Why does Ireland have some of the highest relative price indices in the EU?

Comparisons are hard.  Whether it is through time or across countries making comparison is hard because things are different.  It is hard to compare like with like. 

One of the key objectives of economic policy is to raise living standards.  And we would like to see whether that objective is being reached. How do living standards now compare to what they were in the past? How do living standards here compare to what they are over there?

We don’t have a direct aggregate measure of living standards but do have some reasonable proxies.  From the national accounts, we can use per capita national income such as GDP, GNI (or its bespoke Irish equivalent GNI*) or per capita consumption such as Household Final Consumption Expenditure or Actual Individual Consumption. 

Changes in these from one year to the next can provide information about the changes in living standards. However, to fully see the true impact on living standards we need to make an adjustment for prices.  If the GDP per capita number has gone up but only because of an increase in prices then people aren’t better off at all – in volume or real terms they are still using the same amount of goods and services but the current prices and incomes for which these are bought and sold have gone up.

So we want to deflate this year’s GDP per capita number (nominal GDP) by the increase in prices since last year (the GDP deflator) to be able to make a like-for-like comparison of living standards based on the quantity of goods and services we get to use (real GDP).  By adjusting the per capita national income figures for inflation we can make comparisons of living standards in the same country for different time periods.  The comparisons can be made using this year’s or last year’s prices what matters is that they use the same, or constant, prices.

We would also like to make comparisons across different countries at the same time.  Again, we could use measures like GDP per capita or Actual Individual Consumption (AIC) per capita.  Each country will have its own per capita number and typically its own currency so to make a volume, or real, comparison we need to first convert to a common currency and then adjust for the different price levels in each country.  The quantity of goods and services you can get for a given level of spending will vary by country because the prices vary by country.

So we want to adjust the national figures by a measure of purchasing power to reflect the amount of goods and services that can actually be purchased and consumed with a given amount of income or spending.  By adjusting income and consumption figures for national price levels we can make comparisons of living standard across different countries in the same time period. 

This currency and price level adjustment can be considered putting income or spending figures from different countries into purchasing power standards – a common reference unit that reflects equal purchasing power in all countries.  Although they arise from estimates in the national accounts these purchasing power standard (PPS) units can be used across a variety of income and living standards measures.

Indeed, the EU’s own set of Statistics on Income and Living Conditions (EU-SILC) uses purchasing power standards to help us make cross-country comparisons of the income figures derived from the national surveys.  One of the headline measures in the SILC is equivalised disposable income.  This table shows the 2018 outcomes for the EU15.

The table is relatively straightforward. It starts with the nominal figures in national currencies as determined from the national surveys and other sources.  This are then converted into the same currency using the exchange rate (here the average annual exchange rate with the euro which for 12 of the 15 countries is 1.00 as they use the euro to begin with).  Once, converted into euro, a price level index is applied to get a comparable figure in what we could call purchasing power standards or PPS units. 

To see how significant this adjustment can be, here are the € and PPS columns of the above table in ranked order with the change in Ireland’s relative position highlighted.

In nominal euro terms, at €24,900, Ireland had the fifth-highest median equivalised net income in the EU15 in 2018.  But when we adjust for national price levels to reflect the living standards that can be achieved with that income Ireland falls to tenth.  That is a very significant ranking change due to a price adjustment. 

Trajectories and growth rates mean that it would not be unreasonable to expect that Ireland will have the third-highest median equivalised net income in nominal € terms when the 2019 figures are released towards the end of this year.  But even that might not be enough to raise the PPS ranking which could stay at tenth. 

So, for the same income measure you could have Ireland in top three in the EU15 or in the bottom half of the EU15 depending on whether you adjust it for prices or not.  But this raises the question are prices in Ireland really so different to the rest of the Eu15?

The first table shows that the price index used by Eurostat for the purposes of the SILC puts Irish prices at 128 per cent of the level of the EU28.  The arithmetic mean for the rest of the EU15 is 110 per cent.  On average, this suggests prices in Ireland are around 15 per cent higher than the rest of the EU15.  We may think things are expensive in Ireland but that is a large difference with other well-developed countries, most of whom we share the same currency with.

If we take Germany as an example. In nominal terms, Ireland’s median equivalised income is estimated to be around 10 per cent greater.  When the price level is applied, Ireland changes to be 10 per cent lower than Germany.  Ireland’s price level of 128 per cent of the level of the EU28 compares unfavourably to Germany’s which is put at 103 per cent of the level of the EU28.  Indeed, Germany has the highest gain between the € and PPS rankings above, rising six positions from ninth to third.

So, lets look a little closer at these relative price indices.  There are lots of them we can use but we will focus on the one derived for Household Final Consumption Expenditure (HFCE).  Here it is for a selection of years since 1998.

It can be seen that the 2018 figures closely correspond to the price indices applied by Eurostat to the SILC data.  It is noticeable that for most of the countries, the comparative price level indices in 2018 are little changed from what they were in 2008.  This doesn’t mean that they haven’t had inflation; just that there price changes have been in line with the average.

For Germany, its HFCE price level index stayed around 103, France went from 109 to 110, Italy stayed at 100 with Finland also unchanged at 122.  For Ireland we see that it rose slightly from 127 in 2008 to 129 in 2018.

In and of itself, this raises an eyebrow. Why? Well, relative to the rest of the EU, Ireland has had below average consumer price inflation for more than decade yet our relative price index is unchanged from what it was in 2008 and is actually up on what it was in 2013/14.

Here are figures for the Harmonised Index of Consumer Prices for the EU15.  In this instance we are looking at a comparison through time in the same country and all countries are set equal to 100 in 2008.

Look at the column for 2018.  Ireland is by far the lowest.  Compared to 2008, Ireland’s HICP was just 1.3 per cent higher in 2018.  No other country in the EU15 comes close to that level of non-inflation.  Greece is next at nine per cent but then we can go through Germany (14 per cent), France (12 per cent), Italy (13 per cent) and Finland (17 per cent).  And for the EU28 as a whole, HICP inflation is measured at 16 per cent between 2008 and 2018.

So now we have a disconnect.  When measured through time, consumer prices for the EU28 have risen significantly faster than consumer prices in Ireland since 2008 (16 per cent versus one per cent).  If this was to be translated into a relative price index we might expect Ireland’s price index relative to the EU28 to have fallen by 15 per cent.  But when we look at the relative price indices, Ireland has gone from a price level that was 127 per cent of the EU28 in 2008 to 129 per cent in 2018.  Something doesn’t seem to add up.

We want to measure purchasing power.  On aggregate, consumer prices in Ireland have been flat for more than a decade.  They have risen everywhere else.  Yet, the price levels indices say the bang for a buck (or a euro) in Ireland has actually decreased. 

So, lets look at the price index for Household Final Consumption Expenditure (HFCE) in a bit more detail.

In 2018, aggregate HFCE in nominal terms was a little under €100 billion or around €20,000 per inhabitant.  We can see comparative price indices by component relative to the level of the EU28.  There are a number of categories where the price in Ireland is put well above the average level of the EU28. Alcohol and tobacco (178), health (160), communications (140) and restaurants and hotels (including pubs) (121) are all significantly higher than the level of the EU28.  But the share of most of these in HFCE is relatively modest.

In PPS terms, HFCE on housing and fuels (excluding motor fuels) was 20 per cent of consumption expenditure.  It is 24 per cent of nominal HFCE.  The price level for housing is put at 158 per cent of the level of the EU28 in 2018.  By looking at share and level this is the price index that seems to have the biggest impact on the overall price index for HFCE.

Here are the relative price indices for each component for selected years.

Given what we have seen for inflation, the relative price indices for most of the categories correspond to what we would expect since 2008: they have fallen.  Relative to the rest of the EU28, in the last ten years in Ireland all of food, clothing and footwear, furniture and household equipment, transport, recreation, education, and pubs and restaurants have become cheaper.  But this still hasn’t been enough to bring down our overall relative price index. 

In total, there have been relative price drops for categories that make up 70 per cent of real per capita HFCE.  Of the categories that have risen the only one that is of any significant size is housing and fuels (excluding motor fuels).  Within Household Final Consumption Expenditure this category has driven much of the recent increase in Ireland’s price index relative to the rest of the EU28.

So let’s see the outlandish prices increases in Ireland for this category…

Again, these are comparisons through time in the same country with all countries set equal to 100 in 2008.  Unsurprisingly, the price of housing and fuels (excluding motor fuels) rose in Ireland in the ten years to 2018.  Per the HICP these prices rose by 26,5 per cent.  But it also rose in all the countries of the EU15. 

No country had a price increase in housing from 2008 to 2018 of less than 12.5 per cent and three had consumer price inflation in housing that was greater than Ireland (Portugal, Finland and the UK).  Indeed for the EU28 as a whole consumer prices for housing were 21 per cent higher than the were in 2008, which is not much different to the 26 per cent increase recorded in Ireland.

Now this disconnect is becoming bizarre.  At a time when the price of housing in household consumption in Ireland went from 132 per cent of the level of the EU28 to 158 per cent, the HICP recorded 21 per cent consumer price inflation for housing in the EU28 and 26 per cent for Ireland.  Where is this relative price increase in the HFCE price level index coming from that is not showing in the HICP which is based on the money that people actually spend?

So let’s look at housing in the HICP in a bit more detail.

There doesn’t seem to be a whole lot here that is surprising.  We have already seen that between 2008 and 2018 the price of housing services in the HICP for Ireland rose 26.5 per cent.  Looking at the weights to find the important categories we can see that this was driven by rents (+26 per cent) and fuels (+18 per cent).

But as we also saw, in the same period that housing in the Irish HICP rose 26.5 per cent, it rose 21 per cent in the HICP for the EU28 as a whole.  So why did Ireland’s relative price index for housing in HFCE go from 128 per cent of the level of the EU28 in 2008 to 158 per cent in 2018?

A clue is in the weights in the above table.  The category for housing services is about 11.5 per cent of the All Items HICP, with rents making up over half of this.  But when we looked at Household Final Consumption Expenditure we saw that the consumption of housing services was 24 per cent of Ireland’s nominal total in 2018. 

So the share of housing services is nearly two and half times greater in household consumption (HFCE) than it is in consumer prices (HICP).  What is in consumption of housing that is not in consumer prices for it?  Here is a breakdown of the housing services category in HFCE.

The key figure is “imputed rentals for housing”.  If we exclude this item housing would be 10.5 per cent of the remaining HFCE, pretty much in line with the weight for housing services in the HICP.

Household Final Consumption Expenditure is a measure of household use of goods and services.  In the main this is measured by household spending: the goods and services that households use are the goods and services that they buy.  This means it excludes most domestic production: cleaning, cooking, child rearing etc.

If it was only based on the purchases of goods and services, housing is another service which would be excluded from HFCE for a large share of households.  Most households don’t buy housing services; they own a housing asset.  In Ireland, around 70 per cent of households are owner-occupiers.  They provide their own housing services (with the house purchase and any associated mortgage or loan showing on the household balance sheet).

These housing services could be ignored for the purposes of household final consumption expenditure much as they are with domestic cleaning, cooking and child rearing.  But that would create distortions.  Countries where more households rent (pay third-parties for housing services) would show higher levels of consumption than countries where more households are owner-occupiers (provide their own housing services) where there is no rent spending to include. Other domestic services can be left out on the assumption that they are produced and used relatively equally across countries.

So for housing services to get a more consistent picture of the use of goods and services an “imputed rent” is added to household consumption.  Essentially, this is an estimate of the rent owner-occupiers would pay for the housing services they use.  As they are both the owner and the occupant the imputed rent is paid to themselves so we have an equal amount on the income and expenditure side of the household sector accounts.  The amounts net out but we get a more consistent measure of living standards – household use of goods and services – by including the housing services used by all households, not just those who pay actual rent.

The previous table gave nominal, or current price, figures for imputed rent.  We can see that this has risen by around 50 per cent in recent years.  And now we are back to something we set out right at the start. When making this comparison through time does this 50 per cent increase in imputed rents represent more owner-occupier use of housing services or has the price increased causing the nominal figure to rise? 

Well, we should know the answer to this.  The price-level for imputed rents is based on the price level for actual rents.  So as the price of actual rents has risen in recent years so too has the price of imputed rents.  There isn’t a constant price series for imputed rents in Eurostat’s data but the CSO do provide one.

Just look at the changes from 2010 to 2018.  In nominal terms, imputed rents rose by over 50 per cent.  But this was almost entirely a price effect as in real, or constant price, terms imputed rents rose by less than two per cent in those eight years.

This is obviously correct. It would have been hard for the household sector to increase the amount of housing services consumed when very few new houses were being built.  Owner occupiers continued to live in the houses they owned but the imputed rent of the housing services they provided to themselves rose in line with market rents.  [Aside: there could be some concerns with the volume levels of imputed rents in Ireland’s national accounts but that is a related, but somewhat separate, matter. Here our concern is with prices.]

So, within household final consumption expenditure (HFCE) we have an item which:

• now makes up over 15 per cent of total nominal HCFE
• is based on imputed rather than actual expenditure
• rose significantly in price over the past decade

The rise in the price of imputed rents is correct.  Here are actual rentals for housing in the HICPs of the EU15.

We can see that from 2010 to 2018 actual rents in Ireland rose 55 per cent, by far the highest in the EU15.  This corresponds to the price deflator the CSO used between their current price and constant prices series for imputed rents.

The increases in actual rents are rightly reflected in the consumer price indices of the countries shown above – but using a weight relative to the amount of money households actually spend (around seven per cent of the HICP in the case of Ireland).  This is a price increase which reduces purchasing power and affects living standards.

The issue is with the inclusion of the price of imputed rents in the estimation of price level indices used for income and spending measures that do not include imputed rents.  Is an increase in the rise of an imputed rent something that reduces the purchasing power of households?

Let’s go back to something we started with: median equivalised net income from the SILC.  Here is a comparison of the outcomes for Ireland relative to a population-weighted average of the EU15 from 2010 to 2018 in both nominal (euro) terms and price-level-adjusted (PPS) terms.

The path of the nominal line corresponds to what we would expect: falling relative to the EU15 until 2012, then flat for a couple of years before returning to positive growth in 2015. 

Since 2014, nominal income in Ireland has had an annual growth rate that has been around two and half percentage points higher than the average for the EU15 (4.6 per cent versus 2.2 per cent).  Ireland’s median nominal income in the SILC has gone from 108 per cent of the estimated EU15 level in 2014, to 123 per cent in 2018 – a rise of 15 percentage points.  This is what has us pushing into the top three in this ranking.

But if we look at the price-level adjusted series Ireland has made little or no improvement and has remained close to the average of the EU15 (and tenth overall); the rapid nominal improvement has apparently been eroded by relative-price increases.  Ireland’s median equivalised income was 96 per cent of the EU15 in 2014.  In 2018, after four years of very strong nominal income growth, it was 103 per cent, an increase, yes, but at just seven percentage points is not as much as the nominal growth might imply.

And, as we have seen a further disconnect is that consumer price inflation has actually been lower in Ireland (averaging 0.2 per cent per annum in Ireland versus 0.9 per cent for the EU28 for the past five years).

So where do the nominal income gains go when we do the cross-country comparison?  In recent years, Ireland has had nominal household income growth that has been two and half percentage points higher and consumer price inflation that has been three-quarters of a percentage point lower.  As this has been maintained over a five-year period it should have translated into much larger real income gains than is showing in the cross-country income comparisons.

So how does three become one? Or in aggregate terms over the five years how does 15 become seven?  What wiped out what should have been eight percentage points of additional real income gains for Ireland versus the rest of the EU15.

As we have seen, the price-level adjustment means some of the nominal income gains have been eroded by increases in imputed rent in the relative price indices.  This is a price increase that no one pays – it is imputed.

Here is an attempt to estimate the contribution of prices changes for imputed rent to the HFCE price level index of each country in the EU15 to the overall price level of the EU28.  It applies the inflation rate of actual rentals in each country to the share of HFCE that arises due to imputed rents.

The final column shows the sum total for 2014 to 2018.  Over this period, Ireland’s HFCE price level went from 123 per cent of the EU level to 129 per cent of the EU level.  As shown above, imputed rents contributed an increase of nearly five percentage points to increase in Ireland’s price-level index relative to the EU28. 

Without imputed rents Ireland’s price-level index would essentially have been flat for that period and the nominal income gains that have been recorded in the SILC would have translated into much more plausible gains in real income when doing cross-country comparisons.

So instead, of Ireland’s median equivalised net income being 103 per cent of the level of the EU15 once adjusted for prices, a more appropriate measure might put it five percentage points higher.  In the relative-ranking table this could see Ireland move from 10th in the EU15 to seventh.  That is quite an impact for a number that is essentially made up (though it is a bit more formal than that to be fair).

How can this be fixed?  There are two possible solutions:

1. Use a relative-price index to adjust the incomes derived from the SILC that excludes imputed rents, or
2. Include imputed rents in the income measures of the SILC.

Either of these would solve the problem.  And it applies in many areas where price-level adjustments are made using PPSs.  It should be possible for Eurostat to produce a set of price indices that omit imputed rents. 

And consideration has been given for some to including imputed rents in the SILC.  Doing so would improve measures of income inequality as the ability to command resources from a given income can be very different for owner-occupier versus renting households (particularly if the owner-occupiers have no outstanding mortgage or loan).

The easiest solution would probably be for Eurostat to produce a price-level index that excludes imputed rent.  Then we could make price-level adjustments across countries for the goods and services that households actually spend their income on.  We have reasonable measures of household income from the SILC and employee earnings from the SES but maybe not for price measures for the goods and services that these incomes and earnings are spent on.

For now, caution is warranted when Ireland is ranked in cross-country comparisons using Purchasing Power Standards.  Most households can actually buy a greater volume of goods and services, that is, enjoy a higher standard of living, than these comparisons might imply.

Tweet

The exploding balance sheet of the Irish-owned non-financial corporate sector

The previous post looked at the current and capital accounts of the domestic non-financial corporate (NFC) sector and painted a positive picture of rising output, employee compensation, profits, corporation tax, investment and savings. 

Here we look at the financial balance sheet of the Irish-owned NFCs (excluding redomiciled PLCs) from table 2.9 of the release.  Before getting to the detail here is a summary chart.

The data go back to 2012, and though there has been some volatility in between, the bottom line, financial net worth, is pretty much the same in 2018 as it was in 2012.  The financial net worth of the sector was –€108 billion in 2012 and was –€104 billion in 2018.  To get overall net worth we would need the value of non-financial assets such as fixed capital and land which is not provided but there is value in looking just at the financial balance sheet.

Although, the bottom line is essentially unchanged the size of the balance sheet of the Irish-0wned NFC sector has exploded in the last six years – and particularly in 2015 and 2016.  For example, total financial assets increased from €167 billion in 2012 to €428 billion in 2018.  This is equivalent to increase from 132 per cent of GNI* in 2012 to 217 per cent of GNI* in 2018.

So, lets see what the detail shows (click to enlarge):

Unfortunately, there are some categories where suppressed values means we can’t complete the above table.  All values are included in the balance sheet for the overall NFC sector so we can see roughly where the residual amounts would show.

For financial assets, we can see actually where most of the increase arose: loans and equity.  Loan assets rose from €54 billion to €121 billion and equity assets rose from €56 billion to €177 billion.  There was also an increase in ‘other accounts receivable’ from €39 billion to €99 billion.  These increases account for almost all of the €260 billion increase and again it should be noted that they took place in just six years, with €170 billion of the increase accounted for by 2015 and 2016 alone.

On the liability side the increase is from €275 billion in 2012 to €532 billion last year.  The available figures show some increase in loan liabilities but most of the increase is accounted or by equity liabilities.  There was also about a €60 billion increase in financial liabilities accounted for by the suppressed categories with most of this due to ‘other accounts payable’. 

For this, note that for overall NFC sector (Irish-owned, foreign-owned and redomiciled PLCs), the amount of debt securities rose from €10 billion to €18 billion while there are relatively minor overall amounts in the other suppressed category above: financial derivatives and employee stock options.

It’s well and good going through the increases by category but the overall increase is immense.  Usually, we can point to the activities of US MNCs when trying to pick through the distortions in Ireland’s national accounts but the above shows that Irish-owned firms might be throwing a distortion or two of their own into the mix.

The Irish economy has been performing well in recent years but nothing that would seem to justify a quarter of a trillion expansion in the financial balance sheet of the Irish-owned non-financial corporate sector.  The concurrent rise in financial assets and liabilities could point to circular transactions of some kind. 

However, at this stage, it is hard to tell what impact this expansion of the financial balance sheet has had on output, income and other flows in the national accounts.  That is likely where the real story lies.

Tweet

The Domestic Non-Financial Corporate Sector in the Institutional Sector Accounts

The release by the Central Statistics Office of the 2018 Institutional Sector Accounts saw their work in helping users overcome the impact of globalisation in Ireland’s national accounts.  In this year’s release, the non-financial corporate sector was subdivided into “foreign-owned” and “domestic” sub-sectors with figures provided back to 2013.

In general terms, sub-dividing the NFC sector is something that is set out in the European System of Accounts (ESA2010), and the CSO say:

Non-financial corporations are sub-divided into foreign-owned (S.11a), domestic (S.11b) and redomiciled (S.11c) in these accounts. [.]  The sub-sector S.11a corresponds to the ESA 2010 definition of sub-sector S.11003, foreign controlled non-financial corporations.

The ESA2010 manual gives the definition of foreign NFCs as:

Foreign controlled non-financial corporations (S.11003)

2.54 Definition: the foreign controlled non-financial corporations subsector consists of all non-financial corporations and quasi-corporations that are controlled by non-resident institutional units.

This subsector includes:

(a) all subsidiaries of non-resident corporations;

(b) all corporations controlled by a non-resident institutional unit that is not itself a corporation; for example, a corporation which is controlled by a foreign government. It includes corporations controlled by a group of non-resident units acting in concert;

(c) all branches or other unincorporated agencies of non-resident corporations or unincorporated producers which are notional resident units.

However, deviations from ESA2010 arise with the domestic sector due to the treatment of government-owned NFCs and the presence of the ‘headquarters’ of re-domiciled PLCs in Ireland:

Redomiciled PLCs and domestic NFCs are a part of sub-sector S.11002, national private non-financial corporations, however, following the treatment in the definition of modified GNI, Redomiciled PLCs are separated out in these accounts as S.11c. Government controlled non-financial corporations (S.11001) are included as part of S.11b.

Here we will focus on new domestic NFC sector.  First, the current account (click to enlarge):

The current account takes us through production, generation of income, allocation and distribution of income and the use of disposable income (which for companies is just saving as they don’t engage in final consumption – they have intermediate consumption). So what do we see?

In the past five years, the output produced by the domestic NFC sector has increased by €26 billion (27 per cent).  Intermediate consumption (goods and services used in the production process excluding labour) has not increased in line with output so that the Gross Domestic Product (Gross Value Added) of the sector increased by €23.5 billion (54 per cent).

What we have seen though, is an increase in the pay bill of companies in the domestic NFC sector.  This has risen in line with output.  In 2013, these companies spent €28.0 billion compensating their employees; by 2018 this had risen to €40.4 billion, a rise of 44 per cent, with 2018 showing an increase of 6.4 per cent.

Labour costs did not consume all the additional value added and the Gross Operating Surplus for the sector rose €11 billion (76 per cent) in the past five years.  Over the five years, the labour share of value added for domestic NFCs fell from 64.8 per cent in 2013 to 60.5 per cent in 2018.

After Gross Operating Surplus, we get different allocations due to property income such as interest, dividends and retained earnings.  In line with the increased profits the dividends distributed by these firms has increased.  They distributed €1.5 billion in 2013 with this increasing to €2.7 billion by 2018.  These distributions are relatively small compared to the overall Gross Operating Surplus generated meaning most profits are not distributed to other sectors.  The use of the non-distributed profits will be shown in the capital account.

However, in the allocation of income account the most significant change is the increase, on the resource side, in the retained earnings of direct foreign investment.  This is the profit earned by foreign-subsidiaries of companies in Ireland’s domestic NFC sector that are retained in the country in which they are earned rather than being transferred as a dividend to the parent in Ireland.  Such retained earnings have increased from €0.9 billion in 2013 to €3.4 billion in 2018, a near 300 per cent increase.  Whoever these companies are their foreign subsidiaries seem to be doing pretty well. [There are likely to be genuine reasons underpinning some part of this success but one might wonder whether there is a tax story related to it as well.]

Adding and subtracting the above property income from Gross Operating Surplus gets us to Gross National Income. This has increased from €11.6 billion to €25.4 billion in the past five years, with the increase (€13.7 billion) slightly outstripping the increase in Gross Operating Surplus.

The increased profits has led to an increase in the Corporation Tax paid by these companies from €0.7 billion in 2013 to €1.7 billion in 2018 which shows that some of the recent surge in Corporation Tax has come from companies in the domestic NFC sector.

We can get a measure of the effective tax rate on these companies by looking at Net Operating Surplus.  This is Gross Operating Surplus less the consumption of fixed capital (i.e. depreciation, which is shown in the capital account below).  The national accounts measure of Net Operating Surplus is akin to the accounting concept of EBITDA (earnings before interest tax depreciation and amortisation).

Over the five years, the effective rate on NOS averaged 8.2 per cent and exhibited a slight upward trend over the period going from 7.2 per cent in 2013 to 8.7 per cent in 2018. This could be linked to the exhaustion of losses generated during the crash for use against future profits.

After current transfers (mainly linked to insurance premiums and claims) we get to Gross Disposable Income and as firms don’t have final consumption this is equivalent to Gross Savings.  As shown, this increased from €10.2 billion in 2013 to €23.5 billion last year. 

We now turn to the capital account to see how those gross savings were used. Again click to enlarge.

The main use of the Gross Savings (arising from the increased Gross Operating Surplus) shown in the current account is capital formation.  The Gross Fixed Capital Formation of companies in the domestic NFC sector has increased from €7.8 billion in 2013 to €15.4 billion in 2018.  In five years, the sector has essentially doubled its level of fixed capital investment. 

The companies have also been increasing their inventories.  In 2013, inventories in the sector reduced by €350 million while in the four years since inventories were increased by an average of €1.4 billion per annum.

The investment rate (capital formation as a share of gross operating surplus) averaged 60 per cent across the five years and has shown a generally rising trend from 50 per cent in 2013 to 63 per cent in 2018.

After consumption of existing fixed capital (i.e. depreciation) is accounted for from this investment, Net Capital Formation increased from €3.9 billion in 2013 to €8.5 billion in 2018.  In aggregate terms, the domestic NFC sector is reinvesting a large share of the additional profits being made and this is replacing existing capital, adding new capital and increasing inventories.  Of course, we cannot know that the individual companies undertaking the investment are the ones generating the profits but this is what we see in am aggregate sense.

However, it should also be noted that the additional investment is less than the surpluses being generated and the bottom line shows that the domestic NFC sector is a net lender, and this is increasing.  Per the OECD:

Net lending/borrowing reflects the amount of financial assets that are available for lending or needed for borrowing to finance all expenditures – consumption expenditure, gross capital formation and capital transfers – in excess of disposable income.  If it is positive it is described as net lending and if negative, as net borrowing.

So, the disposable income of the domestic NFC sector exceeds all expenditures.  In 2013, this was €3.6 billion and this had risen to €7.9 billion by 2018.  In part, this could be linked to the ongoing deleveraging of the Irish economy – with companies possibly using surpluses to pay down debts.  In due course, we might look at the financial accounts of the sector to see what insights that might through up.

For our purposes here the bottom line of the capital account, net lending, is far enough. And this links to the discussion in the previous post about the large surplus on the modified current account of the balance of payments recorded in 2018. In that post we said:

One reason to pause before we get excited with highfalutin plans to spend the surplus is that, in the latest figures at any rate, almost half of it arises from the non-financial corporate sector and we really don’t know what is going on there.  Given the scale of the gross amounts in this sector revisions to the figure could be significant.

Before the sector accounts it wasn’t clear where the NFC surplus was arising – with some concerns that maybe it was a residual from the adjustments necessary to go from the headline to the modified current account.  Now we know that this is not the case – a large source of the increase in the modified current account in recent years has been the domestic NFC sector, from which companies involved in the so-called “star” adjustments (GNI*, CA* etc.) are excluded.

And we also know one reason why the domestic NFC sector might be running an increasing net lending balance – the increase in the retained earnings of their foreign subsidiaries.  It may that the companies are investing these earnings abroad so they would not be available for investment or other spending in Ireland.  Or they could simply be held as a financial asset by the foreign subsidiaries and would be available for use if they were transferred as a dividend back to the parent companies here.

This retained earnings strand might be something for another day.  All-in-all these new figures on the domestic NFC sector paint a very positive story: all of output, value added, employee compensation, operating surplus, corporation tax, and investment have risen strongly in the last five years.  The domestic NFC sector has been a major contributor to Ireland’s recent growth.

Tweet

All sectors of the economy are now net lenders

Ireland’s economic history is one that has been pockmarked by concern for deficits that are too high or debts that might be unsustainable.  We have had numerous examples of both in the past fifteen years with large current account and public deficits and high debt levels across all sectors of the economy. 

While some concerns about debt levels remain, it now seems we are running unprecedented balance of payments current account surpluses as shown here in CSO data from 1970.

Data before 1970 would show persistent, and on occasion unsustainable, deficits.  The latest estimates from the CSO of the  the modified current account show it reaching 6.5 per cent of GNI* in 2018.  The patterns of Ireland’s current account from 1975 to 1990 and from 2005 to 2020 will not be dissimilar (see another lap for the Celtic Hare).  But this time the surpluses following the adjustment of living a way beyond our means are at a level not seen before.

In terms of the EU15, the turnaround in Ireland’s modified current account has seen us move from keeping company with Greece, Portugal and Spain in 2007 to near the levels of Denmark, Germany and the Netherlands in 2018.

We can try to get some insight into the underlying changes behind this transformation by looking at the net lending or borrowing from the institutional sector accounts.  Per the OECD:

Net lending/borrowing reflects the amount of financial assets that are available for lending or needed for borrowing to finance all expenditures – consumption expenditure, gross capital formation and capital transfers – in excess of disposable income.  If it is positive it is described as net lending and if negative, as net borrowing.

Due to internal and external distortions we have to do a small bit of cleaning up to get a view of the underlying changes.  The main internal distortion we will try to remove is the bank bailout, a large part of which was a capital transfer from the government to financial sector while the external figures are hugely distorted by the activities of MNCs and in particular the impact of IP onshoring and aircraft for leasing.  Something similar was done in section 7.3 of this recent paper from the Department of Finance.

So for the next chart it should be noted that:

^The impact of Other Capital Transfers (D.99) from general government to financial corporations are removed from both sectors;

* All the adjustment necessary to make the sectoral net lending figures consistent with the modified current account is applied to the non-financial corporate sector.  These adjustments mainly relate to R&D IP imports, aircraft for leasing and net acquisitions of non-produced, non-financial assets.

What we see is not going to surprise anyone. An unadjusted version is here.

Although the current account surpluses of mid-1990s had been eroded, up to 2004 the economy was in a position to fund the expansion in net borrowing by the household sector from domestic sources.  However, the continued increase in household borrowing meant this was not possible after 2004 and a significant balance of payments deficit opened up (this would have been funded through transactions which impacted the financial account of the balance of payments).

Household net borrowing as a ratio of GNI* peaked in 2006 by which time net borrowing by the non-financial corporate sector was growing (at least in the adjusted terms shown here).  The surplus that the government sector was running in 2006 could have partially funded this but fiscal policy led to this surplus vanishing in 2007 and the government sector ran a large deficit from 2008 as tax revenues evaporated and social transfer spending rose.

By 2009, the household sector was a significant net lender with these funds mainly used to reduce debts – a position it remains in a decade later.  2009 also saw the underlying deficit for the government sector reach its highest level during the crisis when it was just over 14 per cent of GNI*.  Over the next decade this deficit was gradually reduced and was finally eliminated in 2018.

Indeed, 2018 was the first year when all sectors of the economy were net lenders (% GNI*):

• Households (2.2%)
• Government (0.0%)
• Financial Corporates (1.7%)
• Non-Financial Corporates (adjusted) (3.1%)

One reason to pause before we get excited with highfalutin plans to spend the surplus is that, in the latest figures at any rate, almost half of it arises from the non-financial corporate sector and we really don’t know what is going on there.  Given the scale of the gross amounts in this sector revisions to the figure could be significant.

There is also the concern due to the impact Ireland’s booming Corporation Tax receipts are having on the government’s position and on the current account. Further, the extent to which the IFSC impacts the net lending of the financial sector is unclear.  That only leaves the household sector without a question mark.

The Department of Finance paper also urges caution with an expectation that increased investment by the household and government sectors will reduce the current account surplus:

The net lending position of the household and government sectors is likely to deteriorate in the coming years, however, due to the expected increase in investment in these sectors (that is unlikely to be fully offset by an increase in savings in these sectors). This will require monitoring as it could result in a deterioration of the current account balance.

This may be downplaying the risks of increased current or consumption expenditure being a source of the possible deterioration.  On the other hand, though, there may be sufficient income growth for the economy to absorb the impact of increased consumption and investment spending on net lending as has been the case in recent years.

One of the remarkable features of the Irish economy has been that recent growth has been so strong even as the government has been reducing its deficit and the household sector has been reducing its debts.  Our conclusion from April is probably still valid:

Eventually the deleveraging will stop.  Whether that leads to an increase in consumption or investment is hard to tell.  The vulnerable position of the government sector probably means that some caution in the household sector is warranted but whether this caution will persist remains to be seen.

Tweet

Housing Costs and At-Risk-Of-Poverty Rates

The most commonly used cut-off for determining households who are at-risk-of-poverty is households with an equivalised disposable income that is less than 60 per cent of the national median equivalised disposable income.  The EU’s Statistics on Income and Living Conditions (EU-SILC) give comparable outturns for this measures.

To start here is the headline at-risk-of-poverty rate using the 60% cut-off.

Ireland and the UK are the only EU15 countries for which 2018 figures are still not available.  In any event Ireland has around the sixth-lowest at-risk-of-poverty rate in the EU15, with the rate itself having been remarkably stable over the past ten years or so.

An important determinant of the living standards of any household is the amount of their income they have to devote to cover housing costs.  As part of the EU-SILC, at-risk-of-poverty are also calculated for income after housing costs are deducted. 

The housing costs include any service charges, utilities, taxes and repairs paid by the occupant as well as rent for tenants and mortgage interest for owner occupiers.  The same income thresholds are used as for the headline rate.

Here are the at-risk-of-poverty rates after housing costs are deducted for the EU15.

Naturally, the rates are higher as a lower income (income after housing costs) is being assessed relative to the same threshold.  In this instance, Ireland’s relative position improves and has around the fourth lowest at-risk-of-poverty rate after housing costs are deducted from income.

One notable change is Denmark which goes from second-lowest for the headline rates to third-highest after housing costs have been deducted.  The reason for this is that at-risk-of-poverty households in Denmark face housing costs that are a higher share of their income than in other countries.

This can be shown by looking at the median of the housing cost burden as a share of disposable income for households that are at-risk-of-poverty.

If can be seen that the median household cost burden for Irish at-risk-of-poverty households is close on the lowest in the EU15.  Around half of at-risk-of-poverty households in Ireland face a housing cost that is more than 20 per cent of their disposable income.  Unsurprisingly, Denmark is high in this chart with half of at-risk-of-poverty households there facing a housing cost that is more than 50 per cent of their disposable income.

Tweet