20 November 2017
I returned recently from Kilkenny, Ireland where I attended Kilkenomics – an engaging mix of global finance and comedy sponsored by the FT and hosted by the irrepressible David MacWilliams. I often found myself thinking only the Irish could pull off this unlikely mix, but then I look at Twitter, and am reminded we receive a daily dose from the President Trump!
Ten years after the onset of the Global Financial Crisis, which morphed into the European Sovereign Debt Crisis, this was a perfect occasion to evaluate Ireland’s post-bubble adjustment, and how they have fared compared to the other PIIGS: Portugal, Italy, Spain, and Greece.
As my Irish drinking buddy told me at the onset of the Crisis, the Irish know how to have a party, but are aware that overindulgence leads to hangovers. They may grumble, but they take their medicine, recover, and look for a better future. This apt metaphor describes well Ireland’s recent experience. Following the deep post-bubble recession, the nation’s willingness to implement painful remedies early on has set Ireland apart from Europe’s other crisis countries. To be sure, the job is not done, and challenges remain: both legacies of the past and new ones too. However, while the “Celtic Tiger” has been tamed, Ireland should no longer be considered one of the PIIGS, as the nation has distanced itself from the others tagged with this unfortunate moniker.
External Adjustment: Competitiveness Restored
Ireland’s willingness to implement painful adjustments early in the crisis produced a more severe recession in the early stages. Chart 1, however, illustrates that as a result of the recent upturn, Irish GDP now not only exceeds pre-recession levels and other PIIGS, but has now even caught up with Germany. On the other hand, Spain’s economy has only recovered to pre-crisis levels this year and output in both Portugal and Italy remains well below pre-recession levels. While the Greek economy has fortunately hit bottom finally after a 25% depression, there are few indications of a sustained rebound yet.
One off the key reasons for Ireland’s recovery (and outperformance) has been its success in restoring competiveness. Following the Euro’s introduction, Europe’s one-size-fits-all monetary policy set interest rates well below those required in Ireland (and elsewhere). And, as long as the ECB kept the punch bowl out, Ireland overindulged. Chart 2 illustrates that wage and price inflation led to a dramatic 43% loss of competiveness prior to 2008. Indeed, the appreciation in Ireland’s real exchange rate exceeded that in all other crisis nations. And, while the double-digit current account deficits in Spain, Greece, and Portugal where even larger (10-15% of GDP), Ireland’s CAD ballooned to nearly 7% of GDP from near balance (see Table 1).
Without the option of currency devaluation, deflation was the only route to improved competiveness. Chart 2, however, illustrates Ireland’s achievement. Indeed, its real exchange rate is now 14% lower (better) than in 2000. Germany has not made the job easy, as they too improved their standing 12% during the period. Nevertheless, Ireland has even caught their German neighbours. To be sure, all the crisis countries have dramatically improved their competiveness since 2008. But all, especially Italy, lag well behind Germany and Ireland. Indeed, the recent external surpluses achieved in Spain, Italy, and Portugal largely reflect still weak domestic spending and imports.
Of course, this painful adjustment produced dramatic increases in unemployment. Fortunately, the worst is over, and the jobless rate has declined in all five nations. However, double-digit unemployment in Portugal and Italy is unacceptably high. Nearly a quarter of the Greek labour force remains idle, while 17% unemployment and long-term joblessness in Spain are serious social ills. As a result, deflation remains a considerable risk in these countries, and stagnant wages remain social and political problems.
In Ireland, by contrast, the 6% unemployment rate is well below the EU average of 9%, and 3% wage increases are contributing to healthy gains in income and consumer spending. Nevertheless, while 6% joblessness is relatively enviable, slack remains in the economy and inflation at 0.6% remains undesirably low.
Housing and Banking: Repeating Past Mistakes?
The exact nature of the crisis differed from country to country. Of course, in Ireland (and Spain), the credit-fuelled boom and bust in the housing market was at the epicentre of the storm. Where do things stand now in the banking and housing sectors?
After collapsing by over 50% since the peak, Irish residential property prices have risen by roughly one-third since hitting bottom in 2013. More worrisome, perhaps, rents now exceed levels experience in the “Tiger” period. It is too early to tell if Ireland is repeating past mistakes. To be sure, house price fundamentals are favourable: rising wages, employment, and incomes combined with low interest rates. Moreover, Chart 3 illustrates that prices did over-shot on the downside, e.g. the property price to income ratio was 20% below the long term average in 2012. The ratio, however, has now risen above the long term average, so the situation requires careful monitoring.
By contrast, housing prices in Italy and Greece are still declining, and Chart 3 indicates that prices are in line with long-term affordability indicators. Fundamentals, however, remain unfavourable. After declining 40%, Spanish prices have edged modestly higher since 2013. Having never really become cheap, however, prices are above levels supported by long term valuation metrics. In Portugal, where a property bubble did not occur, prices are also now edging a bit higher, but still appear the cheapest of the group.
The Irish banking system, decimated by the collapse in the housing market, is also recovering. Not surprisingly, concerns are being voiced about the pickup in mortgage lending. However, mortgage approvals are only 25% of the 2006 peak levels. Beyond common sense, banks have reasons to remain cautious. Overall, credit has contracted 25% since 2012, and is still declining. Non-performing loans are below the 2012 peak of 25%, but still account for 15% of loans outstanding. The bulk of NPLs are mortgages, 70% of which are more than 2 years in arrears. Overall, bank assets contracted another 8% in 2016. In short, the banking sector is still deleveraging.
It will come as little consolation that credit is still declining and NPLs are higher in most of the other crisis countries: NPLs in Greece 40%, Portugal 20%, and Italy 16%, but lower in Spain 10% and Germany 2%. The profitability of Irish banks has also improved: second best in Europe. Return on assets is 0.9% compared to -2% in 2012, resulting from unpopularly high rates on new lending. Even though bank profitability is better than the other crisis countries, ROA of US banks stands 1.1%, which is depressed compared their pre-crisis 1.4% performance.
This suggests that rising Irish housing prices may reflect a well-documented supply/demand imbalance, rather than renewed profligacy in the bank sector. The government released recently a 160 page plan to tackle this problem, but my contacts suggest much more is needed.
Structural Headwinds: Ireland Well Positioned
Long-term structural issues played an important role in the crises in Italy, Greece, Portugal, and Spain (perhaps to a lesser degree). Future prosperity will require solutions to these tough problems. During the past decade, for example, productivity gains in these countries have been minimal, e.g. efficiency has actually been declining in both Italy and Greece (falling 0.5% and 1.5% pa respectively). To be sure, Ireland is not immune. But, while productivity has slowed from the 2.5% pre-crisis pace, efficiency gains of 1% per year is well above the global trend. Of the many possible explanations, Ireland’s investment rate of 31% of GDP is well above Spain 20%, Italy and Portugal 16%, and Greece’s paltry 10%.
Likewise, Ireland’s demographics are far better. The combination of stronger domestic population growth and immigration, Ireland can expect labour force gains of nearly 2% per year. And, while the EU’s labour force should expand 0.5% annually, Italy, Greece, and Portugal are likely to be nearly stagnant.
All in all, Ireland’s GDP growth potential of 3% exceeds the EU and Spain (1.25%), Portugal at 1%, and stagnant in both Italy and Greece. Turning around these population and productivity patterns will be challenging. Ireland has its issues, but these are not among them.
Debt Overhang: Troubles Ahead?
Excessive borrowing and debt accumulation were at the heart of Ireland’s crisis. And, despite painful adjustments, more progress is required still to correct this legacy. Private sector leverage, in particular, remains a problem. To be sure, household deleveraging has sliced debt loads nearly in half: from 100% to 60% of GDP. Nevertheless, this only brings Ireland in line with elevated debt levels in the EU and Spain. From a different angle, Irish household debt stands at 150% of disposable income – still above the 2003 level of 120%. Even more worrisome, corporate borrowing towers at 210% of GDP – double the level in the EU and Spain – and has shown no improvement since 2012.
Additionally, higher public sector debt is one of the legacies of Ireland’s financial sector meltdown. Following the enormous success in reducing the budget deficit, Irish government debt remains at 70% of GDP compared to 29% prior to the crisis (Table 1). Fortunately, with the budget nearly balanced and growth strong, this ratio should decline further in coming years.
All crisis countries have succeeded in curbing fiscal shortfalls and stabilising the accumulation of debt (Table 1). However, Ireland is noteworthy. Public sector debt is both well below the PIGS, and has fallen dramatically in recent years. In contrast, debt/GDP in the PIGS is only now beginning to stabilise at high levels. In addition, Ireland has been left with the lowest level of spending and taxation within Europe; providing the nation with more options should future problems appear.
Most importantly, perhaps, the combination of Ireland’s higher GDP growth and larger primary surplus means that its debt/GDP ratio will continue to fall even after European interest rates normalise. Given the stagnant GDP growth potential in the PIGS (and throughout the EU), rising (normalising) European interest rates will require additional budget cuts of 1% of GDP or more to prevent further increases in already elevated ratios. This could be the next chapter of Europe’s debt crisis. As a cautionary tale, this time France may not be excluded from any future crises unless President Macron delivers tough budget cuts.
Brexit: Watch Irish Farmers?
Donald Trump’s election as US president poses a new risk for Ireland. Low Irish corporate taxes have attracted massive American direct investment. What happens if the US slashes its own corporate tax rate, as appears likely. The Kilkenny consensus was that American investors will remain attracted to Ireland as an English-speaking access point to the European Union, especially after Brexit.
In Kilkenny, regardless of the topic, the discussion always turned to Brexit! This is understandable. The UK is Ireland’s second largest trading partner: exports of goods and services to Great Britain represent 10% of GDP. And, despite GB’s ambitions to deepen ties with China and India, Ireland is the UK’s 5th largest export market, with exports exceeding the combined sales to the two Asian giants. However, UK exports to Ireland represent less than 1% of GDP; thus, Ireland is more vulnerable.
Likewise, the stock of UK direct investment in Ireland totals about $80 billion, and Ireland has a similar amount invested in the United Kingdom. Nearly 400,000 Irish citizens reside in the UK, and 112,000 UK nationals live in Ireland (2.5% of the population).
Despite the deep ties and great uncertainties, the risks appear manageable. The prestigious ESR Institute estimates that even with a “hard” Brexit (WTO rules), Irish GDP will take a 4% hit over 10 years. First of all, investment into Ireland may actually rise, as UK firms seek an entry point into the European Union. As much of the bilateral trade is in manufactured good, tariffs will remain low: 80% of UK exports to Ireland will face tariffs below 10% and 50% of sales will face no tax. Likewise, 75% of Irish sales will face tariffs below 10%.
Energy, however, will require special treatment, as 90% of Ireland’s energy needs are met by Great Britain.
Northern Ireland, and specifically NI farmers, however, presents special challenges. The Republic of Ireland is NI’s top trading partner, representing 30% of foreign sales. However, 50% of these sales are agricultural products. Under WTO rules, nearly 40% of NI sales to the Republic will confront tariffs of 25% or more, with taxes on dairy products as high as 80%! Likewise, this will adversely impact farmers in the Republic, as agriculture represents 30% of sales to NI.
However, the amounts are manageable. The combination of lost EU CAP subsidies and agricultural export sales could cost NI’s farmers about £1.5bn per year. This amounts to only 3.5% of NI GDP, which the UK government could absorb. However, the impact on Ireland’s rural communities could still be significant. Given the Tory government’s reliance on NI’s DUP, a “hard” Brexit could threaten not only Irish farmers, but Teresa May’s government as well!
Strategic Conclusions
- With bond yields below US Treasuries (ex Greece), PIIGS sovereign credits are not attractive. Greece and Spain are my favoured options.
- As Irish property prices are in line with long term valuation metrics, I would steer clear. While rental yields are attractive, the Irish government recently imposed rent caps in certain areas. Additional arbitrary measures are possible if prices continue to rise. Avoid.