War and the Irish economy: Prepare for a long economic squeeze

One the most notable aspects of the recent economic forecasts from the Central Bank and the ESRI were the health warnings both made about the risks that things could turn out worse than predictions . As when Covid-19 broke, economic predictions are now surrounded by huge uncertainty. The cumulative impact of Covid and the Ukraine war is taking its toll and means that the risks for the months ahead look to be firmly to the downside – in other words that growth will be hit harder than current forecasts anticipate. Here are the main risk factors.

1. The cumulative hit

The economy came through Covid-19 better than anticipated. The Government supports kept businesses in exposed sectors alive and the resilience of the rest of the economy was notable. But Covid-19 took a toll on the exposed sectors and the customers they hoped would flock back to bars, restaurants, hotels and concerts this year suddenly have less disposable income. The big block of post-Covid savings in many people’s bank accounts may provide some support here. But those with built-up cash are more likely to be older and already financially comfortable, while the younger age group – on which many consumer business rely – were more likely to be squeezed by Covid lay-offs and soaring rents.

Many SMEs face a "rocky road to recovery", according to a report from the Banking and Payments Federation Ireland this week. It points to the risk facing the accommodation and food sector in particular, where the wage subsidy scheme, which is now being wound down, has been supporting up to 70 per cent of jobs. Some 95,000 businesses in the sector have warehoused tax debt which they have a year to repay.

The path to reopening the consumer sectors risks being a lot less smooth than had been anticipated, while the war is also likely to have an impact on the wider tourism industry.

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2. The inflation issue

Higher energy costs act like a tax on the State’s income, leaving the country less well-off. The ESRI’s recent quarter estimated that real inflation-adjusted disposable income will fall this year by around 2 per cent – inflation will be around 7 per cent on average on their forecasts while wages will rise by around 5 per cent.

And the Central Bank report crunched the numbers on energy prices and on plausible scenarios showing inflation could be 1 to 1.5 percentage points higher again, adding to the hit to spending power. And all the signs are now that while energy remains the main driver, wider inflationary pressures are building too.

Businesses face this from another viewpoint – wage pressures and higher input costs. Most sectors are facing an unprecedented labour shortage and wages are rising. In turn, the impact of higher consumer price inflation will add to these wage demands. Many businesses will get through if demand remains strong – and clearly there has been a big pick-up in spending in the early months of the year. But the hit on disposable incomes – and on the health of overseas markets – now poses uncertainty.

3. The energy dilemma

The big uncertainty, of course, is energy prices, with questions too over the risk of supply disruption.

The Central Bank warned that its forecasts of growth in the domestic economy of 4.8 per cent this year could fall to 4.3 per cent if energy prices remained very elevated – and this did not take into account the possible impact of knock-on inflation in other sectors or a rise in uncertainty which could hit consumer spending and business investment.

It also cautioned about the risk of supply disruption. This is tied up with politics and the recurring questions about whether the EU will keep buying Russian oil and gas – a coal embargo is under discussion and there may be a push to act on oil. The president of the European Council, Charles Michel, pointed out that week that the EU had paid Russia €35 billion for energy supplies since the start of the war, compared to €1 billion given to Ukraine to buy arms. Mario Draghi said on Wednesday that a gas embargo was not on the table at the moment but continued:"Do we want to have peace or do we want to have the air conditioning on?"

Even without an EU decision, the row over how the EU pays for Russian energy – and particularly gas – could lead to disruption or a cut in supply.What would this mean for Ireland? It would certainly lead to another spike in prices as Russia supplies around one third of the EU’s gas and more than one quarter of crude oil. An oil embargo, as well as elevating prices, could lead to some international shortages, with experts pointing to diesel as one area of risk.

A disruption to gas supply would hit countries such as Germany, Austria, Italy and a number of Eastern European countries hard. Ireland does not rely directly on Russian gas, with more than 70 per cent of our gas coming through the UK, mostly originating in the North Sea. The balance comes from the Corrib field.

The Government is confident that gas supply would be maintained here. Under Europe-wide agreements, Norway could be obliged to divert from gas to markets hit by supply shortages. However a number of Norwegian wells are directly connected to the UK. Also expert analysis by the Oxford Institute for Energy Studies suggests that there may not be enough capacity in pipelines from Norway to Continental EU countries to take much more gas than is currently flowing. Norway could send more gas as LNG, but again here capacity at EU ports and technical facilities is limited – and the easiest route might be to send LNG to Britain which has spare capacity to be piped to the continent.

The final part of the puzzle is that the UK, now out of the EU, is not bound by EU agreements. And so the Republic is in part reliant on UK policy and bilateral agreements and on the interplay between the UK gas market – which we need – and the continental EU ones. In short, the structure of our gas market may give us some protection in terms of supply in the event of shortages, but prices would rise further and heading into next winter there could still be questions over supply.

4. The bottom line

There has been a lot of – understandable – focus on the impact on consumers of higher energy prices and inflation. And this will be one of the main channels of economic impact. However, businesses are also being hit hard. Many SMEs face the cumulative impact added to Covid-19. And big manufacturing businesses are now facing much higher energy costs. Business sources say that this is threatening to make some product lines in major sectors such as pharma uneconomic, threatening cutbacks. And, also faced with higher wages and costs, businesses are now actively re-examining investment plans: some projects that made sense last year won’t this year.