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Komal Sri-Kumar
Senior Fellow; President, Sri-Kumar Global Strategies
Asia and California and Capital Markets and Europe and Finance and Global Economy and Public Policy and U.S. Economy
Dr. Komal Sri-Kumar is president of Santa Monica-based Sri-Kumar Global Strategies, Inc., a macroeconomic consulting firm that advises multinational firms and sovereign wealth funds on global risk and opportunities.
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Ireland Seeing Green Shoots
By: Komal Sri-Kumar
August 14, 2013
   
   

The Irish economy, known as the Celtic Tiger, brought the 20th century to a roaring close, with GDP increasing at an average annual rate of 9.4% between 1995 and 2000. The pace of expansion remained robust in the following years with an average annual growth rate of 5.9% until the 2008 crisis (chart below). The global financial crisis, however, brought the boom to a quick end. GDP fell by 7.4% in 2008, and despite some signs of stabilization since, growth is nowhere close to the former glory times. Still, there are some promising signs of recovery in recent data and, unlike Iceland, Ireland has managed to arrest the decline even though it does not have the ability to devalue its currency.

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And unlike Greece, which already bore a debt burden equivalent to 90% of its GDP in 2007 - - well into the danger zone - - Irish public debt remained benign, at 25% of GDP in 2007. What explains Ireland’s sudden fall from grace? Even though Irish public debt was a small percent of the overall economy, the country’s banking system was mismatching maturities on the asset and liability sides during the housing boom which peaked in 2006. Deposits taken in were lent for longer time frames in domestic real estate as well as through the purchase of subprime mortgage securities in the United States. While this was a profitable activity for Irish banks through 2007, real estate values subsequently fell precipitously and, as deposits exited the banking system, the financial institutions were faced with a solvency problem.

That is not the end of the story. What should have been just heightened banking sector risk was converted into a surge in sovereign risk when the Irish government decided in September 2008 to take over most of the obligations of the banking system—not only backing depositors, but also holders of senior and some subordinated debt. Notice how, in the chart below, Ireland’s public debt-GDP ratio (green dotted line) rose from 25% in 2007 to 44% in 2008, and to over 100% by 2011. As in the case of Greece and Portugal, the Irish government needed bailouts led by the European Union, the ECB and the IMF.

Compare Ireland’s situation with that of Iceland in the chart below (red solid line). Iceland also had a low, benign debt-GDP ratio until 2007 and, coincidentally, has seen the ratio rise to 118% in 2012, the same level as Ireland. In the case of Iceland as well, the downturn was precipitated by ill-timed investments in subprime real estate-based securities and the inability to redeem bank deposits. However, Iceland massively devalued its currency, the krona. Ireland can no longer use the exchange rate mechanism since the Irish pound was superseded by the euro in 1999.

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What then explains Ireland’s turnaround? It is a consequence of two important developments. First, in terms of its economic structure, Ireland has been more welcoming of foreign direct investments compared with its larger Eurozone neighbors such as France and Italy. Ireland’s 12.5% corporate tax rates is one of the lowest in the world, and has served to attract multinational companies to locate a large part of their operations in the country. Google’s headquarters for Europe, Middle East and Africa is in Dublin, making the city a technology hub for the region. Furthermore, the Irish population’s facility with English - - even though Celtic is the country’s principal language - - has made foreign firms major employers of skilled labor.

Second, even though Ireland was unable to devalue its currency to boost export competitiveness, authorities resorted to something known as “internal devaluation.” Rather than lower the domestic currency’s value in foreign currency terms, wages denominated in euros were lowered massively after the crisis began in late-2008. Note in the chart below, unit labor cost (or labor per unit of output, in technical jargon) was reduced by more than 15% from the third quarter of 2008. Economists often consider unit labor cost to be a good measure of a country’s competitiveness in a global economy.

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Despite the positive news, Ireland has not exited the crisis. Travel to Ireland - - on a business trip in the autumn of 2011, and conversations with Irish residents of different income levels when on vacation earlier this month - - suggests that the population is going through “austerity fatigue.” The coalition government led by Prime Minister Enda Kenny finds, however, that it has to persist with belt-tightening in order to limit the fiscal deficit and the extent of foreign borrowing necessary. Also, despite the strenuous efforts made by the Irish since the crisis to implement economic reforms, a deterioration of the situation in Greece or Cyprus, for example, could still have a major negative impact on the Irish economy.

Notwithstanding these notes of caution, there is a lot that is green in Ireland.