Ailing Tiger: Why Ireland Isn't Out of the Woods YetPublished: May 12, 2010 in Knowledge@Wharton
While the economic storm of the last two years has left virtually no nation untouched, few countries have felt its wrath like Ireland. Once dubbed the "Celtic Tiger" for its transformation from a laggard to a growth powerhouse, Ireland is now suffering from a stunning reversal of fortune.
From 2008 to the end of this year, the Irish economy is expected to contract 11.6%, according to the International Monetary Fund (IMF). "Ireland is a disaster," says Desmond Lachman, a resident fellow at the American Enterprise Institute for Public Policy Research (AEI), a Washington, D.C.-based think tank. "To call this a recession [in Ireland] is a gross understatement. It is halfway between a recession and a depression."
The bust, and the electrifying boom that preceded it, were caused by a confluence of factors. One contributor: Ireland's entry into the euro zone in 1999. Low interest rates set by the European Central Bank (ECB) fueled a real estate bonanza in the country, which the Irish government was all too happy to sustain. "The government wanted the residential and commercial boom in property to continue because it was so important to employment and consumption and other economic indicators," notes Mary O'Sullivan, a management professor at Wharton. "At some point, the government got locked into the cycle and attacked anyone who worried that [the boom] was unsustainable." When the real estate market overheated and collapsed, it brought the Irish economy down with it.
Can Ireland regain its former glory? "I don't see [the country] ever regaining the rates of growth seen during the boom years," states Melanie Bowler, an economist at Moody's Economy.com. "That is over."
During the last 20 years, Ireland's economic boom had two distinct periods. In the late 1980s and 1990s, the country's economy was fueled largely by a low corporate tax rate -- now at 12.5% -- and hefty amounts of foreign direct investment, particularly from the United States and other European countries. According to Moody's Economy.com, foreign companies employed about 15% of the country's workforce before the recession and continue to account for an estimated 90% of its exports, including pharmaceuticals, chemicals and high-tech products.
As Philip Nichols, a Wharton professor of legal studies and business ethics, notes, "Ireland was in the right place at the right time [as] an English-speaking country with strong, reliable institutions; a relatively well-educated workforce that accepted comparatively lower wages; [and] completely free trade in the [European Union, when] along came the relatively transportable high-tech industry looking for a home."
The second half of the boom, which came post-2000, was due to real estate. The ECB held interest rates low among all EU members over the past decade as the larger economies in the euro zone, including Germany and France, grappled with sluggish growth. The problem: Ireland's GDP was growing rapidly and the cheap money was like throwing gas on a fire. "It overheated the economy," says Diego Iscaro, senior economist at research firm IHS Global Insight. "That created not only a huge increase in consumer spending, but also a housing boom."
The Irish government, and its fiscal policies, did little to dampen the exuberance. "Taxes on capital gains were reduced and the government offered incentives to real estate investors," O'Sullivan says. "If the government had been intent on getting rid of the housing bubble, tax breaks should have been the first thing on the list" to go. As for the restrictions that EU membership put on the government, O'Sullivan adds, "there is no evidence to suggest that, if it had control over monetary policy, [the Irish government] would have acted appropriately to prick the property bubble."
That bubble is what AEI's Lachman calls "the mother of all housing booms." According to a study published in December 2009 by Morgan Kelly, an economics professor at the University College Dublin (UCD) Centre for Economic Research, housing construction in the country jumped from between 4% and 6% of GNP in the 1990s -- the typical range for a developed nation -- to 15% in 2007. Other types of construction contributed a further 6% to the national income.
Banks were falling over themselves to lend, a force that helped drive housing prices to stratospheric levels. In 1995, the average first-time buyer took out a mortgage equal to three times the average annual earnings for workers in Ireland. By the end of 2006, that figure had soared to eight times annual earnings, according to the UCD report.
Building a Disaster
Between 2001 and 2007, Ireland's GDP grew an average 5.5% annually, compared with 1.9% for the whole euro zone. All the construction activity, including taxes on homes sales, helped fill the coffers of the Irish government, which became overly reliant on those funds. The toxic mix, along with hefty pay hikes for government employees, drove up per capita income, making the nation less and less competitive.
Signs of trouble began appearing as early as 2007. Bank losses mounted, credit contracted and unemployment soared. According to the UCD study, new home prices and commercial property prices could eventually bottom out at two-thirds of what they were at the peak. As tax receipts slumped, the government deficit ballooned to an estimated 14.3% of GDP.
Now, the country is bracing itself for a protracted downturn and a weak recovery. The repercussions of having lost the competitive advantage that attracted so much investment have been tough. In early 2009, computer giant Dell announced it was shuttering a plant in Limerick, its largest facility outside the United States, cutting 1,900 jobs and shifting operations to lower-cost Poland. Once a low-cost country for companies to establish a presence, Ireland ranked as the second most expensive in the euro zone, after Luxembourg, in a May 2009 IMF report. And the country's share of foreign money invested in the euro zone has plummeted from about 13% in 2001 to roughly 6% in 2007.
"The big question for Ireland over the next 15 years is, 'What now?' in terms of its development strategy," says O'Sullivan. "Ireland has made a name for itself as a base for international investment and, as a result, the country has done well in terms of exports and productivity. However it has had a hard time moving from there to becoming a highly innovative economy in its own right, and [therefore] lacks the foundations for sustainable prosperity in terms of the economic indicators that most people care about, like employment and wages."
The response of the government has stood in stark contrast to other weak countries. While Greece moved slowly, the Irish government slashed spending quickly. Wages for government workers are down between 5% and 15% and welfare benefits have been reduced. In some respects, the Irish government has had no choice -- failing to get its financial house in order would have driven costs for financing its debt to impossible levels, risking default.
Where the government has moved more slowly, however, has been in implementing a rescue plan for its ailing banks. In 2009, the government nationalized Anglo Irish Bank, invested 3.5 billion euro into two other financial institutions and created the National Asset Management Agency (NAMA) to buy problem loans from Ireland's banks. The government announced a package of measures on March 30 -- dubbed locally as "Bailout Tuesday" -- to take control of mortgage lenders Irish Nationwide Building Society and EBS Building Society, while injecting 8 billion euro of capital to support Anglo Irish Bank and increasing the capital that banks are required to hold against losses.
Where There's a Will ...
Although Moody's downgraded Irish sovereign debt last summer, markets do not appear to expect the country to default. Still, as the situation in Greece intensifies with protests and violence stemming from the government's austerity plan, investors are growing increasingly nervous about the debt levels in ailing nations like Ireland. Jon Taylor, managing director of global and international bonds at Principal Global Investors in London, points out that as Greece's situation has worsened, rates on that country's 10-year bonds are over 12%, compared with about 5.8% for 10-year Irish bonds. While government workers in Ireland are protesting cuts to their wages and benefits, so far the country does not appear to be facing the unrest witnessed in Greece. "In Ireland, there is recognition of what they need to do and there is a will to do it," says Taylor.
The work, however, is still daunting. The austerity plan may appease the credit markets, but it is likely to extend and deepen the recession in Ireland. Meanwhile, unemployment climbed to 13.3% at the end of 2009 and the IMF expects it to average 13.5% this year.
What's more, experts warn that NAMA won't be the silver bullet for fixing the banking sector that many were hoping it would be. The head of NAMA recently disclosed that the loans the agency is acquiring are performing worse than initially thought. And the UCD's research suggests that even if NAMA provides some banking stability, it will not be enough. As funding sources other than deposits -- such as bonds and inter-bank borrowing -- dry up for the banks, their balance sheets will shrink further. This could intensify real estate's decline, pushing housing losses higher, and create what the report calls "zombie" banks, or institutions that are entirely reliant on government guarantees and committed solely to reducing their own debts.
In many ways, the Irish government's hands are tied. While the United States and other nations used stimulus packages to jump-start their economies, the EU restricts the size of deficits its members are allowed to carry, making such an effort impossible for Ireland. At the same time, being part of the euro zone means Ireland doesn't have the ability to devalue its currency, a move that would make its exports more competitive and provide much needed economic juice.
Still, EU membership is important for Ireland. The European Central Bank has provided liquidity to its member institutions during the crisis, and EU membership allows the country to borrow at rates that are lower than they would be if Ireland were on its own because credit markets assume the EU will not let it default.
But the country's plight -- and that of Europe's other troubled economies such as Greece, Spain and Portugal -- is testing the foundations of the EU. John Kimberly, a Wharton management professor, says the EU is grappling with how far healthy member countries need to go to help members in dire financial straits and whether members should be kicked out of the euro zone if they don't keep their financial house in order. In addition, he notes that the EU must find a way to balance the need for unity with the reality that each member economy is developing at a different rhythm. Last weekend, the coalition announced a 750 billion euro rescue package for heavily indebted countries using the currency. "Where do you have standardization across all countries and where do you build in adaptability?" Kimberly asks. "The situation has raised serious questions in the minds of many about the viability of the expanded EU, if not the idea of the EU itself. The proposed rescue package is certainly intended to demonstrate continued belief in the viability of that idea. Time will tell."
While the rescue package plays out, there are some positives for Ireland. The painful recession and decline of personal incomes will help the country regain some of its competitiveness. And the nation's low tax rate remains intact, a factor that will attract foreign investment as the global economy recovers. "Ireland has a tremendous advantage over most emerging economies," says Wharton's Nichols. "There are no trade barriers between it and the largest economy in the world. As consumers and industries in Europe recover, Ireland is well placed to satisfy needs in those markets."