The Economic Outlook October 2011 Oliver Mangan Economic Research Unit AIB Global Treasury.

The Economic Outlook

October 2011

Oliver ManganEconomic Research Unit

AIB Global Treasury

PART I

The Global Economy

3Global PMI leading indicator falls indicating slowing growth– not at

recession levels (yet?)

2000200120022003200420052006200720082009201035404550556065Source: Thomson Datastream

Global Purchasing Managers Index

(reading above 50 indicates growth in GDP)

4

But fears of a double-dip recession A recession caused by a financial/banking crisis is generally followed by a

weak recovery in activity…deleveraging by households and banks

Moderate, uneven growth in developed economies since recovery began in mid-2009 – credit still tight, private sector spending remains very weak

Recovery has lost momentum this year, with growing fears of a double-dip recession, especially if euro-debt crisis worsens

Marked rise in inflation on higher commodity prices, fiscal and monetary tightening as well as euro debt crisis all dampen activity in 2011

Earthquake pushed Japan back into recession in H1 2011, and hit GDP growth in many economies in Q2

Key point is that private demand not picking up baton as fiscal stimulus ends

Furthermore, fears about a sovereign debt default leading to worries about banks bond holdings and impacting on financial flows and funding

Weak growth, fiscal and financial linkages could feed off each other- debt worries, weaker banks, less lending, slower growth, more fiscal cuts……

Hope is that recession can be avoided, helped by fall in interest rates, lower inflation, further US fiscal stimulus, rebound in Japan and actions to ease problems in euro debt markets

5IMF downgrades world growth forecasts

GDP (Vol % Change) 2008 2009 2010 2011(f) 2012(f)

World 2.8 -0.7 5.1 4.0 4.0

Advanced Economies 0.1 -3.7 3.1 1.6 1.9

US -0.3 -3.5 3.0 1.5 1.8

Euro Area 0.4 -4.3 1.8 1.6 1.1

UK -0.1 -4.9 1.4 1.1 1.6

Source: IMF World Economic Outlook Sept 2011

IMF cuts growth forecasts in advanced economies by 0.6-0.7% for 2011-12 after a serious of shocks cause recovery to slow

GDP growth of around 1.5% this year in US and euro area and staying subdued in 2012

IMF says even these weaker forecasts count on a lot going well and growth could be much lower given the clear downside risks

Global GDP Growth

-4

-2

0

2

4

6

2003 2004 2005 2006 2007 2008 2009 2010 2011(f) 2012(f) 2013(f)Source : IMF/AIB

%

Advanced Economies

World

6

Interest rates to remain very low into 2013

Official Interest Rates in the US, UK and Eurozone (%)

0

1

2

3

4

5

6

7

Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10

Fed Funds

Source: Thomson Datastream

ECB Repo Rate

BoE Bank Rate

7

The eurozone debt crisis Problems in Greece are extreme and need to be ring fenced – only

Greek debt needs to be restructured

But nearly half of the €6.5tr in euro gov debt shows signs of stress

However, overalll eurozone deficit and debt levels lower than in the other major economies and euro remains a strong currency

Important that Italy and Spain can continue to fund at reasonable rates

EU institutions need to give whatever support is required to Italian and Spanish debt markets to avoid a financial crash

ECB playing a keep role and the scope of the EFSF is being expanded

More and more sovereign debt winding up in the hands of EU institutions – risk moves from private sector to EU taxpayers

The crisis has revealed major fault lines in the single currency – narrow role of ECB, no common bond market, poor fiscal oversight, competitiveness issues, boom and bust cycles

Euro break up would be very dangerous as it could trigger a global financial and economic crisis on a par with a depression

Logistically impossible to break up euro in any sort of orderly fashion – fx rates had to fixed well ahead of euro’s introduction to allow smooth launch

PART II

The UK Economy

9Sharp weakening in UK growth – economy has almost stalled. CPI way above 2% target on tax

hikes and oil

UK GDP99000102030405060708091011-2.50-2.00-1.50-1.00-0.5000.501.001.50-8-6-4-20246UK GDP QoQUK GDP YoY(R.H.SCALE)Trend Growth of 2.75%(R.H.SCALE)Source: Thomson Datastream UK Inflation99000102030405060708091011-10123456UK CPI RateUK CPI Ex Energy, Food, Alcohol and Tobacco RateSource: Thomson Datastream

10

UK : Q-o-Q Growth Rates

Source: National Statistics Office, Thomson Datastream

Q2 2010 Q3 2010 Q4 2010 Q1 2011 Q2 2011

GDP 1.1 0.6 -0.5 0.5 0.2

Private Sector Consumption 0.3 -0.1 -0.2 -0.6Government Consumption 0.5 0.0 0.1 0.5Fixed Investment -1.4 3.9 -0.7 -2.0Exports 3.0 1.5 2.1 2.4Imports 2.1 1.7 2.8 -2.4

11

UK consumer spending now declining year-on-year, despite falling savings ratio

UK Retail Sales2008200920102011-5-4-3-2-10123-1.00-0.5000.501.001.502.002.503.00MoM %YoY % 3 Month Moving Average(R.H.SCALE)Source: Thomson Datastream UK Household Expenditure and Savings Ratio99000102030405060708091011-6-4-20246-1012345678Household Consumption Expenditure YoY %Household Savings Ratio %(R.H.SCALE)Source: Thomson Datastream

12

Sterling’s sharp fall does not result in any lasting improvement in the UK trade deficit

UK Total Trade Balance (£bns)

-6

-5

-4

-3

-2

-1

0

Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

Source: Thomson Datastream

13

UK house price inflation turns negative again while activity levels remain very subdued

UK House Price Inflation99000102030405060708091011-20-15-10-505101520253035Halifax YoY %Nationwide YoY %Source: Thomson Datastream UK Housing Market Turnover200720082009201020115060708090100110120130140150160000'S 20406080100120140Number of Property Transactions - over £40,000 ('000)Number of Mortage Approvals ('000)(R.H.SCALE)Source: Thomson Datastream

14

Sharp fall in UK PMIs especially manufacturing

UK CIPS/RBS PMI: MANUFACTURING SOURCE: MARKIT ECONOMICS200420052006200720082009201020113035404550556065Source: Thomson Datastream UK CIPS/RBS PMI: SERVICESSOURCE: MARKIT ECONOMICS2004200520062007200820092010201135404550556065Source: Thomson Datastream

15

UK economy still facing many headwinds

Household spending weighed down by many factors, in particular high inflation, high unemployment, low wage growth, weak consumer confidence and higher savings

Credit conditions remain tight

Sharp fiscal tightening amounting to 8% of GDP

Housing market remains very weak

High inflation and rising unit wage costs making economy less competitive

International slowdown to weigh on manufacturing and exports

Economy to grow by 1% in 2011 and 1.5% in 2012 – helped by Olympics next year

MPC mulling further quantitative easing and likely to move on this before long

But policy options limited with rates very low, budgetary policy constrained and sterling already a weak currency

Unemployment Rate (%, LFS Measure)

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5

Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

Source: Thomson Datastream

UK Bank Lending to Firms (Non-Financial) and Households

-10

-5

0

5

10

15

20

Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

Source: Thomson Datastream

Lending to Households (Y/Y%)

Lending to Firms ((Y/Y%)

PART III

THE IRISH ECONOMY

17

Irish economy rebounds in H1 2011 GDP rose by 1.9% s.a. in Q1 and 1.6% in Q2 2011 after a fall of 0.4% in 2010.

GNP has risen in five of the last six quarters; 2.6% above trough by Q2 2011

However, domestic sector remains weak, with consumer and government spending as well as construction activity all set to decline again in 2011

Decline in business investment, though, appears to be over

Signs that we are approaching the bottom of the sharp fall in housing output too, with marked slowing in rate of decline in house completions this year

Exports continue to perform strongly, rising by 3.1% s.a. in Q1 and 1% in Q2

Balance of payments moves into surplus; (2010 saw the first surplus since 1999)

Employment continues to contract but at a slower pace. Fell by 0.2% in Q2 2011

Levelling off in unemployment since Q2 2010 at around 300,000 level. Monthly Live Register range bound since May last year. Redundancies in marked decline.

Irish HICP rate remains very low at 1%, while earnings still in decline in H1 2011

Public finances are running in line with target year to date on both the spending and revenue sides. On course to meet the 10% budget deficit target for 2011

18GDP starts to recover and BoP moves into

surplus

Monthly Redundancies (12 Month Running Total)

30000

40000

50000

60000

70000

80000

Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11

Source: Dept of Enterprise, Jobs and Innovation

GDP Growth (% YoY)

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011

Source: Thomson Datastream

BoP Current A/C Balance (4 Qtr Total)

-14000

-12000

-10000

-8000

-6000

-4000

-2000

0

2000

01/02/2000 01/02/2002 01/02/2004 01/02/2006 01/02/2008 01/02/2010

€bn

Source: Thomson Datastream

Irish Export Orders and Global Composite Output PMIs

30

35

40

45

50

55

60

65

Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11Source: Thomson Datastream

Global

Irish New Mfg Export Orders

19

Exports lead Ireland out of recession

Ireland small but very open economy - exports equated to 96% of GDP last year

Exports provided Ireland with a way out of the recession – exports rose by 6.3% in 2010 and up 5.5% yoy in H1 2011

Net exports added 3.5% to GDP in 2009 and 3.7% in 2010

Overall, GDP fell by 0.4% in 2010, much smaller than the declines of 7% in 2009 and 3% in 2008

Indeed, excluding housing, GDP rose by 1.3% in 2010, with same rate expected in 2011 also, reflecting strong exports

Most forecasts are for GDP to grow by between 0.5-1% in 2011, with net exports adding 3.3% to GDP

GDP growth forecast at 1.5-2% in 2012, assuming the major economies avoid recession

Exports as % of GDP 2010

0 20 40 60 80 100 120

Spain

Portugal

Ireland

Italy

Greece

France

Germany

UK

Source: Thomson Datastream

*

* 2009 Data for Greece

Total Exports (Y-on-Y % Change, Volume)

-6.0

-3.0

0.0

3.0

6.0

9.0

12.0

Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011

Source: Thomson Datastream

20

Domestic demand still contracting

Deleveraging by households and banking

sector, major fiscal tightening and construction

slump all weighing on domestic economy

Construction investment big negative drag on

GDP growth, taking 11.5% off real GDP over

2007-2011 period

Smaller decline in housing output in 2011 as

it’s now nearing bottom of cycle

Business investment looks to have troughed

Real government spending on goods &

services to decline by 12.5% in 2009-12

Contracting employment and falling wages

saw consumer spending decline by 0.8% in

2010 and it fell by over 2.5% in H1 2011

Domestic spending to contract by around 4%

in 2011 after declines of 5.8% in 2010 and

11.8% in 2009.

Domestic spending forecast to fall by some

1% in 2012 but to grow from 2013 onwards

Housing Completions

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

90,000

100,000

1970 1975 1980 1985 1990 1995 2000 2005 2010

Source: CSO; DoEHLG and AIB ERU forecasts

Irish Retail Sales (Volume, Yr-on-Yr % Change)

-25

-20

-15

-10

-5

0

5

10

Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011

Source: Thomson Datastream

21

But drag from domestic demand abating

GDP Contributions (2008-2013)

-15

-12

-9

-6

-3

0

3

6

2008 2009 2010 2011(f) 2012(f) 2013(f)

Personal Spending Govt Spending Stocks & Fixed Investment Net Exports

%

Source: CSO and AIB ERU forecasts

22

Labour market beginning to stabilise

2008 2009 2010 2011(f) 2012(f) 2013(f)

Unemployment Rate % (average)

6.3 11.8 13.6 14.2 14.1 13.7

Labour Force Growth % 0.8 -2.4 -2.2 -1.2 -0.2 0.5

Employment Growth % -1.1 -8.2 -4.2 -1.9 0.0 1.0

Net Immigration : Year to April (‘000)

39.0 -7.8 -34.5 -35.0 -35.0 -20.0

Source: CSO and AIB ERU forecasts

Big easing in the pace of job losses since early 2010 as economy stabilises and improves

Unemployment levels off in last 18 months on fall in redundancies and pick up in emigration

Live Register largely range bound since May 2010, another sign of stabilising labour market

Unemployment should start to edge downwards from 2013 as growth picks up and jobs market improves

Unemployment Rate (%)

3

5

7

9

11

13

15

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11Source: Thomson Datastream

23Positive adjustments to support economic

recovery Household savings have risen sharply

from 2006-2007 lows

Restructured banking system to be focused on supporting Ireland’s economy

Housing affordability is now back to best levels since pre-1996 i.e. before the boom

Limited overhang in new housing market

Contraction in construction activity should have largely run its course by end 2011

Irish inflation rate remains well below UK and is the lowest rate in the EU

Sharply falling unit wage costs (-8.7% in 2009-12) helping competitiveness

Exports growing strongly as Ireland refocuses on FDI and foreign trade

BoP has moved into surplus

Unit Labour Costs 2009-2012 (% Change)

-9 -6 -3 0 3 6 9 12 15

Ireland

Spain

France

Eurozone

Germany

UK

Italy

Portugal

Greece

Source: EU Commission

Irish and Eurozone & UK Inflation (HICP Rates)

-4

-2

0

2

4

6

Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

Ireland

Eurozone

Source: Thomson Datastream

UK

24

% change in real terms unless stated

2008 2009 2010 2011(f) 2012(f) 2013 (f)

GDP -3.0 -7.0 -0.4 0.7 1.5 2.5

GNP -2.8 -9.8 0.3 -0.3 1.0 2.0

Personal Consumption -1.0 -6.9 -0.8 -2.5 -0.5 0.5

Government Spending 0.5 -4.5 -3.8 -3.0 -2.0 -2.0

Fixed Investment -10.2 -28.7 -24.9 -12.3 -3.0 3.0

Contribution of stocks to GDP growth (%)

-1.1 -1.3 1.0 0.8 0.1 0.1

Domestic Demand (inc stocks)

-4.0 -12.5 -4.9 -3.2 -1.0 0.4

Exports -1.1 -4.2 6.3 4.2 3.0 4.0

Imports -3.0 -9.3 2.7 1.0 1.0 2.5

HICP (%) 3.1 -1.7 -1.6 1.2 1.2 1.5

Personal Savings ratio (%) 6.9 10.5 7.5 7.2 7.0 6.5

Construction Investment as % GDP

13.6 10.2 7.1 5.7 5.1 5.0

BoP Current A\C as % GNP -6.6 -3.0 0.6 0.5 0.8 1.1

Source: CSO, AIB ERU Forecasts

AIB Irish Economic Forecasts

25Budget figures made worse by treatment of banking costs

Treatment of banking recapitalisation greatly boosted Gov. deficit/debt figures in 2010

Actual or underlying deficit and debt figures were much lower, as set out in table below

The actual national debt ratio stood at 60.7% of GDP at end 2010 and should top out at around 90% of GDP in 2013-15

Public finance figures on target in past two years with the key aim being to get the budget deficit down below 3% of GDP by 2015

% of GDP 2009 2010 2011(f) 2012(f) 2013(f)

2014(f) 2015(f)

General Gov Deficit 14.3 32.4* 10.0 8.6 7.2 4.7 2.8

Gross General Gov Debt

65.6 96.2 111.0 116.0 118.0 116.0 111.0

Actual National Debt** 47.0 60.7 76.6 85.0 89.5 90.5 90.0

*To comply with Eurostat rules, the Gen Gov deficit and debt figures in 2010 include the cost of capital injections into banks via promissory notes (some 20.5% of GDP) even though these funds are to be put in over the next 10 years and not in 2010. Thus, the underlying Gen Gov deficit in 2010 is 12% of GDP. ** The actual National Debt provides for bank promissory notes, not in 2010, but as funded each year by Exchequer (€3.1bn from 2011 onwards). Also assumes €8 billion in fresh bank capital injection by the Exchequer this year following the March 2011 PCAR exercise. It also nets off cash balances (€16 billion). The National Debt stood at €93.5 billion at end 2010. Source: Dept of Finance (for Gen Gov data and forecasts); NTMA (historic) and AIB ERU (forecasts) for National Debt

26Key fiscal indicators challenging but

surmountable

Gen Gov Net Financial Liabilities (% GDP 2011)

0

20

40

60

80

100

120

SPN GER UK EURO FRA PORT IRE US BELG ITALY GRE

Source: OECD Dec 2010

Debt Interest (% GDP)

0

1

2

3

4

5

6

7

8

9

10

1980 1985 1990 1995 2000 2005 2010 2015Source: NTMA; Dept of Finance

Underlying* Gen Gov Budget Balance (% GDP)

-12.5

-10

-7.5

-5

-2.5

0

2.5

5

2006 2007 2008 2009 2010 2011(f) 2012(f) 2013(f) 2014(f) 2015(f)

Source : Eurostat ; Dept of Finance; AIB ERU*Excludes banking recapitalisation costs in 2009/10

National Debt (% GDP)

0

10

20

30

40

50

60

70

80

90

100

2008 2009 2010 2011(f) 2012(f) 2013(f) 2014(f) 2015(f)

Source: AIB ERU

27Irish bond yields fall sharply even though euro

debt crisis escalates Sharp fall in Irish bond yields since the mid-

July Euro Group summit which saw a marked improvement in the Irish bailout terms

Marked outperformance compared to Greece and Portugal

Irish bond rally has occurred despite renewed severe sovereign debt pressures in Greece and difficulties in Italian and Spanish markets

Recognition by market that Irish funding needs are covered until end 2013

Major progress in resolving banking crisis as balance sheets cleansed and capital ratios boosted by large capital injections

Irish exports performing well with the balance of payments now in surplus

Economy has started to grow as exports provide the route out of recession

Public finances on target with very positive quarterly assessments by the Troika

Irish 10 Year Yield

7

8

9

10

11

12

13

14

15

31-Mar 30-Apr 31-May 30-Jun 31-Jul 31-Aug

%

Source: Thomson Datastream

10 Year Benchmark Spread v Germany

400

500

600

700

800

900

1000

1100

1200

1300

31-Mar 30-Apr 31-May 30-Jun 31-Jul 31-Aug

bps

Ireland

Portugal

Source: Thomson Datastream

28

Ireland clearly different to Club Med countries

Ireland now running a surplus on the balance of payments in contrast to the continuing big current account deficits in Spain, Portugal, Italy & Greece

Ireland as a nation is now a net lender unlike the Club-Med countries

Exports are an enormous part of the Irish economy at close to 100% of GDP and growing strongly, which is now more than offsetting weak domestic demand

Club Med countries have a small export base so difficult for them to emerge from recession with domestic demand contracting

Irish economy much more flexible than Club-Med and has made major painful adjustments to correct the imbalances in the economy

Ireland has undergone a large real internal devaluation, with a 14% fall in unit wage costs relative to other industrialised countries over 2009-12

HICP fell by 3.3% in Ireland in 2009/10 in contrast 6% rise in Greece, 1.8% in Spain and 0.5% in Portugal. Ireland has the lowest HICP (1%) in EU at present

Irish funding needs catered for until end 2013 under its IMF/EU bail-out deal. Not so in Portugal and Greek bail-out deal running into difficulties.

29Risks to the prospects for an Irish economic

recovery

The marked slowdown in the recovery in the international economy which has seen a fall in Irish PMI indicators recently and could hit exports

Marked weakness of Irish consumer spending- sharp fall in H1 2011 probably in response to severe 2011 budget and concerns over further fiscal tightening

Scale of balance sheet repair by households, which is a new phenomenon for Ireland and thus difficult to estimate its speed, breath and duration

Low levels of consumer confidence

Continuing credit contraction - need to get bank lending moving again

Ongoing sharp fall in house prices and very low levels of market turnover despite favourable affordability conditions

Even deeper budgetary cuts than currently envisaged

Contagion effects from ongoing crisis in peripheral eurozone debt markets

Lack of access to market funding for sovereign and banks despite ample domestic savings – Ireland Inc. is a net lender but can’t borrow on markets

30

Note: All Irish data in tables are sourced from the CSO unless otherwise stated. Non-Irish data are from the IMF, OECD and Thomson Financial. Irish forecasts are from AIB Economic Research Unit. This presentation is for information purposes only and is not an invitation to deal. The information is believed to be reliable but is not guaranteed. Any expressions of opinions are subject to change without notice. This publication is not to be reproduced in whole or in part without prior permission. Allied Irish Banks

p.l.c. is regulated by the Central Bank of Ireland.

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