The Irish Economy ECONOMIC OUTLOOK

Transcription

1 The Irish Economy ECONOMIC OUTLOOK April 2007

2 AIB Global Treasury Economic Research AIB Global Treasury Economic Research Unit John Beggs Chief Economist Phone: ; Oliver Mangan Chief Bond Economist Phone: ; Geraldine Concagh Senior Economist Phone: ; Jenny Pollock Senior Economist Phone: ; Research available online at :

3 Irish Economy THE IRISH ECONOMY Contents Page COMMENTARY 1-3 EXTERNAL ASSUMPTIONS 5 MACRO FORECASTS 6-7 CONSUMER SPENDING 8-9 FIXED INVESTMENT EXTERNAL TRADE AND INDUSTRY LABOUR MARKET INFLATION PUBLIC FINANCES All data quoted are sourced from official statistics published by the CSO unless otherwise stated, all forecasts are prepared by AIB s ERU.

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5 Irish Economy COMMENTARY ECONOMIC PERFORMANCE Recently published data confirm that the Irish economy performed exceptionally well last year. GDP rose by 6%, with GNP up by 7.4%, the best performance since Employment increased by 4.4%, with unemployment remaining very low. Furthermore, the General Government budget surplus is put at over 4 billion in Although there has been much comment about the economy becoming lopsided and overly dependent on the housing sector, the fact is that GDP growth has been very well balanced to date in this decade, as the chart below shows. All of the main components of GDP have averaged growth rates of very close to 5% in the period In 2006 itself, both domestic spending and exports rose by close to 5%. New housing output rose by 3% last year, half the growth of GDP. Furthermore, the growth rate of the economy accelerated in 2006, even though there was a marked weakening in the pace of growth of housing output. % Average Growth Rates CONSUMER SPENDING GOVERNMENT EXPD FIXED INVESTMENT EXPORTS IMPORTS GDP GNP Source : CSO Looking forward, it is likely that the growth rate of the Irish economy will slow in 2007 and more particularly in 2008, as many of the factors which have been boosting activity begin to wane. Housing output is set to decline, while the effects of maturing SSIAs and an expansionary fiscal policy are likely to be less pronounced in Interest rates have also moved higher. We expect a significant deceleration in consumer spending growth next year. Nonetheless, the prospects for much of the economy are still quite favourable. Nonresidential construction activity is expected to remain very buoyant. It is also encouraging to see a marked pick up in Irish manufacturing output and a rebound in service exports. Global growth is expected to stay quite strong, helping exports. A strong export performance is very important for future economic growth prospects, although it must be admitted that the performance of merchandise exports has been disappointing in recent years. We look for GDP growth to remain relatively robust at 5.0% in However, GPD growth is forecast to slow to 3.7% in 2008 on the back of weaker growth in the three main components of domestic demand - household spending, current government expenditure and fixed investment. We look for domestic spending to rise by just 2.5% next year, down from over 5% in 2006 and Net trade should make an increasingly important contribution to GDP growth in the next two years. A stronger export performance, helped by a rise in manufacturing output, should see net trade contribute 0.75% to GDP growth in This is forecast to rise to 1.75% next year as imports weaken in response to sluggish domestic spending. 1

6 AIB Global Treasury Economic Research % GDP Contributions Personal Spending Stocks & Fixed Investment Govt Spending Source: CSO Net Exports A deceleration in the pace of growth in economic activity will have predictable consequences for the labour market. We expect the growth in employment to decelerate to 3.6% this year and 2% in 2008, from 4.4% in However, labour force growth is also projected to slow, given recent signs that inward migration has peaked and with a noticeable deceleration evident in recent quarters in the uptrend in the participation rate. This should help curtail the rise in unemployment in 2008 as economic growth moves below trend, with a jobless rate of 5% forecast for next year, up from 4.4% in 2006 and THE IMPLICATIONS OF THE HOUSING SLOWDOWN The boom in housing has come to an end but we do not expect a housing market crash or severe negative consequences for the economy. It is worth noting that we expect the economy to grow by 5% this year and close to 4% in 2008, despite a fall of 15% in housing completions over the two years. Indeed, the recent stabilisation of house prices and expected fall in housing output are welcome developments as the market was in danger of becoming over extended. The slowdown in housing should be offset to some extent by strong growth in non-residential construction activity, which had been quite weak up until last year, especially public capital spending. The new National Development Plan provides considerable additional resources for infrastructural spending. Private non-residential building activity is also growing rapidly. Furthermore, buoyant property related tax receipts have generated unexpectedly large budget surpluses in recent years, as the Dept of Finance has based its budget arithmetic on very cautious tax projections. This has left the public finances in a healthy position as the economy faces into a period of slower growth. Overall, then, the slowdown in housing activity should not derail the economy. Instead, it is likely to see it move on to a more moderate growth path by This would still represent a very strong growth rate by international standards. Employment is also still forecast to grow by 2% in 2008, implying an additional 42,000 jobs, despite a contraction in employment in construction. It should also be borne in mind that we are looking for a slowdown in the pace of economic growth from its very robust pace in 2006 and not a slump in activity. The economy proved able to withstand the global downturn and severe contraction in the ICT sector at the start of this decade. We expect the economy to display the same type of resilience in the face of a downturn in housing, especially given the strong global economy, notably Europe. 2

7 Irish Economy INFLATIONARY PRESSURES Inflation has picked up a lot since the start of last year, especially the headline CPI rate, which has been running at around 5% in recent months, double its level at end Much of the rise, though, is due to increased mortgage costs. The rise in the EC measure of Irish inflation, the HICP rate, which excludes mortgage interest, has been much less pronounced. It is forecast to average 2.7% this year, the same as in However, there has been some deterioration in Ireland s inflation performance compared to our eurozone trading partners. The most recent data show eurozone inflation at 1.9%, or 1% below the level in Ireland. On the other hand, though, the UK HICP rate has been running above the Irish rate since last autumn. It is very important that Ireland keeps domestically induced inflation under control. The errors made at the start of this decade, when sharp hikes in indirect taxes and public service charges plus very large wage increases caused high inflation to become embedded in the economy, must be avoided on this occasion. Headline inflation should fall sharply in 2008, with the CPI rate expected to decline to below 3%, assuming that the ECB does not continue to tighten monetary policy next year. FISCAL POLICY Ireland s fiscal position remains very sound as is evidenced by the fact that the General Government budget recorded a large surplus in 2006, while the government debt/gdp ratio fell to just 25%. It is the case, though, that the strong fiscal position is dependent on the continuation of relatively robust economic growth and that the tax base has been bloated by a large intake of property taxes from a buoyant housing market, which could well decline. The Exchequer returns for the first quarter of the year suggest that the Government is on course to meet its target of a budget surplus in 2007 of 2.3 billion or 1.2% of GDP. The Dept of Finance is forecasting that the General Government budget will show surpluses of 0.9% of GDP in 2008 and 0.6% in The risks are to the downside for these projections, given our forecast for a more significant slowdown in economic growth than envisaged in the Dept s medium term budget arithmetic. All of the major political parties have made generous commitments on either tax cuts or public spending increases, or on both, in the context of the upcoming general election. Delivery on expensive political commitments on taxation and public spending must be conditional on the economy s ability to generate the wealth and activity to finance these electoral packages, without resulting in a serious deterioration in the overall public finances. Balanced public finances at current tax rates are far more beneficial to Ireland s longer term future than a scenario where tax cuts are implemented against the backdrop of slower economic growth, threatening the benefits of budgetary discipline that Ireland has enjoyed for the past decade or more. Public capital spending was scaled back and income tax allowances and bands were left unchanged in 2003 and 2004 when the last slowdown in economic activity impacted on the public finances. If a similar situation occurs again in the next couple of years, the focus should be on curtailing the rise in gross current spending on services, which has risen rapidly this decade from 22 billion in 2000 to 49 billion in Indeed, in any event, the current rate of increase in government spending on services, which is set to rise by almost 25% in the two years , is not sustainable. 3

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9 Irish Economy EXTERNAL ASSUMPTIONS OUR FORECASTS ARE BASED ON A NUMBER OF EXTERNAL ASSUMPTIONS The global economy will remain robust but experience somewhat slower growth in 2007, mainly reflecting weaker growth in the US as a result of the downturn in its housing market. The European economy is expected to register strong growth again this year. Growth in Asia is forecast to remain robust. The global economy should remain strong in Oil prices eased a lot from their highs of last year against a backdrop of a very mild winter in the northern hemisphere and high inventory levels. They have picked up again, though, in recent months. We assume that oil prices will average $64 and $65 per barrel in 2007 and 2008, respectively, down slightly from $66 in With crude oil prices levelling off, headline inflation in 2007 and 2008 will be lower than in However, core inflation pressures have risen in most countries, except for Japan. The ECB will increase official interest rates further to 4% in mid-2007 with another 0.25% rate increase possible around end-year. The US Federal Reserve will cut the Fed funds rate by up to 0.5% in the second half of The Bank of England will increase official UK rates by another 0.25% in May and could leave rates on hold thereafter. On foreign exchange markets, the euro/dollar rate will trade in a $ range over the balance of 2007 before falling back to under the $1.30 level in The sterling/euro rate, meanwhile, will mainly trade within a Stg range until end GLOBAL ECONOMY: KEY ASSUMPTIONS Annual Average (Unless stated) (f) 2008 (f) Economic Growth (% Change) OECD US Euro UK Official Interest Rates (%) (End Period) US Euro UK Exchange Rates US Dollar-Euro Sterling-Euro US Dollar-Sterling Crude Oil Prices (Brent $/b) Forecasts prepared by AIB s ERU, historical data sourced from Thomson Datastream More detailed forecasts on interest rates and exchange rates are contained in our Exchange Rate Outlook and Central Bank Watch publications, available on our website 5

10 AIB Global Treasury Economic Research THE MACRO FORECAST The economy performed very well in 2006, with real GDP growing by 6% and employment rising by 4.4%. The pace of growth in both output and employment looks set to moderate in 2007 and 2008, reflecting in particular a slowdown in housing activity. GDP growth could ease to 5% in 2007 and 3.7% in Inflationary pressures should abate considerably next year. The economy grew by 6% last year reflecting robust growth in domestic spending and service exports. Buoyant growth in consumer spending, which rose by 6.2%, accounted for half of GDP growth, with fixed investment and stockbuilding both contributing 1%. Consumer spending should be the main engine of growth again in We expect consumer spending to grow by 7% this year, buoyed by strong labour market conditions, an expansionary fiscal policy and maturing SSIA accounts. The pace of growth of consumer spending is likely to moderate considerably in 2008, as these factors abate. Growth in fixed investment slowed sharply to 4.2% last year as the rise in housing output moderated and investment in machinery and equipment declined. We expect fixed investment to grow by 2% in 2007, with strong growth in non-residential activity more than offsetting a decline in housing output. Fixed investment may decline in 2008, though, as falling housing output drags down overall investment spending. Manufacturing output picked up momentum last year but this was not reflected in improved merchandise exports, possibly due to stockbuilding. Total exports, though, were boosted by a rebound in service exports, and rose by 4.9% last year. Strong industrial survey data, recent very robust industrial output figures and a favourable external environment suggest that manufacturing and exports will perform well in 2007 and into Export growth is forecast at 6% this year and 5.3% in Employment growth remained very robust at 4.4% last year. Employment gains were particularly strong in a number of service sectors and construction. Employment growth is likely to moderate in the next two years in line with a deceleration in the pace of economic activity, most notably housing. We look for jobs growth of 3.6% in 2007 and 2% in 2008 but a slowdown in the pace of labour force growth should curtail a rise in unemployment. There has been a marked pick up in the rate of inflation in Ireland since end The headline CPI rate is likely to average 4.7% this year after a 4% rate in Rising mortgage costs has been the main factor boosting CPI inflation. The HICP rate, which excludes mortgage interest, averaged 2.7% last year and is forecast at 2.7% again in We expect inflation to fall back next year, with the ECB likely to call a halt to its rate hike campaign by end The CPI rate may fall to 2.6% in 2008, with HICP inflation averaging 2.3%, assuming that oil prices average around $65 a barrel next year. Exchequer returns for Q show that the government is broadly on course to meet its budget target surplus of 1.2% of GDP this year, in contrast to the big overshoots of tax receipts and budget surplus targets recorded in recent years. The budget balance will disimprove this year with Exchequer spending forecast to rise by 13% compared to expected growth in tax revenues of 8%. The fillip provided to tax receipts in recent years by the buoyant property market is coming to an end. Much more modest growth in government spending will be required in the years ahead to keep the public finances close to balance. 6

11 Irish Economy SUMMARY FORECAST TABLE IRISH MACRO ECONOMIC FORECASTS Annual average % change unless (f) 2008(f) otherwise stated Real GDP Real GNP Domestic Expenditure Personal Spending Government Spending Fixed Investment Contribution of Stocks to GDP Growth Total Exports Total Imports Level of GDP ( bn, current prices) Level of GNP ( bn, current prices) Industrial Production (Vol) Total Modern Other Housing Average House Price (end year) House Completions (CSO basis '000) Labour Market Labour Force Growth Employment Growth Unemployment Rate (%) Net Immigration (Apr '000) Costs and Prices CPI Core CPI Irish HICP Mfg Output Prices (Home Sales) Earnings Growth (Whole Economy) Unit Wage Costs (Whole Economy) External Account Total Trade Balance (% of GNP) Current A\C Balance (% of GNP) Public Finances General Gov. Balance ( m) 1,623 5,031 2,300 1,000 General Gov. Balance (% GDP) General Gov. Debt /GDP ratio (%) Private Sector Finances Personal Disposable Income Personal Savings Ratio (%) Private Sector Credit % (adj end year) Personal Sector Debt/ Personal Disp. Income Ratio (%) Forecasts prepared by AIB s ERU, historical data sourced from CSO, Dept of Finance, Dept of Environment and permanent tsb 7

12 AIB Global Treasury Economic Research CONSUMER SPENDING Real consumer spending has grown at a robust rate of over 6% in the past two years, buoyed by strong employment and income growth. Maturing SSIAs are adding fuel to the fire and we expect that household spending could grow by 7.0% in 2007, before slowing down in The personal savings ratio may be around 9.5% in 2007 and Savings ratio revised down The detailed National Income and Expenditure Accounts for 2005 contained marked downward revisions to the personal savings ratio for the earlier years of the decade. The savings ratio is now put at 9.5% in 2004, the latest available official data, well below previous estimates of %. This is still a relatively high ratio, though, by international standards. It seems likely that the savings ratio rose significantly in 2005, partly due to timing factors that boosted farm incomes and current transfer payments. We estimate that the savings ratio could have risen to 11.0% in However, it is likely that the savings ratio fell back again in 2006 as these timing factors unwound, amidst continuing strong growth in consumer spending. Thus, despite further strong growth in employment and wages, the savings ratio is estimated to have declined to about 9.7% last year. Strong income growth to continue in 2007 The savings ratio could well move lower again in 2007, because of continuing strong growth in consumer spending. Income growth should be robust in 2007, at just above 9%, reflecting continued good growth in employment and wages and the big rise in social welfare payments and income tax cuts announced in this year s budget. However, while personal disposable income may increase by over 9% this year, nominal consumer spending may rise by around 9.7%. Thus, the personal savings ratio could edge downwards to 9.2% in Much weaker income growth in 2008 Our forecasts are for growth in personal disposable income to slow markedly next year, reflecting much more subdued employment growth in particular. Furthermore, the increases in social welfare payments and cuts in income taxes in 2008 are unlikely to be as generous as in the 2007 pre-election budget. Thus, growth in personal disposable income could slow to about 6.7% in There is likely to be an equally strong fall-off next year in the growth rate of consumer spending from its SSIA-elevated levels in We look for the growth in nominal consumer spending to slow from 9.7% in 2007 to 6.5% in As a result, the savings ratio could edge slightly higher to 9.4% in 2008, despite much slower income growth. PERSONAL INCOME, CONSUMPTION & SAVINGS (% Change Nominal) (e) 2006(e) 2007(f) 2008(f) Personal Income Disposable Income Consumer Spending Savings Ratio (%)

13 Irish Economy Robust growth in consumer spending Real consumer spending grew by a robust 6.2% last year, slightly below the rate of 6.6% recorded in 2005 and well up from the % rate registered in the period Retail sales data, though, show that the volume of retail spending rose by 6.2% last year, up from 4.8% in Excluding cars, retail spending grew even more sharply at 6.9%, up from 4.9% in Thus, the growth in consumer spending on services appears to have slowed last year compared to There is little doubt that the robust growth in consumer spending reflects the very favourable backdrop for the household sector, notably the strong growth in employment and earnings as well as the stimulatory stance of fiscal policy, with the 2005 and 2006 budgets providing a significant boost to disposable income. Consumer Spending % Change (Vol) Y/Y Q1-02 Q1-03 Q1-04 Q1-05 Q1-06 Source: CSO Budget boosts spending power Employment growth, though, is expected to moderate this year to around 3.6% from 4.4% last year. On top of this, interest rates have risen by 1.75% since the end of The housing market has also cooled a lot, while consumer confidence has fallen over the winter. Growth in disposable income, though, is expected to remain strong this year, helped by a stimulatory pre-election budget. Meanwhile, the bulk of SSIAs, which total over 15 billion, mature in the opening months of Overall, the strong uptrend in consumer spending should be maintained in Indeed, it has made a strong start to the year. New car sales rose by 6.8% in the opening quarter of the year, according to SIMI data, a clear sign that consumers are still willing to spend. VAT receipts were up a healthy 10.3% in Q1. Retail sales rose by 7% year-on-year in volume terms in the first two months of 2007, or 6.5% excluding autos. Helped somewhat by maturing SSIAs, we expect consumer spending to grow by around 7% in 2007, a bit stronger than in 2005 and Slowdown in spending in 2008 More moderate growth in consumer spending looks to be on the cards for 2008 given that we are forecasting slower employment and income growth next year. Fiscal policy is also likely to be less stimulatory post the general election, especially in relation to boosting personal disposable income. Indeed, growth in personal disposable income could slow to less than 7% from over 9% in The housing market should also be well past its peak by next year and we also may begin to see the lagged effects of higher interest rates impacting on spending activity. The effects of maturing SSIAs on household spending should also have waned by next year. Thus, growth in consumer spending could slow to around 4% in 2008, well below the growth rates in the period. 9

14 AIB Global Treasury Economic Research FIXED INVESTMENT Growth in fixed investment has turned more subdued, rising by 3.9% last year as investment in machinery and equipment declined and housing slowed. Housing output is expected to fall this year but investment in machinery and equipment should rebound, with non-residential construction remaining strong. Overall, total fixed investment may increase by just 2% this year as housing contracts and could decline in Housebuilding activity starts to falter There was a further jump in housing completions last year, with the total rising to over 88,000 from the already elevated levels of 86,000 in (This 2005 figure includes some 5,000 units that were completed in that year but not connected to the ESB network until 2006.) The rise in new housing output, though, slowed in 2006 to just 3%, having risen by 12% in the previous two years. Indeed, housing output fell by 1.7% year-on-year in the final quarter of Forward looking indicators suggest that new housing output will decline in 2007 and Housing registrations, which are often taken as a proxy for housing starts, fell by a steep 28% year-on-year in the opening quarter of 2007, having declined by 14% in the final quarter of The 12 month cumulative total fell to 61,500 in March, which is over 10% down on its peak level reached in September last year. Planning permissions for dwellings have been on a downtrend since mid ,000 House Guarantee Registrations * 12 Mth Cumulative Total 65,000 60,000 55,000 50,000 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Sources : DoEHLG, HomeBond & Premier Guarantee * Excludes one-off and local authority housing Housing output to fall in 2007 and 2008 Housing completions were up slightly in Q (+0.6% yoy adjusted). However, given the weakness of forward looking indicators, we expect housing completions to fall to 82,500 in 2007 from over 88,000 in 2006, with a further decline to 75,000 in prospect for Meanwhile, expenditure on improvements to existing dwellings is also slowing rapidly and, indeed, declined in the final quarter of last year, tracking the decline in new housing output. The contribution from transfer expenditures (fees, stamp duty etc) to housing output can also be expected to fall as turnover declines. Overall, then, total housing output could fall by around 4.5% in 2007 and 8% in Non-residential output output up sharply Non-residential construction output picked up strongly in 2006, rising by over 12% compared to a 2% increase in Output growth was strongest in the second half of the year, rising by over 14%. This reflects increases in both non-residential building activity and public capital spending. Output of industrial and commercial buildings rose strongly in 2006 for the second consecutive year. Meanwhile, the volume of public capital spending, which fell by over 13% in the three years 2003 to 2005, also rose in

15 Irish Economy Strong growth to continue in nonresidential construction Continued strong growth in non-residential construction output is anticipated in 2007, reflecting the favourable economic and business climate and rising public capital spending to meet the nation s infrastructural deficit. CSO data show a surge in planning permissions for non-residential developments. These rose by 35% in floor area terms in 2006, including a 70% rise in Q4. This points to a further strong rise in building activity in this sector in 2007 and, indeed, into PCP expenditure is projected to rise by 24% this year, although it is unlikely that all of the money will be spent, judging by the experience of recent years. Under the new National Development Plan, a significant rise in PCP expenditure can be expected in the next few years to tackle the infrastructure deficit. Overall, we are forecasting a rise of around 10% in the volume of total non-residential construction output in 2007, with the pace of growth moderating to 7% in FIXED INVESTMENT (% Change, Volume) (f) 2008 (f) Total Housing Other Construction Machinery & Equipment Total Machinery & equipment spending fell in 2006 Investment in machinery and equipment rose strongly in 2005, increasing by 20%. Some of the rise, though, was due to large purchases of transport equipment, mainly aeroplanes. Excluding this factor, business investment was still up by 16% in Not surprisingly, after the big jump in 2005, investment in machinery and equipment fell back in 2006, declining by 6.5%. However, if one excludes the volatile transport equipment component, which declined by 35%, investment was broadly flat. Business investment is very volatile from year to year, especially in regard to big ticket items such as aircraft. It tends to rebound if it declines in the previous year, especially the volatile transport component. Thus, after the weak performance in 2006, it is likely that investment in machinery and equipment will recover in Business investment to pick up again in 2007 Certainly, robust global and domestic economic growth, improved corporate profitability and a still relatively low interest rate environment form a favourable backdrop for business investment. After the weak performance in 2006, we look for investment in machinery and equipment to grow strongly by 10% in 2007 and 7% in However, these forecasts carry a very wide margin of error, especially given the volatility of aircraft purchases. The expected rebound in business investment and continued strong growth in nonresidential construction will help underpin fixed investment. Overall, though, we are forecasting a rise in total fixed investment of just 2% in 2007 and a decline of 1% in 2008 as the downturn in housing activity, which accounts for 55% of total investment, takes its toll. It should be noted that our forecasts carry a wide margin of error given the volatility of investment spending, but the main trends seem clear. 11

16 AIB Global Treasury Economic Research EXTERNAL TRADE AND INDUSTRY The pick up in manufacturing output evident in 2005 continued 2006 and early However, this is not reflected in external trade data, which show very weak goods exports last year. External trade in services, though, is performing very strongly. Meanwhile, the BoP deficit widened further last year. We expect stronger growth in external trade in Rise in manufacturing output and employment... The recovery in manufacturing activity evident in 2005 continued in Manufacturing output rose by 5.2% last year, up from the 3.1% increase recorded in The high-tech industries, most notably the ICT sector, performed well, with high-tech output up by 6.7% in Meantime, output growth in indigenous industries was up by 1.5%, in line with its trend rate of recent years. The pick up in manufacturing is also reflected in survey data. Monthly data from both the EC industrial confidence index and the output component of the PMI for manufacturing rose strongly in 2006, the former hitting its highest level since Meanwhile, the CSO s quarterly industrial employment survey shows a 1.7% rise in employment in the sector in 2006, the first increase since not reflected in external trade data One would expect the pick up in manufacturing output to be reflected in merchandise trade data, given that the vast bulk of output from the sector is exported. However, goods exports were up by just 0.5% in volume terms in 2006, compared with an increase of 2.6% in Thus, the trend in goods exports moved in the opposite direction to manufacturing output in % Industrial Production Volume:3 Mth Moving Average Y/Y % Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Source: Thomson Datastream However, upward revisions to external trade data have become the norm in recent years. This could well prove to be the case again for 2006, when final full year data are published. The discrepancy between industrial output and exports may also be partly due to a build up of inventories of finished goods. The turnover of manufactured goods rose by just 2.7% in value terms in 2006 compared to 4.2% in 2005, despite a pick up in the rate of growth in industrial production. This points to a rise in stock levels in industry. Service exports rising strongly Meanwhile, service exports performed very strongly in 2006, increasing by 12.8% in volume terms, up from growth of 6.3% in The strong growth in service exports in 2006 was very broadly based and included insurance, I.T., financial and business services, leasing and trade related services. Overall, then, the total exports of goods and services grew by 4.9% in volume terms in 2006, up from 3.9% in 2005, driven by the strong rebound in service exports. 12

17 Irish Economy Weak growth in goods imports Meantime, the growth in the total imports of goods and services in volume terms is put at 5.3% in 2006, down from 6.5% in 2005, but still close to the growth rate of exports last year. The growth in the import of goods slowed sharply in 2006, largely as a result of a marked decline in imports of machinery and equipment. Goods imports rose by 3.4% in 2006 compared to 9.2% in This slowdown was partly offset, though, by much stronger growth in service imports, which rose by 7.4% in 2006, up from 3.7% in % 15 Total Export & Import Volumes (Yr-on-Yr % Change) 12 9 Imports 6 3 Exports 0 Q1-04 Q3-04 Q1-05 Q3-05 Q1-06 Q3-06 Source : CSO The outlook for exports in 2007 and 2008 would appear to be reasonably favourable. It is encouraging from an export point of view that there has been a good recovery in output in the export-oriented, high-tech manufacturing sector. Indeed, output has surged recently in the sector, rising by over 20% year-on-year in the three months to February. This is being driven in particular by a big jump in the production of chemicals, pharmaceuticals, communication equipment and recorded media. Meanwhile, the resumption of the strong uptrend in service exports last year, which account for almost 40% of total exports, is also very encouraging. Favourable external environment in 2007 and 2008 On the external front, both the UK and eurozone economies have picked up considerable momentum and are expected to register solid growth rates in 2007 and Furthermore, although there has been a significant economic slowdown in the US, the global economy is still expected to register solid growth in 2007 and Thus, the external environment for exports should remain reasonably favourable in the next couple of years. Overall, then, total exports could grow by around 6% in 2007 but this could slow to 5.3% in 2008, as more firms move abroad. As in recent years, this ranks as a disappointing performance, especially in an export orientated economy like Ireland. The European economy, our main export market, is growing robustly and world trade is expanding at close to double-digit rates. Thus, Ireland s share of global trade looks set to continue declining, in line with the trend evident in recent years. Robust consumer spending and a rebound in business investment should result in solid growth in merchandise imports in Meanwhile, service imports seem likely to continue growing strongly. Thus, we expect total imports to grow by 6.0% in A weakening of import growth is likely in 2008 as consumer spending slows in a more subdued economic environment. Net trade contributing to growth in Net external trade was a major drag on GDP growth in 2005 but made a modest contribution of 0.4% to GDP growth in 2006, as service exports picked up and goods 13

18 AIB Global Treasury Economic Research imports weakened. We expect net trade to make a contribution of 0.75% to GDP growth in Net trade is forecast to make a much bigger contribution of 1.75% to GDP growth in 2008 as import growth slows in response to a more subdued environment for domestic spending. Big jump in BoP deficit There has been a marked widening of the current account deficit on the balance of payments in the past two years. The deficit was relatively stable in the first half of this decade, averaging 660 million in the period However, it blew out to 4.2 billion in 2005, or over 3% of GNP, reflecting a marked decline in the merchandise trade surplus and a continued rise in net factor income outflows. It widened further to 5.8 billion in 2006, or close to 4% of GNP, as the merchandise trade surplus continued to contract. Merchandise trade surplus contracts The merchandise trade surplus declined by 4.2 billion in the period. However, part of this fall is directly related to a rise of 1.7 billion in fuel imports, reflecting sharply higher oil prices. Meanwhile, there was a big jump of 3.4 billion in imports of machinery and transport equipment in the past two years. Some of this rise is directly related to an increase in business investment in There has been some comment that the decline in the merchandise trade surplus and marked widening of the balance of payments deficit are evidence of a loss of competitiveness by the Irish economy. However, none of the factors identified above as contributing to the contraction in the trade surplus and widening BoP deficit can be related to a deterioration in competitiveness. Indeed, there has been a marked improvement in the external trade balance on services in recent years. Nonetheless, the subdued growth of merchandise exports is disappointing and is a sign of a loss of competitiveness in the manufacturing sector of the economy. BALANCE OF PAYMENTS ( M) Year Goods Services Income Transfers Current A/C ,423-10,203-22, ,606-10,091-24, , ,207-8,280-24, , (f) 24,700-5,750-25, , (f) 24,670-3,700-26, ,900 Further widening of BoP deficit likely in 2007 There is likely to be a further jump in the BoP deficit in 2007 as goods imports rise strongly in response to buoyant consumer spending and business investment activity. Thus, the merchandise trade surplus looks set to fall further. We expect the deficit on services to continue contracting but net factor income outflows should rise. Overall, the BoP deficit may climb to around 7 billion, or 4.3% of GNP this year. Turning to 2008, we foresee an improvement in the balance of payments as import growth falls in response to much more subdued growth in domestic spending, especially by households. The deficit on services is likely to continue contracting, allowing the BoP deficit to fall back to under 6 billion, or 3.4% of GNP next year. 14

19 Irish Economy LABOUR MARKET The Irish labour market continues to experience very strong jobs growth, even with the economy at close to full employment. Robust labour force growth is being sustained by large net inward migration and rising participation rates. Job gains have been most pronounced in a number of service sectors and construction. A slowdown in the rate of growth in the labour force and employment is forecast for 2007 and Strong labour force and job growth The Quarterly National Household Survey (QNHS) data for the final quarter of 2006 show that the economy continues to experience very strong labour force and employment growth. However, the growth rates for both are decelerating. The labour force grew by 83,000 or 4% in the year to Q This represents a continuation of the decelerating trend in labour force growth evident since mid-2005, when it peaked at 5%. Meantime, employment growth has eased from a peak of over 5% in mid-2005 to 4.25% in H Net inward migration is estimated to have accounted for 57% or 47,000 of the 83,000 increase in the labour force in the year to Q4 2006, with rising participation rates accounting for another 24% or almost 20,000 of the increase. This implies that only 16,000 or less than 20% of the increase in the labour force was due to indigenous population growth. 6 % Labour Force and Employment Growth Y/Y % Change Q1-01 Q1-02 Q1-03 Q1-04 Q1-05 Q1-06 Labour Force Employment Source; Thomson Datastream Immigrants main supply source to meet robust labour demand The large influx of migrants and marked rise in participation rates is a clear reflection of the strength of the jobs market and strong demand for labour in Ireland. Employment grew by 85,500 or 4.3% in the year to Q Of particular interest is the fact that the number of non-irish nationals in employment rose by over 44,000, while the number of Irish nationals increased by 41,000 in the year to Q Thus, inward migration is now the prime source of employment growth. The labour force data also show that, despite large scale net inward migration, unemployment remains very low, with the jobless rate falling to 4.2% in Q4 2006, down from 4.4% in previous quarters. The vast bulk of the migrants entering the Irish labour force find employment. However, the unemployment rate amongst non- Irish nationals at 6.2% in Q was higher than the 3.9% rate for Irish nationals. This is not surprising as it is likely to take new migrant workers some time to find employment and many of their jobs could be temporary. Looking ahead, it is doubtful whether the Irish labour market can continue to exhibit such robust growth rates. In terms of the labour force, inward migration may well have peaked. Indeed, the number of non-irish nationals entering the labour force 15

20 AIB Global Treasury Economic Research declined during the course of Meanwhile, the rise in the participation rate has been slowing since mid-2005, especially amongst females, possibly because job growth also slowed somewhat. Further, the trends in indigenous demographics have turned less favourable because of the low birth rate in the 1990s. Narrow base for recent job growth Another concern is that the base for employment growth has narrowed a lot in the past year. In the year to Q4 2006, construction (+28,400), financial and other business services (+15,000) and public services - public administration, education and health - (+34,800), accounted for 78,200 or 91.5% of the 85,500 rise in employment over the period. Construction Employment % % Q1 01 Q1 02 Q1 03 Q1 04 Q1 05 Q As % of Total Employment : LHS YoY Growth in Construction Employment : RHS Source: CSO Construction still churning out the jobs Much attention has been paid in particular to the strong growth in construction employment in the past three years. The growth in construction employment did slow to under 10% in the first half of 2006 but picked up again in the second half of the year. For the year as a whole, construction employment rose by 24,000 or 10%, accounting for 27.5% of total job growth in As a result, construction s share of total employment continued to climb, reaching 13.6% by Q This is a very high share and there are concerns that the economy has become over dependent on the construction sector. However, a collapse in construction employment would not appear to be imminent. While activity in the housing market has cooled, other building sectors are performing strongly, especially the commercial and public infrastructure sectors. Survey evidence also points to continued job growth in the sector. Thus, while the pace of employment growth in construction is likely to slow, it should remain an important driver of job growth this year, adding close to 15,000 jobs on average in By year end, though, the rate of increase may have slowed to zero. Renewed contraction in manufacturing employment likely A contraction in the numbers employed in industry, though, could be on the cards this year following the stream of job losses announced in recent months. Employment in industry rose modestly over the course of 2006 but this trend seems likely to be reversed during By end year, employment in the sector could well be in decline as the marked downtrend in industrial employment evident in the first half of the decade resumes. Strong growth in both private and public services employment is likely in Although decelerating over the course of 2006, employment in private services rose by 3.7% or 33,000 on average last year, with a big contribution from financial and 16

21 Irish Economy Further strong job growth in services business services and the wholesale & retail sectors. Given the favourable prospects for consumer spending and service exports, and high job vacancies, we should see broad based gains in employment in the private sector services this year, possibly over 30,000 jobs. As in 2006, the financial and retail sectors are expected to register the biggest increases in employment. ('000) 35 Health and Education Employment % Q1 01 Q1 02 Q1 03 Q1 04 Q1 05 Q1 06 Health : Increase in Year ('000) : LHS Education : Increase in Year ('000) : LHS Health & Education : % of Total Emp : RHS Source: CSO Employment in services dominated by the public sector- health, education and public administration - rose by 31,500 or 7.7% in Another large rise is likely in 2007 given the big increase in government spending this year for public services as well as the continued expansion of the private sector into health and education. Job growth in these areas has averaged close to 6% in the last six years. A similar performance can be expected in 2007, boosting employment by 27,000. Slowdown in labour force and job growth in 2007 and 2008 In summary, then, the labour force should experience slower growth in 2007 and beyond, given that inward migration may have peaked and with the strong uptrend in participation rates now slowing down. We see labour force growth easing to 3.7% in 2007 and 2.7% in 2008 from 4.5% last year. KEY LABOUR MARKET FORECASTS (f) 2008 (f) Labour Force ( 000) % Change Employment ( 000) % Change Unemployment Rate (%) Unemployment to rise in 2008 Employment growth should moderate also, given the expected slower pace of economic expansion, in particular in the construction sector, as well as the likely job losses in manufacturing. We expect employment growth to slow to 3.6% in 2007 and 2% in 2008 from 4.4% in The unemployment rate is forecast to remain unchanged at 4.4% in 2007 but rise to 5.0% in

22 AIB Global Treasury Economic Research INFLATION Inflation has picked up sharply with the annual headline CPI rate moving back above 5% in March. Much of the rise in inflation is accounted for by higher mortgage costs; excluding mortgages, inflation is currently running at 2.7%. However, a gap has opened up between inflation in Ireland and the rest of the eurozone as measured by the HICP. Inflation is likely to remain high for much of 2007, only falling below 4% at year end. It should fall to under 3% in CPI inflation rises sharply on higher mortgage costs The annual headline rate of CPI inflation rose back up to 5.1% in March, from 4.8% in February. In January, it stood at 5.2% which was the highest inflation rate recorded since June Thus, inflation has more or less doubled from its level of 2.5% at end Increased housing costs have been the main factor putting upward pressure on inflation in the past year. The housing component of the CPI rose by 23% in the year to March, principally due to a 47.5% rise in mortgage costs. Excluding mortgage interest, the CPI rate stood at 2.7% in March, having being boosted by 0.4% since December by the sharp hike in excise duty on cigarettes in the budget. Meantime, the EU HICP rate for Ireland stood at 2.9% in March. These measures are much lower than the headline CPI inflation rate and indicate the extent to which rising mortgage costs are impacting on the CPI. % 6 Headline and Core CPI Y/Y % Change 5 4 Headline Inflation Core Inflation (ex mortgages) 0 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Source: Thomson Datastream But high service sector inflation also However, it is not just higher mortgages that are pushing up inflation. Service sector inflation in Ireland is running at very high levels. Based on CPI data, service sector inflation was running as 9.3% in March, but this measure includes mortgages. According to HICP data, which exclude mortgages, service sector inflation was running at 5.6% year-on year in Ireland in March. By contrast, goods price inflation was running at just 0.3%. This is in marked contrast to the eurozone as a whole, where the inflation rates for the services and goods sectors are much closer, at 2.4% and 1.5%, respectively. It is clear from these figures that Irish service sector inflation is very high compared to the rest of the eurozone. Services inflation well above eurozone levels The detailed data show that service sector inflation is higher in Ireland than in the eurozone in all the main services sub-components of the HICP - health, education, housing, recreation, restaurants, bars, communications etc. Thus, high service sector inflation is quite broad-based in Ireland. This, no doubt, largely reflects the strength of economic activity here and a low unemployment rate and the consequent 18

23 Irish Economy high rate of wage inflation, which contrasts with very subdued wage growth in the rest of the eurozone. % 10 Goods and Services CPI Components (Y/Y % Change) Services 2 0 Goods -2 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Source: Thomson Datastream However, it is also noticeable that service sector inflation is much higher in Ireland even where prices are determined by the State or a regulator, such as public utilities, health and education. Thus, government policies and a lack of competition also look to be contributing to high Irish service sector inflation. Gap with eurozone inflation widens A significant gap has opened up between inflation in Ireland and the rest of the eurozone. As already noted, this reflects much higher service sector inflation in Ireland. The eurozone flash HICP rate was 1.9% in March, 1% lower than the Irish rate. Thus, the gap between HICP inflation in Ireland and the rest of the eurozone has widened in 2007 from the average of 0.5% in 2006, a concern from a competitiveness point of view, especially given the survey evidence that price levels in Ireland are already well above those elsewhere in the eurozone % Irish and Eurozone Inflation HICP Y/Y % Change Irish HICP Inflation Eurozone HICP Inflation 1.0 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Source: Thomson Datastream Little escape for consumer from higher prices In general, prices in Ireland have been rising much faster in the non-discretionary areas of consumer spending where there is little escape for consumers in terms of either the ability to avoid expenditure or to substitute for lower cost products. We have redistributed the CPI into two baskets of discretionary and non-discretionary items, with food lying somewhere between the two. The annual inflation rate for non-discretionary expenditure, which generally constitutes services, was 10.5% in March, if food items are excluded. Though food is a necessity, there is significant scope for product substitution in this sector. 19

24 AIB Global Treasury Economic Research The inflation rate for our basket of non-discretionary items was below 2% at the start of 2004, very similar to the annual rate for discretionary items and for the all items headline inflation rate. The subsequent acceleration in the headline CPI rate to over 5% in early 2007 largely reflects strongly rising prices for non-discretionary items. In contrast, there was little change in the inflation rate for discretionary items, until the budget hike in excise duty on cigarettes pushed the rate above 2%. CPI inflation to fall only slowly in 2007 Looking forward, significant price increases for alcohol, the recent renewed rise in oil prices and continuing ECB rate hikes mean that there is unlikely to be a deceleration in inflation until the summer. After mid-year, ECB rate policy could be put on hold for some time. This would cause headline inflation to fall significantly later in 2007, as interest rate increases totalling 0.75% in the second half of 2006 drop out of the annual rate. Indirect taxes may not be increased to the same extent either as they were at end CPI rate should fall below 3% next year Thus, headline CPI inflation is likely to hover around the 5% level until mid-year, before decelerating to 4.6% in Q3 and to under 4% at end year, with a further decline to around 3% likely in early The headline CPI rate is forecast to average 4.7% in 2007 as a whole, well above the average rate of 4.0% recorded for CPI inflation should fall to average around 2.6% in 2008 assuming that the ECB does not tighten policy further next year. Meanwhile, the Irish HICP rate is likely to average 2.7% in 2007, the same as in Although oil prices have largely stabilised this year, this has been negated by the large excise duty hike on cigarettes. A HICP rate of 2.3% forecast for INFLATION FORECASTS Annual Average Change (%) (f) 2008(f) Consumer Price Index (CPI) Core (ex-mortgages) CPI Irish HICP Important to keep lid on domestic costs and wages Thus, we believe that the current spurt in inflation will not prove to be quite as severe or prolonged as the previous surge in inflation in the period Part of the problem in the period was that the rise in inflation was accompanied by a surge in wage inflation, which reached close to 10% at one stage in most sectors of the economy, while there were also some significant increases in indirect taxes and public service charges. Thus, it is crucial that the terms of the current national pay deal are adhered to, in particular given the weaker productivity growth recorded in recent years. It needs to be understood also that excluding mortgages, inflation remains below 3% and that headline inflation will fall when the ECB eases up on raising rates. The government, meanwhile, should avoid further indirect tax increases and large hikes in public services charges. Overall, we are confident that inflation can fall back in However, risks remain, such as a renewed surge in oil prices, an extended campaign of ECB rate hikes or a domestically induced wage/cost spiral in the current tight labour market conditions. The first two risks are beyond our control, but the latter is not. 20

25 Irish Economy PUBLIC FINANCES The Irish public finances remain in a very healthy state following an unexpected and large budget surplus in The Exchequer budget is expected to have a small deficit this year, while the general government budget should record another large surplus. It is expected to stay in surplus in 2008 and The general government debt/gdp ratio should fall to around 22% in 2007, way below the level in most other EU countries. Large budget surpluses in 2006 The 2006 budget outturn was much, much better than expected, largely because of unanticipated strength in tax receipts, which exceeded target by 4 billion. As a result, there was a sizeable Exchequer surplus of 2.3 billion compared to the budget day target of a deficit of 2.9 billion. Meanwhile, the General Government surplus exceeded 5 billion last year, or close to 3% GDP, compared to the budget day target for a deficit of 1 billion. In the 2007 budget, the Minister set a target of 0.5 billion for the Exchequer deficit but forecast a surplus of 2.3 billion (+1.2% of GDP) for the General Government budget. The main reason for the forecast deterioration in the budget balance in 2007 is that the rise in government spending is quite large this year at 13%. This is forecast to comfortably exceed the expected growth in tax receipts of 8%. Q1 07 Exchequer returns on target The Exchequer returns for the first three months of 2007 show that the government is on course to meet its budget targets. At end Q1, there was an Exchequer surplus of 1.86 billion. While this is below the 2.4 billion surplus recorded in the same period last year, it is in line with the decline in the Exchequer balance forecast in the 2007 budget. Both tax receipts and spending were very close to target in the first quarter. Total Tax Receipts -Year To Date (Year-on-Year % Change) Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Source: Dept of Finance Growth in tax receipts is decelerating Total tax receipts were up by 10.2% in Q1, very much in line with the 9.9% rise forecast for the period. This is an impressive performance as tax receipts were very buoyant in the opening quarter of 2006, when they rose by 19%. Unsurprisingly, receipts from capital taxes and stamp duties are slowing in line with the property market, but they still rose by 20.6% and 12.8% year-on-year, respectively, in the first quarter of Meantime, while solid consumer spending growth is evident from VAT receipts, which increased by 10.3%, these are running behind schedule, as are excise duties. Furthermore, income tax receipts which were up by 8.8%, are also running behind target. 21

26 AIB Global Treasury Economic Research However, by contrast, buoyant corporate earnings lifted corporation tax receipts by 14.2%, well ahead of target. Overall, but for the unexpected buoyancy of corporation tax, total tax revenues would have been behind target in the opening quarter of In our view, though, the Department of Finance s monthly forecasts for 2007 may not have made sufficient allowance for the exceptional strength of tax receipts in Q Thus, we expect that VAT, excise duty and income tax receipts will move back into line with forecast in the coming months. Property related taxes losing buoyancy However, the growth in property related taxes can be expected to continue decelerating over the balance of the year given the clear signs of lower activity levels in the housing market. These receipts are difficult to forecast but could well end the year below target. Overall, though, on the basis of the trend in tax receipts for the first quarter of the year and given the prospects for the economy, it would seem that total tax revenue will be close to target in 2007 as a whole. However, monthly Exchequer Returns will bear close watching for any signs of greater than expected weakness in property taxes that could see the total tax take undershoot target. On the expenditure side, current spending was on target in Q1 but capital spending was ahead of budget. Recent years have been characterised by undershoots in government spending but the data for Q1 suggest that government spending will be close to target in Overall, then, the Government seems on course to meet its target of a budget surplus of 2.3 billion, or 1.2% of GDP. The Dept of Finance is forecasting that the General Government budget will show surpluses of 0.9% of GDP in 2008 and 0.6% in The risks are to the downside for these projections given our forecast for a more significant slowdown in economic growth than assumed in the Dept s medium term budget arithmetic. Gov debt/gdp ratio to fall to 20% by 2008 The government debt/gdp ratio has fallen very sharply since 1993 when it stood at 95%. The ratio had declined to 27.4% by 2005 and an estimated 25% at end We expect the ratio to fall to 22% by end 2007 and 20% by end This compares with an average public sector debt/gdp ratio of around 70% for the eurozone in 2006, highlighting again the strong state of the Irish public finances. But no room for complacency... However, there is no room for complacency as the favourable Irish budgetary position is dependant on the continuation of relatively strong economic growth, as well as the high activity levels in the housing market, which have greatly inflated stamp duty and capital gains tax receipts in recent years. Thus, it is entirely appropriate to maintain the General Government balance in comfortable surplus at the present time. It will help avoid the need for a tightening of fiscal policy in the event of a sharp decline in property related taxes or, indeed, an economic downturn.... need to be careful about expensive election promises All of the major political parties have made generous commitments on either tax cuts or public spending increases, or on both, in the context of the upcoming general election. Delivery on expensive political commitments on taxation and public spending must be conditional on the economy s ability to generate the wealth and activity to finance these electoral packages, without resulting in a serious deterioration in the overall public finances. Balanced public finances at current tax rates are far more beneficial to Ireland s longer term future than a scenario where tax cuts are implemented against the backdrop of slower economic growth, threatening the benefits of budgetary discipline, that Ireland enjoyed for the past decade or more. 22

27 Irish Economy The publication is for information purposes and is not an invitation to deal. The information is believed to be reliable but is not guaranteed. Any expression of opinions are subject to change without notice. This publication is not to be reproduced in whole or in part without prior permission. Allied Irish Banks p.l.c. is regulated by the Financial Regulator.

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