Wednesday 26 April 2017

Dan O'Brien: Economic 'miracle' would be at risk if rates go up

'As the accompanying chart shows, the department expects its total revenues - taxes, social contributions and all other sources of funds - to rise gradually over the next five years, from €73bn in 2016 to €87bn by 2021.' (stock photo)
'As the accompanying chart shows, the department expects its total revenues - taxes, social contributions and all other sources of funds - to rise gradually over the next five years, from €73bn in 2016 to €87bn by 2021.' (stock photo)
Dan O'Brien

Dan O'Brien

Last week saw the publication of the most important economic and budgetary document of the year so far. The Department of Finance's Stability Program Update contains an assessment of the state of the economy, along with - much more importantly - a full set of forecast figures on the public finances for the next five years.

All eurozone governments have to produce an identical report as part of the wide-ranging and complicated set of rules put in place since the sovereign debt crisis almost brought down the euro. The rigour this has brought to thinking in the department is evident in the rising quality of these reports over the years (although, lamentably, this rigour has not changed the flawed overall strategy provided by the politicians of still running budget deficits half a decade into a recovery). As has been the case in the post-crash period, the department's latest economic forecasts are reasonable, even if they are a tad higher than those of other bodies in the predictions business.

Its forecast for the evolution of both the spending and revenue sides of the public finances are also plausible, even if there is more that one might quibble with in these projections compared to the economic growth numbers.

As the accompanying chart shows, the department expects its total revenues - taxes, social contributions and all other sources of funds - to rise gradually over the next five years, from €73bn in 2016 to €87bn by 2021. That is in keeping with the revenue trajectory in evidence since the recovery began in 2012. The rate of increase over the next half decade amounts to less than 4pc annually on average - a sensibly-conservative estimate given the central forecast for economic growth.

On the expenditure side, the Government expects the increase in its outlays to rise at a considerably slower pace out to 2021 - around 2.5pc per annum. Given the overall record of this Government and its predecessor, it would be wrong to say that this target is unachievable, but with strong and growing spending pressures from multiple sources it will certainly be hard to achieve.

Among the largest and most politically explosive spending pressure is public-sector pay. No lobby group is as powerful when it comes to appropriating for itself the biggest possible slice of the pie - the latest figures show that more than 45pc of the total increase in general government expenditure in 2017 will go on extra pay.

The Government's attempt to partially depoliticise the public pay setting mechanism came in the form of the public-sector-pay commission set up last year. While the logic for establishing such a commission is very strong, it will only be of value if it produces rigorous and impartial research.

There is not long to wait to find out how well it does its job. The commission is due to issue its first report by the end of the month. Even if its report reflects the overwhelming body of available evidence (that evidence shows that the public sector in Ireland is well remunerated relative to private sector and international counterparts), there will be a battle royal to keep the increase in the total bill to the projections set out last week's budgetary plan. Along with spending pressures, the update acknowledges and analyses other risks to the economy over the short and medium terms. These are set out in matrix format, which assesses both the likelihood of each risk coming to pass and the impact if it does. Brexit, US policy uncertainty and a whole host of others risk factors, both domestic and external, are covered. The report, quite rightly, correctly states that the balance of risks is "tilted to the downside".

One could debate the risks until the cows come home, but one of the risk factors that possibly needs more attention is the impact of higher interest rates. The department sets out in detail how a 1 percentage point increase in rates by the European Central Bank would hit the Irish economy over a five-year period. It discusses how a rate hike would impact via the exchange rate channel (it would cause the euro to appreciate) and the export channel (it would cool demand for Irish goods and services across the continent). But the impact on still heavily-indebted Irish households is not discussed. This channel may well be the most important.

As interest rate normalisation looks to be moving closer by the week, with the European economy picking up steam, a 3-4 percentage point increase in interest rates for households and businesses over the time frame of the forecast (2017-21) is now quite likely. With the effects of interest rate normalisation likely to be kicking in just as the UK is scheduled to be leaving the EU, Ireland is facing two major shocks simultaneously.

One could also take issue with the Government's projections on its own debt servicing costs. Three years ago the Department was expecting to be paying an interest bill on the national debt of €10bn. Happily, things turned out very differently. Last year, servicing the national debt cost taxpayers just over €6bn.

That €4bn saving was mostly to do with the very unusual things that have been happening in sovereign bond markets internationally in recent years. Across the world, many governments have been able to borrow for next to nothing. The collapse in sovereign bond yields has been particularly marked in the eurozone, most probably (one can never be entirely certain about cause and effect) as a result of the continued purchasing by the European Central Bank of government bonds as part of its stimulatory 'quantative easing' programme.

Predictably enough, the windfall arising from the low interest rate phenomenon was not used to accelerate a balancing of the Government's books, but was spent instead. If that made things easier politically in recent years, a reversal of the trend would make them harder in the years ahead. The Government is not only hoping to avoid that, it is banking on paying even less interest. Last week's projections foresee a further fall in the debt servicing bill each year out to 2021, and that is despite an increase in total public debt - from €200bn last year to €214bn in 2019.

That, again, is achievable, but it will depend on the rate at which more than €50bn of the total, which is due for repayment before the end of 2020, can be refinanced. If rates rise to the point that newly issued debt comes with a higher interest rate than the debts that are being repaid, then the debt servicing bill will rise rather than fall.

There is a lot of uncertainty out there. In fairness, the government's analysis could not be accused of failing to acknowledge that. Overall, the latest Stability Programme Update is probably the most rigorous yet.

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