A ray of light on the horizon?

By Business & Finance
03 May 2010
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Is talk of an economic revival premature or are we on the cusp of a recovery, albeit a very slow one. John Walsh weighs up the arguments.

­­Is the Irish economy on the verge of a recovery or will it remain in a sclerosis for over a decade similar to what happened in Japan when its property market collapsed in the early 1990s? There is a sharp divergence of opinion among experts on what the medium-to-long term holds for us.

What seems certain is that the gravity defying growth rates that were posted between the years 1994-2007 are unlikely to be seen again. The emphasis now is on moving the economy towards a much more sustainable growth model, which would remove or, at least, reduce the type of boom/bust cycle that brought the economy to its knees over the past two years.

But whether this is a realistic aim over the near to medium term is far from certain. And that’s largely because there is still a heated and unresolved debate about the nature of the economic boom in the first place.

Will the real economy stand up?

Over the course of the rapid growth period, there were two phases of expansion: an export-driven model which gave way to a construction boom based on cheap and plentiful credit. The former had its roots in the developing world tiger economies. The latter took its inspiration from the cheap credit speculative construction boom in the US, UK and some other OECD countries.

The widely disparate views on where the economy goes from here reflects the uncertainty over how much damage has been done over the past two years. The estimated €81bn in loans that are being transferred to the National Asset Management Agency (Nama) is testament to the scale of reckless lending that caused the near-collapse of the banking system. The viability of any economy hinges on having a well functioning financial system.

Then there was the reputational damage wreaked in the aftermath of the Anglo Irish Bank debacle. There were plenty of international commentators lining up to claim that Ireland was nothing more than a loosely regulated tax haven. For a country that is highly dependent on foreign direct investment (FDI) having a sound reputation is crucial.

There are a number of reasons why there is so much pessimism hanging over the economy. There was a huge erosion in competitiveness over the past decade. Moreover, the catalyst for the rapid growth in economic expansion in the 1990s was a one-off decision by US multinationals to locate abroad. Ireland soaked up a disproportionate amount of this investment on the back of a low corporate-tax rate, a business-friendly environment, cheap labour costs, a well educated English speaking workforce and access to the EU.

In a conversation with this magazine recently, a senior figure in one of the semi-state companies argued that for the first time in the history of the State, there was no coherent industrial development policy. Consequently the economy is hamstrung and will not produce the sort of robust growth needed to create jobs.

The Government has consistently pointed to the smart economy as the way forward. But that has a growing legion of critics. University of Limerick economics lecturer Stephen Kinsella is one of them: “I am very critical of the smart economy. I don’t think it will work at all. I don’t think it will deliver on what it promises.”

But Kinsella does not support the idea of a top down industrial policy. He argues that the path to growth is through developing the domestic economy and indigenous industry. “If you have a bottom-up approach, it is much better. You allow entrepreneurs to develop. To do that, you need an efficient debt resolution mechanism – you need to have credit and subsidies available.

“Make sure that these guys are taken out of the tax net for a few years. You don’t directly give them a subsidy – you let them keep what they earn for a few years.

“In terms of getting places to work, office space is cheap. The problem is how do we incentivise people to take their redundancy money and start up a business. There should be a start your own business course in every single Fás centre and in universities and secondary schools. Currently there are not.”

Kinsella is bearish on Ireland’s prospects for the immediate future. He says that this country will never attract the largescale foreign direct investment projects similar to the Dell manufacturing plant in Limerick. Consequently, there will be a slow crawl out of recession and it will be about 15 years before the economy reaches buoyant levels of activity again, he adds.

The former chief executive and chairman of Intel Craig Barrett made a series of damning comments at the Government’s Irish diaspora forum in Farmleigh in September 2009. He said that the education standards, particularly in maths and science, were well off the pace needed to attract future investment flows.

And what must have sounded alarm bells ringing in Government quarters, he reasoned that the economy needed to be weaned off FDI. One of the main planks of economic growth since the 1958 Government-commissioned Whitaker report has been to attract FDI.

Frank Barry, lecturer in international trade and economics at Trinity College Dublin, says that there is still potential in the FDI component of the economy. “I am not taken with the Craig Barrett argument that we need to wean ourselves off FDI. I don’t think his argument stacks up. I think our FDI development strategy is in good shape and has helped hold up the economy during the recession.
“One thing we know is that Ireland’s export performance was the strongest in Europe over the course of the recession. It didn’t fall nearly as much as the rest of the euro zone and it is largely attributable to the pharmaceutical and chemicals sector.”

Barry argues that the type of FDI is changing and it is moving in much higher value added areas. He cites Dell, Apple and IBM which have all shed their manufacturing operations over the past decade, but have replaced these with higher value added functions. In the case of Apple and IBM, the headcount in areas such as sales, marketing, logistics and treasury management functions now exceed the numbers employed in manufacturing. even at its peak.

Looming recovery?

The ERSI is sticking to the forecast it issued in May 2009 that growth in the economy will not resume until 2011, although it will be 2012 before the economy sees a return to rapid growth. “The economy will be dragged out of recession by the rest of the world buying our goods and services,” says the ERSI’s John Fitzgerald.

“It is the export industry, which will move into balance of payment surplus which will enable Ireland to repay debt even though the Government is still borrowing a lot of money. Next year, people will still feel insecure and, as a result, will be saving at an abnormally high rate.”

Alan W Gray, managing partner at Indecon Consultants, says that there is still a healthy future for FDI flows into Ireland. He agrees with Barry that the internationally traded services sector offers huge potential for growth.

And even though there has been much speculation that Ireland would lose out to East European countries, there is little evidence that these countries are securing FDI flows at the expense of Ireland, says Gray. “We have certain advantages including an English speaking workforce and a history of successful development of FDI projects. The biggest issue in terms of FDI is the recovery in the EU and US economies. We did lose out on certain projects over the past few years because of the erosion of our competitiveness, but that has improved considerably over the past year. Our comparative advantage for FDI has improved rather than disimproved over the past year.”

But even though this country has the potential to maintain current levels of FDI and attract buoyant flows in the future, it will not be a panacea for the unemployment problem, says Gray. He estimates that on a best-case-scenario, another 20,000-to-30,000 jobs could be added through foreign investment in the future. There are currently 150,000 employed by US multinationals. The unemployment rate is running at close to 400,000.

The prospects for the overall economy hinge on a recovery in the domestic economy. Confidence plunged following the collapse of the investment bank Lehman Brothers and the ensuing financial crisis in September 2008. The construction sector has gone into meltdown. Retail sales have plummeted and the demand for domestic service providers has tailed off significantly.

The two most labour-intensive sectors are construction and services. Unless there is a turnaround in confidence and consumer spending picks up again, then the level of job creation will be far off the levels needed to alleviate the unemployment problem.

Uncertainty over when this will happen opens up the biggest faultline between those who are optimistic about the economy’s fortunes and those who think the worst is yet to come.

The latter camp argue that there is a huge debt overhang in the private sector, which is going to take a while to work its way through the system. Moreover, the banks will remain fragile until the true extent of post-Nama losses is revealed. And because of these factors, the economy will flatline for the foreseeable future.

The ERSI’s John Fitzgerald forecasts a recovery in a much shorter timeframe. He says that once exports pick up, confidence will seep into the economy, which will mean that people feel more secure about their jobs and there won’t be any further significant hikes in taxation.

Then begins a virtuous circle with the export and domestic economies. He expects this process to gain traction from 2012 onwards. The ESRI forecasts that the economy could grow at 5% each year to 2015 which has the potential to reduce the unemployment rate down to 6-7%.

“You enter a virtuous circle when domestic demand rises. But I do not see that before 2012/13/14, when you will see substantial growth arising from both export and domestic demand.”

The IMF was less bullish than the ERSI in it assessment of the Irish economy in 2011, pencilling in growth of 1.9% compared with the latter’s 2.5%. Moreover, the Washington headquartered institution confirmed that the Irish economy has experienced the worst crash of any European country.

The re-adjustment needed to restore fiscal rectitude is massive and ongoing. If there is a sovereign debt crisis, then Ireland would inevitably come under severe pressure. How the economy pans out depends on external factors. The only thing that can be said with any certainty is that the outlook remains uncertain but on balance, there are reasons to be optimistic.

Tax and regulation: Impact on recovery

The low corporate tax rate and the business friendly regulatory environment were seen as two of the most compelling factors in attracting foreign direct investment (FDI) from the early 1990s onwards. Maintaining the 12.5% corporate tax rate is seen as critical to maintaining current levels of FDI and attracting future investment.

But, corporate tax is becoming a highly politicised issue which has implications for Ireland. In the last issue of Business & Finance, associate editor of the Financial Times Wolfgang Munchau argued that it was inevitable that the Government would have to compromise over the corporate tax rate on the basis that it form a quid pro quo in return for financial assistance from Brussels. And if it wasn’t ceded this way, then it would go through EU fiscal harmonisation.

Munchau is reflecting the views held by larger member states, particularly Germany, that Ireland’s corporate tax rate is unfair and distorts competition. The Lisbon Treaty enshrined the right for every country to determine its own tax rates. Nevertheless, the EU Commission is pressing ahead with plans to introduce a common consolidated corporate tax base (CCCTB), which is seen as a necessary precondition for harmonising the tax rate.

“Ireland does have a comparative advantage because of the corporate tax rate. As a result, competitor countries do not like it. They never liked it and felt it was undesirable for many years and that is a function of when a country feels another country has an advantage and they would prefer to remove that advantage. The Lisbon Treaty guarantees the corporate tax rate and I don’t think that is in danger of being changed,” says Indecon’s Alan Gray.

TCD’s Frank Barry says that corporate tax policy is a much more complex issue than is often depicted and if Germany was successful in its attempts to remove Ireland’s low corporate tax rate, then it could undermine its own efforts to attract US multinationals. “Because US firm are not eligible for a tax rebate from the US authorities, when foreign taxes in excess of the US rate are levied. Since all foreign income and taxes paid are added together in the computation of the foreign tax credit issued by the US authorities, low tax environments allow US firms to operate in other foreign high-tax environments without penalty.”

The Government secured a cast iron guarantee on individual sovereignty in setting the corporate tax rate in the ratification of the Lisbon Treaty. But if Ireland was to run into a fiscal crisis and needed a bailout from Brussels, it would almost certainly be on the agenda.

If the corporate tax rate was to go, the consequences could be very damaging, says Gray. “We are a very small country on the periphery of Europe. The only way we could compensate is through a lower standard of living and even that would not compensate for capital intensive FDI where labour costs are a small component of their cost base. If it was removed, it would be a huge blow to Ireland’s ability to attract FDI but I don’t think that is a likely development.”

Having a sound regulatory environment has become crucially important, particularly in the aftermath of the G20 Summit in London on April 2 2009. Any jurisdiction that is deemed to be a tax haven or loosely regulated will fall foul of the post-banking crisis standards.

There was a concerted effort to lump Ireland into that category before the economic meltdown. The New York Times ran a damaging article in 2005 which depicted this country as the wild west of financial markets.

The crisis scandals at Anglo Irish Bank and Irish Nationwide appeared to confirm this view. But experts point out that Ireland is not an offshore jurisdiction. It is an onshore location that is regulated by EU legislation. What happened at domestic institutions was a failure of the regulatory arms of the State rather than a failure of regulation. The appointment of Patrick Honohan as governor of the Central Bank and Matthew Elderfield as Financial Regulator is seen as a very positive move towards shoring up the country’s battered image.

Access to credit: Vital for trading out of the crisis

The resolution of the banking crisis is an important part of the restoration of stability and recovery. The Government has set up the National Asset Management Agency (Nama) to handle €81bn in development loans that could cripple the banking system, if allowed sit on the balance sheets of the banks.

If the economy is to trade its way out of this downturn, then indigenous firms need access to capital to exploit export opportunities. The indigenous IT services sector is seen as an area with huge potential. But anecdotal evidence suggests that even firms in this lucrative sector are having problems maintaining working capital.

“That is a real concern and that is why recapitalisation of the banking system needs to happen now,” says the ESRI’s John Fitzgerald.

Compounding the problems for Irish businesses is the absence of a thriving venture capital sector. Moreover, the level of wealth destruction that has been wreaked across the Irish high net worth sector means that the venture capital/angel investor sector has been wiped out for the foreseeable future.
Having a thriving banking sector is seen as the most effective way of pumping credit through the system.

“You need the ‘fois gras’ approach to the banks which basically means that you shove cash down their gullets and then nationalise them. It is only when they are so full of capital that they will go out and lend. The recapitalisation of the banking system is urgent. If that doesn’t happen, then it is a real problem,” says Fitzgerald.