Irish
ESRI highlights risks from balance of payments, public finances and US dollar; Transport 21 slammed as seriously flawed; Banks' foreign borrowings to fund Irish mortgages rose from 10% to 41% of GDP in 2 years
By Finfacts Team
Dec 21, 2006, 03:01

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Dr. Alan Barratt

The Economic and Social Research Institute (ESRI) says in its latest Quarterly Economic Commentary (QEC), which is published today, that all the indications point to 2006 as another year of strong growth in the Irish economy.

With GNP set to grow by 6.2 per cent and employment growth in the region of 90,000, it is clear that the economy is performing strongly. The ESRI says this is, of course, to be welcomed. However, it is important that some of the challenges facing the economy be set out so that any sense of complacency can be avoided. It highlighted the balance of payments, the management of the public finances and the fall in the value of the dollar.

In special articles in the QEC, Trinity College lecturer Sean Barrett reviews the Transport 21 transport development programme and Patrick Honohan focuses on the finance that has fuelled the Celtic Tiger.

The ESRI says that starting from a position of a small deficit in 2004, the deficit on the current account of the balance of payments rose to 3.1 per cent of GNP in 2005. According to our forecasts, this will rise to 4 per cent of GNP in 2006 and to 5.6 per cent in 2007. Others, such as the Department of Finance, are also forecasting an increase in the size of the current account deficit.

The authors Dr. Alan Barrett, Dr. Ide Kearney and Yvonne McCarthy say that precise implications of a current account deficit on the balance of payments in the context of a monetary union are not entirely clear. One view is that the current account deficit is the result of investment exceeding savings in Ireland. Investment is certainly high in Ireland due to our infrastructural needs in the areas of housing and roads. It could be that the current account deficit will reduce in the years ahead without any negative consequences arising through an adjustment process.

An alternative view of the current account deficit sees it as a consequence of the economy growing above trend, with international borrowing funding the deficit. In this situation, rising indebtedness on international markets will eventually translate into higher risk premia on loans in Ireland. Through the mechanism of higher borrowing costs, debt-financed spending will be reduced and through this route, growth will be reduced.

It is not clear which process is in operation in Ireland and elements of both could be at work. Either way, it is desirable that the underlying causes and implications of the deficit be understood and it is the authors intention to return to this issue in future Commentaries.

Regarding the management of the public finances, the authors say that among the issues that they raise are the generally expansionary nature of the Budget and also the reduction in the top rate of income tax at a time when questions are growing about the sustainability of recent increases in other taxes, in particular property-related taxes. In addition to these, they say: we would also echo the concerns raised in the ESRI’s recent report on public investment priorities, published in October regarding the evaluation of public spending. These same points are also raised in the article by Sean Barrett, which is published along with this Commentary. At a time when public revenues are buoyant, a degree of discipline may be lost in pursuing value for money in the use of public funds. With current spending set to grow by 12 per cent next year, there is an onus on the Government to ensure that this extra money, and the existing funds, are spent with best effect. One challenge that will arise for the Government in this context in 2007 is with regard to the report of the Public Service Benchmarking Body. Wage rises in the economy have been exceeding productivity growth in recent years. For this reason, it would be preferable for wage rises in the public sector to be constrained so that additional upward pressures on private sector wages can be avoided as the private sector competes for employees in the labour market.

Dr. Ide Kearney
Our final concern relates to the recent downward movement in the dollar and the possible consequences for Ireland. The ESRI’s Medium-Term Review published last year showed the critical importance of developments in the US on Ireland’s economic prospects. If the recent slide in the dollar, along with the slowdown in growth in the US, is an early indication of the onset of the long awaited adjustment to the US current account deficit, then our forecasts for 2007 will be in doubt. As shown in the Medium-Term Review, a change in circumstances in the US which is consistent with a sustainable current account deficit has the potential to reduce growth in Ireland from a rate of around 5 per cent to a rate of around 3 per cent. The knock-on effects in terms of the public finances and employment are significant and so a close eye on developments in the US will be required for 2007.

Some of the main findings of the analysis include:

2006 has been another year of strong economic growth. the ESRI expects that real GNP will have grown by 6.2 percent. For 2007, it expects a continuation of this strong performance with real GNP growth expected to be 5.3 percent.
Consumption will grow more strongly in 2007 relative to 2006. This is because of the SSIA effect and also because of the generous Budget.
Exports will grow less strongly in 2007 relative to 2006. This is because both the euro-area and the US will grow less strongly next year relative to this year. Also, the fall in the value of the dollar relative to the euro will slow down export growth.
One positive effect of the dollar slide is that it may contribute to limiting further interest rate rises on the part of the ECB. The Institute expects one more 25 basis point rise in 2007 but then for rates to be left unchanged.

In its General Assessment of the economy, it looks at three issues.

The deficit on the current account of the balance of payments has grown since 2003 and is expected to rise again next year, reaching 5.6 percent on GNP. The benign view of this development is that it reflects a high level of investment in the economy relative to savings. Under this view, balance will be restored when investment needs are met. A more troubling view sees the deficit as a sign that the economy is growing too fast whereby demand is outpacing supply. In this situation, borrowing from abroad is accumulating and so the economy is vulnerable to changing lending conditions on the part of foreign lenders. The ESRI says that its is not able to say which is the case for Ireland but see it as being important that the situation be analysed more fully.
It believes that the recent Budget was overly expansionary, given that the surplus planned for 2007 is lower than the outturn for 2006. Its own tax forecasts suggest that the Budget will not be as expansionary as official figures suggest. Even still, the Budget will fuel demand at a time when the economy is growing above potential.
The fall in the dollar once again draws attention to the possible impact of events in the US on the Irish economy and the need to maintain competitiveness.

Yvonne McCarthy
There are three Special Articles in this Quarterly Economic Commentary, as follows:

Electricity shortages in Ireland: likelihood and consequences By Laura Malaguzzi Valeri and Richard Tol (ESRI).

To What Extent Has Finance Been A Driver of Ireland's Economic Success? By Patrick Honohan.

Evaluating Transport 21 b Some Economic Aspects. By Sean D. Barrett, Economics Department, Trinity College, Dublin.

Transport 21 is a large transport investment programme over the years 2006 to 2015 costing €34.4 billion. In a review of Transport 21 published with the ESRI Quarterly Economic Commentary today, Dr. Sean Barrett of the Economics Department, Trinity College, Dublin states that Transport 21 is a seriously flawed document.

Individual projects are not costed but bundled to cost €34.4 billion.
No cost benefit analyses have been published.
No alternatives are compared.
No origin and destination data have been published to support the investments in Transport 21.
Transport 21 shows the lack of any evaluation culture in the Department of Transport and its spending agencies.
Transport 21 has no set of shadow prices for evaluating the benefits of transport investment such as time and accident cost savings.
Transport 21 ignores the Goodbody Report on the independent bus sector, which showed that the sector had a larger passenger income than Dublin Bus, Bus Eireann and Iarnrod Eireann and a bus fleet double the Dublin Bus, and Bus Eireann fleet combined.
Transport 21 ignores the large recent reductions in bus fares achieved by the licensing of independent bus operators between Dublin and Cork and Dublin and Belfast and the large increases in service frequency resulting from deregulation. These results have been obvious for some time between Dublin and Galway and Dublin and Waterford.
Transport 21 has no consumer focus. Competitive bus services are invariably cheaper and more frequent than railways. Air travel on competitive routes such as Dublin-Cork is faster and frequently cheaper than railways but air and bus are ignored in favour of rail.
Transport 21 ignores the unused capacity of QBCs (quality bus corridors) in Dublin but opts for rail based solutions for 155 million of the 175 million extra passengers it seeks to attract to public transport.B It ignores the low market shares, high costs, declining productivity and declining yields from rail transport.
Transport 21's Rural Transport Initiatives also fails to examine market based alternatives and will cost an average of €36 return to bring its passengers to local towns and villages.
Transport 21's excess costs of over-investment in motorways between Kilcullen and Waterford and Portlaoise and Cork will cost a combined €1.5 billion to provide capacity of 55,000 vehicles a day where traffic volumes now and for decades ahead will not reach that volume.
Transport 21 does not take into account the Comptroller and Auditor General's analysis of the large costs overruns on national road investment between 2000 and 2006, which had a €10.8 billion, overrun on an initial cost estimate of €5.6 billion. Projects were so frequently reclassified as non-standard that the outturn cost systematically exceeded the standard costings.B Cost overruns occurred on the Drogheda bypass, the Youghal bypass (built under a more stringent design and build contract), the Ennis bypass (a fixed price contract) and the Edgeworthstown bypass reported at opening as within budget but investigated by the Comptroller because of an increase from €12m to €46m.
The rail emphasis in Transport 21 lacks economic appraisals of projects such as the Airport-Swords metro, the Tallaght-Ballymun metro, the Lucan luas and the Dublin Interconnector, which duplicates the existing Houston-Connolly line.
Transport 21 shows regulatory capture of the Department of Transport by its spending agencies such as CIE, NRA, RPA and engineer dominance in these bodies.
Detailed proposals for the development of economic appraisal of transport investments by the Departments of Finance and Transport and the development of an Irish public sector evaluation culture are included in the paper.
Pending proper economic evaluation of its contents Transport 21 should not become a letter of comfort for the spending agencies favoured in it.

To What Extent Has Finance Been A Driver of Ireland's Economic Success?

Patrick Honohan's paper (adapted from a talk given at the recent Dublin Economic Workshop Conference in Kenmare) looks at the role of the financial sector in Ireland's economic success.

Despite evidence in other countries that large and efficient financial systems are key contributors to growth, few commentators have suggested that the Celtic Tiger had any special financial fuel in its tank.

There have been notable successes, such as the export of financial services from the IFSC. And Ireland has been relatively free of the kinds of bank insolvency problems which have plagued many other countries at some time or another in recent decades. But the data do not show Ireland's financial sector as standing out in terms of either scale or efficiency.

Nevertheless, the business sector and indirectly -Irish mortgage borrowers have had access to global finance. Indeed, there has been a very rapid recent growth in foreign borrowing by banks to finance their mortgage lending. In the past few years banks borrowing from abroad to onlend to Irish residents has soared from 10 to 41 per cent of GDP.

In the past, financial markets served a watchdog role, and penalized national overborrowing with high interest rates. But now that Ireland is in the eurozone, Honohan notes, the watchdog is muzzled and even high rates of borrowing can proceed without any warning sign from the markets.

Source: ESRI

Honohan writes:

Certainly, there has been a remarkable growth in the ratio of private credit to personal income from 48 per cent in 1995 to 132 per cent in 2005 – about 82 per cent of the latter figure relating to housing finance. Household mortgage borrowing amounted to less than 12 per cent of the total value of the housing stock in 1999; by 2005 this ratio had jumped to 18 per cent (based on data in Kelly, 2006). The jury is still out on whether this credit growth is an autonomous driver of house prices or the response of a globalised credit supply to demand from house-buyers. Some interesting patterns emerge from Figure 6 showing credit and house-price growth. Spikes in house price inflation preceded credit growth before 2004, but the latest price surge might have been preceded by credit growth.

Where did the money come from to fund this credit growth? A very large quantity came from abroad, because the Irish banks still have ready recourse to external sources when necessary. The econometric analysis of Hosford (2002) showed causality from credit growth to banks’ accumulation of foreign liabilities, and this is a pattern, which has been evident for most of the period since at least the end of the First World War. But now the scale has become huge. In net terms, about 15 per cent of credit institutions overall resources were sourced from abroad by 2005.

Put more dramatically, the net import of funds credit institutions doing business in Ireland to lend to Irish residents amounted to 41 per cent of GDP by the end of 2005. This has changed with astonishing speed (up from about 10 per cent at end 2003) (Figure 6). This shows the extent to which it is global finance, and not solely the Irish financial system, that is providing finance to Irish borrowers.