David McWilliams

Sunday 13 July 2014

2014 looks brighter -- but another banks crisis could derail recovery

David McWilliams

Published 01/01/2014|02:30

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Starbucks is to open in the former Anglo Irish building on Stephen's Green
Starbucks is to open in the former Anglo Irish building on Stephen's Green

ON the day that's in it, let's examine some of the big economic and financial questions that will impact on our lives in 2014.

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Will the economy continue to recover slowly or will it slip back?

The short answer is that the economy should keep moving along in a positive direction but it could be derailed by another banking crisis, sparked by the ECB's stress tests.

The good news is that Ireland's two largest trading partners, the USA and the UK, are performing better than expected. In the UK, the economy has turned around much quicker than even the most optimistic Tory could have hoped for. However, the UK is back to its old tricks again as we are seeing, especially in London, a massive bubble building in the housing market and a return to bank lending to the housing market in general. This makes the population feel a bit richer, but this could be derailed again by a slump in house prices, particularly in ridiculously priced central London.

Much depends on how Mark Carney, the (Irish-passport-holding) governor of the Bank of England, reacts in the next 12 months. My hunch is that he will keep the party going as long as he can, rather than tighten interest rates too quickly. Even if there is a small rise in the UK's rate of interest, the economy is growing at an annualised rate of 3pc and unemployment is falling quickly towards 6pc. Both of these factors should keep up consumer spending in our biggest single trading partner.

All of this implies that the UK will perform healthily this year, which is great news for labour-intensive Irish exports such as agriculture, tourism and services. Let's not forget that Ireland and Britain do €1bn of trade with each other per week.

Meanwhile, in the USA, the Fed has signalled "peak stimulus" and will begin the process of trying to unravel five years of pumping cheap money into the economy. This will have a bigger than anticipated impact on stock prices than the financial markets seem to be worried about. But all told, the US economy is creating jobs, its housing market is not just stabilised but is improving across the board, and wages will begin to rise this year as workers demand a bit more of the pie.

In the past few years, the spilt in the US between wages and profits has been skewed to profits, so much so that US corporations are sitting on the biggest cash pile in history. This has to be spent and it will either be spent on investment or wages, or both.

The bit that is spent on investment is important to Ireland because that is the bit that may be invested by multinationals here.

As long as global tax authorities don't make good on the intentions of the G8 in Enniskillen, 2013, and try to tighten up on flagrant tax manipulation by countries such as Ireland, extra multinational investment, driven by US companies having too much cash on their balance sheets, will continue.

But what about domestic demand?

This is the major question for most businesses in the next 12 months. In the past three months there was evidence the domestic part of the economy could begin to improve, buoyed up by a better-than-expected improvement in the jobs market and some increases in house prices. As a result, tax revenues were slightly better than forecast and retail sales in October and November were strong, as too was the rebound in consumer sentiment. However, according to anecdotal evidence from retailers, the final weeks up to Christmas did not see a surge in spending as the retailers had hoped.

So where do we stand now in January 2014?

For the economy to chug along, domestic demand needs to recover because this is where the vast majority of Irish jobs come from. Domestic investment -- a much smaller component of GDP than consumption -- also needs to rebound.

Irish companies -- like their counterparts in the US -- have been saving hugely and paying down debts. This implies that there could well be a strong return to corporate investment this year, and continued small falls in unemployment.

Our recession has been a balance sheet recession. Balance sheets are broken; too much debt and plunging houses prices have caused the savings ratio to rise. This implies that there may be pent-up demand, which we are now seeing in the guise of "cash" buyers in property, but we may see this in other areas of consumer spending in the next 12 months.

But you may ask how can we have an uptick in consumer spending, investment and some house prices, while at the same time have double-digit rates of unemployment, shrinking bank lending and prohibitively higher marginal rates of tax?

This is because there are at least two Irish economies out there, and by and large the difference between the two economies is generational.

The middle generation between 30-45 has no extra spending power because of the legacy of the housing bust. They were the ones who bought houses in the boom and are the ones who suffered most in terms of negative equity.

THE younger generation in their 20s -- the ones who have stayed -- have actually benefited from the housing bust, as housing costs up until this year remain subdued. But they have little disposable income because wages for people in their 20s have fallen quite dramatically and schemes such as "internships" are becoming increasingly popular. These don't pay well but are seen as the only way of getting experience to ultimately get a job.

The people who are spending again are the late middles between 50-65 who have built up savings, have equity in their houses and who are the ones emerging as "cash" buyers for suburban houses all over the country.

As European interest rates will probably go lower this year, it is difficult to see these broad trends reversing.

The one unexploded financial landmine out there is another bank crisis, as the new stress tests signalled by the ECB reveal that Irish banks don't have adequate capital -- yet again. This is a very real fear and if the banks need more capital, where will it come from?

It won't come from the taxpayer, because we have no more money. Will the Government borrow from future taxpayers again? I doubt the financial markets would welcome Ireland borrowing more money to pay not for today but for yesterday. So where will it come from?

This is where the ghost of Cyprus lingers. Might it come from a raid on deposits over €100,000, as happened in Cyprus? I suspect it might.

If that happens, all bets are off and we slip back again.

If, however, the €24bn war chest borrowed by the NTMA last year is spent on the banks yet again, the landmine won't go off, but the bill for the collateral damage will be given to the next generation and the next.

I believe this, sadly, could be the plan for 2014.

David McWilliams' new daily finance and economics newsletter, www.globalmacro360.com, is out now. Sign up for your free trial today.

Irish Independent

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