Covid-19: Five crucial factors behind an economic recovery

There’s now a consensus that the Irish economy will remain relatively subdued for the first half of 2021, with both the duration of Level 5 restrictions more prolonged and their relaxation more gradual. Assuming the successful deployment of vaccines, the second half of 2021 – we’re told – will see a strong rebound in economic activity, driven by a resurgence in domestic demand as things open up and a further acceleration in multinational exports.

Even with this rebound, unemployment is expected to remain elevated for an extended period. We've had three economic reports in the past week which essentially plot the same narrative. In its latest quarterly bulletin on Thursday, the Central Bank said economic weakness in the first half of 2021 would give way to a strong recovery later in the year.

The regulator upped its headline growth forecast to 5.9 per cent for 2021, two percentage points higher than most other forecasters, citing better trading conditions globally, which will boost the export component of Irish GDP (gross domestic product).

Employers’ group Ibec and the Economic and Social Research Institute (ESRI) were less bullish in their assessments, cutting their forecasts on the back of the severity and length of the current lockdown. However, like the Central Bank, they predicted the current lockdown would be followed by a sharp acceleration in activity as conditions normalised.

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Even with warnings around unemployment, the economic horizons presented in these reports are broadly positive – some say too positive – in the context of the worst global recession in 100 years. It’s a testament to the two-tier nature of the economy here than you can have consumer booms and elevated unemployment in the same forecast. They should, in theory, be mutually exclusive.

The positive outlook for the second half of this year is by no means guaranteed and remains subject to significant downside risks. Here are five pressure point areas that we need to go our way for these positive forecasts to play out.

The evolution of the virus and the easing of restrictions

The Republic's economic trajectory is tied into one thing at the moment: the evolution of Covid-19. Prior to the Government's minimal lifting of restrictions this week, the National Public Health Emergency Team (Nphet) warned it that a misstep at this stage could see virus cases numbers tick up to 2,000 a day within four weeks. It warned that Ireland does not have the "headroom" that was available last summer when case counts were low, noting the more transmissible B117 variant means that viral transmissions and the effective reproduction number "will be 30-70 per cent greater than in 2020".

Regardless of how you view the current lockdown, which is considered severe by international standards, the Government is unlikely to deviate significantly from Nphet’s advice after what happened at Christmas. The Government’s decision to ease restrictions in early December – on foot of pressure from industry – led to a major upsurge in cases after Christmas.

As a result, we’re looking at Level 5 restrictions being in place in some shape or form until at least June and possibly beyond. By then the vaccination programme will be more advanced and the disease – hopefully – more under control. This will permit the gradual opening-up of the economy, including the hard-hit consumer-facing sectors of retail and hospitality. This is what the previous economic projections assume. Further delays in the rollout of vaccines and/or more virulent strains pose big downside risks to these assumptions.

Medical experts warn, however, that a fourth wave of the pandemic later this year is still likely given the circulation of new variants and the proportion of the population that will not be vaccinated. Deciding whether to keep the economy open amid such an upsurge – even if the vulnerable end of the population are vaccinated – will be tricky. Ibec’s director of policy and public affairs, Fergal O’Brien, says the Government’s approach to the easing of restrictions is still “too vague”.

He says businesses still don’t have the clarity or certainty that once we hit 20 or 30 per cent of the population vaccinated – and we have a vastly reduced mortality risk – it will automatically lead to the opening-up of certain sectors.

Pent-up consumer demand and the unwinding of savings

The rebound in domestic demand forecast for the second half of 2021 is predicated heavily on pent-up consumer demand being unleashed. Consumers tend to hold off making purchases during a recession – in this case a lockdown – building up a backlog of demand that is unleashed when signs of a recovery emerge. Consumption contracted by 9 per cent or €9 billion last year “due to restrictions and reduced opportunities and willingness to spend”, the Central Bank noted in its report. It expects household consumption to rise by 3.7 per cent this year, the growth coming almost exclusively in the second six months.

A factor in this is the unwinding of savings built up during the pandemic. There was a net inflow of deposits amounting to €15.7 billion between March last year and February this year. The Central Bank says about €10 billion is what it would classify as “excess savings” and that, based on previous spending patterns, about €5 billion is likely to flow back out into the economy as additional spending once the restrictions are lifted. This is expected to act as a stimulus to recovery.

“A key determinant of what proves to be trapped or trend savings is the policy stance of the Government,” says KBC Ireland chief economist Austin Hughes.

If Government remains “appropriately supportive”, consumers will be more likely to spend. “Conversely, fears of a move to restrictive policy may significantly offset the economic boost from reduced health-related restrictions,” he says.

“ There is definitely a sense that the second half of 2021 could prove to be an inflexion point for the Irish economy – either leading to solid, sustainable and more broadly balanced gains or lower and more limited-reaching growth,” he says.

In its report, the Central Bank noted that consumer spending was now back at a pre-pandemic level despite the current lockdown. This was down to “compositional effects”, it said, meaning people were spending more in certain sectors than before and that businesses in the hard-hit sectors were selling via a different platform, presumably online. Consumer trends appear to be in flux at the moment – half curtailed by the lockdown, half shifted towards a more digital consumption pattern.

Unemployment, wage supports and avoiding a ‘cliff fall’

The Covid-adjusted unemployment rate, which includes approximately 445,000 Pandemic Unemployment Payment (PUP) recipients, was 24.2 per cent in March. When combined with the Government’s other wage support measure, the Employment Wage Subsidy Scheme (EWSS), this means 960,000 people, about 40 per cent of the labour force, are currently in receipt of one form of income support or other.

The State's Covid bill – which also includes spending on these and other supports as well as additional health spending – is expected to be a whopping €32 billion by the end of this year. While Minister for Finance Paschal Donohoe has repeatedly promised there will be "no premature withdrawal of budgetary support", it's clear that a period of retrenchment is inevitable. The tension between supporting vulnerable workers and sectors and tackling the budget deficit, expected to be €19 billion again this year, is likely to emerge in the coming months.

The Covid bill is expensive, but should be seen as a capital expenditure rather than current, investing now to avoid longer-term damage

A strong bounce in the economy will help improve the Government’s debt metrics; a more modest one is likely to place a greater focus on its budgetary shortfalls.

"The Irish Government has been the most aggressive in its fiscal response to the crisis, replacing business cashflows and supporting incomes," says Goodbody chief economist Dermot O'Leary. "As the economy is reopened from May onwards, business conditions will improve, but the Government would be advised to avoid a cliff-edge and instead taper reliefs and incentivise re-hiring of workers.

“The Covid bill is expensive, but should be seen as a capital expenditure rather than current, investing now to avoid longer-term damage,” Mr O’Leary says. “An ongoing separation of Covid-related expenditure with core expenditure is vital so that the various departments are fully aware of the split between temporary and permanent expenditure components of their departmental budgets.”

The true scarring effect of Covid – in economic terms – is arguably the residual unemployment that’s left when the virus abates. The Central Bank believes up to 100,000 people will permanently lose their jobs.

The current acceleration in house prices also owes something to the massive stimulus programmes taking place nationally and via the European Central Bank. When this sugar rush is removed, the market may look different.

US tax reform

Threats to Ireland’s low corporate tax regime are never far away. However, US president Joe Biden’s proposal for a new 21 per cent minimum tax rate on US multinational profits may irrevocably undermine the Republic’s 12.5 per cent rate, as it would no longer be relevant in attracting US companies here.

The fear is it that the US move may also be the initial salvo in a push for a global minimum rate across the OECD (the Organisation for Economic Co-operation and Development). The concept of a global minimum tax rate has been part of OECD negotiations, but observers had thought this might be set at a rate close to or equal to our 12.5 per cent rate. Now it seems the US might push for a higher rate as part of a global agreement.

There is much talk about market diversification as a hedge against Brexit, but there's no getting away from our dependence on the UK market

The Government has previously warned that the State could lose up to €2 billion of its corporation tax revenue under the OECD reform proposals, potentially removing a fifth of our €11 billion corporation tax haul. But these proposals, if acted on, could prove more damaging.

Corporation tax is now the Government’s third-biggest tax category behind income tax and VAT, and a big reduction in revenue could be expected to affect future spending plans.

Brexit trade frictions

While the Brexit deal assisted in removing the very near-term risk of a "cliff edge" move to tariffs and increased trade tensions, it hasn't removed trade frictions. Many Irish firms have shifted from using the UK as a land bridge to export into Europe to going directly to the continent to avoid Brexit-related bureaucracy and red tape in the UK. This is evidenced in the fall-off in freight volumes from the UK at Dublin Port, down 50 per cent since Christmas, and the increased use of direct shipping routes from Ireland to the continent.

“We speak to lots of businesses that tell us they’ve de-risked out of the UK land bridge in terms of getting product to Europe,” Mr O’Brien says. “This and all of the other things Brexit has brought about just means a higher cost of doing business.”

Early evidence from UK and Irish trade statistics of the impact of Brexit points to a significant drop in EU-UK trade in January that was much larger than corresponding changes in trade between the UK and non-EU countries, the Central Bank notes in its report. “ While much of this drop in trade volumes may be related to pandemic effects and stock-building in the last three months of 2020, it also provides some early, albeit tentative, evidence of a negative Brexit effect,” it says, while noting that the negative impact of the UK’s EU exit on trade flows, migration and productivity will reduce output in the Irish economy.

There is much talk about market diversification as a hedge against Brexit, but there’s no getting away from our dependence on the UK market. Despite the increasing proportion of Irish exports going to the US, there are far more jobs here dependent on exports to the UK than on exports to the US.

And that’s unlikely to change. Studies consistently show geographical proximity is the dominant factor in trade patterns despite technology and the removal of trade restrictions globally.

Ireland is likely to experience one of the most exaggerated K-shaped recoveries from Covid in the world, with some sectors already surging ahead while others, such as hospitality, remain in the doldrums. What’s likely to emerge is a more two-tier economy than we had before.