Country Report Ireland
Economic stabilisation, restructuring and recapitalisation of the banking sector and the success of the government to stick to the agreements made with the IMF/EC/ECB (troika) in exchange for financial assistance have pushed government bond yields for Ireland significantly downwards. But uncertainty remains high, with economic recovery far from complete, a sizeable private debt overhang still to be dealt with and new austerity and reform measures acting as strong headwinds. Also, uncertainty remains regarding the restructuring of the recapitalization of the banks that was promised by the euro zone governments in July 2012, absent which government debt will remain very high, making the Irish public finances very vulnerable to adverse shocks.
Ireland is beating the odds by avoiding recession…
After three consecutive years of decline, the Irish economy returned to economic growth in 2011. Real GDP grew by 1.4% and 0.9% in 2011 and 2012, respectively. Of course, given the scale of the decline that came before that, the level of economic activity is still around 7.7%-points below the pre-crisis peak (07Q4). The return of growth has led to an improvement in the labour market. The jobless rate has been moving down since reaching a peak of 15% in 2012 and is now almost 1%-point lower (14.1% in February 2013). Admittedly, the pace of decline is still much too slow to call it a genuine labour market recovery.
More importantly, Ireland’s economic outlook is improving on the back of the export sector. The massive gain in price competitiveness has supported the country’s exports and pushed the current account balance into positive territory. The trade-weighted exchange rate of Ireland (adjusted for inflation) has fallen the most when compared to the advanced countries (figure 1). Note that the country has managed to achieve this feat through a process known as ‘internal devaluation’ (i.e. wage/price suppression) given that it is in a monetary union. Domestic demand is not likely to be supportive of growth due to the ongoing deleveraging in the private sector. Figure 2 illustrates that total credit to households has fallen from 114% of GDP in end-2008 to 109% in September 2012. High unemployment combined with falling wages have made the balance sheet repair process a painful affair. The total private sector credit-to-GDP ratio of Ireland is still remaining uncomfortably high because deleveraging by non-financial corporates has not begun in earnest. The public sector will also act as a net drag on economic activity. The IMF expects Ireland’s fiscal adjustment measures in 2012-14 to amount to 3.6% of GDP. As such, the cyclically adjusted primary budget balance is expected to improve from -2.9% of GDP in 2012 to 0.7% in 2014. All in all, the simultaneous private and public sector retrenchment would weigh on growth during the forecast horizon but an outright economic contraction is not expected due to the offsetting effect of exports.
…and improving market conditions…
The Irish government has been able to deliver on all the agreements made with the troika for nine consecutive quarterly reviews. As a result, financing for Ireland’s deficits and debt redemptions has been forthcoming without delay. The government’s strong commitment to the adjustment program is being rewarded. Market conditions for Irish bonds continue to improve, with benchmark 10-year yields now around 4% and recent bond issues attracting broad investor interest. Ireland issued EUR 5bn of 10 year bonds at 4.15% in March. That said, the country cannot take all the credit for improving financial conditions. For one, the announcement by the ECB that they are willing to buy unlimited amount of government bonds of countries that are in a European rescue package and abide by the conditionality of that package improved market sentiment. Second, the ECB decided in February to permit the Irish government to exchange EUR 25bn worth of high-interest promissory notes (PNs) – originally created in 2010 to recapitalize Anglo Irish and Irish Nationwide Building Society – for long-term government bonds. Ireland’s new government bonds will mature in 25-40 years instead of amortising on an annual basis (around EUR 3.1bn per year until 2023, and smaller payments until 2031, with a weighted average maturity of 7-8 years), and they will also carry lower interest rates. The exchange of PNs for longer-term bonds significantly reduces the government's debt-servicing costs and refinancing risk . Liquidation of IBRC and the debt exchange improves the fiscal balance by 0.1% of GDP in 2013 and 0.7% in 2014, according to the European Commission. More importantly, this operation generates support for medium-term fiscal consolidation as it fulfilled the commitment made by Prime Minister Enda Kenny when he ran for office two years ago. Without this deal, Mr. Kenny’s credibility would be at stake and he could have faced extra resistance for pushing through further austerity/reform.
 ^ Financing needs are lowered over the next decade by about 1.3% of GDP annually.
 ^To date, the Irish state has committed EUR 64bn, or 40% of GDP, to recapitalize the banks. The support to Anglo Irish Bank and Irish Nationwide Building Society, which have been merged into the Irish Bank Resolution Company (IBRC), has been the most expensive.
…but the country is not out of the woods, yet
The marked fall in government bond yields reflects Ireland’s success in (i) abiding by the Troika conditionality, (ii) experiencing economic growth, (iii) achieving sizeable budgetary adjustments and (iv) restructuring the banking sector. But it is still too soon to give the ‘all clear’ signal. The country’s growth is picking up but it is not quick enough to make a meaningful dent in the unemployment rate. The jobless rate is still deep into the double-digit territory and this figure would have gone up further had it not been for a spectacular increase in emigration of Irish workers (figure 3). Therefore, it remains to be seen for how long the public would put up with years of low growth and weak labour market. So far, there are no signs of broad-based social unrest, suggesting that the Irish citizens have accepted the need for economic rebalancing.
Another reason for caution is that the country’s fiscal metrics, although on an improving trend, are still very weak (figure 4). The government’s debt-to-GDP ratio is expected to peak at around 122% of GDP this year . Weak growth combined with still large primary budget deficits means that the declining trend will be very slow indeed. And any serious growth slowdown can hamper the debt reduction process and undermine the possibility of tapping the capital markets for financing needs. The IMF estimates that if real GDP growth were to stagnate at 0.5% per year in the medium term, public debt would be on an unsustainable path to 150% of GDP by 2021. On a positive note, we expect further financial assistance from the ‘troika’ to be forthcoming if Ireland faces difficulty to obtain market access at sustainable interest rates.
A final risk stems from the country’s banking sector. To be sure, banks have been put on a sounder footing over the past years. But the challenge will be to increase profitability and cope with the remaining excess debt in the system. There is still a large amount of non-performing loans (around 25% of total loans) that have to be dealt with. Bad debt is rising in banks’ loan books as many households are in negative equity. In January 2013, house prices were down by a whopping 50% since their peak in September 2007. Positively, the housing market seems to have bottomed-out since early 2012. But even if house prices are no longer in free fall, a recovery is still be a long way off. Tight credit conditions, low demand and excess capacity act as strong headwinds for the housing market.
The health of the Irish banking sector is key to the country’s recovery and improvement of sovereign risk. A welcome step is that the authorities have established targets for banks to resolve distressed mortgages . An even better outcome would be to allow the European Stability Mechanism to deal with the legacy debt and retroactively recapitalize banks. As a consequence, the vicious circle between the banks and the sovereign would be broken and this would go a long way toward Ireland’s durable exit from drawing on official support.
 ^ This figure excludes the public sector’s contingent liabilities that IMF estimates to be around 28.5% of GDP.
 ^ Banks are required to propose sustainable solutions to 50% of distressed mortgage accounts by end-2013.