Euro Fiscal Rules to the fore in Irish Medium Term Outlook

The Irish Government has just published the annual Stability Programme Update, incorporating macro-economic projections out to 2020 and  a forecast of the fiscal position over that period. The figures indicate that this  Administration has the scope to deliver some further modest tax reductions in the 2016 Budget, and no doubt that will  garner the most column inches, but a key feature of the text is the degree to which EU fiscal rules will remain a constraint for Irish Budgetary policy.

The near term economic and fiscal outlook certainly looks brighter than it appeared in last year’s Update, or indeed at the presentation of the 2015 Budget (in October last year). Tax receipts are running well ahead of target and the Department of Finance now expects a €1bn overshoot, which appears conservative. Non-tax receipts have also surprised to the upside , thanks to a higher Central Bank surplus, and debt interest is now expected to be substantially lower than initially forecast. Capital receipts are also likely to be well ahead of the Budget projection, with the result that the Exchequer deficit ( the cash sum that  it needs to  borrow ) is now forecast at  €3.5bn instead of the initial €6.5bn. The impact on  the  General Government deficit is not as large ( some of the unplanned capital receipts are excluded ) and that is now expected to come in at €4.6bn, or  some 2.3% of GDP , against a Budget target of 2.7%.

Surprisingly, perhaps, the Department has resisted the temptation to  materially revise its previous growth forecasts; real GDP in 2015 is now projected to increase by 4% instead of 3.9%, with 2016 now 0.4 percentage points higher, at 3.6%, but growth in each of the next two years is now expected to be 0.2 percentage points lower. Nominal GDP is forecast to rise strongly this year, up 6.9%, but by 2018 is only 1% higher than previously envisaged.

In the past greater tax buoyancy often resulted in higher exchequer spending and/or tax reductions ( ‘if I have it I’ll spend it’, to quote Charlie McCreevy) but Ireland’s membership of the euro imposes fiscal constraints. One, under the corrective arm of the Stability and Growth Pact,  was the requirement to reduce the  fiscal deficit to under 3% of GDP. That achieved, Ireland has now to adhere to the Preventive arm, and this imposes two constraints over the next few years.

The first is that Ireland has to move to a structural budget balance ( the actual balance adjusted for the economic cycle). According to the EU Ireland is now operating around full capacity ( a strange assumption, in truth ) so none of the actual  deficit forecast for 2015 is deemed cyclical. Hence the structural deficit is projected at 2.6% and under the rules Ireland has to reduce that by at least 0.5% of GDP each year.

A second rule, designed to complement the first, limits the  amount the government can spend. Certain items are excluded from the requirement, such as debt interest, capital spending and some unemployment benefits , which in Ireland’s case means  that €66bn falls under the with the limit, from a grand total of €73bn. The former can only grow in line with the potential growth rate of the economy or in Ireland’s case at a lower rate in order to ensure that the structural deficit declines. That potential growth rate is in turn calculated periodically by the EU, and it appeared that the existing  formula would leave the Government with little room to manoeuvre  in the 2016 Budget ( with little ‘fiscal space’ in economic jargon) . However, the EU has now been persuaded to update potential growth estimates on an annual basis and although spending is still constrained the permitted rate of  spending growth in Ireland has increased, to 1.6%, and it  now appears that the Government has around €1.3bn in terms of ‘fiscal space’, or around €1bn more than envisaged a few months ago, Those additional resources , according to the Minister for Finance, will be used to increase spending by around €0.6bn in 2016 while also reducing taxation by a similar amount.

One issue is that the structural deficit is only projected to decline by 0.4 percentage points in 2016 ,to 2.2%, which may cause problems for the EU. Further out, the Update projects that tax receipts will rise slightly faster than GDP and that the structural deficit  will decline by 1% per annum in both 2017 and 2018 , before moving to surplus in the following year. Yet  that outcome is achieved by assuming  unchanged  current spending in nominal terms, which is clearly incompatible with any real increase  if inflation is anything above zero.  The implication is that any Irish government, of whatever political hue, will continue to face significant fiscal constraints over the medium term, and the limited resources available will intensify the debate about  the efficacy of tax cuts as against  spending increases.

Ireland’s Debt Dynamics turn more benign

Irish government debt stood at €47bn in 2007, just 24% of  GDP, one of the lowest ratios in the euro area. Debt then ballooned, rising to over €215bn by 2013, reflecting capital injections to the banking system, the impact of the recession on the underlying budgetary position, and latterly, the inclusion of IBRC’s liabilities. The impact on the debt ratio was compounded by the trend in the denominator, nominal GDP, which fell by some €32bn or 16% from 2007 to 2010, with only a modest pace of recovery evident up to 2013.  As a result the debt ratio ended  the latter year at 123.2% of GDP, one of the highest debt burdens across the single currency area, and one some felt was not sustainable. That ratio now appears to have peaked, however; the CSO  estimates that  the debt ratio fell to 109.7% in 2014, with the level of debt declining to €203.3bn, in part due to the sale of liquidation and sale of IBRC assets.

Ireland’s debt dynamics are now turning positive and , based on current expectations, the debt ratio should now fall steadily, with the caveat that events can and do throw up consequences which render previous expectations redundant. That aside, the factors which determine the debt ratio are all moving in a more benign direction for Ireland.

Take nominal GDP.  That rose by 6.1% in 2014, to over €185bn,and the Government is currently projecting a  5.3% increase this year, with a similar rate of growth forecast out to 2018. The 2015 figure is based on real growth of 3.9% , which some feel is now too low, and an upward revision is possible when the next set of official projections appear (they are due later this month).

The other key drivers in terms of debt dynamics are the average interest rate on the debt and fiscal position excluding interest payments , or primary balance. The former is projected to average 3.5% this year( which appears too high now in the light of QE) but in any case is well below the growth rate of GDP, a  reverse of the malign  dynamics operating between 2008 and 2013 and one that will now put downward pressure, albeit modest, on the debt ratio.  The official forecast envisages a marginally upward path  in the interest rate  over the next few years. although still below the projected growth in GDP, which implies a further continuation of that more benign trend.

In addition, Ireland is now running a primary surplus (i.e. revenue exceeds non-debt expenditure) which is required to ensure a more rapid decline in the debt burden. In 2015, for example, the primary surplus is currently projected at 1.1% of GDP, rising to  4% by 2018. The debt ratio is also influenced by one-off adjustments ( e.g. the NTMA  running down cash balances, revenue from asset sales)  and leaving those aside the above interaction of  nominal GDP,  the interest rate and the primary surplus results in Ireland’s debt ratio falling to 107.5% this year before declining to under 100% in 2017 and 94% by 2018.

That projection is also  based on the current forecasts for the fiscal balance, which envisages a steady decline in the overall  deficit, from 2.7 % of  GDP this year to 0.9% in 2017 and a marginal surplus in 2018. That now also looks conservative, given the strength of tax receipts in the year to date, and so a stronger primary surplus path may emerge, albeit one  that takes no account of the political cycle, although any Irish government will be constrained by EU rules on government spending, even if some leeway is given in terms of interpretation. A noted above,  economic shocks may  emerge but in their absence the Irish debt ratio does look to be on a downward path to a more sustainable level, if at a steadier pace than experienced during its upward trajectory.

Why buy Bonds with negative yields ?

Negative bond yields are no longer a rarity across the Euro area,  accounting  for over half the government debt at issue in some countries (Germany, the Netherlands and Finland) and well over a third in others (Austria, France and Belgium).  Moreover, what was generally confined to shorter term debt is now extending along the yield curve, and  many now expect German 10-year yields  (currently 0.15%) to  follow Switzerland into negative territory.

Low bond yields are one thing but negative yields are a rare if not unique phenomenon. The former may be generated by a flight to quality but if widespread imply that investors expect short term interest rates to stay low for a long time. That in turn signals an expectation of limp growth and little or no inflation for a prolonged period.  Nonetheless, very low yields still mean a positive return, albeit a limited one: if I buy the German 10-year benchmark, which pays a coupon of 0.5% per annum, I will receive €5 per €100 invested in interest , offset by the capital loss on the bond ( it is trading at  €103.35). This will reduce my total return over 10 years to just €1.65.

That level of nominal yield is obviously  very problematical for savers or for the pension funds that are investing the savings of companies or households. That meagre return is also nominal, of course, and would mean a substantial loss in real terms even with very low inflation over the period.

Nonetheless,  any holder to maturity will not face a nominal loss, in contrast to that  awaiting  an investor with the same time horizon  buying a bond at a negative yield . Take the  2%  Jan 2022 Bund, which is priced at €113.80. Over  the 6.7 years  to maturity the interest will amount to €13.40 but this will be offset by the capital loss of €13.80, ensuring a negative nominal return.

Why  would anyone buy a bond which gives a loss if held to maturity? Some argue that investors are now  simply buying on the expectation that someone else will buy it at a higher price, a classic bubble, but there are other explanations. In the Swiss case investors may believe that the currency will appreciate  significantly, so ensuring a positive return for a non-Swiss  buyer. One doubts if many expect the euro to  outperform most of the other major currencies, however, so other factors are at work. One is QE, in that the ECB is a buyer in the market at any yield above -0.2%. The ECB will not buy all the bonds at issue, however,( the limit is 33% , at least for now)  so  investors  will still be left holding two-thirds of the market.

A second rationale relates to banks, the main buyers of shorter-dated bonds.  For them, any excess liquidity deposited with the ECB costs them 0.2% so any yield above that, even if negative, is viewed as a plus. The implication is that banks would also prefer to park liquidity in bonds, however low the yield, than lend it to firms or households – such lending requires higher capital backing and in general carries  a higher perceived risk. One should also remember that banks are also now required to hold a specified amount of assets in liquid form, as part of the Basel 111 regulatory changes, which  in effect means a greater demand for government bonds at the same time as the ECB has entered the market as a buyer.

For investors as a whole the low or even negative return on bonds is supposed to act as an incentive to switch to other assets, including equities and corporate debt, although again, regulatory constraints for pension funds and insurance companies may make a significant switch into riskier assets problematical.

In the short term, then, a combination of QE and pessimism on growth and inflation has led to a collapse in the risk free rate of return, with the possibility of 10-year yields and beyond turning negative. That has serious practical implications for savers and those relying on annuities in retirement. At another level, it throws up difficulties for asset valuation models, as the risk free alternative is now a negative number. How all this ends is anyone’s guess but there is a paradox at its heart; if QE stimulates growth and leads to a rise in inflation over the medium term, perhaps due to a much weaker currency, it makes negative bond  returns in real terms all the more likely for anyone buying to hold at these levels.



Ireland is a High Wage and High Price Economy

The euro is now is its seventeenth year and although consumer prices across the zone have shown some convergence  there is still a wide divergence and one that has actually grown again over the last five years. Prices in Germany and Italy in 2013 were around the euro average, in France  7% above and in Spain 9% below. Finland is the most expensive country  (20% above the euro norm) followed by Luxembourg, with Ireland in third place; prices here are 17% above the average in the euro area. For those looking for a cheap holiday, prices in the Baltic states are 30%-40% below average , or for a warmer climate, Portugal and Slovenia ( around 20% cheaper than the norm)

Ireland’s inflation rate, as measured by the HICP,  generally outpaced its euro neighbours in the first decade of membership but fell below the euro average from 2009 to 2013. That latter period of price convergence is not as apparent  when measured on the broader household consumption deflator  used by Eurostat for comparative purposes, although it also shows that Ireland’s relative price position has improved, with the  current 17% differential  compared with over 23% a decade earlier and 19% in 2009.

Prices in Ireland are also substantially higher  when measured at the micro level, as confirmed by a recent ECB  survey (1) of grocery prices across the single currency area,  using data from 2011. That found prices  in Ireland on a basket of household  items  to be 17% above the euro average and a massive 32% for branded goods only, and that excludes VAT. The study found that competition at the retail level had a role to play  in explaining cross-border price divergence, alongside consumer shopping patterns ( the degree to which people buy in bulk for example) but macro factors such as the level of national income play a strong part.

One would therefore expect to find a close relationship between the price level and  the wage level in a given economy , as the latter  is the main cost of production and  as well as a key determinant of household incomes. That does appear to be the case; there is a 96% correlation between the price data discussed above and wage levels across the euro area as revealed in the latest Eurostat  data on hourly labour costs for 2014 ( the survey  excludes agriculture and public administration)

The figures reveals that in Luxembourg hourly wages are 45% above the euro average, with Belgium in second place at 32%. Given the price data one would expect to see Ireland towards the top of the wage league and that is indeed the case; hourly wages in Ireland were €25.8 against an average of €21.4  or 20% above the euro norm. That is an average figure ,of course, and hides a wide distribution around the mean, but it is undeniable that the average wage level in Ireland is among the highest in Europe.

Against that, the non-wage  cost of employing labour here (mainly employers PRSI) is remarkably low , and at 13.5% of total labour costs is around half the euro area average. Consequently, Ireland’s overall ranking in terms of  labour cost is very different to that using wages alone, with total  hourly labour costs less than 3% above the euro norm.

High wages, per se,  need not be damaging to competitiveness as long as they are supported by high productivity and that may well be the case in Ireland for some of the main export industries if perhaps less so for non-traded services. What is clear is that Ireland is a high wage and high price economy in the euro area ,  however uncomfortably that sits with the narrative some prefer, with implications for the type of industries and companies the country can attract.

(1) ‘Grocery prices in the euro area’, ECB Economic Bulletin No.1, 2015