1% growth forecast for this year

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1 Produced by the Economic Research Unit April 2013 A quarterly analysis of trends in the Irish economy 1% growth forecast for this year Group Chief Economist: Dr. Dan McLaughlin Exports have slowed and are a risk National Accounts Page 2 Exports slowdown dampens growth Marginal increase in domestic demand expected The Irish economy recorded a second consecutive year of growth in 2012 but the 0.9% expansion masked a number of divergent developments in the second half of the year, some a cause for concern. On the positive side domestic demand grew in the final six months which represents a significant and welcome change to the downward trend seen since Consumer spending picked up and capital expenditure rose, including some signs of life in building and construction, but against that the external sector, the previous driver of growth, began to falter. Exports grew by just 0.5% in the latter half of 2012 while imports expanded by 2.7% with the result that net exports proved a drag on GDP, leading to a flat reading in Q4, following a 0.4% contraction in the third quarter. Inflation Page 4 Sharp deceleration of late The Labour Market Page 5 Employment finally starts to rise The Patent Cliff no doubt played a part but merchandise exports were weak before the pronounced downturn in Chemical and Pharmaceuticals impacted in earnest (from September) and we expect the external sector to remain under pressure given the weak outlook for activity in Europe. Consequently we now expect export growth of just 1.5% this year, with downside risks. Import growth is forecast to be 1%, with the result that the external sector continues to contribute positively to GDP, but at a much more modest pace than seen in recent years. Despite the recovery in the second half of last year domestic demand still fell in 2012 as a whole but we expect the first increase this year since 2007, albeit a very modest 0.3%, with flat consumer spending set against a further increase in capital spending, particularly on machinery and equipment. Real household incomes may be supported by modest increases in wages and employment, a cut in the ECB repo rate and a fall in inflation to just 1.1%, but crimped by higher taxes. Spending is also likely to be curbed by ongoing deleveraging and it appears that the gross savings ratio rose sharply last year after declining over the previous two. Overall we envisage GDP growth of 1%, which is below the current 1.3% consensus although that is moving down. Exchequer Finance Page 6 Downside risk to receipts Funding the Exchequer Deficit Page 7 Size of cash balances key positive Contact Us Page 8 Last year the income of Irish residents rose faster than GDP due to weak multinational profits and a rise in income earned on Irish investments abroad and we expect this to be a feature again this year, with GNP rising by 1.5% following a 3.4% increase in That international income inflow also contributed to a record Balance of Payment surplus for Ireland in 2012, amounting to some 5% of GDP, but the key factor was a trade surplus in services, the first in 26 years, and we expect the BoP surplus to increase further this year. Finally the 2013 Budget appears on target but there are downside risks to excise duty and VAT and in that context it is noticeable that the IMF would not advocate any additional fiscal adjustments this year or next in the event of a tax undershoot.

2 National Accounts Exports slowdown dampens growth 0.9% growth last year despite weak H2 According to the latest seasonally adjusted data, the Irish economy, as measured by real GDP, bottomed in the final quarter of 2009, following a 10.7% contraction, and has recovered some ground since, with GDP in Q standing 3.4% above the cycle low. That upturn, slow and uneven as it is, was also driven by one component, net exports, and in that context the second half of 2012 was something of a turning point, as domestic demand rose for two consecutive quarters, by a cumulative 1.7%, for the first time since Government spending fell but this was offset by strong gains in consumer spending (1.7%) and capital formation (5.5%), with the latter including an increase in the output of building and construction. Unfortunately this revival in domestic demand coincided with a marked deceleration in export growth, which slowed to 0.5% in the second half of the year, against a 2.7% increase in imports, with the result that the external sector made a negative contribution to GDP, contrary to the trend over the past few years. Consequently, overall GDP fell by a seasonally adjusted 0.4% in the third quarter and was flat in Q4, leaving the annual growth rate in the final quarter at zero. The slowdown through the year was not enough to offset the positive momentum entering 2012 and as a result the economy recorded annual growth last year of 0.9% following an advance of 1.4% in weaker exports forecast this year but domestic demand has stopped falling. The recent performance of the export sector and the uncertain international outlook represents a clear risk to GDP this year and we have reduced our export forecast in light of these developments. Merchandise exports have been particularly weak, falling by an annual 3.8% in the final quarter of 2012, and although the Patent Cliff is a factor the slowdown pre-dated that impact, which materialised in a substantial way from September. Service exports have also lost some momentum, although still growing at an annual 7.5% in Q4 but down from 11.8% in the first quarter and may surprise to the upside again this year, but we now expect total export growth of just 1.5% in volume terms in This is still likely to outpace import growth, which we forecast at 1.2%, but as a result the contribution of net exports to GDP is just 0.6 percentage points against 2.8% in 2012 and some 5% in Despite the second half recovery last year domestic demand fell by 1.2% on the year as a whole and we expect a modest rise of 0.3% in 2013, the first since This forecast increase is driven by one component, however, capital formation, with spending on machinery and equipment projected to rise by 10% alongside a marginal rise in construction spending. Government spending is expected to continue to decline, this time by 2% in volume terms, and consumer spending may be flat following a 0.9% decline last year. The latter component of demand has been more volatile than generally perceived, rising in 2010, for example, and there are some factors that may be supportive of household incomes this year, including modest increases in both employment and wages, a deceleration in inflation, and a probable cut in ECB rates, but that has to be set against a rise in taxes and the evidence that households are still de-leveraging; the available data from the sectoral accounts shows a rise in the gross savings ratio in 2012 following declines over the previous two years. Retail spending fell over the first two months of 2013 although the trend in the data in recent years implies that consumers are now bringing spending forward into the final months of the year in anticipation of tax increases in the December Budget, with a corresponding decline in spending in the first quarter. 2 Bank of Ireland Global Markets

3 GDP to rise by 1%. Overall then we now expect GDP growth in 2013 to be 1% and as such broadly similar to last year, with downside risks stemming from the international environment and the export sector. The export slowdown in the latter part of last year, (and no doubt the additional impact of the Patent Cliff on multinational profits) contributed to a broadly flat reading on income paid abroad on investments held in Ireland, while the income earned on Irish investments abroad rose by 4%. As a result the income of Irish residents grew at a faster pace than Irish output, with GNP growth of 3.4%, the highest since 2007, outpacing the 0.9% expansion of GDP. That divergence may be less pronounced this year but is still expected to be a feature of the national accounts and we forecast a 1.5% rise in GNP. The relatively strong performance of income on Irish foreign investments last year also contributed to a record surplus in Ireland s Balance of Payments, which reached 8.1bn or 4.9% of GDP, but the key driver was the strength of service exports, which resulted in the first surplus on the services balance since We expect another larger BoP surplus in 2013, equivalent to 6% of GDP with the turnaround in Ireland s external position from the large deficits in 2006 and 2007 reflecting the rebalancing of the economy over that period. Unfortunately it required a collapse in Irish output and employment to drive that change, although the economy is growing again and the stabilisation in domestic demand is a positive development. Real GDP (% change) (f) Personal Consumption Government Consumption Capital Formation Machinery & Equipment Building and Construction Stocks (% of GDP) Exports Imports GDP GNP Bank of Ireland Global Markets

4 Inflation Sharp deceleration of late Inflation has fallen sharply Irish inflation, as measured by the CPI, averaged 1.7% last year, down from 2.6% in 2011, and we expect a further deceleration this year. There is little in the way of underlying inflationary pressures in the economy (average wage growth last year was just 0.6% and consumer spending fell again in real terms) so any volatility in the index usually reflects the impact of energy prices (7.8% of the index), mortgage interest (6.6% of the index) and administered prices. On that basis, a significant factor in the recent fall in inflation, to just 0.5% in March from 2.2% a year earlier, is the slowdown in energy inflation which a year ago was adding 1% to the overall index but last month added just 0.2%. VAT rose by 2% in 2012 and that tax impact has dropped out of the annual comparison. On the mortgage side, interest payments had just started to fall on an annual basis a year ago, and hence were having a marginal downward impact on the overall CPI but in March this year were down by 7%, so reducing the index by 0.4 percentage points. The latter disinflationary effect peaked back in September, however, and its impact will continue to diminish as the year unfolds. Consequently, we expect the annual inflation rate to tick up from here, ending the year around 2%. The fact that inflation is lower on average through the year than in 2012 will help support real incomes nonetheless, and a key positive for the household sector, along with the prospect of modest increases in both employment and wage income. and may rise from here to average 1.1% for Inflation on the HICP measure, a better indicator of relative inflation across the euro area, is less volatile as it excludes the mortgage effect. The energy impact is clearly evident however, and has been a key factor behind the decline in the annual inflation rate to 0.6% in March on that measure, from 2.2% a year earlier. Again we expect some pick up from here for inflation to average 1.1% for the year, down from 2.0% last year. This keeps Irish inflation below the euro average and as such means that the gap between Irish prices and the European norm is narrowing; Irish prices were 17% above the EU norm in 2011 and about 14% above the euro average. CPI Inflation (annual change, %) (f) Q Q Q Q Annual HICP Bank of Ireland Global Markets

5 The Labour Market Employment finally starts to rise Employment rose in second half of 2012 The recent data, albeit subject to revision, supports the view that 2012 proved a turning point for the Irish labour market seasonally adjusted employment rose over the final two quarters of the year, the first six-monthly increase since the latter part of The increase was modest, a net 9k, but it left the unadjusted total in the final quarter of 2012 marginally higher on an annual basis and hence indicating that the prolonged and substantial fall in Irish employment over the previous five years was finally at an end. The improvement in labour demand was not uniform however, as Q4 still saw annual falls in manufacturing, construction and a range of service industries, offset by gains in information technology, the retail trade, professional services and healthcare. Wage trends have also shown a similarly wide distribution across industries but average weekly earnings rose in 2012, albeit by a modest 0.6%, and again this represents a change from the falls seen over the previous three years. In contrast, the labour force is still declining according to the Q4 Household Survey, with the fourth quarter showing an 18k annual fall. Net emigration is a factor but in that quarter there was a substantial increase in the numbers not in the labour force but still in the country, implying a significant disengaged worker effect. and further marginal increase expected this year. The seasonally adjusted unemployment rate fell to 14.2% in the final quarter of 2012, from 14.6% in Q3 and a cyclical peak of 15% in the first quarter. The monthly estimates since then, based on the trend but not the actual numbers in the Live Register, have shown a further decline, to 14% in March 2013, with that month seeing a ninth consecutive decline in the Register. This supports the view that the improvement in the labour market in continuing, as does the strength of income tax receipts. We do not expect a significant increase in job creation this year, however, given the expected backdrop of broadly flat domestic demand and only 1% GDP growth, and have pencilled in a very modest 5k average rise for the year, equivalent to 0.2% after a 0.7% fall in We also expect the labour force to continue to fall, by some 14k on average, leaving the average number unemployed at 300k, with an unemployment rate of 14.0%. Labour Market (annual averages 000) (f) Employment (% change) Labour Force Unemployed (% of labour force) Bank of Ireland Global Markets

6 Exchequer Finance Downside risk to receipts Tax receipts above target but VAT and excise duty behind Fiscal policy in Ireland is driven by the medium term plan agreed with the Troika in 2010, envisaging a gradual reduction in the General Government deficit to under 3% of GDP by The 2013 target is for a deficit of 12.6bn or 7.5% of GDP, although this does not involve a substantial fall from the 2012 outturn, which may emerge at under 8% of GDP (the figure has yet to be finalised). Indeed, the cash deficit in 2013 (the Exchequer Borrowing Requirement or EBR), at a forecast 15.4bn is actually higher than the 2012 outturn of 14.9bn as the latter benefitted from much stronger than expected receipts in December. The 2013 Budget was predicated on real GDP growth of 1.5% which looks too high relative to the consensus and our own view, although the first quarter exchequer returns are still consistent with the fiscal targets. Tax revenue emerged marginally ahead of profile (by 0.5%) and day-to-day spending (voted current expenditure) is running 4.9% down on last year, against a Budget target for the year of -3.0%. The current Budget deficit came in at 4.9bn, exactly in line with the first quarter of 2012, while the EBR as a whole was lower, at 3.7bn against 4.3bn in the first quarter of The tax figure was flattered by a jump in corporation tax in March, however, and both VAT and excise duty are running behind profile, the former by 2% and the latter 3.5%. Consequently, we feel that there is now a downside risk to the revenue target, and in that context it is worth noting that the IMF believes that any undershoot in tax receipts this year should not be met with further budgetary adjustments. cash deficit to benefit from unbudgeted capital developments. It is too early to be definitive about the full year current budget outlook, nonetheless, and for now we expect the target to be met. The capital deficit may well emerge well below target, however, given recent developments relative to the original budget forecast. They include a 3.1bn payment to IBRC which will not take place in the wake of the deal on the Promissory Note. There will be partial offsets (including interest on the 25bn bonds issued to the Central Bank as payment for the note and ELG related spending following the liquidation of IBRC) but the Government has also received 1bn from the sale of the Bank of Ireland CoCo and over 1bn from the sale of Irish Life. Consequently, we project an EBR of around 13bn. Exchequer Finances ( bn) Budget (f) Current Expenditure Voted Non-voted Current Revenue Tax Other Current Budget Balance Capital Balance Exchequer Borrowing Requirement General Govt Deficit (% of GDP) 7.7%(e) 7.5% 7.5% 6 Bank of Ireland Global Markets

7 Funding the Exchequer Deficit Size of cash balances key positive Overfunding leaves balances in healthy position Under the terms of the 2010 bail-out Ireland can access 67.5bn of official funding, including 4.8bn in bilateral loans, largely from the UK. At the end of December the NTMA had drawn down some 56bn at an average interest rate of 3.36%. The weighted average life of the IMF and the bilateral loans is 7.5 years, against around 12 years on the EU loans, to give an overall average of 10.5 years. Ireland is seeking an extension to the maturity of the EU loans and current indications are that this is supported by the Troika. The NTMA ended last year in highly liquid form, with balances of 24bn including over 15bn in cash and continued to overfund in the first quarter of 2013, raising 12.8bn (excluding the 25bn bonds issued to the Central Bank) against an exchequer deficit of 3.7bn, so boosting balances by 9.1bn and taking the end-march figure to 33bn, and over 19bn in cash. This leaves the Agency in a healthy position in the event of any market disruption but investors have continued to view Irish debt in a much more favourable light; 5-year yields started the year at 3.3% and have fallen to around 2.60%. The NTMA responded to demand by issuing 2.5bn via a syndicated tap on the benchmark 5-year and then raising an additional 5bn via a syndicated issuance of a new 10-year benchmark, the 3.9% The Agency had indicated a 10bn target for bond issuance this year and is likely to tap the market again on an opportunistic basis as it seeks to disengage from the bail-out and re-engage on a consistent basis with the market. but debt level makes for vulnerability. The strength of the funding balances in place is certainly a positive, as they can carry the Exchequer through 2014 and into 2015 assuming that Troika payments are fully drawn down and next year s deficit is on or below target. In addition, the ending of the ELG scheme reduces the State s contingent liabilities and the Promissory Note deal means that the EBR will be around 2bn lower each year out to The latter did not affect the total stock of debt, however, which is extremely high, at 117% of GDP in 2012 and a projected 122% this year. The Irish Government is still hopeful of achieving a reduction in the bank-related debt through the ESM but we are doubtful if that will materialise. Consequently, the scale of the debt burden remains the major risk factor, as it makes Ireland vulnerable to any disappointment on GDP growth. 7 Bank of Ireland Global Markets

8 Contact Us Economic Research Unit (ERU) To discuss any aspect of this report, contact your treasury specialist or our Economic Research UNIT (ERU): Chief Economist, Bank of Ireland: Dr. Dan McLaughlin Tel: +353 (0) Senior Economist: Michael Crowley Economist: Patrick Mullane Contact your treasury specialist Corporate Treasury or Business Banking Treasury Institutional Treasury Specialised Finance +353 (0) UK Sales Team (within the UK) US Sales Team Our Offices Dublin 2 Burlington Plaza, Burlington Road, Dublin 4, Ireland Tel +353 (0) London Bow Bells House, 1 Bread Street, London EC4P 4BP, UK Tel +44 (0) Belfast 1 Donegall Square South, Belfast, BT1 5LR, UK Tel +44 (0) Stamford (US) 300 First Stamford Place, Stamford CT 06902, US Tel Keep in touch with the markets, visit Market data supplied by Thomson Reuters Disclaimer This document has been prepared by the Economic Research Unit at Bank of Ireland Global Markets ( GM ) for information purposes only and GM is not soliciting any action based upon it. GM believes any information contained herein to be accurate but GM does not warrant its accuracy and accepts no responsibility, other than any responsibility it may owe to any party under the European Communities (Markets in Financial Instruments) Regulations 2007 as may be amended from time to time, and under the Financial Services Authority rules (where the client is resident in the UK), for any loss or damage caused by any act or omission taken as a result of the information contained in this document. No prices or rates mentioned are bids or offers by GM to purchase or sell any currencies, securities or financial instruments. Except as otherwise may be specifically agreed, GM has not acted nor will act as a fiduciary, financial or investment adviser with respect to any currency or derivative transaction that it has executed or will execute. Any decision made by a party after reading this document shall be on the basis of its own research and not be influenced or based on any view expressed by GM. This document does not address all risks. Any party should obtain independent professional advice before making any investment decision. Any expressions of opinion reflect current opinions as at 12 April This publication is based on information available before this date. This document is property of GM. The content may not be reproduced, either in whole or in part, without the express written consent of a suitably authorised member of GM staff. Bank of Ireland is regulated by the Central Bank of Ireland. In the UK, Bank of Ireland is authorised by the Central Bank of Ireland and authorised and subject to limited regulation by the Financial Services Authority. Details about the extent of our authorisation and regulation by the Financial Services Authority are available from us on request. Bank of Ireland incorporated in Ireland with limited liability. Registered Office - Head Office, 40 Mespil Road, Dublin 4, Ireland.Registered Number - C-1. Bank of Ireland Global Markets