Death of the Celtic Tiger

June 4 (Bloomberg) -- Every inch of the Elysian, Ireland’s tallest building, is designed to entice viewers to splurge as much as 1.8 million euros ($2.56 million) on an apartment in the 17-story tower. A signature three-bedroom duplex penthouse offers a black-lacquer kitchen with taps designed by Porsche SE and a panoramic view of Cork, Ireland’s second-largest city.

The only feature missing: buyers. Eighty percent of the Elysian’s 211 apartments were still on the market in late April, according to Michael O’Flynn, 51, developer of the 150-million euro project. About half the office and store units also stand empty on the site.
“It’s not the product, it’s just the times we’re in,” says O’Flynn, who has reduced his company’s payroll to about 400 employees from some 1,200 three years ago.

From the top of the 266-foot (81-meter) building, prospective buyers gaze upon a tableau that includes a multistory parking lot, a factory and a busy highway. The Elysian is a symbol of how an export-driven economic boom became an unsustainable property bubble. Irish house prices quadrupled to an average 311,000 euros in the decade to January 2007, a year when construction accounted for about a quarter of the country’s gross domestic product and the economy grew 6 percent. Even in a world convulsed by the worst recession in 70 years, Ireland’s rapid shift from boom to bust stands out as an example of what can happen when government officials fail to slow an economy overheating on property speculation.

Worst Performer
The country’s GDP, after expanding by an average of more than 9 percent a year from 1997 to 2001 -- faster than any other European Union country -- will shrink about 12 percent from 2008 through 2010, according to the Economic and Social Research Institute in Dublin. That would be the worst performance by an industrialized nation since the Great Depression, the group said on April 29. The government is cutting public employee wages and hiking taxes to reassure continental neighbors that the country won’t need a bailout like Iceland, its neighbor to the north. Iceland’s banks collapsed last October after overseas investments went sour, triggering a run on the krona, which lost 85 percent of its value against the euro in 2008. In November, Iceland received a $5.1 billion International Monetary Fund-led rescue package to keep its economy alive.

Low Taxes
Investors appear to be supporting Ireland’s austerity efforts. The difference in yield, or spread, between Irish and benchmark German 10-year government bonds jumped to 284 basis points on March 19, the most in 10 years, compared with an average of 22 basis points over the previous decade. The difference on June 3, following the government’s tax raises and cost-cutting, was 194 basis points. A basis point is 0.01 percentage point. Irish executives say the low taxes, open business environment and educated population that transformed a rural society on the edges of Europe into a free-enterprise showcase will also help the country survive the current crisis. “People are always inclined to look for dramatic, Iceland- type situations, when what you’re talking about is something totally different,” says Peter Sutherland, Irish-born chairman at BP Plc and Goldman Sachs International and a former EU commissioner. “Ireland still has a gross domestic product which is incredibly high, a significant balance of trade in positive terms and a vibrant manufacturing sector.”

Property Bubble
At the moment, the Celtic Tiger has not only lost its swagger; it has retreated into its lair. In the glory days of the 1990s, companies such as Pfizer Inc. and Microsoft Corp. fueled growth in this country of 4.4 million people --attracted by a corporation tax rate that fell to 12.5 percent by 2003, then the EU’s lowest for business. The surging economy lured back thousands of Irish citizens who fled the country in the 1980s, swelling property values. Unemployment, which exceeded 15 percent in the mid-1980s, plunged to 3.9 percent by 2001. Then it all came crashing down as the global recession cut off easy credit and curtailed demand for exports. The IMF says the Irish economy will shrink 8 percent this year, following a 2.3 percent contraction in 2008. The country’s implosion was foreseeable and avoidable, says Simon Johnson, former chief economist at the IMF and now a senior fellow at the Peterson Institute for International Economics in Washington. “Ireland’s done very well in the past 30 years, improving people’s skills, bringing in sensible new productive investment; it was a Singapore-style strategy,” Johnson says. “Then they took their eye off the ball. Property is the classic emerging- market blind alley. You’re gambling that the world economy stays stable forever.”

Austerity Program
Ireland’s coalition government, led by Prime Minister Brian Cowen’s Fianna Fail party, is trying to repair the damage as tax revenues plummet. Ireland’s budget deficit is projected to soar to 10.8 percent of GDP in 2009, more than three times the EU limit. In May, the government imposed a special levy that raises the rate of tax on incomes over 175,000 euros to 47 percent from 41 percent last year. A new state agency will buy as much as 90 billion euros in real estate loans from the banks, which may make the government the country’s biggest landlord.
“The recession in Ireland is going to be longer, deeper and more painful than in any other European country,” says Michael O’Leary, chief executive officer of Dublin-based Ryanair Holdings Plc, Europe’s largest discount airline. “Ireland is going to be terrible for the next two years.”

Bank Bailout
In January, Cowen’s government seized control of Dublin- based Anglo Irish Bank Corp., once the country’s No. 3 bank, which had some 80 percent of its loan book in the hands of commercial developers, according to Dublin-based Goodbody Stockbrokers. Anglo’s lending rose to 73 billion euros by September 2008 from 18 billion euros in 2003. The lender’s demise was accompanied by scandal. Sean Fitzpatrick, 61, the bank’s CEO from 1986 to 2005 and then chairman, resigned in December after a public revelation that he obtained a series of loans from Anglo Irish that had previously not been disclosed to investors. Those loans amounted to 106.8 million euros in outstanding debt on March 31, the bank said in a May 29 statement. Police and regulators are investigating Anglo Irish’s affairs. Fitzpatrick, in a phone interview, said he had been advised by lawyers not to comment.

Wrong Place
Ireland will spend 13.9 percent of its GDP on a bailout program for lenders including Allied Irish Banks Plc, Bank of Ireland Plc and Anglo Irish, the IMF forecast on April 21. Cowen’s government disputes those figures without offering its own estimate for the rescue, which will be paid for partly by state pension reserves. On Feb. 21, about 100,000 public employees demonstrated in Dublin to protest pay cuts and bankers’ excesses. “Ireland was in the right place at the right time in the 1990s, in a booming global economy,” says Dermot O’Leary, chief economist at Goodbody. “By 2006, Ireland was in the wrong place at the wrong time, heavily dependent on construction, a sector that relies on credit.” The country’s political leaders aren’t volunteering to take responsibility for the mess. “I can’t remember anyone at any level telling me, ‘The banks are giving hundreds of millions of euros to developers, and they’re borrowing this at short rates, so if anything happens to them, they’re caught,’” says Bertie Ahern, 57, prime minister from 1997 to 2008, in an interview at his north Dublin office. “I know some people say ‘you should have asked.’”

Who’s to Blame
Government officials such as Ahern have only themselves to blame, says Johnson of the Peterson Institute. “Any responsible policy maker should be asking tough questions,” he says. “Ireland’s highly responsible for its own problems.” Ahern resigned in May 2008, as a trawl through his personal finances by a government-appointed tribunal damaged support for his Fianna Fail-led ruling coalition. He wasn’t charged with any offense. His party has been in power since 1997 and led Ireland into the European single currency. From July 1998 to January 1999, when Ireland joined the euro zone, its benchmark rate fell by more than half to 3 percent, as the European Central Bank assumed authority for the country’s borrowing terms.
Falling under the ECB’s purview robbed Dublin of the ability to control its own money supply, says Charlie McCreevy, finance minister from 1997 to 2004.

Colonial History
“If we’d had control over our interest rates at that time, they would have been higher,” says McCreevy, 59, now the EU’s commissioner for financial services. Nevertheless, the benefits of euro membership outweighed any drawbacks, he says. Ireland’s modern struggle to control its own fate can be traced to its fractured independence from Britain in 1922. The country’s rural economy stagnated for decades as the government imposed import tariffs. The policy to isolate Ireland from the U.K. was driven by Eamon de Valera, the republican leader who dominated Irish public life from the 1930s to the early 1970s, serving multiple terms as both Taoiseach, or prime minister, and president. “De Valera wanted self-sufficiency, which was an absurd idea in a country 300 miles long, with no climatic range and very few people,” says Garret FitzGerald, 83, former leader of the Fine Gael party, who served two terms as Ireland’s prime minister from 1981 to 1987.

‘European’ Ireland
In 1973, de Valera’s last year as president, Ireland made a decisive break with isolationism when Fianna Fail Prime Minister Jack Lynch led the country into the European Economic Community, as the EU was then known. The financial benefits of membership were overwhelming: From 1973 to 2008, Ireland received a total of 62 billion euros from Europe, of which almost 44 billion euros went into the pockets of the country’s farmers. By finding salvation in an economic embrace of continental neighbors, Ireland’s politicians followed the advice of Robert Hand, a character in Exiles, the 1918 play by the Dublin-born writer James Joyce: “If Ireland is to become a new Ireland, she must first become European.” Even with Europe’s largesse, Ireland’s economy grew at an average of just 1.7 percent from 1980 to 1986, and unemployment averaged 16 percent from 1983 to 1988, which drove 228,000 people out of the country at the end of the decade.

‘Begging Bowl’
To help create jobs, the government’s Industrial Development Authority began targeting foreign investors. The IDA marketed the country’s educated, English-speaking population as “The Young Europeans,” particularly in the U.S. Such efforts lured overseas companies to establish manufacturing operations in Ireland, including Norwood, Massachusetts-based computer-hardware maker Analog Devices Inc. and Toronto-based telecom equipment company Nortel Networks Corp. “Ireland manipulated the European begging bowl very effectively, but at the same time we were bringing in investment,” says Roy Foster, professor of Irish history at Oxford University and the author of Luck and the Irish: A Brief History of Change from 1970 (Oxford University Press, 2008). “We’ve played both sides of the street very well, being poor in Europe for as long as possible but always looking across the Atlantic.”

Built on Breaks
After debt as a share of GDP peaked at about 112 percent in 1987, the government, unions and employers collaborated on a so- called Program for National Recovery. That year, Fianna Fail Prime Minister Charles Haughey ordered spending cuts, introduced tax breaks to spur the creation of jobs and brokered a three- year agreement to cap salary increases. The rival Fine Gael party, Haughey’s parliamentary opposition, backed the economic reforms.
From the late 1980s, Ireland set out to establish itself as a global financial hub by creating the International Financial Services Centre on the northern banks of Dublin’s River Liffey. The first tenants, including New York-based Citigroup Inc., enjoyed a 10 percent corporate tax rate.
“The international financial services industry in Ireland was really built on the back of tax breaks,” says Brian Lucey, associate professor of finance at Trinity College, Dublin.

No Switzerland
Ireland’s favorable treatment of some companies eventually ran afoul of EU regulations. In 2003, the government complied with continental competition rules and standardized the tax rate for all companies at 12.5 percent. “Ireland is not a conventional tax haven like Switzerland or the Channel Islands,” says John Christensen, international coordinator in London for the Tax Justice Network, a lobby group that campaigns for transparent fiscal rules. “It doesn’t have banking secrecy, so it’s not a major center for private banking involving trusts and similar offshore investment vehicles for tax evasion.” Nevertheless, Dublin became a destination for aggressive profit-maximizing strategies that went badly wrong. Germany’s state-owned banks, for example, set up investment units in Dublin to benefit from the low tax rate and proximity to investors in London. Sachsen LB’s Dublin operation, Sachsen LB Europe Plc, was established in 1999 and loaded up on toxic assets, including subprime mortgages, amounting to more than 27 times the bank’s equity during the next nine years.

Dublin Transformed
The Dublin unit funneled earnings back to Leipzig, Germany, where Sachsen LB was based. After the subprime-mortgage crisis broke in the summer of 2007, Sachsen LB was shut out of the financing market and needed a 17-billion euro emergency credit line from other state-owned banks to avoid collapse. Eventually, the state of Saxony agreed to provide guarantees using taxpayer money of up to 2.8 billion euros to cover losses on toxic assets. The lender, which shut its Dublin unit and was renamed Sachsen Bank, returned to a profit last year.
Ahern lauds Ireland’s success in marketing itself abroad. “Business guys, particularly multinationals, knew we were listening to them,” he says. “People were saying: ‘This crowd of Paddies, they’re up to this. They want to get high growth, keep taxes low.’”
Tax incentives and grants also transformed Temple Bar, a once-derelict district in Dublin’s city center that was reclaimed by restaurants, nightclubs and cultural facilities such as the Irish Film Centre. Wealthy tourists booked into rooms in the Clarence Hotel, a 49-room boutique hostelry that’s partially owned by Bono and The Edge of the rock group U2.

Peace Agreement
Redevelopment efforts created one of Europe’s most generous property tax regimes. Beginning in 1992, for example, the government allowed investors in rundown neighborhoods to write off the purchase price of apartments against other rental income. Financial services, construction and exports nurtured the Celtic Tiger. In 1995, gross domestic output per capita averaged about $17,200, 12 percent below the average in a survey of countries in the Organization for Economic Cooperation and Development. Eight years later, it was $33,000, 22 percent above average. In 2008, 44 percent of Irish exports went to continental EU countries, with the U.K. and the U.S. accounting for a further 38 percent of foreign sales. As the economy grew, Ahern worked with then U.K. Prime Minister Tony Blair to tackle the divide between Roman Catholics and Protestants in Northern Ireland, whose six counties remain part of Britain. The 1998 Good Friday Agreement marked the end of 30 years of sectarian violence and the eventual introduction of self-government to the province of 1.8 million people.

Cycle of Lending
The combination of easy credit, increased wages and tax incentives for real estate spurred the Republic’s property bubble. In 2007, builders in Ireland completed about 18 housing units per 1,000 people, edging Spain as Europe’s construction hot spot, according to Euroconstruct, a building industry research group. In Finland, the No. 3 country, developers built about 6.5 units per 1,000 residents. Total bank lending surged to 392.8 billion euros in the four years to 2008, while the average person was 37,000 euros in debt, the highest level in the euro zone, according to government figures. “The banks gave the money to the developers, the developers paid top dollar and then the banks borrowed the money on a short-term basis to give long-term loans,” Ahern says.

Top of Market
In 2003, in the Cork suburb of Ballincollig, developer O’Flynn bought a site that included disused military barracks from Ireland’s defense ministry for 40 million euros. At its center, he built a shopping mall surrounded by two curving apartment buildings. On a sunny March day, visitors are confronted by a deserted plaza where vacancy signs dot the shop fronts.
Property fever transformed commuter towns such as Maynooth, 15 miles (24 kilometers) west of Dublin. Eamon O’Flaherty, an agent at Brady Property Partners, remembers the scene in 2006 when his firm launched Newtown Hall, a residential development.
“People slept out in their cars,” says O’Flaherty, who sold 49 properties on the first morning. “It was crazy.” It was also, in retrospect, just about the top of the market. Average house prices have plunged 19 percent from their peak in January 2007, according to Irish Life & Permanent Plc. O’Flaherty has since cut prices on a two-bedroom apartment to 195,000 euros, about 35 percent less than the initial price.

Tax Challenge
As Ireland’s government takes on the burden of toxic property loans, it also faces financial pressure from the U.S. On May 4, President Barack Obama said he planned to raise about $190 billion during the next 10 years partly by curtailing the ability of U.S.-based multinationals to write off the costs of overseas units against domestic tax liabilities. “Any tightening up of U.S. tax rules will clearly have an impact on Ireland,” says Ron Davies, professor of economics at University College, Dublin, who specializes in tax competition issues. “But it’s not just disturbing for Ireland. Every other low-tax jurisdiction is going to face the same issues, such as Poland and the Czech Republic.” Ireland will bounce back by rebuilding an “enterprise economy” that values high-tech manufacturing, Irish Foreign Minister Micheal Martin told Bloomberg Television on May 7. “We’re a small, open and trading economy that has performed extraordinarily well over the past 15 years,” he said. “Our manufacturing output is down just about 1 percent in the first quarter -- so there are a lot of silver linings.”

Smart Economy
Cook Ireland, a unit of Bloomington, Indiana-based Cook Group Inc., the world’s largest private supplier of clinical equipment, is one of those bright spots. The company employs some 500 people at its Irish plant, which makes medical instruments ranging from 20-euro catheters to arterial stents that sell for more than 5,000 euros. Many of Cook Ireland’s employees monitor advances in science and health regulations, skilled work that will remain in Ireland, says Bill Doherty, the plant’s manager. “The regulatory and clinical side is not so easy to move to a country like Hungary,” Doherty says. Being smart can be expensive. Ireland’s average manufacturing labor cost was $25 per hour in 2006, five times higher than Poland’s, according to the U.S. Bureau of Labor statistics.

Salaries Slashed
The economy has shed 13 percent of its manufacturing jobs in the past seven years, as companies from Apple Inc. to Dell Inc. shift production to cheaper locales. In January, Round Rock, Texas-based Dell, once Ireland’s largest exporter, said it would cut 1,900 jobs at its Limerick factory and transfer most production to Poland. Salaries are also being slashed as job losses mount. Deloitte & Touche LLP, the New York-based accounting firm, has reduced pay for its 1,200 Irish staff by 5 percent to 10 percent. Leading by example, President Mary McAleese cut her 325,508-euro salary by 10 percent. Martin promised that Ireland will survive the hard times without a bailout. “We will resolve this internally ourselves,” he says. Don’t count on it, says Willem Buiter, former chief economist at the London-based European Bank for Reconstruction and Development.

Test of Faith
“It really depends on whether the markets lose faith in the ability of the Irish authorities to impose the amount of fiscal pain that’s necessary,” says Buiter, now a professor at the London School of Economics. “The Irish are lucky that they’re in the EU and the euro zone, otherwise they’d have been Iceland Mark II.” Ireland’s capital is pockmarked by unfinished construction projects, including an empty lot on the Poolbeg Peninsula, site of one of Anglo Irish’s troubled investments. The bank helped finance a 412-million euro deal in 2007 to buy the land for a 2,000-unit apartment complex scheduled to be built where a bottling factory once stood. By February 2009, the property was worth 30 percent less than its purchase price, according to one of the investors, the government-owned Dublin Docklands Development Authority.
“It’s a fairy tale gone bad, isn’t it?” says Damien Rice, who runs a grocery store opposite the site.
Irish taxpayers such as Rice are now reluctant stakeholders in this and other hobbled projects, collectively paying the price for a decade-long party that ended badly.