Irish growth surge begs questions about upcoming Budget

The Irish economy is now growing at a very rapid pace, both in real and nominal terms, and much faster than envisaged by consensus forecasts or by the Irish Government when framing the 2015  or indeed  the 2016 Budget.  Real GDP grew by 1.9% in the second quarter,  leaving the annual increase at 6.7%, while  first quarter growth was revised up to 2.1% and the annual change to 7.2%. That means that  growth averaged 7.0% over the first half of 2015  so forecasts for the year as a whole are likely to move up to at least  6% or higher. Moreover, nominal GDP is soaring, rising by an average  12.5% in the first half of the year, and GDP for 2015 may exceed €210bn,  implying a General Government debt ratio below 100%, from 107.6% last year.

The initial recovery in the Irish economy was driven by exports but of late domestic demand, which is more labour intensive, has moved to the fore. The external trade data  is still extremely strong,  albeit affected by recent Balance of Payments  (BoP) changes, and while exports  still greatly exceed imports in absolute terms,  import growth is now outpacing, so reducing or even eliminating the positive  contribution of trade to GDP. In q2 imports rose by 6.3%  so  exactly offsetting the impact of  a  5.4% increase in exports. Looking at the annual change in q2, export growth of 13.6% was dwarfed by a 16.9% rise in imports, resulting in a  negative (-0.4%) contribution to GDP.

Domestic demand was generally expected to pick up in 2015 but  the data has also  surprised, with the second quarter seeing a 4.8% rise, leaving the annual increase at an extraordinary 10.1%. Investment spending was the main driver, rising by over 19% in the quarter and by 34% over the year. Construction output is growing but the main factor was a surge in spending on machinery and equipment, although this is very volatile, particularly given the influence of aircraft orders. One puzzling feature in terms of the other components of demand is the performance of consumer spending, which has also picked up but at a slower pace than indicated by retail sales; consumption rose by just 0.4% in q2  and the annual increase slowed to 2.8% from 3.7% in q1.

Commentary on the national accounts often includes caveats about the GDP numbers, with some preferring GNP , the income of Irish residents, as a better measure. Yet growth is also extremely strong using that metric, averaging 6.7% over the first half of the year, although multinational profit outflows did pick up in q2 and the differential between the two measures may widen over the rest of the year.

Irish GDP is now  5.7 % above the previous peak but the unexpected strength of activity in 2015 raises a number of policy issues. On the face of it the economy is growing at a rapid clip and  employment is rising strongly , which would not signal the need for a further boost  to demand from fiscal policy in 2016, particularly as monetary policy is extraordinarily easy and the exchange rate has depreciated. The Government has already received advice from a variety of quarters urging little or no stimulus and the GDP  figures might serve to reinforce such views. Against that, CPI inflation is around zero, wages are only beginning to rise, credit is still contracting and Ireland ran a BoP surplus of  €4.3bn over the first half of the year, a picture hardly consistent with an overheating economy.

There is also an election due within six months, of course, but times have changed in that the Government is now constrained by EU fiscal rules, including one which limits the growth in real exchequer spending to the growth in potential GDP. The latter figure  is determined by the European Commission (EC), using a 10-year average ( including estimates of the current year and forecasts four year ahead) and as it currently stands it means virtually  zero growth in real spending in the 2016 Budget. This  real limit is translated into a cash figure by using the EC’s forecast for price rises across the economy ( the GDP deflator) which is currently  1.6%,  giving a permitted  expenditure figure of €1.3bn to allocate between spending increases and tax cuts.

Yet the GDP deflator is currently rising at an annual 5.2%, so the 1.6%  forecast for 2016 looks too low. Moreover, the potential growth rate  forecast also looks less credible, given the 2015 data. For example, Ireland’s potential growth rate for the year  was put at 2.8% , which implies that the economy may currently be operating 3-4% above capacity, given that the EC assumed  the economy was around full employment in 2014, which  is not consistent with the  observed wage and price behaviour.

There is now little more than a month to the 2016 Budget, so interesting times ahead, although whatever transpires, a buoyant economy can no longer translate into the tax and spending package we might have seen in the past.

 

 

Irish Economy soaring, now well above pre-crash peak

The CSO has just published the Irish National Accounts for the first quarter, incorporating data revisions and an adjustment for aircraft leasing, with gross aircraft flows now  included as against a net figure. In the event the  combined impact was substantial, with upward revisions to all GDP components, leaving nominal GDP in 2014 at €189bn compared with the previous estimate of €185bn. In real terms the recession in 2008-09 is now seen to have been milder, albeit a still bleak 9.8% fall in GDP over 8 consecutive quarters, with the recovery stronger; the  new data  shows the  economy to have grown in every one of the past five years, with the 2014 initial estimate of 4.8% now put at 5.2%. As a result  it now appears that all the output lost in the crash was recovered by the third quarter of 2014  and real GDP is  currently 3.8% above the previous peak recorded in the final quarter of 2007.

The pattern of the recovery as previously understood remains broadly intact, with a positive impact from external trade offsetting falling domestic demand, although the latter is now seen to have grown in 2012 , driven by investment spending, before declining again in the following year. Consumer spending  of late is now  stronger than previously recorded , which is more consistent with retail sales , while GDP as a whole is now better aligned  with the recovery in employment, which started in early 2013.

The recovery picked up strong momentum in 2014, with  all the 5.2% expansion in real GDP driven by domestic demand, led by double digit growth in business spending on machinery and equipment alongside a 10% rise in construction. Consumer spending also grew , by 2%, although the reported 4.6% rise in Government spending is more difficult to fathom, and appears to be related to  the productivity gains assumed to flow from the Haddington Road agreement with public sector unions

The previously published data had shown a marked slowdown in the second half of last year but that has now been revised away, with the result that the economy entered 2015 in a stronger position than initially thought. Moreover, growth in Q1 was also robust, at 1.4%, leaving the annual change in real GDP at 6.5%. Consumer spending is now rising strongly in volume terms, by an annual 3.8% , although the annual growth in investment spending slowed to 4%, albeit dampened by the volatile aircraft sector.

Net exports also made a strong contribution to the annual growth figure in q1, adding 2.1 percentage points, with the  figures now reflecting aircraft leasing as well as last year’s methodological changes. Exports grew by an annual 21% in value terms ,and by 14.3% in volume terms, with the latter marginally lagging import growth of 14.7%, although such is the scale of exports that a similar growth figure in imports still generates a strong net contribution from the external sector.

The external data has also confounded the many looking for much smaller  gains in 2015, and that, alongside the GDP figure itself,  will likely prompt upward revisions to growth  forecasts for 2015 as a whole. The nominal rise in GDP in q1 was also surprising (an annual 12%, largely reflecting a big increase in export prices)  and estimates for nominal GDP  growth  this year may well be raised to at least 10%. The latter would mean a 2015 figure of €208bn, implying a debt ratio around 102% and a fiscal deficit under 2% of GDP. Good news then, but one  final implication: the Central Bank, IFAC and the ESRI have already urged the government to reduce the size of the proposed fiscal stimulus  in the 2016 Budget and the figures published today strengthen their case, it would seem, although one doubts if that  will cut much ice with the governnment ahead of the election.

 

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.