The spectre of a double-dip recession in the Republic of Ireland crept closer yesterday when official figures showed that gross domestic product contracted in the second quarter.
According to data published by the Central Statistics Office, GDP dropped by 1.2 per cent from the first three months of the year, despite government forecasts indicating growth of 0.5 per cent. The markets reacted immediately as spreads on Irish government bonds – the premium investors demand to hold the securities rather than the benchmark German government debt – jumped to a record 500 basis points.
The disappointing numbers will also send shock waves through Europe, where austerity drives that have been implemented to ward off a sovereign debt crisis now risk tipping the economies back into recession.
Dublin has desperately tried to get the worst budget deficit in the EU under control after its once-thriving economy, built on a debt-fuelled construction sector, imploded during the credit crisis. The Prime Minister, Brian Cowen, who is also fending off accusations that he was drunk during a radio interview last weekend, has tried to reassure markets that Ireland's economy is picking up and that tough public spending cuts will avert a debt crisis.
"This is a dismal situation and is now so grave that the Irish have no choice but to introduce even tougher austerity measures," said Chris Scicluna, an economist at Daiwa Capital Markets.
"On every measure – the depth of the recession, the cost of the bailout, the collapse of the construction sector, and the higher cost of issuing debt – Ireland is top of the tree.
"And it is going to live through a prolonged slump – there is unlikely to be any meaningful growth for at least a couple of years. Estimates of 4 per cent growth in two years are now almost impossible to achieve."
The Irish administration tried to put a brave face on yesterday's figures, pointing out that the cost of bailing out Anglo Irish Bank, which was nationalised two years ago, is set to jump to 25 per cent of GDP this year, cancelling out the benefits of initial spending cuts.
Ireland's finance ministry told Reuters it doesn't plan to publish its 2011 fiscal plans, which are due in December, early – adding that the pace of decline in consumption and investment was easing. Faced with a burgeoning budget deficit, Ireland was one of the first countries to implement sharp public spending cuts. The slip back in economic decline in the last quarter will worry policymakers in other weak eurozone countries, especially Portugal, where bond yields have widened in line with Ireland's in recent weeks.
Analysts said yesterday, however, that although Portugal could face similar problems, a Europe-wide sovereign debt crisis is now unlikely.
"The sovereign crisis [in Europe] is not over yet, but we believe the worst was seen in [first quarter of this year]," said Laurant Fransolent of Barclays Capital.
"The more recent pressures on Portugal and Ireland are much less systemic in nature and, for various reasons, are unlikely to lead to renewed global risk aversion."
Spending cuts in the UK will be detailed in next month's Comprehensive Spending Review. The Chancellor, George Osborne, will cut some departmental budgets by up to 40 per cent, but economists argue that the action is necessary to maintain confidence.
"He cannot risk disappointing the markets," Mr Scicluna at Daiwa said.