Debt and global slowdown may muzzle Celtic Tiger's recovery

Ireland is rebounding a year on from its bailout but there are doubts over how long that can last
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The Independent Online

There must be something in the waters of the Liffey, the river that flows through the centre of Dublin, that encourages wishful thinking among Irish officials.

In 2008 they were adamant the country's banks were sound, despite widespread fears over their solvency.

And two years later, government ministers insisted the country would not need an international bailout, despite the fact investors were rapidly dumping Irish sovereign debt.

Those illusions were, of course, shattered. Ireland's banks turned out to be utterly bust. And in November 2010, the country collapsed into the arms of the European Union and the International Monetary Fund, accepting a €85bn (£73bn) support package.

Yeta year on, another fantasy seems to be taking hold: the idea the country's economy can flourish in a eurozone seemingly heading for recession.

The Fine Gael/Labour coalition, which took power in February, expects 1.6 per cent growth in 2012, rising to 2.8 per cent in the following years.

Talk in official circles is of Ireland "dipping a toe" back into capital markets as early as next year.

Policymakers have taken heart from the fact that 10-year Irish bond yields have fallen from highs of 14 per cent to about 8 per cent, indicating an improvement in confidence in the government's creditworthiness. No-one claims the Celtic Tiger is about to roar again, but officials paint an optimistic picture of robust recovery.

In a sense they are entitled to be optimistic. Ireland's efforts in recent years have been impressive. The government has imposed wave after wave of public sector austerity to reduce a vast budget deficit. And in some respects this has been successful. Irish wages, massively inflated during the boom years, have fallen by about 14 per cent.

The country has as a result recovered much of its lost competitiveness. Exports have picked up well, helping to produce two successive quarters of growth in the first half of this year, despite shrinking domestic demand.

All this has made Dublin a favourite in Brussels. But the question is: how sustainable is the recovery given the fierce gales buffeting the global economy? Two of Ireland's biggest export markets – the UK and EU – have embarked on their own austerity drives and may even dip into recession.

That will make it challenging for Ireland to continue to power its growth through exports. And it will be difficult for Dublin to raise money on private markets too. Eight per cent is still far too much for Ireland to pay for its borrowing. When I asked one senior official what 10-year bond yield would allow Ireland to return to the market, he admitted he did not know.

Then there is the debt burden. Even if all goes to plan for the Irish economy, its sovereign debt-to-GDP ratio will hit 120 per cent by 2013. Evidence suggests economies with debt more than 90 per cent of GDP struggle to grow.

The Irish optimists have answers. The finance minister, Michael Noonan, argued this week that demand for Ireland's exports – largely made up of pharmaceuticals, food and computers – is relatively inelastic, which means the country should not suffer too much even if growth abroad is disappointing.

And Treasury officials I spoke to this week insist a debt-to-GDP ratio of 120 per cent is sustainable.

They point out that Ireland had a similar level of sovereign debt in the 1980s and managed to bring it down.

But Philip Lane, an economics professor at Trinity College Dublin, is sceptical. "The 1980s deficit reduction in Ireland was due to super-fast growth," he says. "That's just not plausible now. The government was indebted then, but no- one else was. There was no real household debt or corporate debt." Now, of course, Irish household and private debt is vast – one of the reasons domestic spending is so weak in Ireland almost four years after the bubble burst.

Professor Lane argues that despite heroic efforts to pay what it owes, Ireland might need to restructure its debts to ease its national debt burden.

Since the country is being largely funded by other eurozone governments – and a significant chunk of Ireland's national debt is in effect owed to the European Central Bank – this would mean getting those paymasters to agree.

Ireland has a strong moral case for debt forgiveness. Unlike Greece, the Irish government did not overspend in the boom years. Dublin was even running a budget surplus going into the 2007-08 credit crisis. It was the costs of the domestic bank bailout that really destroyed its public finances. And the European authorities share some responsibility for that. Shortly before he died of pancreatic cancer this year, the former finance minister, Brian Lenihan, said he was pressured by the ECB into putting the state's finances behind the country's tottering banks.

ECB policymakers apparently feared what the failure of a large bank – such as the bloated property lender Anglo-Irish, which borrowed extensively from banks across Europe – would do to the continental financial system.

Mr Noonan says he is pushing Europe for debt relief for Ireland on these very grounds, although he admits serious negotiations have not yet begun.

One piece of leverage Ireland could wield in those talks is the threat of leaving the euro, which eurozone policymakers would be desperate to avoid.

But would Dublin seriously consider such a move? Most economists here privately admit it was a mistake to have ever joined. The present governor of the Irish central bank, Patrick Honohan, wrote an influential paper in 2009 arguing that low ECB interest rates in the boom years helped inflate Ireland's disastrous property bubble.

Yet the idea of quitting the euro is anathema here. Just about everyone argues that the costs of an exit would far outweigh any devaluation benefits.

Those costs would be considerable. Ireland would have to impose capital controls to prevent bank depositors moving money out of the country to avoid their savings collapsing in value when the new currency was introduced.

And it is generally agreed such a move would send a disastrous message to those foreign investors in Ireland that Dublin is desperate to keep sweet.

Yet if Ireland's growth falls short of expectations in the coming years, the perceived benefits of euro membership will also diminish. And if Ireland's European partners refuse to alleviate its massive sovereign debt burden, ill-feeling could easily grow.

Sinn Fein, with designs on power in the Republic, is already exploiting anti-Brussels sentiment. A euro exit is unthinkable now. But the unthinkable has had a nasty habit of materialising on the banks of the Liffey in recent years.