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Wall Street's love affair with Ireland may be over

November 9, 2012: 5:00 AM ET

Many large investors made targeted bets in Europe in the past year, and none has paid off as handsomely as Ireland. Too bad the whiskey's about to stop flowing.

By Cyrus Sanati

FORTUNE -- Wall Street may not like the eurozone, but it seems to be having a quiet love affair with one of its members: Ireland. The small island nation has emerged as an unlikely model of success in a sea full of economic dead ends. Ireland has taken proactive and painful steps to slash spending, increase revenue and pay off its debts in a timely manner, while its fellow eurozone neighbors on the periphery spiral further into economic oblivion. But has Ireland truly beaten the eurozone curse, or has its recent success been a positive blip in an overall negative trajectory?

Ireland was one of the first members of the troubled eurozone to go bust. The nation's banks fueled a massive housing bubble, which popped in spectacular fashion during the financial crisis. By the spring of 2010, Ireland's banking sector was on the edge of collapse as their massive portfolios of mortgages and construction loans turned sour.

The Irish government, with a healthy debt-to-GDP ratio of 26%, decided to bite the bullet and bailout its banks -- absorbing somewhere around 63 billion euros of the bad bank debt. The added debt boosted the nation's debt-to-GDP ratio to uncomfortably high levels, sending traditional investors in Irish sovereign debt running. Unable to borrow in the international debt markets, Ireland asked and received a 67 billion euro aid package from the so-called troika -- the European Union, the European Central Bank (ECB) and the International Monetary Fund.

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Up to this point Ireland looked like the rest of the troubled eurozone periphery – a terrible mélange of insolvent banks, deadbeat consumers and a now hopelessly indebted government. Instead of making things better, the bailout made Ireland look even worse in the eyes of Wall Street. By 2011, investors demanded a whopping 14% yield on Irish sovereign debt – double the level that induced Greece, Portugal and later Spain to request bailouts of their own.

But this is where Ireland veers off from the rest of the PIIGS. Unlike Greece, for example, Ireland has actually met all of its fiscal targets under the terms of its bailout, without huge public disturbances and dramatic delays. Ireland has quietly implemented 24 billion euros worth of austerity measures since 2008 and is on target to implement an additional 8.6 billion euros in cuts and tax increases over the next three years.

This is not to say that the rest of the eurozone members haven't launched austerity programs of their own. But what differs here is that as Ireland cut, its economy was still able to recover while those other countries sank deeper into recession. In fact, Ireland was able to see positive economic growth throughout 2011 while the other PIIGS experienced retractions in GDP.  By the summer of 2012, the yield on Irish bonds had fallen to a comfortable 5%, allowing the government to access the international capital markets for the first time since the crisis began.

"You have to get over the idea that Europe is one monolith – it's really not," legendary investor Wilber Ross told investors at the Bloomberg Dealmakers Summit last month in New York. "Ireland had more foreign direct investment in the country last year than ever in the midst of this whole crisis for so-called 'Europe' as a whole and Ireland individually."

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So how did Ireland do it? First, by focusing on perception. In 2010, The Irish government hatched an agreement with the most powerful labor unions in the country whereby the government agreed to stop cutting pay if the unions promised to stay off the streets. That meant no big strikes or unruly union-led protests. So as riots filled the streets of Athens and strikes ground Italy to a halt this summer, Ireland kept plugging away. This perception of a calm and steady society was inviting to investors – even those who had been burned in the property bubble in 2007 and 2008.

Wall Street took notice and showed up in force when Ireland raised debt this summer. It turns out Wilber Ross isn't the biggest Irish booster in the US – that crown belongs to Franklin Templeton, the large US-based asset manager. The firm may have acquired around half of Ireland's bond issue the summer, roughly around 2 billion euros, traders tell Fortune. The firm holds more than 10% of the nation's debt, somewhere between 8.5 billion and 10 billion euros, according to people familiar with the firm's holdings. This makes the it the largest holder of Irish bonds outside of the IMF.

Michael Hasenstab, the Franklin Templeton portfolio manager behind the bullish Irish bet, told reporters this summer that he believed that Ireland's recovery showed that the country had strong economic and financial fundamentals. One only has to look at the Irish trade balance to understand why he feels that way. Unlike the rest of the eurozone periphery, Ireland has a trade surplus, meaning it actually exports more than it imports, allowing it to service its debts. And it's not just a little trade surplus, it is the third-biggest in the eurozone, right behind export powerhouses Germany and the Netherlands.

"Ireland is a high tech economy," Ross said, explaining his bullishness on Ireland last month. "We tend to think of it as a bucolic place with pretty red-headed girls but its number one export is pharmaceuticals."

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Apparently, the so-called "Celtic Tiger," wasn't dead, it was just sleeping. As Ross noted, Ireland produces high value and high margin exports, from pharmaceuticals to computer microchips, and does it efficiently and cheaply. This compares with Italy, where efficiency is anathema, and Greece, which actually has to import olive oil - from Germany. In contrast, Ireland received more foreign direct investment in 2011 than it ever did, laying the seeds for future economic expansion.

Along with actually producing stuff people want, Ireland has made its exports more competitive thanks to the weak euro combined with private sector wage cuts. Ireland shows an 18.3% increase in competitiveness from 2008, based on unit labor costs. That compares with a 4% increase in Germany and an 11% increase in the rest of the eurozone during the same time period. This means Ireland has been able to woo back manufacturers who may have left the country because it was becoming too difficult to make a profit.

So has Ireland beaten the eurozone curse?  While it is true that the country has fared better on a macro level than its fellow PIIGS, its recovery has been historically slower and less impressive compared to other economic recoveries. In fact, the Irish recovery ground to a halt earlier this year as the nation slipped back into recession after growing for much of 2010 and 2011. The slowdown was blamed on the deepening recession in the rest of the eurozone and slow growth in the UK – Ireland's two biggest trading partners.

If Ireland was able to devalue its currency, then it probably still would be growing. But as is the case with the rest of its fellow eurozone members, it is stuck with trying to export things tied to the relatively expensive euro. It was lucky that all the worry about the eurozone made the currency decrease in value relative to other currencies last year. But as the euro slowly ticked back up this year, Ireland's competitiveness has taken a blow, pulling it back into recession.

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So it's unclear when or if the Irish economy will be able to grow its way back out of the hole as many thought it would. Contributing to the problem is that the Irish recovery so far has been mostly a jobless one. The uncertainty about the future of the currency has made it hard for employers to hire new workers with confidence. Unemployment therefore remains very high, at around 15%, nearly double the rate in the U.S. and nearly triple that of Germany. In addition, the Irish have one of the highest consumer debt-to-income ratios in the world at around 200%, so as long as unemployment remains high, there's the risk of further instability in the nation's banking system, hurting Ireland's chance of growing its economy.

Without effective monetary control, Ireland is likely to experience high unemployment for a number of years. The government will need to continue slashing expenses as long as it has to pay off the bailout it received for saving its banking industry. Talks to mutualize that debt and turn it over to the EU have stalled and probably won't be picked up again until 2014.

Medium-term forecasts conducted by Ireland's Central Bank show that while the nation's economy will continue to improve, it could take two to three years before its GDP returns to those levels seen in 2007. Furthermore, the central bank noted in a study released earlier this month that unemployment will remain elevated for some time and that it may take anywhere between 11 to 22 years for the Irish housing bubble to fully deflate.

So while Ireland has clearly outperformed the rest of its eurozone partners, there seems to be limits as to how far it can take its recovery while still bound in the euro straightjacket. The nation has done everything that it has been asked to do by the troika and has won the praise of Wall Street. But as long as it debts remain its own and its monetary policy is controlled by Frankfurt, the long term fate of Ireland seems to be sealed with that of its fellow PIIGS.

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