Broad based expansion as Irish economy heads into 2007
Author:
John Beggs
As we head into the autumn, attention is turning to the prospects for the Irish and international economies for 2007 and beyond. At the present time, there is a widely held view that the global economy will grow at a slower pace in 2007 than in 2006. This is largely down to a projected weaker growth rate in the US economy. However, European growth may also slow a little while China may witness a less robust performance than in recent years. Overall, therefore, there are grounds for believing that international economic growth will be lower next year but the evidence to date also suggests that the slowdown will be moderate.
Despite the prospects of weaker growth in 2007, activity levels have remained very strong in Europe with both the UK and euro area economies reporting above trend growth around the middle of 2006. However, with the US already showing signs that economic growth there has fallen below potential, the theme of a weaker global economy in 2007 is being set by US developments.
Financial markets are nervous in the face of weaker growth prospects and also because of rising inflation in the major economies. Though current high rates of inflation are largely due to high energy prices, central banks have been very concerned about the risks of second round effects. As a result, interest rates have risen relatively quickly in the US and eurozone. Rates have probably peaked in the US, with official rates at 5.25%, but in Europe, the Bank of England surprised the markets in August by raising official rates by 0.25% to 4.75%. There could be more to come in the UK before the end of 2006. In the eurozone, the European Central Bank has pursued a steady course of removing monetary accommodation. Official interest rates are expected to reach 3.5% by end 2006 with the chance of further tightening in the first half of 2007. Thereafter, eurozone rates should stabilise at no higher than 4%.
The prospects that eurozone interest rates will stabilise at relatively low levels will come as a great relief to the Irish economy where the growing levels of personal and corporate sector indebtedness have made us more sensitive to interest rate changes. Furthermore, as regards exchange rate changes in 2007, the US dollar will remain vulnerable because of the expected slowdown in the US economy and the sizeable US current account deficit. However, the euro is not expected to rise much above the $1.35 level versus the dollar next year. In overall terms, the euro should remain relatively stable on a trade weighted basis. This will limit the damage to Ireland’s international competitiveness in 2007.
In summary, global economic and financial conditions next year, though less favourable than in 2006, should nevertheless provide a reasonable background against which Irish economic prospects will remain more focused on domestic developments. Indicators on the health of the Irish economy point to an overall performance that remains both exceptionally buoyant and resilient with real GDP expected to grow by at least 5.5% in 2006. A similar rate of growth is forecast for 2007, despite the expected downturn in the global economy. Such a performance would represent the continuation of a remarkable period of steady and sustained growth in real GDP since the ending of the Celtic Tiger period in 2000.
In addition to the very favourable outlook for economic growth, other headline indicators are expected to perform strongly in 2006-2007. Employment will continue to expand by about 3.4% this year and by around 3% in 2007. The public finances have clearly benefited from the buoyancy in the economy and, as a result, the general government balance should remain close to surplus. On the negative side, however, inflation has accelerated and the rise in the CPI should average around 4% in 2006, up from 2.5% in 2005. Much of this is due to higher energy prices and to the rise in interest rates. I expect some moderation in the average rate of inflation in 2007 to 3.6%.
Despite this upbeat economic outlook, there are concerns about our more medium term prospects. Many of these are interrelated and centre on the composition of Irish economic growth, particularly the relatively high share of construction related activity in GDP and the growing level of personal sector indebtedness. Another issue is what happens after 2007 when the impact of SSIA related spending wears off? The assumption is that growth will falter after a consumer led boom in 2007 –“what goes up must come down”. There is a tendency here to see our economic success as a consumer led boom, fuelled by excessive levels of borrowing, which, in turn, is fuelling domestic inflationary pressures. While some elements of our recent economic performance need careful monitoring, there is too much gloom about how the economy might evolve over the next few years. There is no doubt that property prices are rising too rapidly and that annual price increases of 15% or more, as currently experienced, are unsustainable. I expect to see a material slowdown in the rate of house price inflation commencing in the autumn. However, I remain confident that the market is well underpinned by solid demand stemming from demographic and employment related drivers.
Next year will see a General Election. The current government is in a very comfortable fiscal position. However, I do not expect that the government will pursue a deliberately vote catching strategy in December’s budget, but based on recent data, where the growth in public consumption on goods and services has averaged around 4.5% per annum in real terms, a similar expansion of public services can be expected in 2007. This should be focused on the recruitment of much needed front line staff in health and education. Tax rates are likely to be left unchanged, but bands and credits are likely to be indexed by much more than the rate of inflation. In aggregate terms, with the prospects of solid economic growth in 2007, the fiscal balance is forecast to stay in surplus. The government will be aware that a high proportion of tax buoyancy is dependent on the strength on the property market. As I do not see the level of housing market activity growing at anything like its current pace beyond 2007, fiscal policy must reflect this and be set in the context of a longer timeframe than the next twelve months.
The IMF has expressed concern about Ireland’s reliance on construction output, arguing in its recent report on the Irish economy that it had become too dependent on building investment. There is, though, limited value in making comparisons between the share of investment in Irish GDP with that in more infra-structurally developed economies. Ireland’s infrastructure is not adequately developed in many areas to make us sufficiently competitive in international markets over the longer term.
The increase in the share of total fixed investment as a percentage of GDP in Ireland since the mid 1990’s is almost entirely due to the rise in the proportion of residential investment. As I expect that housing investment will level off in 2007, its share in total investment should also start to fall back. From the point of view of developing a more competitive economy, it would be preferable if the share of investment in GDP did not fall back in line with the decline in the housing component. In this regard, given Ireland’s obvious economic and infrastructural deficits, non-housing related investment needs to remain strong and the share of total investment in GDP to remain high for several more years.
A remarkable feature of the Irish economy has been the limited evidence that the boom in the housing market has had a sizeable influence on personal spending. Unlike in many other countries, the rise in Irish house prices was accompanied by a sharp rise in the personal savings ratio. While part of the rise in the latter was due to SSIA accounts, there remained an underlying growth in personal savings at a time of rapidly rising household wealth, which is quite unusual. Furthermore, there is little evidence that the growth in personal spending reflected significant wealth effects. Consumption appears to be more influenced by employment trends than any other factors. Looking ahead, therefore, a slowdown in house price inflation need not have a major negative impact on Irish consumers as it had in some other economies.
I expect that the personal savings ratio will ease from its current exceptional level of near 14% of personal disposable income over the next two years. This, together with moderate employment growth and real wage increases should sustain a rise in real personal spending of 3.5-4% per annum after 2007, when the impact of SSIA related spending has worn off.
Thus, overall, despite some predictions to the contrary, growth is likely to remain reasonably well balanced in 2006-2007. Consumer expenditure is forecast to grow by an average 7%, boosted by SSIA related spending, with government spending rising by 4.5% and fixed investment increasing by 5.75%. Export growth is forecast to average around 5.5%, with imports rising by 6.5%. Despite a levelling off in new housing output, therefore, the economy is expected to continue growing above trend in 2006 and 2007. The rate of economic growth will undoubtedly slow after 2007 due to a weaker expansion of domestic demand, particularly consumer spending but our assessment is that export growth will support a rise in real GDP of over 4% per annum over the medium term.
John Beggs is Chief Economist with AIB Global Treasury.