Housing slowdown will constrain Minister for Finance's Budget options, writes Paul Tansey

When the Minister for Finance Brian Cowen rises to deliver the 2008 Budget speech next Wednesday, he will be standing on shifting sands. For growth in the economy is set to subside as the strength of domestic demand ebbs away and external conditions continue to deteriorate.

At present, the economy is experiencing the calm before the storm. To date, the stream of published data for 2007 continues to point to an economy that is cantering ahead quite sweetly. Relative to the first nine months of 2006, the volume of industrial production in the first three quarters of 2007 has risen by 6.6 per cent, retail sales volumes are ahead by 7.1 per cent while total employment levels have advanced by 3.7 per cent. Merchandise export volumes in the first half of 2007 were 8.6 per cent higher than in the first six months of 2006.

These indicators do not signal an economy on the edge of a nervous breakdown. So why worry? There are two reasons not to be cheerful. At home, residential construction is heading south at an accelerating pace. Abroad, the international economic environment has been soured by the sub-prime crisis and the dark financial forces it has released. These are the two key factors in the impending economic storm.

The consensus view among the leading institutional forecasters during the autumn anticipated that Ireland's rate of economic growth would decelerate from 6.5 per cent in 2006 to about 4.5 per cent this year before slowing to some 3 per cent in 2008.

The components of these forecasts are shown in the table. In all cases, a steep slowdown in residential construction was identified as the principal factor depressing the future growth in economic activity.

However, these forecasts have now been overtaken by events on two fronts. In the first place, the expected performance of residential construction next year weakens by the day. In its October Bulletin, the Central Bank grounded its forecast of a fall in gross fixed investment next year on a projection of 65,000 housing completions in 2008, a view shared by the ESRI, though it cautioned that its housing forecast for next year "may well turn out to be overly optimistic".

That is reflected by the Construction Industry Federation (CIF) which is projecting that, in the absence of any remedial action in the Budget, housing completions could fall to just 45,000 units in 2008. If the CIF forecast were to prove accurate, its projected decline in housebuilding would virtually extinguish Irish economic growth next year. For a further downward revision of 20,000 in housing completions next year would, in the first instance, knock some 2.5 percentage points off the forecast growth rate for 2008.

The scale of this impact derives from the size of the housing sector in the Irish economy. In 2006, residential construction accounted for half of all gross fixed investment in the State and for more than 15 per cent of Gross National Product. Ireland's dependence on housebuilding means that when the industry stumbles, it drags down the rest of the economy with it.

With housebuilding slowing, Cowen has moved to ameliorate at least some of its effects. Last week, he announced that the Budget would raise public capital spending by 12.5 per cent in 2008, even if this entailed recourse to public borrowing.

But the housing sector is not hermetically sealed. Sizeable reductions in housing output next year would cause widespread job losses in the industry. This would both puncture the prospects for any appreciable jobs growth in 2008 while raising unemployment. Reduced employment growth would curb increases in consumer spending while rising unemployment would slow wage growth, at least in the economy's market sector.

Although attention has focused on the downturn in housing construction, it should not be forgotten that consumer spending is the largest component of domestic demand, accounting for 55 per cent of home spending. With interest rate increases off the agenda at the European Central Bank for the foreseeable future, Irish consumer price inflation should decline to around 3.2 per cent in 2008 from an average of 4.9 per cent this year. However, even allowing that earnings growth during 2008 should outpace inflation by 1.5 percentage points and total employment might edge ahead by 1 per cent, it is difficult to envisage consumer spending volumes rising by more than 3 per cent in 2008, or about half the rate of growth seen this year.

In the external arena, the continuing reverberations from the US sub-prime crisis present Mr Cowen with a second set of economic problems. The credit crunch has prompted cuts in US interest rates which, in turn, has triggered a flight from the dollar. Sterling has fallen in sympathy. As a result, the euro now stands at $1.48 against the dollar and close to £0.72 against sterling.

Should these exchange rates persist through 2008, they will place great strains on the profitability of indigenous Irish enterprises exporting to Ireland's two principal foreign markets - the United States and Britain. The scale of recent gyrations on foreign exchanges is illustrated by the fact that, as recently as the first quarter of this year, the average exchange rate of the euro against the dollar was $1.31, while against sterling, the average exchange rate was £0.67.

Moreover, there is growing evidence that the sub-prime crisis is snaking its way from the financial markets into the real economy.

Last week, the governor of the Central Bank, John Hurley, noted that, within the euro area, there was now an increasing risk of "a more significant spillover from financial markets to broader economic activity", adding that continuing financial turbulence and tighter credit "has tilted the balance of risks to euro area growth to the downside".

The International Monetary Fund has recently revised downwards its forecast for real growth in the US during 2008 from 2.8 per cent to 1.9 per cent. Slower growth in Ireland's principal foreign markets allied to an appreciating real exchange rate will combine to act as a brake on the rate of export growth next year.

Framing a Budget against such a volatile background is not easy. The Tánaiste has already signalled that he will be adding demand to the economy next year. All he can do is to hope for the best and plan for the worst.

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