Testing times ahead for nascent economic recovery

General election and possible Brexit will be key determinants of economic health in 2016

 

Voters in two countries will have a decisive bearing on the outlook for the recovering Irish economy in 2016 and beyond.

In coming weeks, the general election will determine the immediate course of fiscal and economic policy here. In Britain, meanwhile, preparations for a European referendum raise serious questions for Ireland, with the possibility that its most crucial economic partner could leave the EU.

If uncertainty in electoral contests is a given in a democracy, Ireland’s economy enters the new year in growth mode.

An income tax cut is on the way for the expanding workforce and activity is on the rise in all business sectors. Unemployment is at 8. 9 per cent, down from 15.2 per cent at its peak. There are concerns, however, about regional disparities and the re-emergence of competitiveness pressures.

This is the backdrop against which Taoiseach Enda Kenny and Tánaiste Joan Burton will battle for re-election. They will campaign on the dual mantra of competence and stability: competence, because the economy is in much better shape now than after the economic and banking collapse; stability, on the grounds that the foundations of recovery must be secured to spread the benefits further.

At issue is whether they can overcome the counterblast from disparate opposition forces. In the aftermath of the crash, virtually the entire political establishment rowed in behind a stringent recovery programme. But the extent of the effort stoked the rise of the populist, anti-establishment faction, including Sinn Féin and the hard left. Agitating, too, are Fianna Fáil, assorted Independents and the upstart Renua and Social Democrat parties.

This presents a constellation of political possibilities. From the narrow perspective of the economy and financial markets, however, the salient questions are simple. Will the next administration manage the public finances in an orderly fashion with a view to balancing the books, promoting growth and servicing debts? Allied to that is whether binding EU fiscal rules are observed or whether there is any real traction for parties that would repudiate such rules and even some of Ireland’s debts.

For all the political argument over the social dimension of recovery, this is the unforgiving prism through which the world of money will view the election.

Fiscal rectitude

Still, credit rating agencies Moody’s and Standard & Poor’s have each issued pre- election warnings. Moody’s has said it will downgrade Ireland if the next administration pursues a “materially different fiscal policy”. S&P has said it could take a “negative rating action” on Irish debt if Dublin moves too quickly to cut tax or boost spending after the election. Such moves would lead to an increase in borrowing costs.

It follows that the stakes will be pretty high when it comes to the economic programme of the next government. The adoption of a credible package is crucial for market confidence.

Given Ireland’s tight finances, any escalation in the cost of servicing the national debt would blunt the scope to ease taxes. The public finances got a big benefit in 2015 from lower borrowing costs, along with a surge in corporate tax receipts.

Then there is the Government’s plan to start selling down its controlling interest in the nationalised AIB, helping to recoup some of the €21 billion spent bailing it out. Preparations are afoot for an initial public offering on the Dublin and London stock market next year, which could take place in spring or early summer. Market confidence in the next government’s economic programme is crucial for a successful flotation.

Then there is the “Brexit” question. David Cameron’s Tory government has committed to conduct an in/out referendum on EU membership by the end of 2017, but the vote could yet take place in 2016.

The issues raised for the State by “Brexit” are as complex as they are numerous. There is the prospect, for example, of an external EU border running through the island of Ireland if Britain votes to leave. The economic dangers centre on the likelihood of large trade losses in a worst- case scenario, with the agrifood, tourism, IT and financial sectors particularly vulnerable. There have been warnings of lower wages, higher prices and a cascade of other pressures.

In summary, the British vote could upend Ireland’s recovery. The downside would outweigh any benefit in increased non-EU foreign direct investment that might otherwise have gone to Britain.

Biggest risk

For the moment, however, investors are sanguine enough on the question and its implications for Ireland. All of that would be likely to change – and quickly – if Britain moved into the exit lounge.

Numerous other vulnerabilities remain. Encumbered with large post-crisis debts, Ireland is highly susceptible to the vicissitudes of international trade and financial markets. After years in the horrors, however, a hesitant recovery gathered momentum in 2015, as job creation and consumer spending picked up on the back of increased local confidence. The imperative now is to keep it all up. According to sources familiar with private political polls, the “don’t blow the recovery” argument ranks high among voters’ priorities.

Ireland’s strong turnaround is at odds with the weakness of the major euro zone countries, which are struggling with low inflation and tepid economic growth. Anxiety about the imminent threat of deflation led a reluctant ECB to initiate a major bond-buying programme in January. Deflation was averted, but a big uptick in euro zone growth is still awaited.

Close to the end of 2015, the Frankfurt- based institution expanded the QE scheme. Markets were unimpressed, saying it was not enough. This prompted ECB president Mario Draghi to make clear his readiness to move again if necessary. The ECB stimulus is now set to continue into 2017.

As a result, there is little likelihood any time soon of an official interest rate increase from record low borrowing costs. This benefits borrowers, and carries particular advantages for hundreds of thousands of Irish tracker mortgage holders.

In addition to lowering the costs at which Ireland and other euro zone countries can borrow from private markets, the ECB programme also lowers the value of the euro compared to the dollar and sterling. This delivers yet more benefits in the Irish context, as it increases the return from exports sent outside the euro area.

The same goes for the recent US interest rate increase, which should serve to support the dollar’s value against the euro. The Federal Reserve’s minimal rate rise this month reflects the turnaround in the US economy, a boon in itself for Ireland.

This is on top of benefits Ireland draws from the recovery in Britain. The UK economy itself is highly vulnerable in a “Brexit” scenario, so the potential for consequent disruption in Ireland is clear. At the very least, any sign in opinion polls that British voters were veering towards an EU exit would be likely to spark volatility in the markets in the run-up to the referendum.

Emerging markets

On the plus side, consumers and business continue to derive big benefits from the falling oil price. The low price fits into a confluence of benign external conditions, the others being the low interest rate, low sovereign borrowing costs and the euro’s weakness. All of this helped to spur gross domestic product growth towards 7 per cent in 2015, outpacing other euro states and nearly all other western economies.

Economists argue that Irish GDP flatters due to the heavy imprint of the multinational sector. Better, they say, to take account of gross national product, which strips out the multinationals. But GNP is also growing strongly, rising 5.6 per cent in the first three quarters of 2015. That gives grounds for encouragement.

Separately, the increasing size of Ireland’s GDP is accelerating the pace at which deficit and debt ratios are falling. The upshot is the State enters 2016 with a budget deficit well below 2 per cent of GDP and is now – in all likelihood – within two years of eliminating the headline deficit.

At the same time, the debt-to-GDP ratio is dipping below 100 per cent, having peaked at 125.3 per cent in 2013.

But a zone of relative safety would not be reached until the debt level drops to 70-80 per cent of GDP. Moreover, the actual debt mountain is huge. Ireland owes about €203 billion, roughly €160 billion more than before the crash.While markets are already giving Ireland an implicit benefit from future sales of bank assets, it will be essential in the coming year to execute the part-privatisation of AIB.

On the domestic front, serious questions remain over the State’s capacity to control its vast health expenditure. Large overruns are a constant feature. In 2016, however, new fiscal rules apply. Supplementary spending estimates will not be permitted, closing off a convenient escape chute used by a succession of minsters.

The going is pretty good in the Irish economy right now, but plain sailing is not assured.

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