Recovery falters in first half of year

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1 Produced by the Economic Research Unit October 2012 A quarterly analysis of trends in the Irish economy Recovery falters in first half of year Group Chief Economist: Dan McLaughlin Domestic demand still falling, as is employment Irish GDP Page 2 Flat second quarter following fall in Q1 GNP surprises to upside Inflation Page 4 Irish GDP in the second quarter was 2.6% above the cycle low recorded in late 2009 but the recovery remains slow, uneven, (growth was flat in Q2 following a 0.7% contraction in the first quarter) and solely dependent on exports as domestic demand is still falling. The composition of that export growth is changing, with service exports now accounting for half of Ireland s total exports, but the export-led expansion has not been strong enough to generate employment growth and the recent stability in the unemployment rate reflects falls in the labour force, largely due to net emigration. The second quarter GDP data was dampened by an unusually large plunge in the volatile capital spending component, which may well be reversed in the coming quarters but consumer spending is still on a downward trend and we now expect a 2.2% fall in that component this year. As a result we have revised down our GDP growth forecast for 2012 to 0.8% from 1%, with both exports and imports also projected to be weaker than initially projected. We had forecast a 1.5% expansion for 2013 and are still inclined to retain this projection, although the economy s dependence on exports means that the risks are clearly on the downside given the uncertain global environment, notably in the euro zone. Domestic demand is expected to fall again, albeit modestly, given the prospect of another deflationary Budget. Some analysts had pinned hopes of a recovery in consumer spending on a fall in the Irish savings ratio from elevated levels but it now transpires that the savings ratio has already fallen sharply. Consequently, we expect another decline in consumer spending next year, by 1%. Employment may finally stabilise next year but the unemployment rate is likely to stay around the current elevated levels. HICP inflation rises to euro average The Labour Market Page 5 Immigration now seen as much stronger during boom Exchequer Finance Page 6 Budget ahead of target despite weaker growth Funding the Exchequer Deficit Page 7 Ireland builds cash balances Contact Us Page 8 The recent data did contain some upside surprises; the economy ran a record surplus with the rest of the world in the second quarter and strong income flows from Irish assets abroad helped to generate a significant rise in GNP. Consequently, we now expect the latter to rise by 1.6% this year and 1% in The 2012 Budget is also likely to match or better the fiscal target (nontax revenue has already reached the full-year forecast) and the chances of Ireland funding in the markets in a sustainable manner have risen, although the scale of the deficit makes the debt dynamics vulnerable to any further disappointment in terms of economic growth.

2 Irish GDP Flat second quarter following fall in Q1 Service exports main support for GDP All of the spending components of real seasonally adjusted Irish GDP fell in the second quarter, led by a 29% plunge in capital spending, a 3.9% decline in government consumption and a 0.4% fall in personal consumption. Imports, too, fell heavily (by 5.2%) as a consequence of the fall in domestic demand and this prevented an overall fall in GDP, as exports declined by 0.5%, so generating a net positive contribution from the external sector resulting in a flat GDP reading in the quarter. This followed a revised 0.7% contraction in Q1, which alongside other revisions to last year s quarterly pattern left the annual change in real GDP in negative territory, at - 1.1%, but against a positive 2.1% expansion in the first quarter, resulting in annual average growth of 0.5% over the first half of the year and as such broadly in line with the consensus for the full year. The adverse international environment appears to be taking a toll on Irish merchandise exports as they fell by an annual 4.4% in the second quarter, although industry specific factors were also at work in the pharmaceutical sector, with a number of drugs going off patent. The export of services has surged, however, rising an annual 9% in volume terms following an 11.8% increase in Q1, driven by computer and business services. Indeed, the value of Irish service exports exceeded that of merchandise in Q2, highlighting that the emphasis on the trend in the latter in much of the commentary on Irish trade can be misleading, albeit understandable as there is no monthly data on service exports. Nevertheless, we are revising down our export forecast for 2012, with a 4% volume increase now expected, although the GDP contribution from the external sector is now forecast to be more significant as we are also revising down our imports forecast, to just 1.5% growth, given the weakness in the data of late. consumer spending and overall domestic demand still falling Domestic demand may also be weaker than we initially expected, however, particularly in terms of consumer spending. The Q2 data left that component 2.5% below the corresponding quarter last year and brought the cumulative fall since the peak of the cycle in late 2007 to over 10%. We now expect personal consumption in 2012 to fall by 2.2%, with a fall in employment offsetting a modest increase in average earnings to leave total wage income down on the previous year. Transfers to the household sector are also expected to fall while taxes are forecast to increase. Consequently, the trend in disposable income still points to falling consumer outlays and the latest data revisions from the CSO show that the net savings rate has actually fallen sharply in the last two years, to 5.4%, in 2011, so there is less scope for a consumption recovery from that source. Government consumption is forecast to fall by 4.5% given the trend over the first half of the year and we now expect capital spending to fall this year, against our previous expectation of a marginal increase. Business spending on machinery and equipment may indeed increase but by less than previously forecast so no longer offsetting the expected decline in construction spending. GDP growth revised down but GNP revised up record BoP surplus in Q2... The net result is that GDP growth this year is now expected to be a little weaker than the 1% previously pencilled in, at 0.8%. The picture for GNP is brighter, however, as the income earned on Irish assets abroad in the second quarter grew at a faster pace than income paid on foreign investments in Ireland with the result that GNP in Q2 grew by 4.3%, which with data revisions left the annual change in GNP at 2.9% following 1.4% in Q1. Factor income flows are notoriously volatile but the data to date has prompted us to forecast a 1.6% rise in GNP in The rise in Irish income earned on assets abroad alongside the strength of service exports resulted in a record balance of payments surplus in the second quarter of 3.2bn and although the figures are prone to revision it appears likely that Ireland will record a very strong surplus for the year as a whole, perhaps over 3% of GDP. This highlights the rebalancing that has occurred in the economy over the past few years, 2 Bank of Ireland Global Markets

3 with the household and corporate sectors now enjoying large surpluses which are now dwarfing the deficit run by the public sector. downside risks to 1.5% GDP forecast for next year. We had projected GDP growth of 1.5% for 2013 and for the moment are inclined to retain this forecast, although the risks appear clearly on the downside, given the uncertain global outlook, particularly in the euro zone, and the likely impact of another deflationary Budget. The recent fall in the ECB repo rate may provide some relief for mortgage holders, (the majority are on tracker rates) and the decline in the euro against sterling will help indigenous exporters but any fall in inflation from here is likely to be modest, absent a sharp decline in energy prices. Some analysts had pinned hopes of a recovery in household spending on a fall in the savings ratio although that too appears unlikely given that the rate as reported is now much lower than many had thought. Consequently, we expect consumer spending to fall by 1% next year and to contribute to another decline in domestic demand, albeit small, with some offset from a further increase in business spending on machinery and equipment. Any growth therefore will come from net exports, highlighting Ireland s vulnerability to the external environment. Real GDP (% change) (e) 2013 (f) Personal Consumption Government Consumption Capital Formation Machinery & Equipment Construction Stocks (% of GDP) Exports Imports GDP GNP Bank of Ireland Global Markets

4 Inflation HICP inflation rises to euro average Sharp rise in HICP inflation over past year Ireland s annual inflation rate, as measured by the Harmonised Index (HICP) rose to 2.6% in August, from 2.0% in July, and as such met the euro average for the first time in over three and half years. Indeed, over the past five years inflation has averaged 1.0% below the euro zone equivalent, so Ireland s relative inflation performance has deteriorated of late, with the actual inflation rate accelerating from just 1% twelve months ago. The pick up in Irish HICP inflation over the past year is largely due to the service sector, with the annual inflation rate accelerating from 0.7% to 3.6%. Transport inflation, in particular, have risen sharply, to the current 8.2% from 3.5% a year ago, driven by high fuel costs and a significant pick up in the price of transport fares. Fees for education have also risen substantially and prices in restaurants and hotels are now rising again having fallen for a period. but mortgage costs dampen CPI... As a consequence, HICP inflation is now likely to average 2.1% for the year as a whole from 1.1% last year. We expect some deceleration in inflation on this measure next year, however, on the assumption that the spike in oil prices earlier in the year is not repeated. Higher fees and charges in the public sector may provide an upside surprise, but for the moment we expect HICP inflation to average 1.7% in CPI inflation in August was 2.0% and therefore marginally lower than the figure a year earlier, largely reflecting the impact of mortgage interest payments. Twelve months ago the latter were still rising but are now falling, declining by an annual 13% in the latest figures, hence reducing the overall CPI inflation rate by 0.75 percentage points. For 2012 we now expect CPI inflation to average 1.9%, down from 2.6% in 2011, and to average 1.7% next year in the absence of a significant move in energy prices. CPI Inflation (annual change, %) (e) 2013 (f) Q Q Q Q Annual HICP Bank of Ireland Global Markets

5 The Labour Market Immigration now seen as much stronger during boom Job creation remains elusive Although Ireland s GDP in the second quarter was 2.6% above the cycle low in late 2009 this has yet to translate into jobs creation. Employment fell again in Q2 by a seasonally adjusted 14,000 (0.8%) taking the annual decline to 33,000 (1.8%) and the total of jobs lost over the past five years to over 360,000. Employment had risen on a seasonally adjusted basis in the final quarter of last year but the latest revisions show that this gain was more than offset by a 10,000 fall in Q1, so there is no evidence in the year to date that employment is stablising. Moreover, the decline in Q2 was widespread, with only a few industries recording modest job gains, including hotels and the professional and scientific sector. The decline in the labour force in the second quarter was similar to that of employment with the result that the numbers unemployed were broadly unchanged at 309,000, as was the unemployment rate of 14.8%. The latter has remained at that level over the third quarter, based on the monthly estimates, and we expect the annual average to also emerge at 14.8%, although against a weaker labour market than we had envisaged; we expect employment to fall by an average 20,000 in 2012, or 1.1% with the fall in the labour force now estimated at 14,000 or 0.7%. The stimulus to the economy from net exports is clearly not sufficient to compensate for the weakness in domestic spending in its impact on the aggregate demand for labour and we now project employment bottoming out next year, which with an unchanged labour force will leave the unemployment rate around its current level. and migration flows are significant. The size of the Irish labour force is more volatile than most other EU States due to its open nature and the scale of migration flows. The 2011 census recorded that the population was over 90,000 higher than had been assumed, in turn implying more significant immigration than previously estimated. Consequently, the CSO has recently revised the migration data and it now shows immigration of 151,000 in the twelve months to April 2007 and a net inflow of over 100,000. Immigration peaked in that year and has slowed since, albeit still reaching 53,000 in the year to April 2012, while emigration has picked up substantially, from 46,000 at the peak of the boom to the latest figure of 87,000, with the result that there is now a net outflow of 34,000 a year. This is currently being offset by the natural increase in population, with the result that the total population rose by 0.2% in the year to April 2012, to 4.59 million. Labour Market (annual averages 000) (e) 2013 (f) Employment Labour Force Unemployed (% of labour force) Bank of Ireland Global Markets

6 Exchequer Finance Budget ahead of target despite weaker growth Revenue still ahead of target The latest exchequer figures, to end-september, show that the 2012 Budget is still in line with the official target and indeed could emerge ahead, although November is a very large tax month, accounting for 15% of total receipts, which argues for a degree of caution. Tax revenue has been consistently ahead of profile this year and that remains the case; receipts at end-september were 386m above target, or 1.5%, and 8.4% above the same period last year. Strong corporation tax inflows are a key factor ( 251m or 11% above profile) alongside VAT ( 94m ahead or 1.2%) and income tax ( 101m or 1%), offsetting a 135m (3.9%) shortfall in excise duty. Non-tax revenue also appears to be running ahead of expectations, as the 2.4bn total year to date is already only marginally below the full-year target although as the Fiscal Advisory Council recently noted, the authorities generally provide little commentary on this component. Fees from the guaranteed banks amount to 800m, already at the full-year target, and profits from the Central Bank are now ahead of the 945m assumed in the Budget. The exchequer has also received 300mn in interest payments on the contingent capital bonds provided to the covered banks which was not included in the Budget arithmetic. Voted current spending is still running ahead of expectations, by 600m of 2%, although partly offset by a 270m undershoot on the capital side (13.6%) to leave total voted spending (i.e. excluding debt interest) just 1% behind profile. As a result the current budget deficit for the first nine months of the year emerged at 9.1bn, against an 8.9bn shortfall in the same period last year and could well emerge below the fullyear target of 11.2bn in the absence of a revenue setback in November given the prospect of some savings in terms of debt interest relative to the Budget target. and deficit may emerge below forecast. The capital deficit was projected to fall sharply this year relative to 2011 (from 13.7bn to 7.7bn) largely reflecting the scale of bank support last year, but in the event the deficit will now be lower still, as the 3.1bn payment to IBRC took the form of a government bond instead. Consequently, the Exchequer Borrowing Requirement (EBR) to end-september came in well below last year s 20.7bn, at 11.1bn. The General Government deficit will not be affected, however. The strong budgeting performance to date also means that Ireland continues to meet the Troika fiscal targets, although the latter are set in terms of the primary deficit which came in at 10.1bn in the first nine months of the year, against a target of 11.4bn. Exchequer Finances ( bn) Budget Forecast Current Expenditure Voted Non-voted Revenue Tax Other Current Budget Balance Capital Balance Exchequer Balance General Government Balance (% of GDP) (-13.1%) (-8.6%) (-8.2%) 6 Bank of Ireland Global Markets

7 Funding the Exchequer Deficit Ireland builds cash balances 10bn overfund increases balances to 28bn The NTMA entered the year with cash balances of 17.8bn and has over-funded by some 10bn in the first nine months of the year, so boosting cash balances to 28bn. The Agency has raised 21.3bn in 2012, excluding the bond issued to IBRC, against an EBR of 11.1bn, with 18.7bn of funding borrowed under the EU/IMF programme (including 1.7bn in bilateral loans, largely from the UK) and 1.3bn raised through the various National Savings Schemes, marketed to retail investors in Ireland. The surprise development on the funding side was Ireland s return to the bond market which few expected to occur this year. Irish bonds had rallied steadily from last Autumn and following a becalmed period in the Spring rallied strongly again from late June. This prompted the NTMA to first issue Treasury Bills and then to launch a new bond, the 5.5% 2017, in July. The Agency coupled this with switch terms from bonds maturing in 2013 and 2014 into the new 5-year or the 5% 2020, and raised 5.2bn as a result or 4.2bn in new funds. In addition, the Agency met demand from Irish pension funds for amortising bonds and raised an additional 1bn in August via five different maturities, ranging from 15 years to 35 years. The Irish market has continued to perform well and the yield on the new 5-year benchmark fell from over 5.5% to under 3.5% while the 5% 2020 yield fell below 5%, prompting speculation that the NTMA would tap the market again as yields are now well below the 5.9% average paid to fund a few months ago. but no deal on bank debt. One factor in the bond rally was the expectation that Ireland would receive some relief on the bank debt that had been added to the sovereign debt, but events of late have cast some doubt on that; a statement by the finance ministers of Germany Austria and the Netherland appeared to rule out the transfer of legacy debt from banks to the ESM. The Irish government is still pressing its case, although a near-term conclusion is unlikely. An extension to the maturity of the Promissory Note is perhaps more likely, and it would reduce the 3bn per annum pencilled into the EBR forecasts over the next few years, although not reducing the debt level and no doubt increasing the overall cost in the long run. Despite these setbacks the situation remains positive, in that the Government can draw down the remaining 14bn in official funding which, alongside the 28bn in cash balances, is a comfortable cushion against the 38bn funding requirement estimated for 2013 and 2014, assuming that the exchequer deficits emerge as currently projected. 7 Bank of Ireland Global Markets

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