Ireland: A Promising Outlook After Considerable Pain
26 January 2015
After a period of very sharp losses in output, employment, incomes and asset values, the Irish economy is showing signs of a strong if still uneven recovery. This note examines the intensity of the recent downturn in Ireland and assesses the nature and extent of the recent recovery. It highlights several important characteristics of the Irish economy that make it quite exceptional in the Euro area. These range from comparatively strong demographics and particularly flexible labour markets to the extreme ‘openness’ of the economy and the critical importance of economic links with the US and UK.
The strength of these Irish-specific influences has meant cycles in the Irish economy have rarely matched those in the ‘core’ Euro area economies either in timing or scale. As such, membership of EMU represented a significant shock to the Irish economy. A key channel through which this shock was transmitted was the inflow of capital on a scale that fostered serious imbalances in the Irish economy. In turn, the sharp and speedy exodus of this capital meant the ensuing downturn was similar in many respects to an emerging market currency crisis.
The link between the fortunes of the Irish Government and the domestic banking sector resulted in severe pressure on funding costs at a relatively early stage and prompted a very painful and protracted adjustment process that required the support of an EU/IMF assistance programme. However, the underlying strengths of the economy and continued social cohesion meant that Ireland was able to successfully exit this programme and return to market funding in 2014.
Understandably, Ireland’s strong fiscal adjustment has commanded a great deal of attention but it has been accompanied by a sharp improvement in the economy’s competitive position that reflected similarly painful reductions in domestic costs. This has underpinned exports and thereby supported Irish GDP growth even as domestic demand suffered from the effects of a dramatic squeeze on spending power and a collapse in construction activity. More recently, however, there are signs that economic recovery is broadening as well as strengthening and Ireland seems set to post the fastest growth rate in the Euro area in both 2014 and 2015.
The near term outlook is very encouraging but the Irish economy faces a number of challenges if it to return to a path of sustained strong growth. A legacy of high levels of public and private debt will remain a key issue for some time. So too will finding the right domestic response to the intensity of Irish economic cycles given the likelihood of continuing divergence from conditions in ‘core’ Euro area economies. Finally, maximising the benefits from a flexible economy and a relatively favourable demographic profile while minimising volatility in areas such as property markets will also test domestic policymaking
Ireland’s Downturn Was Relatively Severe And Reflected Several Factors
The upturn now underway in the Irish economy follows a particularly severe downturn. From its end 2007 peak to a trough two years later, Irish GDP fell by 12%, more than twice the decline across the Euro area as a whole. However, this significantly understates the deterioration in Irish economic conditions. Domestic demand fell by 21% in Ireland, four times the Euro area average, and the decline lasted six years only ending in the second half of 2013. As a result, numbers at work dropped by 15% compared to a fall of around 2% across the Euro area.
While the financial crisis that began in 2007 was global in nature, it also had important ‘local’ characteristics that translated into notably different experiences in terms of the length and severity of the downturn in Ireland. The crisis exposed severe fault-lines across the Irish economy that developed in the early years of EMU.
In real time, the picture appeared somewhat different. The enthusiastic approval of most commentators and investors coupled with an exceptionally strong budgetary trend as well as the rude health of most of the main economic metrics meant emerging imbalances did not attract the attention they merited. The July 2006 assessment by the IMF reflected the prevailing view when it ‘’commended Ireland’s continued impressive economic performance, which has been supported by sound policies including prudent fiscal policy, low taxes on labour and business income, and labour market flexibility’’.
With hindsight, a great many mistakes were made in Ireland in the early years of EMU. These covered the spectrum from lax lending by commercial banks through inadequate financial regulation and inappropriate fiscal policy by domestic policymakers to soaring expectations on the part of households and businesses. All played important roles in the severe downturn that was to follow.
So too, did substantial financial inflows prompted by Ireland’s apparent successful adoption of the single currency. In many respects, the experience of the Irish economy through the early years of EMU was closer to that of many of the emerging economies of Asia roughly a decade earlier. Although capital inflows into Ireland could not be described as ‘hot money,’ the speed and scale with which they arrived (and subsequently departed during the crisis) was exceptional. In 2003, overseas funding of the domestic Irish banking sector was equivalent to around two thirds of Irish GDP in that year. By 2008, Irish bank funding from abroad amounted to around two and a half times GDP (by mid-2014 the figure was below 60% of GDP).
Reflecting the new phenomenon of ready access to a seemingly endless supply of cheap credit, private sector borrowing surged. Outstanding mortgage credit increased from €11.9 billion in 1995 to €123 billion in 2007 while private sector lending by domestic banks increased at an average annual rate of 25% between 2003 and 2007. The complexion of Irish economic activity changed significantly through the early years of EMU as domestic demand accelerated. The most notable feature was a reorientation of the economy towards property related activity. Construction surged as a strongly rising population with notably increased incomes and easier access to cheaper borrowing translated into buoyant demand. Taxation incentives boosted this demand notably further and altered its geographic spread by introducing measures designed to encourage activity in poorer and less populated areas.
The most obvious early casualty of the downturn as it occurred was Ireland’s public finances. The General Government Balance which was in surplus in 2007 became a deficit of 7.4% of GDP in 2008 as an excessive reliance on boom related revenue streams became apparent. The speed and scale of this deterioration alarmed financial markets and policymakers in Ireland and at the European level.
Alongside the worsening of the public finances was an even more dramatic decline in the health of Ireland’s banking sector. Again, this owed much to global influences but the intensity of the downturn in Ireland allied to elevated borrowing funded significantly from abroad meant the difficulties they posed for Ireland were particularly acute.
The immediate policy response was a guarantee of all the liabilities of the domestically owned banks and a sharp tightening of fiscal policy. A dramatic worsening in domestic financing conditions and spending power coincided with a dramatic deterioration in global conditions through late 2008 and 2009. The resultant marked weakening of activity and growing market concerns about the solvency of the Irish state allied to broader uncertainty about the single currency itself ultimately led Ireland to enter an EU/IMF assistance programme in November 2010.
The Adjustment Has Been Long And Painful
The crisis led to profound changes in the Irish economy. A fiscal adjustment totalling a cumulative 19% of GDP began in 2009 and is set to achieve a budget deficit of just under 3% of GDP in 2015. Actions taken resulted in lasting changes to the trajectory of taxes and public spending. There have been sharp increases in income taxes and indirect taxes and the introduction of a residential property tax and domestic water charges. These changes should increase the future stability of a tax base whose narrowness and cyclical vulnerability were exposed by the downturn. Similarly, public spending cuts entailed a large drop in capital spending, cuts to public sector pay rates and pensions and reductions in most welfare benefit payments as well as limitations on entitlement. However, successive Irish governments also resisted any possibility of an increase in Ireland’s 12.5% corporation tax rate, thereby emphasizing the continuing importance of foreign direct investment to Ireland.
The healthier trend emerging in domestic spending implies an improved fiscal dynamic through a pick-up in Government revenues and a decline in cyclically related Government spending. The budgetary arithmetic is also notably assisted by the prevailing interest rate environment. The Budget for 2015 envisages modest increases in public spending and incorporates reasonably conservative projections for tax revenues, implying the official forecast of a deficit of 2.7% of GDP for this year does not look unreasonable. In turn, projections envisaging the attainment of a budget balance and an associated primary surplus of around 4% of GDP by 2018 seem attainable if the current momentum in economic growth is sustained.
A comparatively strong Irish growth trajectory and benign interest rate environment, allied to lasting improvements in the public finances from the adjustment programme of recent years have the potential to notably reduce Ireland’s debt to GDP ratio in coming years. In addition, the divestment of the State’s stakes in Irish banks and some reduction in scale of NTMA cash balances and could also have a material impact. This implies Ireland’s Government debt ratio can be reduced below the EU average within a reasonable timeframe.
The Turnaround In Banking Is Lengthy
Restoring the domestic banking sector in Ireland has been a difficult and protracted process. The primacy given in domestic policy-making to the fiscal adjustment and various other factors that weighed on domestic activity and asset values meant that loan problems lagged the economic cycle. In view of the scale of the problems in the sector and the degree of uncertainty about the outlook for the broader Irish economy, it proved extremely difficult to arrive at reliable estimates of likely loan losses. However, a transparent and prudent recapitalisation process together with a gradual turn in Irish economic conditions has contributed to a notable improvement in sentiment in this regard of late.
Progress in ‘rightsizing’ domestic banking in Ireland-to the needs of an economy that is most unlikely to be credit driven in coming years- is still some way from complete. However, measures to deal with ‘legacy’ lending problems are progressing and this process is benefitting from the improvement in the Irish economy in general and the property market in particular. From a market perspective, the risk of major adverse shocks from loan losses is regarded as notably diminished in these circumstances.
With the financial position of the banking sector further clarified by the recent Asset Quality Review and supported by improving access to market funding, lending capacity is increasing. This is being accompanied by some pick-up in loan demand. New lending may fall short of maturing loans for a time implying outstanding credit will continue to fall. This should be regarded as marking a transition to a less credit driven Irish economy. However, as long as new lending moves in an incrementally positive direction, this will be supportive of stronger economic activity.
Irish Upturn Now Strengthening And Broadening
Since late 2012, evidence of a clear if uneven improvement in Irish economic conditions has gradually emerged with most data through the past year suggesting activity is now set on a comparatively strong trajectory. Statistical considerations mean the measured GDP growth rate for 2014 which we see close to 5% likely overstates the true pace of improvement in the Irish economy at present. We think the underlying growth rate for 2014 is probably around 3% and we expect GDP growth of around 3.5 %in 2015.
The strengthening turnaround reflects a range of influences that relate to profound changes both in terms of the improvement in the competitive position of the Irish economy and the progress made in relation to the public finances and the banking sector. Initially, the recovery was concentrated on exports as domestic activity was hit by the fiscal adjustment and private debt deleveraging. So, in classic open economy terms, the upswing in Ireland was led by production rather than spending. However, as employment improved and the scale of adjustment eased, domestic spending has begun to turn. As a result, both exports and domestic demand are now contributing positively to growth in output, incomes and numbers at work.
The emergence of a more balanced recovery is important in several respects. In an economic sense, it augurs favourably for the sustainability of the upturn. It also improves the dynamics of the fiscal position. Finally, given that a general election must be held by spring 2016 and a significant element of ‘austerity fatigue’ has become evident of late, it is important, politically, that domestic spending is set on a healthier trajectory.
The Irish economy is also producing consistently large balance of payments current account surpluses. The prospective surplus in 2014 is likely to be around 6% of GDP. While the extreme openness of the Irish economy –the sum of exports and imports in 2013 was 190% of GDP, and the scale of multinational operations caution against over-interpreting the precise magnitudes involved, nonetheless these data suggest the Irish economy is now delivering strong growth and significant levels of national savings.
Domestic Activity Boosted By Employment Growth
The emerging turn in domestic economic activity has been led by a marked improvement in employment. Diagram 1 provides a good illustration of the dramatic changes in the jobs market in Ireland in recent years. The sharp and rapid deterioration in employment through 2008 and 2009 was followed by a lengthy ‘bottoming-out’ process through 2010 to 2012. A progressive improvement has emerged in the interim as a turnaround in the economy began to build. More recent labour market data confirm that recovery has now become firmly established.
Numbers at work have now grown for seven quarters in a row and survey indicators suggest new hiring may be strengthening further of late. Although numbers at work in the public sector have declined, job creation in the private sector is running at around 2.5% pace. We now see economy-wide employment growth of slightly less than 2% in 2014 and expect a slightly faster increase in 2015. Increasingly, sustained growth in employment in the Irish economy (rather than outward migration) is the predominant driver of a fall in unemployment. Joblessness should ease further through coming years. Indeed, on the current trajectory, the unemployment rate could drop below 10% during 2015.
Competitiveness Gains Have Been Substantial
A key feature of the global economic environment at present is exceptionally low goods and services inflation across the developed world. This means businesses have little pricing power that would allow them pass on significant increase in their costs. For a variety of reasons, many of which relate to the scale and nature of the multinational sector, it is difficult to measure precisely how the cost structure of the Irish economy as a whole is evolving. However, most indicators show a common trend. For example, ECB data on unit labour costs suggest an improvement in Ireland’s position vis-à-vis its Euro area partners of about 18% since 2008. Similarly, diagram 3 shows that Irish consumer prices are currently below 2008 levels. Across the Euro area as a whole, consumer prices are around 9% higher than six years ago while in the UK they are around 18% higher. These indicators hint at a material improvement in Irish competitiveness trends of late that is consistent with a strong pipeline of foreign direct investment and new job announcements.
We see Irish inflation declining from a +0.4% rate last year to a marginally negative rate in 2015 reflecting the sharp drop in oil prices through the latter stages of 2014 that has carried into the start of this year. A substantial output gap and the continuing influence of the forces that boosted Irish competitiveness since 2008 mean domestic cost increases will remain limited. Consequently, there seems little likelihood of a broadly-based surge in Irish wages although divergent trends are becoming evident across sectors reflecting in part industry- specific imbalances. With wage gains set to be relatively modest in aggregate, the prospective improvement in spending power in 2015 is unlikely to be spectacular.
Domestic Income And Spending Only Now Improving
The flip side of a substantial adjustment in Irish costs through recent years has been significant pressure on living standards for most Irish consumers. However, a notably more important influence on household incomes has been a fiscal adjustment since late 2008 that delivered a cumulative €30billion of adjustment measures (equivalent to 19% of GDP). This had a profound negative impact on domestic economic activity, incomes and employment during this period.
Although fiscal support to household incomes is set to be fairly limited in 2015, the coming year will nonetheless mark a major turning point. Budget 2015 is expected to inject spending power equivalent to about €1billion or 0.6% of GDP into the Irish economy. The end of an extended period of austerity will not prompt a rapid return to boom conditions. As controversy over the introduction of domestic water charges illustrates, there has been significant ‘scarring’ both in terms of enduring pressures on household spending power and in terms of trust in institutions. However, financially and psychologically, the end of the austerity programme of the past six years should support a notably more positive trend in domestic economic activity and incomes in the coming year.
The onset of a period of even modestly rising incomes should encourage a gradual strengthening in domestic spending. As recovery progresses, pent-up demand for consumer durables and an easing in precautionary saving should help sustain growth in Irish household spending. The comparatively young age profile of the population will support a propensity to spend. However, a desire to reduce debt levels allied to the painful experience of the recent crisis will act as significant restraining influences. While a significant rebound in household spending is in prospect, this is unlikely to become a generalised consumer boom.
Property Market Trends Reflect Dearth Of Supply As Well As Return Of Demand
Alongside the improvement in the jobs market, the clearest indication of healthier conditions in the broader Irish economy of late is the pick-up in property market activity both in terms of prices and transactions.
Commercial property values have been supported by strong overseas interest and a significant shortfall of prime properties reflecting a strong pipeline of foreign direct investment into Ireland and a dearth of new building. With activity now strengthening and broadening, a further pick-up in prices as well as transaction and construction activity is envisaged. However, sectoral and regional differences seem set to remain important features of the Irish commercial property market.
Positive momentum in residential property prices and transactions clearly reflects confidence in the broader economy. As such, the current buoyancy owes much to pent-up demand underpinned by solid demographics. In addition, the scale of price declines through the downturn has assisted affordability and other valuation metrics. With little new construction in recent years, relevant supply in key market segments is quite limited at present and probably for some time to come. So, as often happens in Irish property markets, a range of factors are pointing in one direction.
This ‘snap-back’ in the Irish residential property market is leading to an exceptional pace of increase in both purchase prices and rents. There has also been a marked increase in transactions of late. We estimate that Irish housing prices will increase by almost 13% in 2014 and transactions by about a third. Clearly, this pace of growth is unsustainable but, equally, current levels of activity and prices lie below what might be regarded as equilibrium levels.
We would expect positive momentum in property prices and transactions to continue in 2015. However, the ending of some exemptions from capital gains taxes and proposed caps to loan-to-value and loan-to-income ratios for new lending are likely to have some dampening effect. With the specific limits to lending ratios only set to be announced in early 2015, the precise impact of the proposed macro-prudential measures is unclear at this point.
Strong Growth Potential Emphasises Particular Policy Issues For Ireland
In the pre-crisis years of 2003-2007 rapid Irish growth was primarily driven by expansionary policy settings, immigration and an associated debt-fuelled housing boom that proved to be unsustainable. The legacy of the crisis will act as a constraining influence on growth through its implications for fiscal policy, credit growth and risk appetite. However, competitiveness has been improved, foreign direct investment is healthy and demographics remain comparatively favourable. In addition, the flexibility of the economy and social cohesion appear to be largely intact in spite of the intensity of the downturn. These factors should support recovery and help address what remains a very high level of private debt.
We see Ireland’s potential growth rate lying close to 3% and expect growth to run above this rate-at around 3.5%, for the next two or three years This is notably less than the average annual GDP growth rate recorded between 1987 and 2007 (5.9%), but still substantially higher than most other European economies and roughly twice the prospective growth rate of the Euro area as a whole. This reflects both the prospect of relatively strong productivity growth related to the Irish economy’s role as a hub for international investment and exceptionally favourable demographics that see Ireland with the highest birth rate and lowest death rate in the EU.
In such circumstances the key policy tasks centre on how to put the economy on a path of steady and sustainable growth that is compatible with conditions in its key economic partners. History suggests the Irish economy has an enormous capacity for economic growth. However, it appears to lack a natural tendency for modest and relatively painless corrections to occur as imbalances emerge. This suggests an urgent need to focus on the ways in which the levers available to domestic policymakers can be used to limit the extent to which the Irish economy strays from a steady path. The diverse characteristics of fiscal policy, social partnership, competition policy and macro-prudential regulation suggest significant scope for worthwhile interventions but they also require a clear understanding of the various effects such interventions might have.
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.