"Irish Eyes Are Smiling" But Should They Be?

Submitted by Dr. Constantin Gurdgiev via True Economics blog,

Ireland has been basking in the spot of an unusual sunshine this October. The cold spell, that normally takes the island over at the end of the month and into early November, coating it in a wet blanket of wind-swept and never ending rains was nowhere to be seen, replaced by the strangely regular appearances of the sun, blue skies and sight of the still leafy, colour-turned trees.
Similarly, the markets have been kind to Ireland too. There is not a day going by without a praise for the country reforms or recovery or both from some European leader or a Wall Street analyst or a hired gun from the 'official' sectors of the Irish state gracing international newspapers and media screens. CDS are down, estimated probabilities of default are down, bond yields are down. Sales of new bonds are up. Foreign direct investment figures are up. Jobs announcements are up. And forecasts… well, forecasts just keep on climbing.
In the latest round, the European Commission weighed in with its prediction that Ireland will outgrow its euro area peers by some 3-fold in 2014 and 2015.
Truth is, all of this is largely nonsense. Ireland is a small open economy with trade and investment exposures to the Euro area, the US and the UK. In almost even shares.
This means three things, relating to the Irish economy forecasts. 

Firstly, Ireland benefits from the accommodative monetary policy in the Euro area (making its gargantuan public and private debts overhang more manageable, for now, and its exports cheaper).


Secondly, due to the geographic distribution of its trade and investment links, Ireland is also benefitting from the faster growth in demand in the UK and the US.


Both points translate into more robust exports performance for Ireland than for its European peers. But both also mean that most of Ireland's trade in goods and services is nothing more than transfer pricing and tax optimisation-driven shifting of digits across the borders. Yes, the multinational companies provide some employment - roughly 10 percent of the country total. But beyond that, they deliver little. The hiring they are doing is increasingly about bringing people with skills from abroad rather than taking people for training from within. And while in January-October 2013 corporation taxes accounted for just 9.46% of total tax revenues collected in Ireland, over the same period this year, the number is 9.24%.


So whilst the external trade tends to boost Ireland's GDP, the fact that over 3/4 of the country exports are accounted for by the multinationals, making Ireland's GDP / GNP gap the largest of all advanced economies. That's "growth in and profits out" model of an economy run on FDI.


Which brings us to the third point about Ireland's growth outlook: it is highly unpredictable. Whilst exports are volatile because they are dominated by the considerations of tax optimisation rather than actual production, the domestic economy is desperately searching for a growth catalyst, and to-date, finding none strong enough.


In H1 2014 the GDP / GNP gap was actually slightly lowered. But not by a pick up in the domestic activity. The reclassifications of R&D spending as investment in ESA 2010 standards adopted by Ireland ahead of all other countries in the euro area generated a significant uplift in GNP. Overnight, Irish 'investment' side of the National Accounts boomed by almost EUR10 billion (in full year 2013 terms). And surprisingly high retention of profits by the Multinationals in Ireland (most likely prompted by the sluggish capex spending in the stagnating global economy) further helped to temporarily and superficially boost the GNP.

Meanwhile, in the real Irish economy, the country remains the second worst hit by the crisis in the euro area. As shown below, Ireland's real GDP in per capita terms is down off the 2007 peaks and all the miracles of the recovery are unlikely to get it anywhere near the euro area averages any time soon.


Of course, the real long-run question for Ireland is whether the current rates of growth observed in 2014 to-date (closer to 5% per annum) are sustainable in the medium term.
The answer rests with the potential growth rates in the two sectors that make up Ireland's bipolar economy:

1) Domestic demand: Domestic demand is starting to show some signs of revival, exactly in the areas where one would expect these signs to materialise at this early stage of the recovery: first domestic investment, then domestic consumption.


Domestic spending is rising (at 1-2% per annum rate) on both household consumption and public spending uplifts. We can expect this trend to continue, without significant acceleration until H1 2016, as domestic spending is being held back by slow growth in wages and continued high rates of tax extraction from personal incomes.


Domestic investment has been a beneficiary (at the aggregate level) of institutional investors and some domestic cash buyers flooding into the distressed property markets since H2 2012. Accounting gimmickry of ESA 2010 standards is boosting this side of the National Accounts too. The property markets cash-buying spree is now tapering off, and is being partially replaced by the banks starting to issue new mortgages. I suspect this trend will lose more momentum over H1 2015. Aside from this, there is no uplift in domestic investment. Corporate investment is weak, stripping out foreign companies tax inversions. Demand for capital goods is weak. Which underpins the nature of jobs creation claims presented by the Government. Official figures for new jobs created include adjustments made to the labour force surveys in the wake of the last Census, resulting in a massive uplift in the numbers declaring themselves as being employed as farmers back in 2013. Stripping these adjustments out, instead of ca 70,000 new jobs 'created' claimed by the Government, real private sector non-farm payrolls are up roughly 27,000 on 2011 levels. No wonder capital investment is running weak. Meanwhile, labour force participation rate is falling due to exits from the workforce, early retirements, and emigration.


2) External demand picture is more complex. Rates of growth in exports of services - the factor that drove up Irish current account surpluses in 2010-2013 - are slowing down as Ireland exhausts large FDI sources in the ICT and Financial services sectors, and as negative reputation of Ireland's tax optimisation policies sets in. In the short run, however, we can see an acceleration in FDI inflows as some of the MNCs rush in to lock into Irish 'domicile' before it becomes obsolete. Volatility of exports growth figures will be high in 2015-2016. But in the longer run, we can expect a downward trend in the rates of growth in exports and a pick up in the rates of growth in imports, assuming domestic demand picks up. On manufacturing side, things have been improving due to weakening of the euro. However, there are few new catalysts for growth in the sector at this point in time. Over the longer time horizon there are adverse potential headwinds coming up as patent-cliff-hit pharma companies are gradually starting to bypass Ireland in locating new activities.

In brief, there is little clarity on the future potential growth dynamics. Key ingredients for sustained optimism that are lacking include actual structural reforms (virtually none have been implemented to date and even fewer have been properly planned and resourced) and clear catalysts for growth (there are no broadly-based sectoral drivers for growth other than "things are so bad, they can only get better" argument for domestic demand and "we have lots of FDI" argument for externally trading sectors).
One last caveat - we are already witnessing the process of unwinding of reforms that aimed to deliver moderate savings in public spending. The Government is aggressively trading down any expectations that savings in public expenditure secured in 2009-2013 will continue into the future, beyond 2015. Political cycle does not favour continuation of the past reforms as deeply unpopular and internally torn governing coalition is facing general elections before April 2016.
As Europe gets hungrier and hungrier for a feel-good story, as Brussels longs more and more for a poster child for its 'crisis management' efforts of 2008-2013, as Dublin politicians get closer and closer to facing the crisis-hit electorate, the sunshine being lavished by politicians and the media onto Ireland's economy is likely to get only brighter. It might not feel much warmer, though, on the ground. Nor will it stave off the onset of winter.