Irish Economic Developments: An Update - Governor Philip R. Lane

Remarks prepared for Consulate General of Ireland event, New York City

I welcome the opportunity to provide an update to a New York audience on economic developments in Ireland. I will divide my remarks into two parts: (a) an analysis of prospects for the Irish economy; and (b) a discussion of Brexit.

Prospects for the Irish Economy

The Irish economy is currently experiencing a sustained expansion phase. The sectoral pattern of growth is broadly based across both export-orientated sectors and domestically-orientated sectors, with both Irish-owned firms and multinational firms contributing to job creation and new investment. In addition, public spending has picked up in recent years, enabling an expansion in public sector activity and public investment.

Taken together, this has delivered significant growth in employment and household incomes, which is reflected in increases in consumer spending. In addition, domestic demand is further supported by the ongoing recovery in business investment, construction investment and public investment. Looking ahead, the central forecast remains positive: underlying domestic demand is projected to grow by 5.6 per cent this year, moderating to 4.6 per cent in 2019 and 3.8 per cent in 2020. The projections for the labour market continue to signal that the economy is moving towards full employment, although some extra capacity is possible through further inward migration and increased participation in the labour market. Nevertheless, under the central forecast, capacity is set to tighten further in coming years.

It would be a mistake to focus solely on this positive central forecast. Rather, the intrinsic volatility of the Irish economy means that there can be sudden and sizeable adverse shifts in fundamentals. The list of downside risks includes: an unexpected tightening in international financial conditions or a downgrading of future global growth prospects, relative to the benign environment that has been in place for the last number of years; shifts in international trade and tax regimes that fundamentally challenge the Irish economic model; disorderly Brexit scenarios; and domestic policy errors that add to pro-cyclical dynamics in the economy.

Given this current configuration of risks, macro-financial risk management should have two aims. First, policy actions should not amplify pro-cyclical dynamics, if overheating risks in the economy and the financial system are to be contained. Second, macro-financial resilience requires buffers to be accumulated during good times that will enable Ireland to cope more easily with future downside shocks.

In terms of fiscal policy, the running of budget surpluses during phases of strong economic performance is a pre-condition for the running of stabilising counter-cyclical deficits in the event of a future downturn. In relation to the financial system, our macroprudential policies such as the countercyclical capital buffer that we triggered this summer and our mortgage rules are intended to ensure that resilience is enhanced during phases of good economic performance. The aim is that a more resilient financial system will be better placed to absorb the impact of future downturns, with more sustainable funding positions and greater capacity to tolerate a decline in the credit environment.

Brexit

Let me focus on two alternative paths for the future EU-UK economic relationship. One path follows the withdrawal agreement laid out last week. The other path is the default option of a hard Brexit, in the absence of any agreement prior to the end of March 2019.

Compared to the pre-referendum status quo in which the UK was a permanent member of the EU, the path laid out by the withdrawal agreement entails the post-transition exit of the UK from the single market. Even if a long-term customs agreement is ultimately negotiated, this means the introduction of trade frictions such as regulatory checks for trade in goods between Great Britain and the EU 27 and the inevitable limitations of equivalence regimes for trade in services.

Furthermore, while the common travel area between Ireland and the UK will be preserved, restrictions on the free movement of people between the UK and the EU27 will disrupt the operation of labour markets, given the high levels of two-way mobility that have developed over the last forty years. Beyond the implications for individual citizens, restricted labour mobility will also affect the dynamics of different industries (including the financial sector) in the coming years. For instance, the productivity boost from the clustering of specialised talent pools in specific locations will be undercut by the geographical dispersion implied by restrictions on labour mobility. It will also affect relative business cycle dynamics, given that UK-EU27 migration serves as an adjustment mechanism in response to asymmetric shocks.

While some of these costs will only kick in after the transition phase concludes, forward-looking firms, households and investors have already responded in various ways since the referendum. One major adjustment mechanism has been the significant weakening of Sterling against the euro, which constitutes a terms of trade decline for UK residents. It is also estimated that UK firms have already started to pull back from EU-orientated export strategies, in anticipation of future trade barriers (Crowley et al 2018, Douch et al 2018).

More generally, as emphasised by the Bank of England, uncertainty about the final crystallisation of Brexit has had a chilling effect on business investment in the UK. In one direction, the ratification of the withdrawal agreement would provide some guidance to firms as to the general trajectory of the future UK-EU27 relationship, even if much will remain uncertain until the negotiations about the post-transition environment are concluded. It follows that the passing of the withdrawal agreement could unlock business investment in the UK through a reduction in uncertainty. In the other direction, a hard Brexit would constitute a much more uncertain environment, in view of the lack of clarity about the future UK-EU27 relationship under a hard Brexit and the absence of a road map as to how this future relationship will be negotiated.

In relation to financial services, the general nature of the long-term post-Brexit environment is well understood: the UK and EU27 financial systems will be separately regulated, with each making its own decisions as to the extent that trade in financial services can be permitted under equivalence principles.

In the post-Brexit environment, it is unlikely that financial activity will cluster in a single location in the euro area, since there is no single city sufficiently predominant to lock in agglomeration advantages across all segments of the financial sector. This is already evident in the Brexit plans of firms, with authorisations sought in a range of locations (including Dublin). Still, over the longer term, the future dynamics of the EU27 financial system could take several directions, given the “multiple equilibria” nature of the economics of locational choices. In addition, an open question is whether the decentralisation of the European financial system will impose significant efficiency costs.

An important factor facilitating the decentralisation of activity within the EU27 is the commitment to regulatory and supervisory convergence, such that firms can be confident of a regulatory level playing field across the EU27. This is most advanced in the context of banking, through the operation of the Single Supervisory Mechanism. However, Brexit has also prompted a greater focus on supervisory convergence across the entire financial system, including through the coordinating role played by EIOPA and ESMA.

Even with considerable reconfiguration by firms to conform to a post-Brexit regulatory environment, there is little doubt that there will continue to be very extensive ongoing UK-EU trade in financial services, with associated intertwining of sectoral balance sheets across the two jurisdictions. Moreover, a substantial proportion will take the form of intra-firm transactions, through the internal markets of globally-significant financial institutions. Internal trade within these institutions enables scale economies to be achieved and also facilitates diversification against geographical exposures. In view of the common interest in effective supervision and the maintenance of financial stability, I expect that EU and UK regulators (in partnership with other global regulators) will continue to work closely together to ensure the prudential management of the post-Brexit environment.

Still, the lack of a transition period means that a hard Brexit scenario would be far more challenging than under the withdrawal agreement. As emphasised by President Draghi, it would take significant mismanagement for financial stability risks to materialise in relation to the identified cliff edge risks of a hard Brexit, in view of the clear responsibilities of firms to make contingency plans for a hard Brexit and the capacity of legislators, regulators and central banks to address residual systemic risks. This has included a major push by regulators to require that financial firms make preparations for worst-case scenarios rather than “hoping for the best”. In addition, the shift in regulatory regimes after the crisis mean that banks now are much better capitalised and, as underlined by the recently-published EBA stress tests, have a greater capacity to absorb adverse shocks.

At the same time, if a hard Brexit generates sharp movements in asset prices and in the Sterling-euro exchange rate or is associated with a significant macroeconomic downturn in the UK, the balance sheets of financial firms with exposures to the UK will be affected. In assessing exposures, it is necessary to take a broad view, since the complexity of supply chains mean that firms with only an indirect connection to the UK economy will be affected, while large and persistent currency movements can give rise to new substitution options even in sectors previously sheltered from direct competition from UK rivals.

Conclusions

In these remarks, I have outlined that Ireland is currently enjoying strong economic performance but also faces significant tail risks. The next few weeks and months will tell us much about the future EU27-UK relationship: however it turns out, the Central Bank of Ireland will be focused on the resilience of the financial system, in order to mitigate the adverse impact of Brexit (whether hard or soft) on the Irish economy.

References

Crowley, Meredith, Oliver Exton and Lu Han (2018), “Renegotiation of Trade Agreements and Firm Exporting Decisions: Evidence from the Impact of Brexit on UK Exports,” mimeo, University of Cambridge.
Douch, Mustapha, Edwards T. Huw and Christian Soegaard (2018), “The Trade Effects of the Brexit Announcement Shock,” The Warwick Economics Research Paper Series 1176.