Domestic economy now fuelling our remarkable recovery

Strong growth can help tackle challenges of Brexit, tax changes and higher interest rates

  Taoiseach Leo Varadkar  and  Minister for Finance  Paschal Donohoe. They have inherited an economy that continues to perform ahead of expectations. Photograph Nick Bradshaw

Taoiseach Leo Varadkar and Minister for Finance Paschal Donohoe. They have inherited an economy that continues to perform ahead of expectations. Photograph Nick Bradshaw

 

The year 2017 started with warnings – about the impact of Brexit and a new US president in particular. But a year on and the Irish economy is growing strongly, even if official GDP growth – likely to come in at 6.5 per cent to 7 per cent for the year – overstates the underlying picture. The domestic economy is growing strongly, probably by 4 per cent to 5 per cent, and most forecasters confidently expect this to continue.

We crashed harder than the rest from 2008 on, yet the bounce back has also been stronger. Looking back just half a decade to 2012, it is worth reflecting on the remarkable recovery which has followed the extraordinary economic collapse.

The numbers at work are growing strongly, and approaching the record 2.17 million recorded in 2007. The unemployment rate should fall close to 5 per cent next year, and the public finances are close to being back in balance.

It has been an extraordinary recovery by any criteria, and it is continuing with growth strong in 2017, even if the 10.5 per cent annual GDP growth rate recorded for the third quarter is distorted by multinational activity .

The notable factor over the past 18 months or so has been the strength of the domestic economy. The recovery was kick-started by exports, but consumer spending and investment are both rising strongly now as confidence returns.

While we have outperformed international averages, 2017 has also been a surprisingly strong year for the world economy. Pretty much all the major economies – except the UK – exceeded expectations.

Interest rates

A combination of strong international growth and rock-bottom interest rates has been pretty much the ideal backdrop for Ireland. Even in the UK, where growth is below par, the economy is still growing and movements in sterling – while volatile – have not been as threatening as had been feared in the wake of the Brexit vote.

Benign international conditions seem to have helped indigenous exporters in sectors such as agriculture and food, where UK sales are up. Some multinational sectors – notably chemicals – have shown a fall in exports in recent months, pulling down the overall figures. These sales can be volatile and have been hugely distorted by contract manufacturing – done abroad on behalf of Irish-based multinational subsidiaries – in recent years, but it is a trend worth watching as we head into 2018.

A notable plus is the strong positive trend in services exports, which has continued into 2017. Strong international growth should help exporters again in 2018, though Brexit and its impact on the biggest market for our indigenous exporters remains a key risk.

Elsewhere, the economy has been firing on something close to all cylinders. The most up-to-date indicators tend to be those for tax revenues and the jobs market. After a mixed start to the year, tax revenues have been strong in recent months, and indicators from the jobs market are encouraging.

The unemployment rate is now just over 6 per cent, down from 7.5 per cent a year ago, a drop of 29,500. The ESRI has forecast that the unemployment rate will average 5.4 per cent next year, bringing the numbers at work to well over 2.1 million and leaving the economy not far off what might be called full employment.

From dealing with a dire economic crisis five years ago, we are now faced with the problems and challenges caused by strong growth, even if some of the deep-seated problems caused by the crash remain.

Housing crisis

The combination of legacy problems and growth challenges comes together most neatly in the housing crisis, posing both social and economic challenges.

The social issues are obvious reflected in homelessness, soaring rents and house prices, and the inability of many people to afford a property. Economic analysts say that, as of now, house prices are not out of line with the fundamentals of the economy. But for those trying to get on what used to be called the housing ladder, this is scant consolation, as are forecasts that house prices may continue to rise for the next three or four years, albeit at a slightly slower pace.

New Taoiseach Leo Varadkar and his Minister for Finance Paschal Donohoe have inherited an economy that continues to perform ahead of expectations. Yet this also poses challenges. Public expectations are high, there is pressure on public services, and the chronic lack of public investment during the bust is taking a heavy toll, particularly in housing but also more widely.

The Government faces the challenge of trying to prepare the economy for the next phase of growth on one side, and supporting parts of the economy – and the State – which are not doing so well on the other.

It also faces the unpredictable challenge of Brexit. The Government won an important victory in the first phase of the talks in December, winning commitments which it hopes will ensure that a trade border does not return on the island of Ireland.

Assurances

It is clear that the commitments in the UK/EU first phase deal do offer significant assurances for Ireland. Yet Ministers will be aware – and the EU itself has recognised – that it remains far from clear how the UK will marry the promise to avoid a hard Border with its insistence that the entire UK will leave the EU trading bloc, comprising the customs union and the single market.

More battles on this lie ahead, as do potentially difficult talks to scope out new trading arrangements between the EU and UK post-Brexit, and an agreement on a transition period, a kind of standstill to apply after the UK leaves at the end of March 2019, but before new trade arrangements are finalised.

The Central Bank and the ESRI both warned about the potentially destabilising impact of Brexit. The difficulty for the Government and for Irish businesses is that the shape Brexit will take remains completely unclear.

Estimates have suggested that a harder Brexit could cost the Irish economy 4.5 per cent of GDP over the next 10 years. with the bulk of the losses in the early stages of that period.

This would mean annual growth rates being some 0.75 of a point lower than they would otherwise have been for a few years, with losses concentrated in rural Ireland and sectors such as food.

Were the UK to crash out without a deal the initial disturbance and cost in 2019 and 2020 could be even higher.

On the flip side, if we head for a softer Brexit, and a long transition period when not much changes, a huge risk factor for the economy could disappear. Growth rates would still likely to be slow as the economy approaches full employment and problems in housing and infrastructure act as a brake. but official estimates still see growth at around 3 per cent per annum, a respectable rate.

Warning sign

The warning sign is that Ireland has rarely managed in recent times to achieve boring, respectable, middle-of-the-road growth. In the last decade we went from strong growth to a bust and back again. The key job of economic management is to try to achieve the mythical soft landing from the current high growth rates – to move the car down from fifth gear to third.

With international tax policy changes and the likelihood of higher interest rates from 2019 also appearing as threats, alongside Brexit, it is a touch challenge. But strong growth provides a reasonable backdrop heading into 2018.

TWO THINGS TO WATCH EARLY IN 2018

The Brexit transition talks: Now that EU leaders have decided that sufficient progress has been made to allow the Brexit talks to continue to phase two, a huge issue will be whether terms can be agreed for Britain to have a transition period after it leaves the EU in March 2019, while new trade arrangements are sorted out.

This would suit both sides, but the EU will only grant it on its own terms, which will be controversial in the UK. This is very important for Ireland as such an arrangement would remove the threat of Britain crashing out without a deal – which would be very disruptive – and increase the chances of a longer-term trade deal.

International tax talks: A range of initiatives are under way to try to get multinationals to pay more tax and close off loopholes. The European Commission has been asked by EU finance ministers to present proposals on the issue and on taxing the big digital companies. Also the OECD is due to deliver a report on taxing the digital economy to G20 finance ministers in April.

These trends provide some dangers to Ireland as they may involve firms paying more tax in big markets where they make sales. Long-term EU moves to create a common consolidated corporate tax base also threaten Ireland.

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