Thursday, 05 March 2009 04:00

Reggie Middleton on the Irish Macro Outlook


The Republic of Ireland, known as the Celtic Tiger was the fastest growing economy in the Eurozone until last year when the US led recession brought the economy to a grinding halt. Ireland, which has the second highest per capita income (following Luxembourg) and fourth highest per capita GDP in the world, was the first country in the Eurozone to enter a recession. Ireland earned its name Celtic Tiger due to rapid growth of industry, exports and services spurred by huge influx of foreign direct investment (especially from the US). The country grew at a CAGR of above 7% during 2000-2007 but slipped into a recession following sharp decline in the property market which continues to erode public finances and an economic slowdown in major trading partners - primarily the UK and the USA. Ireland now faces twin challenges of reviving key sectors of the economy and managing rising government deficit. It remains to be seen how best the government tackles the domestic crisis in the short term and resumes exports at earlier levels to come back on track and regain its title "Celtic Tiger".


The tertiary sector was the main growth driver of the Irish economy during the last two decades. The availability of the skilled,

Recommended Global Macro Reading:

  1. China Macro Update
  2. Debt - Thoughts On A Global Problem (Part 1),

  3. Banking out of Control (Part 2)
  4. Global Debt Stats (Part 3)

Recommended Reading - The Asset Securitization Crisis:

  1. Intro:
    The great housing bull run - creation of asset bubble, Declining
    lending standards, lax underwriting activities increased the bubble - A
    comparison with the same during the S&L crisis
  2. Securitization - dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble - declining home prices and rising foreclosure
  3. Counterparty risk analyses - counter-party failure will open up another Pandora's box (must read for anyone who is not a CDS specialist)
  4. The consumer finance sector risk is woefully unrecognized, and the US Federal reserve to the rescue
  5. Municipal bond market and the securitization crisis - part I
  6. Municipal bond market and the securitization crisis - part 2 (should be read by whoever is not a muni expert - this newsbyte may be worth reading as well)
  7. An overview of my personal Regional Bank short prospects Part I: PNC Bank - risky loans skating on razor thin capital, PNC addendum Posts One and Two
  8. Reggie Middleton says don't believe Paulson: S&L crisis 2.0, bank failure redux
  9. More on the banking backdrop, we've never had so many loans!
  10. As I see it, these 32 banks and thrifts are in deep doo-doo!
  11. A little more on HELOCs, 2nd lien loans and rose colored glasses
  12. Will Countywide cause the next shoe to drop?
  13. Capital, Leverage and Loss in the Banking System
  14. Doo-Doo bank drill down, part 1 - Wells Fargo
  15. Doo-Doo Bank 32 drill down: Part 2 - Popular
  16. Doo-Doo Bank 32 drill down: Part 3 - SunTrust Bank
  17. The Anatomy of a Sick Bank!
  18. Doo Doo Bank 32 Drill Down 1.5: Wells Fargo Bank
  19. GE: The Uber Bank???
  20. Sun Trust Forensic Analysis
  21. Goldman Sachs Snapshot: Risk vs. Reward vs. Reputations on the Street
  22. Goldman Sachs Forensic Analysis
  23. American Express: When the best of the best start with the shenanigans, what does that mean for the rest..
  24. Part one of three of my opinion of HSBC and the macro factors affecting it
  25. The Big Bank Bust
  26. Continued Deterioration in Global Lending, Government Intervention in Free Markets
  27. The Butterfly is released!
  28. Global Recession - an economic reality
  29. The Banking Backdrop for 2009

English-speaking and cheap workforce (relatively to other countries in the Euro and the US) led to solid growth of services such as insurance, customer service, legal services and banking. Currently the service sector contributes 49% to GDP and employs around 64% of the workforce. Many leading US-based companies (such as Dell, IBM etc.) operating in computer manufacturing, software, pharmaceuticals and machinery have set up shop due to the country's trained workforce, favorable taxation policies and free access to the Eurozone nations; the maximum tax applicable is 12.5%. Consequently industry and trade grew profoundly with the US, not to mention the European nations. Industry accounts for 46% of Ireland's economy and employs 29% of the workforce. In 2007, the country's net exports were US$31.4 billion; Great Britain and Northern Ireland being the largest trading partners followed by the US. Ireland exports beef, computers and software (it is the largest software exporter in the world) and imports steel, car, machinery and trucks.


Irish banks have been the backbone of the economy and played a key role in the development of the country. The Central Bank & Financial Services Authority of Ireland (CBFSAI) is the apex banking and financial services institution. Being a member of the Euro zone, the European Central Bank monitors the functioning of the CBFSAI. The important banks in Ireland are Allied Irish Banks (AIB), Bank of Ireland, Halifax, National Irish Bank, Permanent tsb and Ulster Bank Group. Recently, the government nationalized Anglo Irish Banking after the breaking of a scandal involving the bank. As per data from the European Central Bank, the value of banking assets almost trebled from EUR474.6 billion in December 2002 to 1.3 trillion by December 2007. The value of the banking assets as a percentage of GDP increased from 674.4% in 2006 to 714.8% in 2007.

The economic boom due to growth of the industry and services sectors and rising immigration from other European countries fuelled demand for housing. Consequently construction became an important contributor to the economy and a major employer. The sector accounted for 10% of the nation's GDP in 2006 (as compared to just about 5% a decade ago) and employed around 13% of the population. House prices peaked representing an overvaluation of between 20-40% and filled government coffers with property taxes that constituted 15% of total taxes in 2006 (or 3.8% of GDP). One of the factors responsible for the growth of the Irish housing sector is the easy money made available by the Irish banks. Bank lead financing progressed unabatedly even with 100% LTV mortgage financing. The total value of household mortgages increased from EUR54,000 million in December 2003 to EUR1,14,561 million in January 2009. Lending however curbed during the last three quarters due to rising mortgage defaults on the back of rising unemployment, slowing economy and falling property prices.

However, the beginning of 2007 saw a correction setting in the sector (much like the US) and signaled a looming economic slowdown. House prices started to fall in March 2007 and since then have continued their freefall. This, together with the onset of recession at its two major trading partners (UK and US), declining exports and rising unemployment led the country to enter a recession in September 2008.

According to data from a survey of members of the Irish Auctioneers and Valuers Institute (IAVI), property market sales have decreased from EUR2 billion in 2007 to just EUR300 million in 2008. House prices have dropped between 15 and 20% following a 90% drop in sales volume while rents have fallen by 5% to 9% due to oversupply. With employment rising at an alarming rate the downslide is expected to continue in 2009. Rents are expected to drop further by 10% in 2009. Unemployment is projected to rise to 12% by the end of 2009 leading to mortgage defaults and higher loan write-offs spelling disaster for the Irish banks which have over the years had heavy exposure to the real estate sector.

Key measures taken by government to revive banks

Taking into account the deteriorating condition of its banks, the Irish government in September 2008 announced its decision to guarantee all bank deposits and debts worth €440 billion (US$593 billion) of its six banks for a period of two years. This comes to around 220% of the country's GDP. However this step has been severely criticized by the European Commission citing that such a measure could have a long term impact on public finance.

Furthermore in February 2009, the Finance Ministry announced a EUR7 billion recapitalization plan for AIB and Bank of Ireland that would increase the banks' lending power. Accordingly the government is to invest EUR3.5 billion in Core Tier 1 capital in each bank by way of preference shares. The infusion will increase the Core Tier 1 capital of AIB to EUR12 billion and that of Bank of Ireland to EUR10.7 billion. The preference shares will have a fixed dividend of 8% with an option to buy shares in five years time at a predetermined strike price. The government will not take control of the banks but will have the right to appoint 25% of the directors and 25% of ordinary voting rights. The recapitalization plan had a positive impact on bank lending and made available EUR2 billion for mortgages lending to first time buyers at reduced interest rates. Accordingly, Bank of Ireland announced that it would offer mortgages worth EUR1 billion at a fixed interest rate of 2.45% to first time buyers. AIB made a similar announcement at a fixed interest rate of 2.49%. This in addition to European Central Banks move to bring down interest rates will enable other banks also to shore up lending.

Adding to the woes, a spate of events unturned that tarnished the image of the country's third-largest lender, Anglo Irish Bank and raised concerns about regulatory competence. In January 2009, only days after the government first announced its plan to recapitalize banks, it was discovered that the bank had systematically failed to disclose EUR87 million of personal loans made to its chairman for eight years and that the Irish Financial Services Regulatory Authority was aware of the scandal since 2008 but failed to take a action or inform the finance minister. The revelations were followed by the resignations of Anglo Irish Chairman and CEO and the Chief Executive of the Irish Financial Services Regulatory Authority. In the wake of the scandal and fears that it would trigger the bank guarantee programme to the extent of EUR100 billion, the finance ministry announced its decision to nationalize the bank. Estimates say about EUR30 billion of its loan book could turn out to be bad and this could increase as the housing market further plummeted. Considering the impact this would have on national debt, the government made its decision to nationalize the bank.

Risks facing the economy

Slowing economy

Ireland's economy which grew 6% in 2007 contracted by an estimated 1.1% in 2008 and various estimates suggest that it might further shrink by around 4.0% in 2009. Further deterioration in exports, housing and the state of the financial system are the key challenges facing the economy and could further drain public finances and pile up national debt. On January 09, 2009, the government announced its budgetary strategy over a five-year period up to 2013 to restore public finances. In that, the government aims to bring down deficit to below 3% of GDP by 2013 and significantly reduce public expenditure and increase tax revenues.

Deteriorating public finances

Ireland's public finances continue to deteriorate rapidly. The National Treasury Management Agency (NTMA) estimates a fiscal deficit of EUR12.7 billion (6.3%) in 2008 due to decrease in tax revenues. Tax revenues decreased by EUR8 billion to EUR40 billion in 2008. The various measures undertaken to revive the banks (bank guarantees and recapitalization plan) and decreasing tax revenues associated with the housing sector could push the deficit even further. The Economist Intelligence Unit expects deficit to rise to at least 10.7% of GDP in 2009 and be 10.5% in 2010. This is a far cry from the government's budget strategy. Increased government borrowing to finance the deficits could see a major jump in Ireland's national debt.

Rising cost of debt

According to NTMA, the country's gross external debt stood at EUR1,671 billion at the end of September 2008. This is an increase of over EUR160 billion over that of last year. The debt-to-GDP ratio increased from 24.8% in 2007 to 40.8% in 2008 mainly due to an increase in exchequer cash balances; it however remains substantially low as compared to other countries in the Euro area or European Union. Exchequer cash balances stood at EUR20.6 billion (or 10% of GDP) at the end of 2008. As per the National Treasury Management Agency, Ireland plans to borrow EUR25 billion in 2009. Of this, 40% of the requirement has already been met by new bonds issue since January 2009. Ireland's debt raising has however come under immense scrutiny. Standard & Poor's downgraded Ireland's debt outlook from stable to negative in light of the mounting fiscal pressures and the slowdown in key sectors. The credit rating agency affirmed Ireland's 'AAA/A-1+' ratings on the debt programs and instruments guaranteed by the Republic of Ireland but has warned that the country is at a risk of losing its credit status as fiscal pressures increase. The increasing spread between Irish and German debt is also pointing to the increase in future debt servicing costs. In the second week of February, yield spreads on Irish 10-year government bonds over benchmark German bonds increased to 203 basis points, up from just 20 basis points at the beginning of 2008.

Decreased competitiveness

An important challenge amidst the current macroeconomic scenario is for Ireland to regain international competitiveness which had been its driving force for the past two decades. According to the latest monthly bulletin issued by the Central Bank of Ireland, Harmonized Competitiveness Indicator (HCI) has deteriorated from 110.44 in December 2007 to 113.27 in January 2009. High commodity prices, wage inflation and a strong euro were the main factors for the decrease in competitiveness. However the scenario has been improving since the past six months due to decline in inflation and significant depreciation of euro.

The Irish Government in February announced EUR2 billion of spending cuts as part of its strategy to narrow the fiscal deficit. Most of these cuts, running to the tune of EUR1.4 billion will be in the form of increased pension levies on public-sector employees. Although the announcement invited public wrath (a one-day strike was called by civil servants and nearly 100,000 people protested), the government seems to be firm on its decision. Further planned cuts include EUR4 billion in 2010 and 2011, EUR3.5 billion in 2012 and EUR3 billion in 2013.

Next in the Asset Securitization Series will be my outlook on additional UK, Asian and Eurozone banks, asset managers and insurers.

Last modified on Thursday, 05 March 2009 04:00