Beware the economic paradox now emerging

ANALYSIS:A RAFT of economic indicators released this week provide further evidence of an emerging paradox: as the domestic economy shows fewer signs of recovery, foreigners show a growing willingness to bet on it. What's going on?

Start with the home front. Yesterday, new figures showed the rate of joblessness continued its grinding-if-slow rise in August. At 14.4 per cent, unemployment has risen by a tenth of a percentage point every month since May. Upward momentum in the rate of joblessness is depressing for many reasons. One is that even if the economy were to perk up, unemployment wouldn’t start to fall – it’s an iron law that labour markets always lag in a recovery.

On Monday, another set of numbers – this time on property prices – showed the housing market is still on the slide more than four years after its long descent began. Everything points to further falls over the course of this year and into 2011. Lower property prices further weaken the balance sheets of households. That makes them feel poorer, and less likely to go out and spend.

More evidence of the weakness in consumer spending came on Monday. Retail sales figures for July were less disappointing than the jobs and property price developments, but they showed consumers are nowhere near ready to splash out.

All these weaknesses manifest in many ways. One is the rising percentage of mortgage holders who cannot make repayments. At the start of the week yet another set of figures showed 7 per cent of those who have mortgages are in trouble. That percentage continues to rise relentlessly.

The absence of signs of life in the domestic economy has caused the Economic and Social Research Institute’s economists to become more bearish. Three months ago they were extraordinarily bullish about a recovery in consumer activity. With no evidence to support their optimism, they have abandoned these hopes. Their expectation of further contraction in the domestic economy both this year and next is grim, but realistic.

Despite the absence of recovery domestically, there are multiplying indications the loss of confidence internationally in the Irish economy, which took hold with great rapidity in the autumn of last year, is being reversed.

Yesterday’s figures from the Central Bank show that foreign deposits in the banking system rose by €4 billion in July. Although it would be wrong to make too much of this relatively small amount, the inflow was little short of a miracle. Investors fled to safety everywhere in July as the euro crisis reached its most dangerous point yet.

Another indicator that confidence is returning – and that bank restructuring may be working – is the declining dependence of the financial system on Central Bank cash infusions. At the end of February, the European Central Bank and its Irish subsidiary had €187 billion pumping through Ireland’s crippled banking system. At the end of July, the amount had fallen to €155 billion. That’s still a frighteningly massive sum, but a €32 billion wean-off counts as progress.

Enticing Wilbur Ross to invest in Bank of Ireland earlier in the summer was both a sign of confidence and a builder of it. Having a such a figure put €1.1 billion into a bank almost universally perceived as toxic sent out a powerful signal. It was not far short of Goldman Sachs persuading Warren Buffet to bet on it in late 2008, or Bank of America doing the same recently when that behemoth suffered a massive loss of confidence.

But the most important sign that international investor confidence in Ireland Inc is returning is the huge, sustained and remarkable decline in yields on Irish government bonds. Almost without exception, they have fallen on a daily basis since peaking in mid-July. Yesterday was no exception. Yields on the benchmark 10-year bonds reached yet another low, falling below 8.6 per cent. The last time the perceived risk of Irish sovereign default was that low was in the depths of last January.

What is causing the restoration of confidence if the domestic economy is still flat on its back?

One reason is the much improved bailout terms agreed on July 21st. A considerably lower interest bill makes a real difference to the debt dynamics. ECB bond-buying has also undoubtedly played a role in calming fear in peripheral sovereign debt markets.

Another concrete achievement has been the meeting of bailout targets and winning praise from the troika. This makes Ireland look serious. It also differentiates the country from the other PIIGS. So did the news in mid-summer the economy’s balance of international payments had moved into the black (the Club Meds are all still deep in the red).

Good as these developments are, it is ultimately the growth fundamentals in the economy that will determine how things go. As this economy is still a distance from solid growth, the pile-in to Irish Government paper and stabilisation of foreign deposits in the banking system might not last.

International investor consensus on small economies can move suddenly, and from one extreme to another. That has been Ireland’s experience in recent years.

In October 2008, and despite having the ECB as a backstop, Ireland’s banking system was given just six months before melting down, as Iceland’s had done. Six months later, the banks were still open and Ireland was beginning to earn (exaggerated) praise for getting ahead of the curve by introducing an emergency budget and a de facto pay cut for public service workers. Sentiment turned again a year ago. Foreigners stampeded out of Irish government bonds and whipped cash out of Ireland-based banks in gargantuan amounts.

The recent upturn in financial indicators is welcome. But it is based more on sentiment than economic fundamentals. These remain weak. Beware the herd.