S&P Global Ratings' baseline scenario assumes an orderly withdrawal of the U.K. from the EU, potentially delayed via an extension of Article 50, and the implementation of a transition period until at least December 2020 with the Irish economy adjusting gradually toward a revised trading relationship with its third largest trading partner, the U.K.

With the risks of an alternative scenario, that of a no-deal Brexit rising, uncertainty is mounting over the potential credit risk for Ireland. While a no-deal Brexit would have a significant impact on Ireland's indigenous export sector, we believe that the silver lining for Ireland--in the medium term--could be its ultimately positive effect on the labor-intensive services sectors. We also envisage a limited rating impact on our rated universe. In this report, we take a closer look at what the labor implications of a no-deal Brexit could really mean for Ireland, and address frequently asked questions on the potential credit implications for the key sectors that we rate.

Ireland's Economy Continues To Perform Strongly

Ireland's domestic economy continues to perform strongly. Nor is there any evidence so far, that the many unknowns about Brexit have cooled off Ireland's brisk labor market. Last year employment expanded by 3%, led by jobs in construction, hospitality, administration, public services, and IT. Skills shortages are pushing up wages across many sectors, particularly IT, engineering, and financial services. High labor demand is, moreover, attracting rising labor supply both from domestic and international sources. Net immigration last year reached its highest level in a decade (see chart 1): a combination of Irish nationals reentering the job market, often by returning home from abroad; and foreign nationals coming to Ireland to work at the highest pace since 2008. Notably, British nationals make up the largest group of foreign nationals, comprising over a quarter of net immigration into Ireland last year. The strength of Ireland´s employment boom has made it the fastest growing economy in Europe, with average real GDP growth of over 6% during the three years to 2018, (though Irish GDP is subject to large statistical effects from globalization).

Chart 1

Most economists predict Brexit will weaken the Irish economy

The U.K. is Ireland's largest destination for services exports, accounting for 8.3% of GDP in 2018, and the third largest market for merchandise exports after the EU27 and the U.S., worth approximately 5% of GDP. Consequently, nearly all economists agree that Irish national income will decline in the event of a no-deal Brexit, compared to its current path.

Services sector is key to future growth

In our opinion, however, by focusing primarily on the vulnerable indigenous export sector, most economists have sidestepped the question of what Brexit means for the current hiring and immigration boom into Ireland, which is primarily playing out in Ireland's services sector. At 63% of GDP, services dominate the Irish economy, as well as its labor market. We think a lot of the hiring activity taking place now is opportunistic, meaning that services jobs will be created wherever the strong candidates are going, and currently they are going to Ireland. We also think that the pace of employment growth in services is likely to survive a no-deal Brexit. Indeed, in some of Ireland's largest sectors, including financial services, hiring may very well accelerate because of a no-deal outcome.

There are several reasons why Ireland is attracting particularly high levels of net immigration, and these attractions will remain regardless of the nature of the U.K.'s departure from the EU. Whether you look at the speed of labor transitions in Ireland, the degree of labor market churn (job changing), the lower redundancy costs, or redundancy judicial proceedings, Ireland compares favorably to nearly every European country including the U.K. Like New Zealand and the U.K., Ireland is, moreover, one of the few countries in which a unified labor contract exists, although there are increasing challenges to this position. New labor market entrants are more likely to find a first time job in the Irish labor market, and workers are more mobile across jobs in Ireland compared to European peers (see chart 2). This enables better and faster matching of employees with suitable employment, benefiting labor productivity.

One indicator that highlights the flexibility of the jobs market is Ireland's Labor Inertia Factor: the difference between the percentage of the workforce in positions for 60 months or more and the percentage in positions for less than a year. A low Labor Inertia Factor (34.2 for Ireland) signifies greater mobility across different jobs, what is known as labor churn. A high Labor Inertia Factor, such as Italy's (58.6) signifies lower mobility, and more difficult entry for new applicants into first time positions, as well as a tendency for workers to settle into jobs for longer periods, given the costs of unemployment are likely to be higher, the longer it takes to find another position.

Chart 2

Several other observations support our view that the silver lining of a no-deal Brexit for Ireland could be its ultimately positive effect on the services sector:

• U.K. nationals--including Northern Ireland residents--will retain the right to reside and work in Ireland regardless of the nature of Brexit under The Common Travel Area (CTA), as set out in the U.K. Immigration Act of 1971. The CTA is a crucial pillar of the Good Friday Agreement.
• The most recent Office for National Statistics data suggest that while net migration into the U.K. has remained positive and stable since 2016, EU net migration into the U.K. is at its lowest since 2012. During the year to September 2018, data indicate that more EU8 citizens (Czech, Estonia, Hungary, Latvia, Lithuania, Poland, and Slovakia) left the U.K. than arrived. Many of those EU8 citizens are relocating to other EU member states including Ireland.
• We expect that no single EU financial center will eclipse any others to supplant London. However, Dublin has significant advantages. These include a low corporate tax rate, flexible labor regulations, a Common Law system, the official use of the English language, as well as a regulator with experience in the supervision of an international financial services industry. We understand that since 2017, applications to the Irish Central Bank from asset managers, insurance companies, and other financial institutions have significantly increased.
• We do not believe that the U.K. government will cut the headline corporate tax rate beyond its current plans to reduce the headline rate to 17% in 2020. We think the cost to strained public finances in the aftermath of Brexit of trying to match lower corporate tax rates of smaller jurisdictions would be too great. Moreover, at 17%, the U.K. corporate tax rate will already be considerably lower than the European effective average corporate tax rate of 21%.

Frequently Asked Questions On The Implications Of A No-Deal Brexit On Irish Issuers

We currently rate over 50 issuers in Ireland across corporates, infrastructure, financial institutions, and structured finance, in addition to the sovereign which we currently rate 'A+' with a stable outlook. Our Brexit baseline case continues to anticipate an orderly withdrawal of the U.K. from the EU (though potentially delayed via an extension of Article 50) and the implementation of a transition period until at least December 2020.

While to date Brexit-related risks have not manifested themselves and contributed to negative rating actions on Irish-based issuers, the risks of a no-deal Brexit are rising and could have negative credit implications.

The extent of the impact would depend upon a number of factors including sector, sensitivity to an expected slowdown in the Irish economy, operational exposure to the U.K. economy, and friction at the border where relevant. Our current thoughts are fleshed out below in a short Q&A section.

Corporates And Infrastructure: Scale Of The Challenge Varies Based On Size And Sector

What are the key risks for Irish corporates?

Supply chain disruption will be the key operational risk for Irish corporates. Larger Irish corporations operate globally, and therefore will be insulated to a degree by in place contingency plans, as well as their geographical diversification of manufacturing and sales. However, smaller Irish companies which rely more on a domestic manufacturing base and the U.K. export market will be more exposed and vulnerable to Brexit-related disruption. The Revenue Commissioners recently highlighted the scale of possible disruption, stating that that import and export declarations could rise to 20 million from 1.7 million, while the number of companies that have to deal with customs could increase to over 100,000 from approximately 17,000.

Financial risks will also increase for Irish companies trading with the U.K. The introduction of tariffs will inevitably affect revenues and margins, new trading and customs procedures will likely increase costs, and we would expect increased working capital requirements to lead to reduced free cash flow.

Finally, as detailed in our "Countdown To Brexit: No Deal Moving Into Sight" report, sterling could fall sharply, and the shock factor could see substantial volatility in financial markets. This would lead to tightening liquidity in the capital markets and provide a more difficult financing environment, at least for a while. Larger corporations will be able to mitigate though not remove these risks through their better access to international credit markets, but smaller companies will rely more on their relationship with bank lenders.

What about the impact on large export and employment sectors and employment sectors (for example, pharmaceutical and agri food)?

No sector will be immune, but we believe Irish pharmaceutical companies--despite being Ireland's largest exporters--are unlikely to be materially affected. Operating globally and with a predominantly U.S. focus, the potential for increased costs from exporting to the U.K. is unlikely to materially constrain operating results. The potential for disruption and delays in the already slow-product approval process may be heightened if the U.K. establishes its own regulatory standards and or approval process. This could also add to research and development expenses. However, this would not be specific to Irish-based pharma companies, and given the U.K. does not account for most of their exports, the potential impact would likely be limited.

At the other end of the spectrum, Ireland's agriculture sector remains the most exposed to a disruptive Brexit scenario. Supply chain disruption and the advent of substantial tariffs will provide very strong headwinds to the agri sector, which employs nearly 175,000 people, predominately in rural Ireland. While larger producers have contingency plans in place and are diversifying geographically, some producers simply do not have the option to diversify away from the U.K. market because their produce is perishable.

As an island economy, what about the energy and transportation infrastructure sectors?

The energy and transportation infrastructure sectors are particularly exposed to a disruptive Brexit scenario given the island market and close connections between the U.K. and Ireland's energy markets. So far, Brexit-related risks have not contributed to negative rating actions on Ireland-based transportation infrastructure and power and gas utilities. The key risks to the power energy sector relate to the continued operation of the Single Electricity market, the wholesale electricity market between the Republic of Ireland and Northern Ireland which is governed by EU law. We understand that after Brexit this law will not be valid but the Republic of Ireland and Northern Ireland can still choose to follow this market set up. That said, we see Ireland as less affected than Northern Ireland by uncertain trade rules governing the import of electricity through interconnectors from Great Britain (East West and Moyle Interconnector) due to Northern Ireland's deficit in generation capacity.

Furthermore, while Ireland depends heavily on U.K. natural gas imports, the regulation on the gas grid in Ireland and Northern Ireland is domestic and immune to volume risk due to the way the regulatory framework is set up. Moreover, utilities are less exposed to a Brexit no-deal scenario given the supportive regulatory framework, including the indexation of allowed revenues, which protect against weaker economic conditions.

Transportation infrastructure such as airports and ferries with significant U.K.-Ireland bound traffic could suffer from a traffic disruption over a period of time, although we believe this to be unlikely to pass due to the contingency measures in progress. Weaker economic conditions in Ireland over a prolonged period of time could have a more significant impact given the historically strong correlation we have seen between traffic for infrastructure assets and GDP growth. However, Irish airports could benefit from increased footfall if net immigration increases as we have suggested earlier. This would further support some airports' solid financial position. Irish ports, on the other hand, have set up new routes or expect to increase capacity on existing sea routes if land and sea ferry routes from the U.K. are disrupted or become less competitive due to tariffs and border custom checks.

Financial Institutions: Not Necessarily A Near-Term Game Changer For Irish Institutions

What are your expectations under a soft Brexit?

This scenario remains our base case, under which we would expect benign macroeconomic conditions, combined with the continuation of ongoing positive trends in terms of asset quality recovery and affordable access to wholesale funding, to continue to underpin our broadly stable view of the sector.

Specifically, we assume that domestic banks' system-wide nonperforming exposure (NPE) ratios will be approximately 9%-10% by end-2018, down from approximately 14% at end-2017, on the back of supportive economic conditions and further portfolio sales. Irish banks' more proactive approach to the sell-down of problematic loan portfolios leads us to believe that funding access won't falter. Therefore, banks will continue to benefit from regular access to wholesale funding, on top of a stable and granular deposit base.

How might a no-deal Brexit affect Irish banks' creditworthiness?

We look at this through two different lenses. First, the slowdown in the pace of growth of domestic income (both household and business), triggered by a net export shock to the Irish economy. In such a scenario, a sharp rise in unemployment and loss of business momentum could result in a return to high personal and corporate insolvencies (albeit not at the level we saw in the recent past). This would negatively affect banks' domestic asset quality and activity levels, undermining their earnings recovery and possibly investor confidence. Second, via the U.K. subsidiaries of the two largest banks (AIB Group and Bank of Ireland Group), which include banking operations in Northern Ireland. Although we consider these subsidiaries to each have sound balance sheet profiles, a no-deal Brexit could result in severe macroeconomic weakness. Currently these operations are not key drivers of group earnings growth and their asset quality is presently superior to their domestic loan book.

And how might we react if a no-deal Brexit materializes?

A no-deal scenario is unlikely to translate into near-term rating actions on Irish banks. Irish banks' credit profiles have improved significantly in recent years and they are now in a stronger position to absorb macroeconomic shocks. This follows several years of deleveraging, a subdued risk appetite, and more recently a heightened focus on the reduction of NPE stock.

Moreover, banks have progressively shrunk their concentration toward real estate construction and development lending, while the weak profile of their domestic mortgage portfolios have improved as collateral values have picked up and employment has recovered. In addition, net interest margins for Irish banks compare well against many eurozone markets.

That said, a no-deal Brexit could have negative credit implications, the materiality of which could vary depending on the sensitivity to an expected slowdown in the Irish economy and operational exposure to the U.K. economy.

What would be the short and longer term impact for insurers of a no-deal Brexit?

To date Brexit-related risks have not contributed to negative rating actions on Irish-based insurance companies and we would not expect any immediate rating impact on domestic Irish insurers that we rate following a no-deal Brexit because their business operations have little direct exposure to the U.K.

Nonetheless, a no-deal Brexit could potentially affect Irish insurers in several ways. Firstly, in a sovereign downgrade scenario--not our base case scenario--we would assess the impact on rated insurers. Furthermore, because of their exposure to domestic assets devaluation, the potential adverse financial market impact of a no-deal Brexit could bring volatility to insurers' balance sheets and constrain their short-term solvency position. Although a no-deal Brexit is not our base-case scenario, we will consider the level of mitigating management actions insurers can take in such a scenario, for example asset reallocation or hedging. Moreover, while exposure is somewhat limited, we see potential operational challenges for insurers who write business in Northern Ireland with potential adverse financial implications stemming from this. Finally, we do not see much disruption risk stemming from U.K. reinsurance providers as most of them have implemented contingency plans to continue writing business in the EU.

Over the longer term, however, the potential negative repercussions of a no-deal Brexit on the Irish economy could see the insurance industry growth rate suffer, and heightened claims' activity which we generally observe in recessions. This may limit underwriting profitability, and subsequently, Irish insurers' capital adequacy.

Structured Finance: Limited Credit Impact With Counterparty Risk Posing The Greatest Challenge

How would a no-deal Brexit affect the collateral performance of Irish structured finance transactions?

Structured finance issuance in Ireland primarily comprises securities backed by mortgages (residential mortgage-backed securities; RMBS), consumer assets (asset-backed securities; ABS) or leveraged loans (collateralized loan obligations; CLOs). We would expect the collateral in domestic asset pools backing RMBS and ABS to come under pressure, and performance to deteriorate from increased arrears and defaults as a result of adverse macroeconomic conditions resulting from a no-deal scenario. However, the ultimate impact will vary between transactions and will depend on loan and borrower composition within transactions. By contrast, we expect the impact on CLOs to be more muted as the asset pools primarily comprise diversified European loan portfolios.

Do you expect any rating impact following a no-deal Brexit?

While the actual impact of a no-deal Brexit is unknown, we expect 'AAA' to 'BBB' ratings for RMBS and ABS transactions generally to remain unchanged, although 'BB' and lower ratings may be vulnerable to a downgrade if performance deterioration was prolonged over time. We would not foresee any immediate rating impact as a result of inbuilt structural features, such as overcollateralization, deleveraging, and performance-based triggers which should help mitigate against increased credit risk.

However, ratings on mortgage-backed covered bonds could be more vulnerable to downgrades if we lowered our ratings on the Irish sovereign or the issuing bank, dependent on the scale of the rating action (our base case does not foresee a downgrade to the sovereign or issuing banks).

What operational and counterparty risks could a no-deal scenario introduce to Irish structured finance transactions?

In our view, the largest risk to structured finance transactions in a no-deal Brexit is the potential termination of cross-border derivative agreements if it became illegal for U.K. counterparties to perform their obligations in rated Irish transactions. We understand that counterparties will generally be able to make payments and post collateral under existing contracts post-Brexit, and therefore do not currently expect an immediate ratings impact. However, if this assumption does not hold, issuers domiciled in Ireland may be exposed to liquidity risks resulting from the termination of cross-border derivative contracts. In addition, counterparties may find it more difficult to make material amendments to existing cross-border contracts. We believe it is premature to take any rating action but will continue to monitor developments in this sector.

Related Research

• Countdown To Brexit: Rating Implications Of A No-Deal Brexit, Feb. 6, 2019
• Countdown To Brexit: Uncertainty Created For Cross-Border Derivative Contracts Supporting Structured Finance Transactions, Dec. 17, 2018
• Countdown to Brexit: No Deal Moving Into Sight, Oct. 30, 2018
• Countdown To Brexit: Financial Institutions Are Past The Point Of No Return, Oct. 11, 2018