistical revisions that will incorporate gross flows related to a large international aircraft leasing sector operating in Ireland imply the likelihood of a notably higher recorded level of imports. More generally, such developments emphasise the need to avoid mechanistic analysis of headline economic data for Ireland.
Activity, employment and incomes
Although the trough in Irish GDP occurred as early as late
2009, this was due to a recovery in exports that offset a deeper and longer decline in domestic activity. Domestic spending reached its low‐point much later in mid‐2013 and only began to show a clear upturn in the course of 2014. The recent improvement in domestic demand largely reflects stronger employment and healthier business and consumer sentiment as increases in average incomes remain limited and tentative to this point.
Numbers at work in the Irish economy have been increasing steadily since the second half of 2012 and recent data hint that a more mature phase in the recovery in the jobs market is underway. In the first quarter of 2015 employment was 41k higher than a year earlier, an increase of 2.2%. The rise in full‐time employment over the same period was 3.6%, suggesting a stronger underlying momentum in the jobs market. In turn, this is causing a notable easing in Irish unemployment. Having peaked at 15.1% in 2012, the jobless rate has fallen steadily to 9.8% in May 2015. We expect job growth to average about 2.5 % in 2015 and 2016 and think this buoyancy will bring unemployment below 9% by the end of this year and close to 8% during 2016.
The rise in employment is likely to be the main driver of household spending power. Average earnings data still hint at muted and narrowly based wage gains‐ on average wage growth was around 0.5% higher year on year in early 2015 although the most notable feature of these data is a marked variation across sectors. Divergent pay trends seem to reflect significant differences in demand/supply balances for particular labour skill sets as the economy recovers and some impact of recent emigration is felt. With inflation set to be flat to marginally positive in 2015 and around 1% in 2016, only a modest acceleration in earnings growth is expected. For the average Irish household, nominal income gains remain limited.
Acting against the influence of strong jobs growth is a still elevated level of personal debt. In spite of a sharp drop in household incomes in recent years, Irish consumers have undertaken a significant amount of deleveraging. As a result, household borrowing has fallen about €50bio from its peak to some €131bio at present. Importantly, the expected persistence of a low interest rate environment through the next year or two enhances the sustainability of such debt. A marked improvement in car sales of late, up
26% in the first five months of the year hints that the debt overhang will slow rather than stop a recovery in Irish consumer spending.
Outlook for public finances
The key change emerging in the circumstances of Irish consumers is a notable change in the stance of fiscal policy. A sequence of Budgets stretching back to 2009 entailed adjustments totalling a cumulative 19% of GDP. This resulted in a marked reduction in household spending power and contributed significantly to a 15% peak to trough in average disposable incomes. The Budget for 2015 presented last October imparted a marginal improvement in household disposable incomes on average and a clearer boost to spending power is expected from the upcoming Budget for 2016. A switch to even a modest expansionary fiscal stance represents a marked change from recent experience. Aside from the direct boost to spending power, the expected transition from a prolonged period of Budget cuts to one entailing some stimulus will also support consumer confidence and thereby assist spending.
Ahead of a general election that must be held by April 2016, political pressure to provide a boost to incomes and employment is likely to be substantial. However, with rapid GDP growth expected both this year and next and Irish public debt still elevated, the rationale for expansionary fiscal policy has been widely questioned particularly as pro‐ cyclical fiscal policy repeatedly had a damaging impact on the Irish economy in the past.
It may be simplistic to suggest all economic arguments run counter to any thought of an expansionary Budget for 2016. A measured stimulus might be economically preferable to an election outcome that translated into little or no prospect of a coherent Government in coming years. If fiscal concessions also made it more likely that the exceptional social cohesion seen in Ireland through the downturn could be sustained and earnings demands remained moderate, this would also support the case for some support. Finally, the recovery is quite uneven and conditions remain weak in some sectors and regions. So, a case could be made for fiscal measures that spread the improvement in economic conditions somewhat wider. The key issue is to strike a balance that delivers some reversal of major cuts to living standards experienced through the downturn but does not fuel expectations to the point that policy is set on a strongly pro‐cyclical path in coming years or risks becoming unsustainable in the event of a further marked weakening in Irish economic conditions.
We think that political realities and some supportive economic considerations are likely to result in tax and spending measures in Budget 2016 that boost economic activity by just over 1% of GDP next year. Notably better than expected tax and spending data for the first five months of 2015 suggest there will be scope to deliver a stimulus of this scale while coming comfortably inside EU fiscal targets. The end May data show tax revenues €734M ahead of target, departmental spending €306mio below target and debt service costs €213M below target.
Irish budget aggregates can be volatile but with economic activity expected to remain on a strengthening trajectory, the trend thus far suggests the final year outturn could be as much as €2B better than initially envisaged. Moreover, there has been a consistent pattern of outperformance of late across most spending and tax headings. Just as the downturn exposed unexpected Irish fiscal frailties, the major adjustment undertaken in the interim that entailed marked changes to tax and spending settings may produce unexpected windfall gains for the Irish exchequer in conditions of robust growth.
The Irish Government is still operating under the corrective arm of the Stability and Growth Pact (SGP) which requires it to reach a deficit below 3% of GDP in 2015. Current official projections envisage an outturn of 2.3% of GDP but on present trends we think an end‐year figure of around 1.7% of GDP is attainable.
Once Ireland’s deficit is no longer deemed excessive, the fiscal position will be governed by the preventive arm of the SGP. This will require a reduction in the structural (i.e. cyclically adjusted) budget deficit of more than 0.5% of GDP each year until Ireland’s medium term objective of a structural budget balance is achieved. Current official projections envisage a reduction of just 0.3% of GDP in 2016. We think faster economic growth and more favourable fiscal dividends from this growth will produce a notably stronger Budget outturn in 2015. Beyond that these favourable tailwinds should increase the prospect that a structural surplus and a structural primary surplus of close to 3% of GDP can be achieved by 2018 rather than in 2019 as envisaged in official projections.
Improving fiscal arithmetic and robust economic growth can be expected to improve Ireland’s debt metrics significantly in coming years. Having peaked at 123% of GDP in 2013, the debt/GDP ratio fell to 110% at end 2014, the first fall since 2006. Official projections suggest this ratio will fall to 105% in 2015 and 100% in 2016. Our judgement is that the decline could be notably larger in time as the Government sells remaining investments in the Irish banking sector and also scale back the current substantial degree of overfunding. We see scope for the debt ratio to fall to 80% of GDP by 2019 about 10 percentage points of GDP lower than currently envisaged by official projections.
If, as we expect, relatively robust growth takes hold and a prudent approach is taken to fiscal policy, a significantly declining trend In Ireland’s debt ratio can become established in the medium term. In the short term, however, there may be a preference for further opportunistic overfunding that may marginally slow the fall in the debt ratio this year.
Property Market Trends
Through the recent crisis, property market weakness was at the apex of concerns about the outlook for the Irish economy and public and private balance sheets in particular. Sentiment has now turned to the point where property is seen as a source of positive momentum in activity, employment and net worth in the years ahead. However, better sentiment is not associated with any material amount of speculative behaviour. In broad terms, conditions in the property market currently reflect an improving Irish economy. That said, the process of dealing with divergent demand/supply imbalances across geographic regions and market segments is unlikely to be an entirely smooth one and may take some time to resolve. By implication, balance sheet changes may be somewhat uneven around a gradually improving trend.
With property market activity still well below what might be considered normal levels, shortages in some key areas have resulted in rapid property price inflation. Inadequate supply rather than excess demand is the key driver of these price developments. Credit outstanding continues to shrink as a modest increase in new lending still leaves it notably short of maturing loans. However, the Central Bank introduced Loan to Value and Loan to Income ceilings in respect of residential property borrowing early 2015. It is too early to draw conclusions about the lasting impact of these measures. In the short term, they have contributed to increased uncertainty on the part of both prospective purchasers and builders. As a result, there has been some easing in transactions compared to what might otherwise have been expected in early 2015. In turn, this has made it more difficult to assess the underlying momentum in the market at present.
We expect that both the residential and commercial property markets will reflect the improving health of the broader Irish economy. As such there should be a trend increase in transactions and an easing in property price inflation through the coming year. However, a relatively slow expansion of new supply is likely to restrain the pace of growth in transactions and constrain the slowdown in property price inflation.
Longer Term Outlook
The picture of the Irish economy emerging in the first half of 2015 marks a dramatic change from the vicious cycle of declining activity, job losses, collapsing asset prices and widening Budget deficits that characterised what is still a recent as well as severe downturn. As the graph below suggests, it is somewhat closer to the longer term pattern characterised by large cyclical swings around a comparatively strong trend growth dynamic. It may be worth briefly examining the drivers of this exceptional turnaround in order to assess the relative contribution of transient and persistent factors.
Importantly, the recent improvement in Irish economic conditions is the product of a combination of positive and potentially lasting factors. A substantial and sustained adjustment in domestic costs has emphasised the flexibility of the economy and underpinned exports. Together with a consistent and credible corporate tax strategy, this resulted in the persistence of a strong pipeline of Foreign Direct investment into Ireland. Scale effects and the open nature of the Irish economy (exports amounted to 112% of GDP in 2014) mean exports look set to remain a source of significant momentum in coming years.
The flexibility of the Irish response to the crisis encompassed a sharp adjustment in domestic costs. Since mid‐2008 Irish consumer prices have fallen by 8% relative to the EU average and by 15% relative to the UK while ECB data show an improvement in Irish unit labour costs between their 2008 peak and end 2014 levels of 16% relative to other Euro area members and 19% against the UK.
In part, the recent cost competiveness gains reflect notably greater labour‐shedding in Ireland through the downturn than elsewhere. Even after recent gains, numbers at work in Ireland are still some 10% below their pre‐crisis peak compared to current employment levels in both the Euro area and UK that are both significantly higher than before the crisis. So, there is an argument that the adjustment in Ireland may have overshot, implying scope for some correction to the upside in terms of the pace of jobs growth in coming years.
The sustained strength of exports meant an improving trend in Irish GDP, albeit modest and uneven, began to emerge as early as 2010. However, an enduring upswing requires a healthy and sustainable trend in domestic spending. This seems now to be emerging as a period of substantial fiscal austerity comes to an end, having delivered a notable and on‐going improvement in the public finances. Progress made in this regard and the related prospect of a recovery in household spending power has contributed to a recovery in business and consumer confidence and is thereby supporting recovery in the jobs market.
Amplifying the potential for recovery in the near term is the prospect of an end to the significant net outward migration of recent years. In the year 2007, Ireland saw net inward migration equivalent to 2.5% of the population. By 2012, there was net outward migration of 0.8% of the population. Some modest easing in emigration and a similar rise in immigration in the interim suggests net migration could be close to balance by next year. As Ireland’s ‘natural’ rate (i.e. births less deaths) of population increases at 8.6 is notably larger than any other EU country and markedly different to the EU average of 0.2, demographic forces represent an important source of relatively strong Irish economic growth into the medium term.
We remain of the view that the potential growth rate for the Irish economy lies in the region of 3% but we think growth could average slightly above 3.5% in the next couple of years as improved confidence causes some spending curtailed through the downturn to re‐appear.
Turning to potential sources of risk, a still uncertain global backdrop represents a significant source of downside risk in relation to the Irish economic outlook given the openness of the Irish economy. Domestically, significant geographic variations in the pace of recovery and the health of the housing market could be problematic particularly if these were to prompt ill‐considered policy interventions. More generally, during the next twelve months, the countdown to the general election could cause some uncertainty related to the prospect of at least a measure of ‘auction politics’.
Looking beyond this year, finding a sustainable trajectory or ‘safe speed’ for a recovering Irish economy could also pose some challenges. The run‐up to a general election in an Irish economy still in the shadow of the recent downturn and the related surge in public and private debt is unlikely to provide the ideal backdrop to forge a consensus as to what policy settings might deliver increased stability to the Irish economy and how they could be implemented. Devising such policies represents a key challenge for the Irish economy in coming years.
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.