Irish Economy Feb 2008 Summary and Outlook The outlook for the Irish economy remains favourable, in an international context, albeit that growth is set to slow sharply from recent impressive levels. GNP growth in 2007 is estimated at 5% but will ease to 2% in 2008, still in excess of trading partners, but the slowest since 1991. A rebound to 4% in 2009 is predicted. Consumer spending was buoyant in 2007, boosted by strong job creation, an expansionary Budget and a limited SSIA effect. However, a sharp deceleration to 3% is forecast for 2008, reflecting slower employment growth (1%) and more moderate wage increases (4%). Inflation remained elevated in 2007 when the average CPI increase was 4.9%. The HICP, which excludes interest rates, was 2.8%, lower but still well above the EU13 2.1% average. The 2008 forecast is 3.1% CPI and 2.9% HICP, closer to, but still above, the eurozone s 2.5%. The 2009 outlook is for further falls in inflation. The 2007 budget surplus was depleted by weaker revenue growth as housing slowed but remained in the black. The 2008 Budget posted a deficit of 0.9%, still comfortably below the EU 3% limit but is likely to overshoot to 1.4% as housing weakens further. House prices fell by 7.3% in the year to December 2007. We expect them to fall further this year but to recover in the second half leaving them down 2% by year end. Housing affordability has improved as ECB rates are unchanged at 4.0% since June 2007, house prices are falling, stamp duty has been lowered, income tax allowances increased and wages are rising. Supply has also been sharply curtailed but confidence has yet to recover. We expect this to happen by mid-year. While interest rates are forecast to remain unchanged there is an outside chance of a cut later in the year if the eurozone economy slows sharply. Growth The Irish economy registered its twenty first consecutive year of growth in 2007. GNP, our preferred measure of growth, (it excludes profits of multinationals which accrue to non-residents, and includes profits earned abroad by residents), is estimated to have risen by 5%, driven by strong consumer and Government spending but also a pick up in exports. While all of these factors are expected to moderate in 2008, the biggest negative will come from investment which is set to contract at the fastest rate since 1974. GNP is forecast to increase by 2% in 2008, the slowest rate of growth since 1991, but to rebound to 4% in 2009. Population (2007): 4.3 million GNP per capita (2007): EUR 36,955 Exchange Rate EUR/STG: 0.74 (30 Jan 2007) EUR/DLR: 1.48 five-year 16 billion Government-assisted savings scheme, equivalent to 20% of Personal Consumer Expenditure (PCE), only materialised to a very limited extent. Surveys and anecdotal evidence indicate that savers invested the proceeds, used them for house maintenance/improvement, paid down credit card debt or took a foreign holiday. These reactions are likely to have been influenced by more subdued confidence levels, in turn, reflecting higher interest rates and energy prices, not to mention continued speculation about a house price crash and high-profile media stories about job losses. Rising mortgage rates also represent a significant additional drain on disposable income. The additional repayment on a 300,000 35-year mortgage from the cumulative 2% point increase in interest rates is 365 a month. This compares with an average of 196 a month saved under the former SSIA scheme. The very substantial increase in the first time buyer mortgage interest relief ceiling for a couple from 8,000 to 20,000 in the last two Budgets, is equivalent to an additional cash refund of 200 a month. Between them, the tax and SSIA effects outweigh the cost of the higher mortgage bill but the tax relief is limited to first-time buyers with sufficient borrowings to avail of the full relief. % 10 9 8 7 6 5 4 3 2 1 - Source: CSO, UB Consumer Spending Forecasts - volume PCE PCE per Employee 1999 2000 2001 2002 2003 2004 2005 2006 2007E 2008F 2009F The outlook for 2008 is more demanding. To the extent that 2007 spending was boosted by SSIAs, there may be some pay back in 2008. The bigger influence, however, is likely to be employment. With housing output slowing sharply, the construction sector will be shedding labour at a significant rate. We foresee significant job losses in construction as housing output virtually halves from the 2006 peak of 88,187 units to 45,000 in 2008. This will depress the overall employment growth rate. After expanding by 3.3% in 2007, we expect the rate of increase to slip to 0.9% this year but to rebound to 1.6% in 2009. While wage growth will decelerate to around 4%, it is the less buoyant employment outlook that will be the major influence on consumption this year at the margin. Consumer spending Consumer spending, 55% of total GNP, expanded by 6% in 2007. Spending was boosted by strong growth in employment which rose 3.3%, although much of this was part-time. There was a positive but limited SSIA effect as evidenced by the spend per employee which bounced but did not exceed the 2005 rate and was below levels attained at the turn of the century. The anticipated boost from the release of SSIAs, a Though we have allowed the volume of spend per employee to fall back in 2008, it remains at levels that are close to the average of recent years. It follows, therefore, that the principal reason for the relatively low, 3%, growth in spending foreseen is the anaemic - by reference to past performance 0.9% increase in employment forecast for 2008. There are factors which could further depress consumption. Job losses are a rare phenomenon and the announcement effect of significant construction lay-offs could be considerable. Ulster Bank Limited accepts no liability for the outcome of any actions taken arising from the use of this report
2 Consumer confidence is also depressed and is not far off its 2003 lows and retail sales have begun to ease back. Uncertainty is likely to boost precautionary savings. Wage increases per capita are likely to average 4%, down from 5% last year but perceived inflation will be much reduced. We expect no more rises in interest rates, there is even an outside chance of a small fall later in the year. This means that mortgage affordability will continue to improve steadily and should eventually attract the first time buyer back into the housing market, assuming, of course, that confidence recovers first. Housing related spending should benefit. On balance, we expect consumer spending to grow by 3% in 2008, its lowest rate of increase since 1993, apart from 2003 when the increase was also 3%. A similar rate is likely in 2009. Investment Whereas investment was a mainstay of the Irish economy in 2003 to 2005, this changed in 2006 when the volume increase was just 3.1%. There were two reasons for this. The rate of growth in housing output slackened off considerably, as new house completions were 88,187, up only 2,000 on 2005. However, non-residential construction took up much of the slack as the commercial sector was very buoyant and civil engineering benefited from the Government s massive infrastructure spending programme. A contraction in investment in Plant & Machinery, reflecting falling aircraft purchases, also helped drag down the overall investment increase. Trade Growth in exports has been depressed since 2000 and only began to improve when eurozone activity recovered. The external sector contributed little to growth in recent years but this changed in 2007 when a positive contribution of 2% points was recorded. Exports of goods and services grew at an annual 8% rate, the strongest growth rate since 2001, while imports increased by 7.8%. Services exports have grown strongly, up 16.6% in the first three quarters of 2007. Strong import growth reflected the nature of Irish manufacturing which is dominated by multinationals, and buoyant consumer demand which generated imports of consumables. In 2008, the external environment will be more challenging because (i) growth in Ireland s main trading partners will be slower and (ii) because the recent appreciation of the euro, particularly against sterling, will make it more difficult to export. Nonetheless, growth in trading partners, while slower, should still be sufficient to generate a reasonable level of exports and a decent positive contribution from net trade. We do not accept the recent IMF report that trade could be significantly affected by a US slowdown. US investment has not had a significant net impact on Irish growth in recent years and is unlikely to have a major negative influence in coming years, barring a wholesale exodus of US investment which we do not anticipate A smaller, but still positive net export contribution is projected for 2009. 10% 5% 0% Housing contribution critical to Investment 20% 10% 0% Industry and Services Volume increases in industrial production slowed significantly after the 2000 boom reflecting the weak international environment and a loss of competitiveness due to the appreciating euro and escalating domestic costs. The deceleration was particularly pronounced in the modern (multinational) sector which accounts for the vast bulk of total output but provides a relatively small amount of employment. -5% -10% -15% Housing (LHS) Other Construction (LHS) Plant & Machinery (LHS) Total Investment (RHS) Source:CSO, UB 2001 2002 2003 2004 2005 2006 2007E 2008F 2009F Investment growth further decelerated in 2007. Housing output was flat in the first quarter but began to contract at an accelerating rate thereafter. New house completions were 78,027, down from 88,187 in 2006. The contribution from other construction, commercial and civil, remained robust but was lower while machinery and equipment spending was relatively strong. The combination of these effects saw overall investment stay in positive territory but the rate of increase was only 1.4%, the lowest since 2001. 2008 is set to see a further significant deceleration as the housing contraction accelerates we now expect 45,000 completions which results in a 30% decline in the housing component and a large negative contribution to investment. This is signalled by sharp declines in the UB Construction PMI and in housing starts. However, commercial and civil activity remains relatively buoyant and Plant and Machinery continues to grow strongly. The forecast decline in total investment is 8.5%, the weakest since 1983. A significant improvement is forecast for 2009. We expect housing output to do no more than level off at 45,000 units but this is sufficient to cause total investment to recover and expand by more than 6%. -10% -20% -30% The recovery began in 2005. The improvement was mainly in the modern sector with several sub sectors, notably beverages, recording strong growth, though chemicals declined. Traditional industry also improved although its overall contribution remained modest. These trends continued into 2007 in the first eleven months, industrial production grew by 7.8%, a rate of growth which would be the fastest since 2001 if it is maintained in the final month of that year. The latest Purchasing Managers surveys point to a weakening in manufacturing which has yet to manifest itself in the official activity statistics. 16% 14% 12% 10% 8% 6% 4% 2% Industrial Production Traditional Modern 0% Source: CSO, UB -2% 2000 2001 2002 2003 2004 2005 2006 2007Q1-Q3 Services activity is still the mainstay of the economy, accounting for more than 60% of total growth. It is, moreover, the fastest
growing of the three main sectors and growth is broadly-based. Business, Finance, TMT (Technology, Media and Telecommunications) and Transport, travel, tourism and leisure (TTT&L) have all grown strongly. More recently all sectors except TMT have eased but there has been a more pronounced weakening in TTT&L. As a result, the overall rate of services expansion, while still strong, is below earlier levels. 70 65 60 55 50 45 40 ROI PMI main activity indicators Manuf Services Construction Source: NTC, NCB, UB PMI Surveys 35 Dec-03 Apr-04 Aug-04 Dec-04 Apr-05 Aug-05 Dec-05 Apr-06 Aug-06 Dec-06 Apr-07 Aug-07 Dec-07 Apr-08 3 slower global growth on prices generally. Whereas the 2007 Budget added 0.4% to prices, the 2008 one boosted them by less than 0.2%. However, the main reason for the forecast improvement is our expectation that the ECB will leave key interest rates unchanged, allowing the impact of past increases to steadily fall out of the annual comparison. Interest rates and energy prices will, again, be critical. A quarter point reduction in ECB rates would subtract about 0.4% point in a full year. We assume that petrol prices will remain around current levels, though at time of writing crude oil prices are trending down a bit. However, a renewed increase in pump prices could boost the CPI. On the plus side, wage inflation is expected to ease significantly in 2008 and services inflation should follow suit. Finally, the upward risks to inflation from additional spending of SSIA savings have dissipated. The result is a very significant deceleration causing the 2008 average to fall to 3.1%, assuming unchanged ECB rates. The corresponding HICP forecast is 2.9%, still 0.4% above the likely euro area rate of 2.5%. Further reductions to 2.5%, CPI, and 2.3% HICP are predicted for 2009. Inflation Inflation 1 averaged 4.9% in 2007. The impact of interest rates can be seen from the CPI rate ex mortgage interest which was 3.1%. Excluding both energy and interest, the rate was 2.5%. The HICP, which also excludes mortgage interest, rose by 2.9%, a good three-quarters of a per cent above the eurozone average and the fastest rate of increase since 2003. Food prices rose strongly but the impact was limited given their low, 11%, weighting in the consumer basket. However, goods prices, ex energy, are now rising at annual rates above 1% whereas they were previously flat. This trend is expected to continue. Core services inflation, ex interest rates, is moving in the opposite direction, having peaked at 5% a year ago, it is now around 3.5%. This softer trend should also continue. % 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 05 avg = 2.5% Consumer Price Inflation 06 avg = 4.0% 07 avg = 4.9% HICP Forecasts 08 avg = 3.1% 09 avg = 2.5% 1.0 Source: CSO, UB 0.5 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 The 2007 wage increases negotiated under the national pay agreement were less than inflation but there was little reaction from the unions who noted that headline CPI was boosted by mortgage rate increases and that the real rate of inflation facing non-home buyers was around 3%.They thus sought mortgage tax relief increases, to alleviate hardship on first time house buyers and these were duly delivered in the Budget. The outlook for 2008 is for a significant deceleration in price inflation, reflecting lower contributions from mortgage interest rates and energy prices as well as the knock-on impact of 1 The measure used is the Irish Consumer Prices Index. This differs from the Harmonised Index of Consumer Prices (HICP) mainly because it includes Mortgage annuity repayments which have increased sharply. Budget The 2007 Budget was quite expansionary with adjustments to Income Tax bands and allowances boosting after-tax incomes and spending increases in double digits. At the same time, policy was designed to post a surplus of 1.2% of GDP but with property-related taxes strongly underperforming, the outturn was a much reduced surplus of 0.5%. Taxes undershot by 1.8 billion but there was an offsetting 700 million saving on current spending, mainly debt interest. While significant tax concessions are promised in the new Government s programme, there is an order of priority which puts fiscal probity at the top, followed by full implementation of the National Development Plan and then tax cuts. This set the tone for the 2008 Budget which curbed current net spending to a still-too-high rate of 8.2%. Tax cuts were more modest and the overall deficit budgeted is 0.9% of GDP. The results of the second Benchmarking of public sector pay, released after the Budget, will not add significantly to the pay bill. The Government is committed to curbing 2008 current spending to an increase of 8%, down from an unsustainable 14% in 2007. Tax revenue will again be under pressure from slower construction activity. Property related taxes have accounted for up to 25% of total tax revenue in recent years. Each 10,000 reduction in housing output reduces GNP growth by 1% and tax revenue by about 1 billion. As we have lowered our completions forecast to 45,000, we accordingly, expect the 2008 deficit to overshoot by a billion, taking the likely outturn deficit to 1.4% of GDP, still comfortably below the EU 3% limit. The benign nature of the overall fiscal situation is further evidenced by the debt:gdp ratio which is the second lowest in the eurozone. The above forecasts imply that the ratio would rise from 25.1% to 26.4% of GDP before account is taken of the assets of the National Pensions Reserve Fund, currently, about 13% of GDP. Employment The labour market was surprisingly resilient in 2007. Employment rose by 3.3%, which compares favourably with an elevated 1.9% in the eurozone and a more usual 0.6% in the UK. Virtually all of the growth was in services as manufacturing and agriculture were essentially static. The construction sector reported a major slowdown, adding jobs in the first quarter but losing greater amounts subsequently to give a net 2,000 reduction in the first three quarters. All of the 44,000 jobs
created in this period were thus in services. The main contributors were wholesale and retail, 12,000, financial and other business, 15,000, and government, 11,000. Other significant trends included a rise in part-time work, more than half of recent jobs growth, but nearly involved all described themselves as not underemployed. More striking still was the huge growth in the self employed. (The underlying increase in employment, adjusted for the fact that part timers are not fully employed, was well below 3%, possibly around 2.5%). A more significant fall in employee numbers was offset by an equal but opposite trend in jobs acquired by the self-employed and relatives assisting. This further explains why recorded total employment held up so well. 4 Housing Housing inflation peaked at 15% annual in mid-2006. By end 2006, the annual rate was down to 12% and by end 2007 was at minus 7.3%. The industry response was to curtail supply as evidenced by housing starts see chart where registrations advanced nine months are used as a proxy for completions - which are projected to fall off sharply. We forecast completions at 45,000 this year and a modest increase to 50,000 in 2009. In reality, the margin of error around the 2008 forecast is quite large and it is best regarded as the centre of a range from 40,000 to 50,000. It is likely that many of the newly self employed are still in construction, having switched as output slowed from employee status into repair and maintenance, a sector that was neglected during the boom. The potential for further shifts must be limited, so from now on we expect to see continued falls in construction employees reflected in slower total employment growth, as happened in 2002. 95,000 90,000 85,000 80,000 75,000 70,000 Housing Supply Indicators Completions (ESB data) Registrations - advanced 9 mnths 2006=88,108 2007 = 78,027 000s 120 100 80 Annual employment changes Employee Self employed & ass relatives Total persons 65,000 60,000 55,000 50,000 Source: DOE, 45,000 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 12 month cumulative rolling totals 60 40 20 0-20 Source: UB, CSO Nov 98 Nov 99 Nov 00 Nov 01 Nov 02 Nov 03 Nov 04 Nov 05 Nov 06 Nov 07 While over 70% of the additional 67,000 jobs created in the year to Q3 07 were filled by non-nationals, the pattern is changing. Non-nationals are no longer finding jobs in construction, but are beginning to move into agriculture as nationals continue to leave the land. It is still the case that the vast bulk of new jobs in services are filled by non-nationals while the government essentially hires nationals only. A further sharp reduction in the rate of employment growth is in prospect as reduced numbers in construction are only partially offset by increases in non-construction employment. The construction outlook, in turn, reflects the forecast decline in housing output from 78,027 units in 2007 to 45,000 units this year. Housing accounts for about 66% of overall construction employment of 280,000 and as we do not expect the shift into self employment noted above to continue, we forecast a fall in construction employment of 20,000 in 2008. With employment in the rest of the economy expanding by 40,000, overall employment will still increase by 20,000, or 0.9%, however, this will be the lowest rate of growth since 1992. The short-term outlook for housing remains poor as sentiment is negative and likely to remain so while current uncertainty and market turmoil persists probably into the second quarter of 2008. Thereafter, the situation should improve in line with better affordability, as outlined earlier. Rents are also rising strongly, up 11% in December, indicative of an effective shortage of accommodation, despite overhangs of new houses completed but not sold and a doubling of the number of unsold secondhand houses to about 50,000, or 7.5 months supply. Finally, the underlying demographics remain favourable with employment forecast to rise by 1% and wages by 4%. We expect house prices to continue to fall in the first half of 2008 but to recover thereafter leaving them largely unchanged by end year. This still implies a 2008 average of minus 7%. Modest increases are forecast for 2009 and subsequent years. Pat Mc Ardle, Chief Economist E- mail: Pat.McArdle@ulsterbank.com Tel: + 353 1 608 4060 Lynsey Clemenger Economist E-mail: Lynsey.Clemenger@ulsterbankcm.com Tel: + 353 1 608 4173 The unemployment rate was 4.5% in 2007, up only marginally on 2006, indicating that the economy remained in full employment. Despite the projected strong decline in construction employment, only a relatively modest increase in unemployment is in prospect. This reflects our belief that surplus housing workers will be absorbed (a) elsewhere in the general economy, (b) in London where the Olympics are beginning to generate activity and (c) elsewhere as nonnationals disperse. On this basis, we project only a relatively modest increase in unemployment to 5.5% in 2008 and 6% in 2009.
5 Summary Table 2005 2006 2007E 2008F 2009F GROWTH Consumer Spending (%YOY) 7.3 5.7 6.0 3.0 3.3 Investment (%YOY) 11.8 3.1 1.4-8.5 8.7 Government Spending (%YOY) 4.0 5.3 6.7 4.5 3.5 Exports (%YOY) 5.2 4.4 7.8 5.0 4.0 Imports (%YOY) 7.7 4.4 6.5 3.3 4.5 Real GDP (% YOY) 5.9 5.7 5.2 2.1 4.0 Real GNP (% YOY) 4.9 6.5 5.0 2.0 4.0 PRICES CPI (% YOY) Average, Nat. Definition 2.5 4.0 4.9 3.1 2.5 HICP (% YOY) Average, Harmonised Definition 2.2 2.7 2.8 2.9 2.3 LABOUR MARKET Employment average (% YOY) 4.7 4.4 3.3 0.9 1.6 Unemployment Standardised avg. % 4.4 4.4 4.5 5.5 6.0 PUBLIC FINANCE Budget Balance (% GDP) 1.2 2.9 0.5-1.4-1.6 HOUSING MARKET Completions (000 s) 86,189 88,187 78,027 45,000 50,000 House Price Inflation (% end-year) 9.3% 11.8% -7.3% -2.0% 3.0% EXCHANGE AND INTEREST RATES ECB Refi Rate (End of Period) 2.25 3.5 4.0 4.0 4.0 EUR/$ (End of Period) 1.18 1.32 1.46 1.40 1.35 EUR/ (End of Period) 0.69 0.67 0.74 0.73 0.72
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