Thursday, January 15, 2015

15/1/2015: 2015 Outlook for Ireland: Domestic Bliss & Foreign Squeeze

This is an unedited version of my article for the Village Magazine, January 2015 (link here)

December data on Irish economy is painting a picture of a major slowdown in growth momentum and once more highlights the troubling nature of our national accounts statistics. With that in mind, and given the spectacular tremors rocking the global economy outside the well-insulated doors of our Department of Finance, Irish economy is set for an eventful 2015.

Let’s take stock of the prospects awaiting our small haven for tax-optimising MNCs and regulations-minimising foreign investors in the New Year.

Domestic Bliss

On domestic front, three drivers of economic recovery are offering some fireworks over the next 12 months. Here they are, in order of their importance.

The ongoing shift in MNCs activities here from profit-booking to cost-based transfer pricing, colloquially known as ‘contract manufacturing’. In simple terms, this means unprofitable low margin activities are outsourced by MNCs to their subdivisions and other MNCs located abroad, and resulting revenues are booked into Ireland. Official GDP rises here, while our domestic economy stands still. In H1 2014 this game of accounting shells has accounted for 2.5 percent of the 5.8 percent recorded growth in Irish GDP. In other words, some 43 percent of the growth ‘miracle’ that is Ireland Inc. was bogus. We don’t have detailed analysis of Q3 2014 data to determine the broader impact of ‘contract manufacturing’ yet, but the National Accounts data is not encouraging. The gap between the National Accounts-reported exports of goods and the same exports reported in our Trade Statistics is growing once again. Over Q2 and Q3 2014, this stood at a whooping EUR7 billion more than what a historical average implies. That is, roughly, 7.65 percent of our entire GDP over the same period. If we correct National Accounts data for this discrepancy, cumulative Q2-Q3 2014 GDP in Ireland would have posted a 0.4 percent decline year-on-year, not a rise of 5.4 percent recorded in the official statistics.

As the trend accelerates in 2015, Irish economy is likely to post greater paper gains and lower real activity amidst continuously deteriorating quality of our economic data.

The second driver to the upside is also MNCs-focused. Budget 2015 introduced massive incentives for the MNCs to book into Ireland intellectual property. Instead of the notorious Double Irish we now have an even more generous Knowledge Development Box. This reinforces already absurd change to the National Accounts estimation practices that re-labels R&D spending into R&D investment. The combined effect of both factors is likely to be more R&D ‘imports’ into Ireland. Latest data shows that overseas-originating patents filled in Ireland rose 22.4 percent year on year in Q3 2014. And that is before the ‘Knowledge Development Box’ opened its welcoming lid. As 2015 rolls on, expect more GDP supports from the new ‘investment’ products to hit the market here. Just don’t count on new jobs and higher domestic incomes to materialise out of this ‘smart economy’ any time soon.

The third force likely to propel Irish growth to new highs is the ongoing squeeze on building and construction sector imposed by a combination of a credit crunch, Nama assets-disposal strategy and woefully poor regulatory reforms that de facto cut down supply of buildable land and redevelopment sites, funding for development and dried out planning applications pipeline. The result is rising rents (GDP-additive) and prices (so-called ‘investment’ side of the national accounts) amidst deepening misery of rising business costs and escalating cost of living. Added up, Irish property sector ‘revival’ is now yet another force that simultaneously transfers money from the households and firms into the pockets of rent-seekers and the Government, whilst gilding with fools gold national accounts.

Foreign Squeeze

The domestic bliss of GDP growth described above will be severely challenged in 2015 by the continued deterioration in the global economic conditions. Here we have some serious flash points of risks, trailing back from 2013-2014 and some new ones that are likely to emerge in 2015 on their own right.

Back at the beginning of 2014, expectations for global growth recovery in 2015 were driven by rosy forecasts for North America and the Emerging Markets.

Euro area was expected to post rather sluggish, but nonetheless above 1 percent recovery in 2014 and rise to close to 2 percent annual growth rate in 2015. Fast forward to today. Latest forecasts suggest near-zero growth in 2014 followed by ca 1 percent growth in 2015. So Europe’s prospects are bleak. That’s roughly 35 percent of our indigenous exports trade in the bin. But at least low growth is likely to delay the inevitable rise in interest rates, giving our heavily indebted households another stay on execution.

The U.S. miracle of economic recovery is heavily dependent on interest rates policy not reverting back to rising rates and in all likelihood, the U.S. Fed might just oblige. Should the Fed change its mind, all bets are off: we might see a slowdown in the U.S. recovery and with it – a fall-off in the U.S. demand for Irish exports, both indigenous ones and MNCs’.

The UK is a great example of the fragility also present in the U.S. economy. Like the U.S., the UK is heavily dependent on supportive monetary policy. And, ahead of the U.S., its economy is starting to hit serious bumps. Latest data shows continued declines in house prices, while demand is stagnating and inflation is slipping to long-term lows. Last time we saw UK inflation at current levels was in 2002 – amidst the bubble-induced recession.

Take U.S. and UK markets and we have over 50 percent of demand for Irish indigenous exports put under rising risk.

Which leaves us with the rest of the world. Here, the Emerging Markets are tanking, fast. Brazil is in an outright recession. Russia is slipping into one at a speed of a rock falling through the foggy ravine. China is on the brink of a major de-acceleration in growth, and that is under rather rosy predictions. India is enjoying some warm afterglow of expansionary monetary policies, but the question is – for how long. South Africa is moving sideways: a quarter of contraction is followed by a quarter of anemic growth.

Irish Government Budget 2015 projections were based on following assumptions:
-       Irish GDP growth of 3.9 percent or 0.85 percentage points above the IMF forecast from October and 0.6 percentage points below November forecasts by the OECD
-       Euro area growth of 1.1 percent or bang on with IMF and OECD forecasts, as well as the EU Commission, but the risks are still to the downside in all of these forecast.
-       U.S. growth of 3.1 percent, virtually identical to the IMF forecast and current consensus amongst the economists, but some business surveys suggest growth closer to 2.4-2.5 percent.
-       UK growth of 2.8 percent or 0.1 percentage points above the IMF forecast from October and OECD forecast from November. More recent forecasts published in early December suggest UK economy might expand by 2.4-2.6 percent in 2015.

Global headwinds are not favourable to Ireland, although we do have some aces in our sleeve. These aces are: aggressive tax optimisation and already suppressed domestic demand, the two drivers that might, just might return that 3.9 percent expansion in 2015.

Still, for now, the forecasts arithmetic suggests that the Government really did miss a major opportunity in Budget 2015. You see, the pesky problem is, as the Irish Fiscal Advisory Council estimates show, Irish growth at 3.5 percent in 2015 will mean the Government missing on the illusive 3 percent deficit target. As the above forecasts slip back over time, the 3.9 percent growth assumption is likely to be revised closer and closer to that critical point at which the Government risks losing face in front of the proverbial International Markets. And that won’t go too well in the Government buildings.

Add to the above some other silly assumptions made in the Budget, such as static current expenditure for 2015-2018 horizon and zero policy change, and you get the idea. Over recent months, the Government has revised its spending plans in relation to Irish Water by some EUR300 million. And over the next 12 months it will have to revise its agreements with the Trade Unions on public sector costs moderation. Then, there is the political cycle that simply commands that the Government unleash a torrent of budgetary giveaways onto electorate itching to send the FG/Labour coalition into the proverbial recycling bin of history.

All told, the real economy is likely to continue underperforming into 2015, just as it did in 2014. In the first 3 quarters of this year, total domestic demand (a sum of private and public consumption and investment, plus changes in the stocks of goods and services in the economy) was up just 2.18 percent year on year in real terms. Over the last three years, covered by the current Government policies, total domestic economic activity has expanded by a miserly 0.29 percent in real terms. That is less than half the rate of growth in GDP over the same period. And the latest quarter has been even less impressive, with domestic demand falling 0.3 percent year on year, same as in Q3 2013.

So tighten those belts for one more year of pain: the slimming down of Irish economy is not over yet.


Anonymous said...

How much more does Ireland contribute to EU budget as a result of inflated GDP figures?
There is a connection between the two, isn't there?

TrueEconomics said...

Yes. ESRI did a paper on that