Celtic Tiger still purring despite strong euro

While politicians in Northern Ireland reflected on Tuesday on the benefits of peace, farther south, the European Central Bank was facing separate pacification issues as it prepared for its meeting in Dublin on Wednesday.

Foremost in ECB officials’ minds will be the challenge of keeping the eurozone’s economy on a stable path, with inflation in check and without foreign exchange shocks. As they gather for one of their two meetings a year outside Frankfurt, the euro is already near an all-time high against the dollar.

The location is apt. Among the 13 eurozone nations, Ireland, which sends almost a fifth of its exports to the United States, would be among the most vulnerable to further sharp euro appreciation – a plausible risk, especially if the ECB raised interest rates too rapidly.

Jean-Claude Trichet, the bank’s president, is expected to signal in Dublin that another quarter-point rise to 4 per cent in the main ECB rate is likely in June.

Ireland’s central bank has been among those highlighting the dangers of a sharp appreciation in the euro.

In its latest quarterly bulletin, two of its economists said the national economy was in “a significantly weaker competitiveness position” than at the start of the decade, and a continuation of recent trends in prices and costs “could leave the economy vulnerable – particularly in the event of a slowdown of the global economy or a sharp depreciation of the dollar against the euro”.

Some businesses have already had to adjust. Martin McVicar’s forklift truck business in County Monaghan used to buy engines from Volkswagen in Germany. Today, Combilift buys in the US. “It means the engines are travelling back and forth across the Atlantic. But we expect we may have to do more of this sourcing of materials . . . in the US to protect our profits,” said Mr McVicar.

Ireland accounts for only 2 per cent of eurozone’s gross domestic product. But its fast growth has meant it is often cited by the ECB as a model for others.

Domestically, the strong economy has provided a benign backdrop for Bertie Ahern, the Irish prime minister, in his quest for a third successive term in general elections later this month.

However, if Europe’s “Celtic Tiger” were vulnerable, the consequences would reach further than the domestic political scene. Other, larger countries facing competitiveness issues – such as France and Spain – would also face questions about the risks of a stronger euro. Like Ireland, they have also seen growth boosted as soaring house prices have fed through to stronger consumer spending, leaving them exposed to a possiblehousing-market correction.

The evidence so far, however, suggests Ireland’s economy will continue to grow robustly. Even the central bank might admit to over-doing its doom-mongering; it still expects a growth rate of 5 per cent this year, slowing to 4 per cent in 2008. This is in line with the trend over recent years – although half the pace seen at the turn of the century.

While the country has lost competitiveness, the problems are seen as lying more with capacity bottlenecks that have driven up prices and costs, rather than with the exchange rate.

“Even when we had our own currency, it was still determined externally. The exchange rate has not really been a strong concern for policymakers as it’s part of the world environment,” said Adrian Devitt, who heads the competitiveness division at Forfas, a government advisory body.

He suggests that a higher interest rate, by acting as a brake on the economy and slowing fast-growing sectors such as construction, might help the process of maintaining competitiveness.

Meanwhile, Ireland’s labour market flexibility should help speed the adjustment – in contrast to the years of economic pain in Germany as it sought to rebuild competitiveness. Economists generally agree that the eurozone’s “one size fits all” monetary policy meant that, in Ireland, interest rates were too low for too long.

At the same time, Ireland’s exposure to dollar weakness is less than it might seem. Against the pound, the euro has been more stable; and the UK is almost as important an export market as the US. In addition, Ireland’s economy is dominated by multinational corporations, which are used to dealing with exchange rate risks.

Growth in the Celtic Tiger is also less dependent on exports than it was in the first stages of its revival. Domestic demand has been boosted by the maturing of government-backed savings schemes, although much of the €15bn ($20bn, £10bn) released over the past year has been reinvested into savings accounts.

A slowing housing market could pose risks, but the consensus view in Dublin is that even if rates rise further, borrowing costs remain low by historic Irish standards.

So how high could the euro-dollar exchange rate go before causing pain? David Croughan, chief economist at IBEC, the Irish employers’ organisation, says the question stumps him. “I don’t know, because Ireland is a very flexible economy. It is not like the juggernaut that other eurozone economies are stuck with. Sometimes small can be attractive.”