18/10/2014: Irish Economy: The State of Recovery

Yesterday I had a chance to speak about the state of the Irish economy at a breakfast briefing hosted by Invesco. Here are my speaking notes (slightly edited).

Where Ireland is today?

1. There is a recovery
2. The recovery is still fragile & highly uneven
3. Risks to the downside of the recovery continue to weigh heavily: external (international risks) and internal (domestic and structural risks)

There are three ‘Irelands’ today co-sharing this economy.

Ireland of ‘haves’ 

• Demographically old       
• Benefited from asset bubble of the 2000s
• Debt-free and secure in income
• This Ireland is growing in numbers, but not in terms of value added in the economy: 52,200 more in retirement today than in H1 2011 (+17.9% on H1 2011)
• This generation no longer saves to invest and is consuming lower value-added goods and services, which are lower in growth intensity

Ireland of ‘hopes’

• Demographically young (20-29 years of age)
• Unencumbered by debt, but assets and credit-poor
• Income is low, generating little surplus savings to invest, but
• Generating economic growth and value added, as well as strong consumption in entertainment and non-durable consumables
• Held back by ageing workforce at the top of career ladders and by lack of jobs in the 'normal' (ex-ICT and specialist skills) economy
• Emigrating for better career opportunities: population of this cohort in Ireland has declined 112,200 since 2011.

Ireland of ‘left-outs’

• Encumbered by legacy debt, 
• Unemployed or in low jobs security and 
• Hit by high taxes and cost of living
• Hit by pensions insecurity and investments values collapse
• Demographically in their prime productive age: 35-49 years
• This cohort is growing over time even if immediate arrears on mortgages are declining

What do we see on the ground in this economy? 

Growth:

• GDP at constant factor cost is up 5.37% y/y in H 2014, but only 3.72% on H1 2011.
• Due to a number of factors impacting changes in the ways that MNCs book profits into and out of Ireland, GNP rose 6% y/y in H1 2014 and is up 8.2% on H1 2011. Again, very strong.
• Taxes in the economy are up 11.5% on H1 2011 and 8.1% on H1 2013. The Governments took EUR11.7 billion in income-related taxes increases since Budget 2009.
• Much of recorded growth in 2014 is coming from the sources that have little tangible connection to reality: reclassifications of R&D activities, MNCs, etc.

Year on year, growth is concentrated in:

• Agriculture (at 11.9% y/y or 2.2 times the rate of overall growth). Large part of this is down to price effects;
• Distribution, Transport, Communications and Software (+10.9% y/y or double the rate of growth overall);
• Building and Construction (+8.3% y/y growth or 1.5 times rate of overall expansion); much of this is down to timing of tax incentives, as well as changes in regulations;
• Public Administration & Defense (+3.7% y/y) as we are witnessing massive shift toward charging for public services and paying interest on debt. In 2015, Interest on Government debt will amount to EUR8.5 billion, more than 1.8 times greater than the projected Corporation Tax take.
• ‘Other Services, including Rent’ (+3.3% y/y)

Much weaker growth was recorded in

• Industry overall (+0.6% y/y) and especially in Transportable Goods Industries and Utilities (+0.16% y/y)

In terms of demand side of the economy:

• Fabled return of consumers is quite overhyped for now: Personal Consumption is up only 1.2% y/y in H1 2014 and is still down 2.7% on H1 2011. Value of core retail sales rose only 0.28% in 3mo through August 2014 compared to 3mo through May 2014. Volume rose 0.29%. This is hardly a ‘boom’.
• Meanwhile, net current expenditure by the Government is up 5.2% y/y in H1 2014 and is basically flat (-0.2%) on H1 2011. Austerity on the spending side of Government has been a transfer of payments from services to national debt funding.
• Gross Fixed Capital Formation is up massive 11.3% y/y in H1 2014 and is up 2.3% on H1 2011, but most of the uplift is down to resale of properties. This also includes buying activities by the vulture funds. 

External Trade is booming – despite tough external economic conditions:

• Exports of goods were up 13.2% y/y in H1 2014 and are up 9.6% on H1 2011
• Exports of services up 7.1% y/y in H1 2014 and 24.6% on H1 2011
• Problem is: national accounts data is now in a total disconnect from the actual trade data. In the past, average discrepancy was around EUR1 billion per quarter. Now we are witnessing National Accounts exceeding trade data statistics by 7 billion. So quality of data is starting to look wobbly.
• Strong support for our exports is provided by our traditional exposure to the US and UK markets. But we are also seeing encouragingly strong performance in some new markets, e.g. Russia and China, again against the general trend toward slower demand in these economies.

What we do know about the domestic economy is still quite troubling:

1. Debt: 165,674 accounts in arrears in Q2 2014 – EUR33.6 billion in balances. Restructured: 125,763 accounts of which 48,862 are still in arrears. Total mortgages at risk of arrears or in default: 256,146 with balances of EUR46.06 billion. Over 50% of all ‘permanently restructured’ mortgages involve same or higher levels of life-cycle debt. 39% of all ‘permanently restructured’ mortgages are back in arrears, absent any significant shocks to interest rates, inflation or incomes.
2. Income: In real (inflation-adjusted) terms, Irish GDP per capita in 2014 is expected to be 11.9% lower than pre-crisis peak. This is the third worst performance in the Euro Area (after Cyprus and Greece). Lack of income uplift means that households’ deposits are trending slightly down in recent months. Labour force participation rate fell in Q2 2014 and at 60% is below the historical average of 60.8%. Which suggests that a large part of declines in unemployment is accounted for by people simply dropping out of the labour force.
3. Tax system: In 2006, Income tax and levies accounted for 27.2% of our total tax burden, while Corporation Tax accounted for 14.7%. This year, Income Tax + Levies will account for 41.9% and Corporation Tax for 11%. In 2015, based on Budget 2015 estimates, Income Tax burden of funding the state will be 42.5% and Corporation Tax burden will be 10.8%. In simple terms, at the peak of the 1980s crisis, Income Tax and Levies burden was 41.8% average for 1984-1989 period. Budget 2015-costed income tax and USC changes total EUR478 million in ‘stimulus’ to the economy. Yet, Budget 2015 for HSE includes EUR330 million of undefined “one-off revenue enhancements” (aka tax on services) and Irish Water is expected to extract EUR175-190 million out of economy net  of tax credits. Which implies that Budget 2015 will still draw money out households.
4. Entrepreneurship and investment: There is no significant growth in entrepreneurship, despite the claims of rising number of companies registrations. In reality, companies registrations numbers tell us little about entrepreneurship as we do not know if these are new enterprises or old ones that were forced to shut down by the crisis re-registering once again. We do not know how many of the new companies are being registered by spinning off existent companies functions to avail of 3-year tax exemption. In a number of sectors, there are now multiple enterprises trading from the same business platform. What we do know, however, is that Budget 2015 contained virtually zero cost-linked measures for business development or entrepreneurship supports. 3 year relief for start-up companies is costed in the Budget at EUR2 million for the Full Year, which, applying 12.5% tax rate implies profit run rate of EUR16 million or revenues / turnover of around EUR64-80 million for start ups launched 2013-2015. This is ridiculously low for an allegedly thriving ‘Entrepreneurial Culture’. Meanwhile, on supports side, Budget 2015 contained 11 measures to support agriculture, with largest measures aimed at supporting incomes from leases on unproductive land ownership. Worse, the starting point for much of entrepreneurship is self-employment. Budget 2015 literally pushed higher earning self-employed (those with higher investments in human capital, skills, knowledge, etc) over the cliff with new USC changes. The Government policy is now to actively pursue, hunt down and kill off anyone who is standing on their own, takes risks and creates own value added.
5. Innovation and R&D: Just three MNCs operating from Ireland account for 70% of all R&D activity here measured by patent filings: Accenture – 31%, Covidien – 24% and Seagate – 15%. In more recent data, foreign companies filings in Ireland have continued to outstrip Irish companies filings by a factor of 3:1. Ireland operates a large number of public intervention and support schemes to increase R&D and Innovation share of our economy. Yet there is not a single, coherent, comprehensive data reporting channel on what these schemes achieve on the ground. It appears that in this country, more knowledge and innovation is a pursuit best managed in the fog of obscured accountability.

On the net, the state of play in the Irish economy is that of a gentle uplift in the domestic economy with risks weighted to the downside.

• This is a fragile (due to risks) recovery on the ground, despite the fact that aggregate numbers are trumpeting the rise of the Celtic Phoenix. For now, there’s a lot of smoke, some strong wings flapping, but not a hell of a lot of flying, yet.
• Global risks are weighting growth prospects to the downside too, but Ireland is clearly benefiting from three idiosyncratic sources of strength:

1. We are benefitting from stronger demand in the US and the UK; and
2. Our indigenous exports, small as they might be, are performing well – a testament to longer-term relationships built by Irish exporters around the world.
3. Finally, the sheer scale of collapse in the economy during the crisis means we should expect a more robust bounce up. 

We can expect:

• Robust aggregate growth figures in 2014 (ca 4.1% on GDP side and 4.7% on GDP side or higher, depending on what and how is going to be booked into Ireland by the MNCs) and weaker, but still substantial growth of 3.0-3.6% on GNP side and 3.5-3.9% on GDP side in 2015.
• Slower growth is expected to result in continued weakening in employment growth: in 2011 we posted 2.3% growth, in 2014 we are likely to post 1.8% growth and in 2015 – closer to 1.5-1.6%. The risk here is to the downside.
• Consumption growth is probably going to be around 2-2.5% in 2015 after 1.5-1.7% rise in 2014.
• Investment will slowdown from 2014 estimated growth of 14.5-15% to 10-12% in 2015. Again, risk here is to the downside, should Budget 2015 changes on property side induce early purchases rush in the remaining months of 2014. Big unknown for 2015 is the rate of foreclosures on arrears-ridden properties. This can derail the recovery altogether and significantly depress sentiment in the economy. 

All in, 2015 is expected to be another year of recovery, amidst risky trading environments.  And 2015 recovery is going to be a bit more balanced.

The key risks, however, are now being shifted to 2016 – the year of more aggressive tapering by the Fed and the expected start of the monetary tightening cycle in the euro area.  Before then, accommodative policies by the ECB will keep rolling in, although their effects on growth will be most felt probably in H1 2015.

Still, for now at least, the theme of ‘fighting for survival’ that characterised the Irish economy in 2008-2013 is over and we have some hopes that the new theme of ‘fighting for growth’ is commencing.