Irish Economy Posts Disappointing Q2 Performance

In recent months, economic indicators have produced a mixed picture of the performance of the Irish economy. Whereas data on retail sales, consumer confidence, and exports had all indicated that a modest recovery was already under way, the numbers regarding the labour market and income tax returns suggested that the economy was still contracting. The second-quarter GDP numbers have confirmed that, unfortunately, the latter was the case. Specifically, according to the Central Statistics Office (CSO), real GDP, seasonally adjusted, fell by 1.2% quarter-on-quarter (q/q) in the April-June period, having seen a strong start to the year, recording a 2.2% q/q increase in the first three months of 2010 (downwardly revised from the previously reported 2.7% q/q). In the same way that the strength of the first-quarter growth numbers was completely unexpected, so was the scale of the contraction in the second quarter. Indeed, the volatility of the q/q GDP growth data is making an accurate forecast almost impossible. Gross national product (GNP), considered a better indicator of the performance of the Irish economy, also fell in the second quarter of the year. However, the rate of contraction in GNP slowed considerably. Specifically, GNP, seasonally adjusted, dropped by 0.3% q/q in the second quarter, down from a 1.2% q/q decline in the first quarter and a 1.9% q/q contraction in the final quarter of 2009. Encouragingly, the second quarter of 2010 witnessed the smallest GNP quarterly decline in many years. The difference between quarterly GDP growth and GNP growth can be significant as the profits of foreign-owned enterprises are excluded from GNP. These profits increased considerably in the first quarter of the year compared with the previous quarter and the same quarter a year ago, suggesting that the strong GDP rebound would not mark the beginning of continued buoyant growth, as it appeared to be partly the consequence of the higher profits earned by foreign-owned multinationals. The second-quarter growth numbers confirmed that this was indeed the case, although the scale of the contraction was unexpected.

Private Consumption Improves Slightly, Investment Surprises on Upside

The detailed breakdown shows that many of the domestic demand components fell in the second quarter of the year, although in most cases the rate of contraction moderated from the previous quarter. This was the case for private consumption, which recorded a 0.2% q/q contraction, compared with a 0.5% q/q fall in the previous two quarters. The contraction in private consumption for the first quarter of 2010 has been downwardly revised from a previously reported drop of 0.2% q/q. The improvements in both consumer confidence and retail sales data are pointing to some stabilisation of private consumption. However, there continue to be significant headwinds that will restrain consumption somewhat for some time to come, in the form of downward pressure on employment and income, together with the need to maintain high savings in order to reduce indebtedness. All of this suggests that private consumption might not return to steady growth until the final quarter of the year.

Government consumption meanwhile posted a 0.8% q/q contraction in the second quarter, having increased by only 0.1% q/q in the first, reflecting ongoing government austerity measures. Interestingly, having been the main drag, investment rebounded unexpectedly in the second quarter, rising by 11.5% q/q. This followed a 14.3% q/q contraction in the first quarter. Indeed, capital investment had plunged since peaking in the first quarter of 2007, mainly as a consequence of the marked correction in the construction sector following extended, heady growth. Unfortunately, the CSO press release does not include a breakdown of capital investment, which makes it very difficult to explain the rebound, given the amount of spare capacity in the economy and ongoing problems in the construction sector. The only possible explanation is that, in light of the strong recovery in the first quarter of the year and resilient exports, business leaders became too optimistic about the future. Therefore, this is unlikely to mark the beginning of a steady upward trend. Moreover, available data and forward-looking indicators suggest that activity in the construction sector is likely to decline further, with very little new construction activity in the pipeline, given stagnant demand, significant levels of oversupply, and limited availability of credit. Therefore, the outlook for capital investment remains gloomy.

Export Growth Slows Considerably

The net exports performance deteriorated in the second quarter. Exports continued to rise in the second quarter, as in the first, but the rate of expansion slowed significantly. Specifically, exports increased by 1.6% q/q, down from a 7.1% q/q rise in the first quarter and a 0.6% q/q drop in the previous two quarters. The resilience of the external sector in the first two quarters of the year was mainly supported by the softer euro. However, the euro rallied appreciably from its early-June lows to trade as high as 1 euro:US$1.3334 in early August, and it then set a new high of 1 euro:US$1.3441 in late September. The euro's gains in July and early August were primarily the consequence of some weaker U.S. economic data, which raised concern that the U.S. recovery could be stalling. Meanwhile, smooth government debt auctions in Greece, Portugal, and Spain in early August eased concerns about the Eurozone's sovereign debt problems, at least temporarily, while the results of the July European Union (EU) bank stress test were reasonably well received by the markets, even if doubts were expressed about their robustness. In addition, July and August saw the release of some decent Eurozone economic data. Nevertheless, the euro dipped below 1 euro:US$1.27 in late August and early September thanks to some renewed market focus on the debt problems in some Eurozone countries. The euro has since returned to the 1 euro:US$1.30 level, and it traded as high as 1 euro:US$1.34 in late September, as the Federal Reserve indicated that it was ready to take further stimulative action to support the U.S. economy. This is likely to have some negative impact on the export performance. Meanwhile, imports also increased in the second quarter, by 4.5% q/q, compared with rises of 3.7% q/q in the first quarter of the year and 0.7% q/q in the final quarter of 2009.

Outlook and Implications

The second-quarter GDP numbers, together with the recent difficulties in European sovereign debt markets and the ongoing crystallisation of banking losses for the government—estimated to be at least 25 billion euro (US$33.5 billion)—suggest that the short-term prospects for the Irish economy remain precarious. In light of the recent numbers, IHS Global Insight's estimate for Irish GDP growth in 2010 will have to be revised downwards in its next interim forecast round. Although we still believe that a double-dip recession in Ireland is unlikely, the outlook for the second half of 2010 is challenging as significant downward pressures remain on the horizon. For example, heightened financial sector problems and very tight credit conditions are currently intensifying the problems facing the economy. Moreover, home-grown imbalances from the boom years could act as a drag on growth, by more than anticipated. The unwinding of these imbalances, arising from rapid credit growth, inflated property prices, and high wage and price levels, will limit the upside potential. More specifically, financial sector weakness, a fall in real-estate prices, and high unemployment could continue to reinforce one another. For this reason, current policy efforts to boost banks' capital ratios are important and will help counter these tendencies. It they fail, the outlook will become gloomier. However, the timing and strength of the Irish economy will ultimately depend on its external performance. Unfortunately, the performances of the major industrialised economies remain patchy and uneven. Nevertheless, we believe that demand is set to expand modestly in Ireland's main trade partners, in contrast to last year's contraction.