Ireland: Staff Report for the 2004 Article IV Consultation

This 2004 Article IV Consultation highlights that in 2003, the economy of Ireland rebounded with GNP growing by almost 3 percent. Recent indicators suggest that activity has continued to strengthen in 2004. During 2003, inflation decelerated and is now close to the euro area average. Most recently, however, oil price increases have led to a mild pickup in inflation. IMF staff projects that the economic recovery will gain momentum with GNP growth of 4½ percent in 2004, accelerating slightly to 5 percent in 2005. Core inflation is forecast to stay close to 2 percent.

Abstract

This 2004 Article IV Consultation highlights that in 2003, the economy of Ireland rebounded with GNP growing by almost 3 percent. Recent indicators suggest that activity has continued to strengthen in 2004. During 2003, inflation decelerated and is now close to the euro area average. Most recently, however, oil price increases have led to a mild pickup in inflation. IMF staff projects that the economic recovery will gain momentum with GNP growth of 4½ percent in 2004, accelerating slightly to 5 percent in 2005. Core inflation is forecast to stay close to 2 percent.

I. Background and Key Issues

1. Ireland experienced a remarkable economic boom in the 1990s. Output growth averaged 10 percent a year in 1995-2000 and per capita income rapidly caught up with the EU average. A salient feature of this “Celtic Tiger” era was large increases in the proportion of the population at work (Figure 1). This reflected both favorable demographic trends that increased participation rates and a dramatic decline in unemployment, which fell from a 16 percent rate in the early 1990s to less than 4 percent by the end of 2000. Employment growth was facilitated by successive social pacts that contributed to wage moderation. Fiscal consolidation during this period, which reduced the public debt from over 100 percent of GDP in 1988 to 36 percent by 2001, provided an important impetus to growth. Rapid revenue growth combined with prudent public spending created the scope for cutting taxes, with reductions in income tax facilitating agreements on wage moderation, while low corporate tax rates encouraged foreign investment. Membership of the EU provided structural funds for infrastructure investment while EMU lowered interest rates and encouraged FDI, particularly from the US, with local operations providing access to a large market. The global ICT boom further boosted FDI, while the depreciation of the euro following its inception aided competitiveness. The latter part of the boom was associated with sharp increases in inflation and property prices, raising concerns about a hard landing and financial system soundness.

Figure 1.
Figure 1.

Ireland: The Boom

Citation: IMF Staff Country Reports 2004, 348; 10.5089/9781451818765.002.A001

Sources: AMECO, Central Statistics Office, MBTS, OECD, and staff estimates.1/ Tax revenues including Social Security Contributions and Capital Taxes.
A01ufig01

Real GNP Growth

Citation: IMF Staff Country Reports 2004, 348; 10.5089/9781451818765.002.A001

Sources: CSO, staff estimates.
A01ufig02

Per Capita Output in Ireland versus the EU

Citation: IMF Staff Country Reports 2004, 348; 10.5089/9781451818765.002.A001

Source: AMECO.

2. In the event, following the global downturn, growth slowed sharply in mid-2001. The substantial contribution of multinationals to Irish output and associated profit flows creates significant differences between measures of output, and the recent cycles in GDP and GNP have not been synchronized (Figure 2). When measured by GNP, which excludes payments to foreign factors of production and better reflects domestic economic activity, growth decelerated from around 10 percent in 2000 to 1½ percent in 2002. Household consumption growth slowed, while business investment collapsed in the aftermath of the bursting of the global ICT bubble but residential investment remained robust. The labor market was relatively resilient to the slowdown (Figure 3). Cushioned by slower increases in labor force participation rates, increases in public sector employment and in part-time work, unemployment gradually inched up from a low of 3.7 percent in January 2001 to 4.8 percent by July 2003. Domestic demand was supported by the ECB’s easing of monetary policy and an expansionary fiscal policy. Even as export growth decelerated sharply in 2001-02, net exports remained a significant positive contributor to growth as import growth, especially of capital goods, fell more.

Figure 2.
Figure 2.

Ireland: The Slowdown

Citation: IMF Staff Country Reports 2004, 348; 10.5089/9781451818765.002.A001

Source: Central Statistics Office.
Figure 3.
Figure 3.

Ireland: The Labor Market has been resilient.

Citation: IMF Staff Country Reports 2004, 348; 10.5089/9781451818765.002.A001

Source: Central Statistics Office.1/ Excluding health.
A01ufig03

Contributions to Growth

Citation: IMF Staff Country Reports 2004, 348; 10.5089/9781451818765.002.A001

Sources: CSO, staff estimates.
A01ufig04

Level of Real GNP

Citation: IMF Staff Country Reports 2004, 348; 10.5089/9781451818765.002.A001

Source: CSO.

3. In sync with the global upturn, growth picked up in 2003. In line with the global recovery in manufacturing, industrial production rose steadily over the year, while rising new export orders saw the PMI rebound strongly in the second half (Figure 4). Private consumption was supported by a recovery in consumer confidence from its trough in the summer and a gradual inching down of unemployment. The drop off in nonresidential investment slowed through the year while residential investment accelerated sharply. Overall GNP growth was 2.8 percent in 2003.

Figure 4.
Figure 4.

Ireland: Signs of Recovery.

Citation: IMF Staff Country Reports 2004, 348; 10.5089/9781451818765.002.A001

Sources: Central Statistics Office, EuroStat, and NCB Stockbrokers Limited.

4. With a lag, consumer price and wage inflation eased but house price inflation rekindled. Having substantially exceeded the euro area average since 1998, consumer price inflation decelerated sharply during the course of 2003 (Figure 5). As the lagged effects of easing resource pressures and especially the appreciation of the euro (Figure 6) fed through, HICP inflation fell from around 5 percent in February 2003 to 1¾ percent in April this year, below the euro area average, before picking up to 2½ percent most recently reflecting higher oil prices. Wage growth also eased, falling from an average of around 9 percent in 2001 to some 5 percent in 2003. Following a significant slowing in late 2001, the rate of house price increases rose to around 15 percent in 2003 and is running just below this presently (Figure 7).

Figure 5.
Figure 5.

Ireland: Inflations has fallen.

Citation: IMF Staff Country Reports 2004, 348; 10.5089/9781451818765.002.A001

Sources: Central Statistics Office, Eurostat, IFS, and staff estimates.1/ Nominal effective exchange rate based on ULC.2/ Average weekly earnings, seasonally adjusted.3/ Building and construction (unskilled)4/ Public sector excluding health.5/ Unit labor cost in manufacturing weighted by employment shares in subsectors.
Figure 6.
Figure 6.

Ireland: Exchange and Interest Rates

Citation: IMF Staff Country Reports 2004, 348; 10.5089/9781451818765.002.A001

Source: Bloomberg, DataStream, MBTS.
Figure 7.
Figure 7.

Ireland: Housing is booming

Citation: IMF Staff Country Reports 2004, 348; 10.5089/9781451818765.002.A001

Sources: Central Bank and Financial Services Authority of Ireland, Central Statistics Office, Davy Stockbrokers, the Department of the Environment, Heritage and Local Government, OECD, and Permanent tsb.1/ Nominal mortgage rates deflated by the CPI.
A01ufig05

Inflation

Citation: IMF Staff Country Reports 2004, 348; 10.5089/9781451818765.002.A001

Source: EuroStat.

5. Ireland has generally responded appropriately to policy challenges identified in previous Article IV consultations. Fiscal policies were expansionary in 2000-02, contrary to Fund advice. However, beginning with the 2003 Budget, the authorities took steps consistent with Fund advice towards consolidating the public finances and the 2004 Budget has held the line. Furthermore, no new temporary fiscal initiatives have been introduced that attempt to fine tune the housing market. In contrast to its predecessors, the present social partnership agreement signed in spring 2003 offered no fiscal concessions, a step in line with the Fund’s recommendation. The latest agreement on wage increases presents a considerable degree of wage moderation relative to the past. Financial supervision has and continues to be strengthened along the lines recommended in the 2000 FSAP. Progress in improving public expenditure efficiency, controlling public sector wages, and increasing domestic competition has been more limited.

6. The relative resilience of activity during the global downturn and the abatement of inflationary pressures suggest a remarkably soft landing from the boom but there are significant challenges and risks in managing the transition to slower growth. With many of the factors accounting for the boom such as the increased employment rate and productivity catch up being one-off by nature, medium-term growth prospects are decidedly lower than in the Celtic Tiger era. Indications are that competitiveness has deteriorated significantly and there are risks from further euro appreciation, while house price increases continue at a rapid pace and there are risks of an abrupt unwinding. There remain large infrastructure needs and a strong demand for higher quality public services. Against this background, this year’s discussions focused on:

  • What are sustainable medium-term growth rates?

  • To what extent have expectations in product, labor, housing markets, and fiscal policy adjusted to slower growth? Are the risks being factored in?

  • Avoiding a procyclical easing of fiscal policy and achieving value-for-money in public expenditures.

II. Report on the Discussions

A. The Outlook: Recovery to Lower Potential Rates

7. In the near term, the shared prospect is for the recovery to strengthen and become more broad-based. Staff’s baseline forecast sees GNP growth picking up to 4½ percent in 2004, with a slightly higher increase in GDP (Table 1). External demand continues to improve though the euro’s appreciation last year will be a restraining influence. With consumer confidence recovering, household spending will rise along with disposable incomes and employment. The recovery in equipment investment is expected to strengthen, while residential investment could well exceed last year’s vigorous pace. At the time of the mission, the authorities agreed with the qualitative characterization of improved growth prospects, and the Department of Finance’s recent update of prospects for 2004 is largely in line with staff’s forecasts.

Table 1.

Ireland: Selected Economic Indicators, 2000-05

(Annual change unless otherwise stated)

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Sources: Department of Finance; Central Bank of Ireland; IMF, International Financial Statistics; and staff calculations.

Based on National Income and Expenditure, compiled in accordance with the new European System of National Accounts (ESA 95).

Underlying productivity growth data may be overstated because of problems related to the measurement of output produced by multinational companies operating in Ireland.

The methodology for calculation of Ireland’s contribution to the Euro area money supply was amended in January 2000.

Adjusted change, which includes the effects of transactions between credit institutions and non-bank international financial companies and valuation effects arising from exchange rate movements.

Estimated prior to allocations for financing of future pensions liabilities and one-off expenditures, but including contingency provision for 2005.

As of June 2004.

As of July 2004.

8. There is broad agreement on the overall prospects for 2005. Staff forecasts GNP growth to rise to 5 percent in 2005 and the authorities acknowledged that their latest official projections of around 4 percent, made at the time of the budget in December 2003, would need to be revised. The outlook reflects the balance of countervailing forces. The widely held expectation is that residential investment should at least decelerate from its extraordinary pace. External demand is projected to also slow as excess capacity in the world economy gets utilized and growth falls to trend rates. Household spending will be supported by increasing incomes and a tightening labor market but a key issue is the extent to which consumption will be restrained by higher debt-servicing costs as interest rates begin to normalize, with the staff emphasizing the implications of the rapid run up in household debt levels. Equipment investment is expected to rebound strongly from substantially depressed levels.

9. The shared outlook is for inflation to remain moderate. Barring major exchange rate changes, staff sees underlying or “core” inflation remaining in the vicinity of 2 percent on a HICP basis, though headline rates will be buffeted by oil prices, while the authorities saw a somewhat higher average rate. From a cyclical viewpoint, staff estimates that the build up of slack during the slowdown was limited and is dissipated under the baseline by next year with little implication for inflation. While sharing the assessment of slack as being limited, the authorities saw faster prospective tightening in the labor market and saw greater potential for wage inflation picking up. From a secular viewpoint, there was agreement that the “catch up” of the Irish price level to other developed countries appears complete and should not be a factor.

10. While the risks to the near-term growth outlook are broadly balanced, further out the staff sees the risks as being on the downside. In the near term, downside risks to external demand from the euro area are offset by upside risks elsewhere, particularly the UK. Looking ahead, significant further euro appreciation in response to global imbalances presents an important downside risk. Staff emphasized and the authorities acknowledged the risks to growth from the potential unwinding of the spectacular booms in house prices and construction (see Section II. C below). On inflation, the slow adjustment of expectations to lower productivity growth and inflation prospects and the potential feed-through of oil price increases to wages and services inflation tilts the risks to the upside.

Output per hour (US = 100)

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Source: EU Commission Sapir Report (2003) p. 23.

11. There is strong agreement that medium-term growth prospects are decidedly lower than they were in the second half of the 1990s. Many of the factors that accounted for the 1990s boom are best thought of as raising the level rather than the growth rate of output. Using a growth accounting framework that embodies a tapering off in productivity catch up and labor force participation rates, staff estimates medium-term potential GNP growth to be at the mid-point of the typically cited range of 4-5 percent.1 Such rates are less than half the average experienced in 1995-2000. There was agreement that potential growth in Ireland is endogenous to a greater degree than in other advanced countries in that capital accumulation is affected importantly by FDI and, therefore, competitiveness, while increases in labor supply depend on migration flows and increasing participation rates, both of which have proved responsive to market conditions. In the budget and official projections, the authorities work with estimates of potential growth obtained from the methodology agreed between EU countries and the European Commission. This methodology currently yields estimates of current potential growth that are significantly above the 4–5 percent range reflecting the weight given by the filtering techniques employed to the boom period. The authorities did not disagree with staff views that the methodology likely overstated potential growth over the medium term and they noted that conditions in the labor market suggested that there was only limited slack in the economy presently.

Potential Growth Rates in Stability Programmes

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Source: Department of Finance.

B. Competitiveness and Incomes Policy Requirements

12. The rapid reduction and convergence of inflation is encouraging, but concerns about the erosion of competitiveness have grown. On a number of measures, competitiveness has eroded significantly. With the strengthening of the euro during 2002–03, the nominal effective exchange rate has now essentially reverted to its level during the relatively stable 1995–98 period. However, with inflation rates persistently in excess of those in partner countries for six years, Ireland’s price level has risen well above those in its main trading partners and the consumer-price-based real exchange rate now stands some 15 percent above its level during 1995–98.

A01ufig06

Nominal and Price-Based Real Exchange Rates

Citation: IMF Staff Country Reports 2004, 348; 10.5089/9781451818765.002.A001

Source: Central Bank of Ireland.

13. Staff estimates a deterioration in the competitiveness of the manufacturing sector of a similar order. The traditional output-weighted real exchange rate for manufacturing suggests only a pause in the rate of trend real depreciation, but this measure is not representative of broad competitiveness developments in the sector. As is now widely recognized, aggregate manufacturing measures for Ireland are distorted by the presence of a handful of sectors dominated by multinationals with limited employment whose gains in productivity often represent returns from intangible foreign inputs into production such as returns on past R&D, patents and advertising campaigns abroad.2 In contrast, the more relevant employment-weighted real exchange rate index for manufacturing has appreciated by some 15 percent over 1995-98 levels. This deterioration has reflected entirely increases in wages in excess of those in productivity since the slowdown began in 2001.

A01ufig07

Labor Cost-Based Real Exchange Rates in Manufacturing

Citation: IMF Staff Country Reports 2004, 348; 10.5089/9781451818765.002.A001

Sources: CSO, staff estimates.
A01ufig08

Decomposition of Unit Labor Costs in Manufacturing

Citation: IMF Staff Country Reports 2004, 348; 10.5089/9781451818765.002.A001

Sources: CSO, staff estimates.

14. Encouraging recent export and FDI performance has allayed concerns in some quarters about the losses in competitiveness, but staff and the authorities agreed that risks remain. First, the authorities indicated that the muted effects of declines in competitiveness in part reflect a willingness on the part of firms to temporarily absorb declines in profit margins and a lagged adverse response of output and employment could be forthcoming. Second, erosions in competitiveness increase the speed with which the composition of FDI flows needs to move to higher value added activities. Here a proactive industrial policy has been effective in facilitating such a shift but the necessary upgrading of skills will have to keep pace. The loss of indigenous industries also increases the reliance on the modern and inherently more mobile high-technology sector. Third, high rates of services inflation may deter labor supply as suggested by the recent slowdown in female labor force participation rates as childcare costs rose. Finally, there is anecdotal evidence of high relative house prices deterring inward migration.

A01ufig09

International Comparison of Wages

Citation: IMF Staff Country Reports 2004, 348; 10.5089/9781451818765.002.A001

Source: European Commission.

15. The increase negotiated in the recent wage agreement is moderate. The wage increase recently negotiated in the second phase of the Sustaining Progress agreement, which forms a benchmark for wage expectations and negotiations in the economy of 5½ percent over 18 months (averaging 3⅔ percent a year) is in line with lower prospective core inflation and productivity developments. There was agreement that with wages in Ireland now amongst the highest in the world, there is a strong case for these agreements not to be exceeded as they often have been in the past.

16. The three-year national wage agreements have served Ireland well but the tradeoff between greater wage flexibility and the costs of renegotiation is likely to shift.3 The recent trend of not relying on granting fiscal concessions within the social partnership to facilitate agreement has been welcome and there is agreement that both the scope for offering further concessions and their potential benefits were now limited. The present three-year agreement is the first to have broken up the wage negotiations into two sub-periods. This change was agreed by the social partners at the time on the grounds of the prevailing economic uncertainty following the Iraq conflict. Staff argued for its maintenance going forward on the grounds of the benefits of greater flexibility in wages in the face of a limited potential for persistent upside surprises in growth than had been the case in the late 1990s. While recognizing the importance of increasing wage flexibility within the social partnership framework, the authorities noted the significant logistical and practical difficulties associated with more frequent negotiations, and the heavy burden this would place on the social partnership process.

17. Competitive and flexible markets are critical to sustaining high levels of macroeconomic performance. Ireland compares well with other countries on indicators of labor market regulation, regulatory burden, levels of bureaucracy, and the administrative burden for start-up firms, but ranks poorly on competition legislation and the intensity of local competition. Improving competition in the non-traded sector, both public and private, is essential for containing the growth of input costs into the traded sector and maintaining external competitiveness. The authorities indicated a number of steps that continue to be taken in this direction. Specifically, two of the reviews of restrictive practices in the professions have been completed and the governing bodies have agreed to the removal of the major restrictions identified. However, the staff noted that progress on the reviews of the remaining six professions has been slow and that steps toward improving efficiency in public transportation have been met with resistance by public sector unions. Overall, results appear to have been limited and the scope for hastening progress in these areas seems considerable.

Indicators of Regulation and Competition

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Source: Annual Competitiveness Report 2003, National Competitiveness Council, Dublin, Ireland.Note: The lower the rank the lower the burden of regulation and the more competitive the business environment.

C. Continued Ebullience in the Housing Market

18. Rapidly rising property prices in the face of slow growth have been a feature in many countries recently, but the extent, scale and duration of the boom in Ireland set it apart. There is agreement that there are many fundamental reasons for why the boom in Ireland should have been bigger: the enormous increases in disposable incomes and employment during the Celtic Tiger era, demographic factors, the change in direction of migration flows, lower and less volatile interest rates following EMU, and financial liberalization and innovation that increased the supply of lending. In addition, the authorities emphasized the strong preference in Ireland for owning property as a factor. The dynamics of house prices have also been affected by tax changes, such as the re-introduction of interest tax deductibility for residential investment mortgages in the 2002 budget. Accompanying the house price boom have been record increases in mortgage credit, which reached a pace of 27 percent recently and household debt has risen to 100 percent of after-tax income, up from 60 percent in 1998. On the supply side, an enormous response has been forthcoming. Last year, some 69 thousand new homes were built, representing 17 new houses per thousand of the population, as compared to 6 in the US, less than 5 in Europe, and less than 3 in the UK.

A01ufig10

Real Residential Prices

Citation: IMF Staff Country Reports 2004, 348; 10.5089/9781451818765.002.A001

Sources: BIS, staff estimates.
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House Price Inflation and Interest Rates

Citation: IMF Staff Country Reports 2004, 348; 10.5089/9781451818765.002.A001

Sources: CSO, The Department of the Environment, Heritage and Local Government.1/ Second-hand house prices, 12-month changes, in percent.

19. The question remains whether the house price increases to date have outstripped developments in fundamentals. During last year’s consultation, the staff presented empirical evidence suggesting price increases had exceeded those that would have been suggested by developments in traditional demand-side factors (disposable incomes, demographics and interest rates).4 The authorities noted that a number of observers have since argued that adding supply-side factors, measured in particular by the price of building land, building costs and the availability of mortgage loans, sufficiently explain house price developments.5 The staff, while sympathetic to the inclusion of supply-side elements, views the price of land, building costs and the expansion in mortgage lending as largely endogenous to the real estate cycle. The authorities also pointed to relatively low household headship rates (or inversely, relatively large family sizes) in Ireland compared to other EU countries and the implication for house price increases in anticipation of future demand as these rates rise over time. While accepting that it could be debated, in the staff’s view there are elements of exuberance in price developments beyond those suggested by fundamentals, particularly in light of the massive increases in supply seen recently. This view is reinforced by a variety of other indicators: some 40 percent of new houses are being purchased as second or buy-to-let properties;6 buy-to-let transactions account for 20 percent of all new mortgages; and building has accelerated despite rents and the rental yield on new construction falling sharply.

A01ufig12

Rents and Housing Construction Costs

Citation: IMF Staff Country Reports 2004, 348; 10.5089/9781451818765.002.A001

Sources: The Department of the Environment, Heritage and Local Government, and Euro Stat.

20. There is greater agreement that recent rates of price increase are running above sustainable rates dictated by medium-term growth prospects and the longer they fail to moderate the greater the vulnerability to a possibly disorderly correction. The staff argued that because real estate represents an asset price whose valuation depends not only on current but also on future demand and supply conditions, future income growth is an appropriate benchmark against which to gauge the sustainability of price developments.7 Recent rates of house price increase of 12-15 percent are out of line with medium-term income-growth prospects of 4-5 percent in real, and 6-7 percent in nominal terms. There was agreement that the predominance of mortgages at variable rates and significantly increased household debt levels made the housing market in Ireland vulnerable to sharp increases in interest rates, though market expectations of the monetary policy tightening cycle in the euro area are for moderate and gradual increases.

21. In the near term, public communication can play an important role in taming expectations and help induce a soft landing in the housing market but over the medium-term structural aspects of the housing market must be addressed. The staff strongly supports the Central Bank’s public expressions of concern regarding recent rates of house price increase and credit growth. Beyond the present conjuncture, the staff argued that policy needs to confront the basic issue that the oft-cited strong preference for home ownership and asset-of-choice for saving in Ireland is an argument against subsidizing housing as such incentives exacerbate price movements when ability-to-buy rises. There is thus a strong case for removing the interest-deductibility of mortgage payments on primary dwellings and for introducing a market-value-based wealth tax on property. Although second homes are not subsidized, they are not taxed either and, given the still scarce infrastructure being provided to these homes, there is a good argument that they should be. The authorities noted the political, likely insurmountable, difficulties of removing interest-deductibility of mortgages or introducing taxation on property given the electorate’s long history of strong attachment to, and preference for owning, property.

22. High profitability and capitalization levels have bolstered the capacity of the domestic banking system to withstand shocks without creating systemic stress. Following rapid increases in lending, the property sector now represents about half of banks’ loan books (residential mortgages 34 percent; commercial property 12 percent; and construction 4 percent). The authorities noted that the results of stress tests indicated that strong capitalization levels provided a significant cushion for absorbing sharp declines in property prices with simultaneous increases in unemployment and interest rates, a view shared by the rating agencies. The authorities and private banks also noted that low effective loan-to-value ratios meant that prices would have to fall considerably before negative equity considerations came into play and there is a strong culture of servicing mortgages in Ireland, as evidenced by the low (1 to 20 basis points) rates of bad or nonperforming mortgages despite the recent growth slowdown. Nearer term, the staff welcomed strengthened surveillance by the supervisory authority to ensure that sufficient account is taken of prudential concerns in banks’ lending behavior. Staff argued that greater attention needs be paid to factoring in the effects of the normalization of interest rates from their present cyclical lows and efforts made to increase borrower awareness of the prospects for interest rates and their impact on debt servicing costs.

23. A sharp correction in the housing market could have macroeconomic consequences, although financial stability is likely not a concern. The authorities noted that while increases in house prices have undoubtedly increased the perceived wealth of homeowners, unlike in some other countries, mortgage equity withdrawals are not prevalent in Ireland. There has not been a strong identifiable relationship between aggregate consumption and house prices either, with the former following more closely developments in disposable income. Thus there is reason to doubt that a correction in house prices would directly slow consumption appreciably. The authorities acknowledged though that such a correction could harm consumer confidence. The authorities stressed that the more relevant channel for a potential impact was through unemployment with coincident large increases in interest rates being the scenario of greatest concern. With new house building representing some 12 percent of GNP last year as compared, for example, to 5 percent in the US and 3 percent in the UK, depending on the severity of the correction, the associated employment losses could have a macroeconomic dimension. A key question is the likely size and duration of the up-tick in unemployment. The authorities and other observers in Ireland noted they were encouraged by the flexibility in the labor market evident during the recent downturn which suggested that labor shed by the construction sector could be absorbed quickly elsewhere in the economy. The staff was more agnostic, noting that the construction boom had been ongoing prior to the slowdown and gathered momentum during the downturn spurred by lower interest rates and tax changes, while increases in public employment had also helped mitigate the effects on unemployment. It is not clear whether a significant autonomous increase in unemployment in the non-traded sector could be absorbed by the traded sector as easily since there was certainly no reason to expect a coincident upswing there and skill-matching would likely be an issue.

A01ufig13

Private Consumption and House Prices

Citation: IMF Staff Country Reports 2004, 348; 10.5089/9781451818765.002.A001

Sources: CSO, The Department of the Environment, Heritage and Local Government.1/ Second-hand house prices

D. Fiscal Policy: Avoiding Procyclical Pressures and Getting Value for Money

24. Following two years of disappointing outcomes and larger-than-anticipated deficits, the 2003 Budget took measures to adjust to slower growth and halt the deterioration. Nominal expenditure growth was lowered from clearly unsustainable rates of 18 percent and 12 percent in 2001 and 2002, respectively, to 7 percent in 2003, and indirect taxes were raised. In the event, the budget outturn surprised considerably on the upside, which the authorities attributed largely to factors unrelated to the economic cycle. Higher-than-expected receipts from changes in the capital-gains tax regime and from stamp duties reflecting the buoyancy of the property market yielded a nominal surplus of 0.2 percent of GDP, almost 1 percent of GDP better than budgeted.

A01ufig14

Nominal Expenditure and Revenue Growth

Citation: IMF Staff Country Reports 2004, 348; 10.5089/9781451818765.002.A001

25. The 2004 Budget continued the pattern of holding expenditure growth down in line with lower revenue and economic growth but revenue outturns so far have again exceeded expectations. The budget, framed before the final outturn for 2003 was available, envisaged a small improvement in the cyclically-adjusted balance of about ¼ percent of GDP and a nominal deficit of 1.1 percent of GDP. The authorities attribute the well-above-expected revenue performance so far this year to one-off successes with anti-fraud measures as well as the continued buoyancy of the property market. They believe both current and capital expenditures will continue to be broadly in line with the budget. These developments have prompted staff to revise its projections to a nominal fiscal deficit of ⅓ percent of GDP this year. Excluding one-off effects, the staff projects a structural or underlying deficit this year of about ½ percent of GDP (Table 5).

Table 2.

Ireland: Summary of Balance of Payments, 2000-07

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Sources: The Central Statistics Office; and staff estimates.
Table 3.

Ireland: Contribution to GDP Growth, 2000-05 (In percent) 1/

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Source: Staff estimates.

Rounding may affect totals.

Table 4.

Ireland: General Government Finances, 1991-2004

(In percent of GDP)

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Sources: Department of Finance and staff estimates.

Including a capital transfer related to the repayment of the government’s pension liabilities with respect to An Post and Telecom Eireann of 1.8 percent of GDP in 1999.

Revenues in 2002 exclude UMTS receipts of 0.2 percent of GDP.

Table 5.

Ireland: Medium-Term General Government Finances 1/

(As a percent of GDP)

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Sources: Staff estimates and Department of Finance

Based on current policies. The staff estimates assume that tax revenues will perform according to the latest SP projections in 2005–06, but are adjusted for the difference between the government’s and staff’s growth assumptions. From 2007 onwards, tax revenues (excluding indirect taxes) are projected using the OECD’s estimates of tax elasticities. Expenditure estimates for 2004 are based on the latest available official information, whereas projections for 2005–06 assume expenditure to increase at the pace envisaged in the SP (except for interest rate expenditure). Due to different accounting conventions, the staff’s estimates of total revenue and expenditure ratios differ from the Stability Programme.

As a percent of potential GDP.

Table 6.

Ireland: Indicators of External and Financial Vulnerability, 1999-2003

(In percent of GDP, unless otherwise indicated)

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Sources: Data provided by the authorities; Central Bank of Ireland; International Financial Statistics; Bloomberg; and staff calculations.

Represents non-euro debt of the government sector.

Includes lending for construction, hotels and restaurants, and real estate activities.

Credit equivalent values.

Owing to differences in classification, international comparisons of non-performing loans are indicative only.

Non-government deposits vis-à-vis Irish and non-residents to M3 ratio.

Non-government loans/non-government deposits ratio.

Projected and Actual Growth in Tax Receipts

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Source: Department of Finance; staff calculations.

26. The staff argued that cyclical considerations presented a strong case for beginning the required modest longer-run fiscal tightening in the next budget. The authorities emphasized their commitment to the SGP, including achieving a zero structural balance over the medium term, which the staff fully supports. The projected structural balances in the 2004 Stability Program are in line with commitments under the SGP and would maintain sufficient margin against the risk of breaching the 3 percent of GDP deficit limit. Given staffs estimate of this year’s underlying deficit of ½ percent of GDP, a modest adjustment would be required over the next few years to reach this target. From a cyclical perspective, with growth picking up, little spare capacity in the economy and the possibility of a larger-than-expected slowing in the property market that could lower stamp duty and capital gains revenues significantly, the staff argued there was a strong case for beginning adjustment in the next budget. From a longer perspective, fiscal policy should be well placed to deal with the pressures from aging. The build-up of assets in the National Pension Reserve Fund (annual contribution of 1 percent of GNP) will help alleviate the budgetary cost of aging. Also, Ireland is in a comparatively good position to meet these costs given the high degree of pension funding and the relatively low tax burden.

A01ufig15

Cyclically-adjusted Fiscal Balances in Stability Programmes (SP)

(in percent of potential GDP)

Citation: IMF Staff Country Reports 2004, 348; 10.5089/9781451818765.002.A001

27. But political pressures to reduce taxes or spend the recent improvements in the public finances are likely to grow, especially in the event of upside surprises to growth, and staff called for an overall multi-year spending framework. There was agreement that any loosening of fiscal policy at this juncture would be procyclical, with deleterious effects on inflation, value for money in government expenditures and competitiveness. In line with the staff’s calls in the past, the authorities extended the use of rolling multi-year spending envelopes from the transportation sector to all public capital spending in the last budget. Multi-year spending envelopes limit the potential for procyclical expenditure changes, increase the predictability and transparency of expenditure policy, improve planning and management of expenditures and thereby encourage efficiency. Staff urged that these be extended to encompass current spending. The authorities viewed the need for expectations to adjust completely to the lower medium-term growth prospects as a necessary precondition for adopting medium-term spending envelopes well-aligned to perspective resource growth.

A01ufig16

International Comparison of Government Net Capital Stock

Citation: IMF Staff Country Reports 2004, 348; 10.5089/9781451818765.002.A001

Source: Kamps (2004).

28. The mission agreed with the authorities’ view that meeting the demand for higher quality public services and infrastructure does not require higher taxes and spending. The size of government is not small in comparison with other OECD countries when compared to GNP, the more relevant measure of domestic economic activity in Ireland. Lower tax rates in Ireland as compared to the EU reflect favorable demographics that require substantially lower social security taxes, prudent fiscal policies that have delivered lower debt and debt-servicing costs, smaller defense requirements and lower unemployment-related social spending. Government capital spending, at the targeted 5 percent of GNP, is well above levels elsewhere. Faster increases risk running up against bottlenecks and serious inefficiencies, as in the late 1990s when spending exceeded this level, leading to double digit rates of associated price inflation.

A01ufig17

Total government expenditures in OECD countries in 2003

Citation: IMF Staff Country Reports 2004, 348; 10.5089/9781451818765.002.A001

Source: OECD1/ Ratio for Ireland is in relation to GNP.

29. Providing higher quality public services requires improving the value for money in public expenditures. Popular dissatisfaction with the quality of public services in health, education and infrastructure runs high despite double-digit rates of growth, suggesting significant expenditure inefficiencies or inadequate information on outputs. The authorities have taken a number of initiatives to improve the efficiency and control of expenditures, including monthly reviews of departmental expenditures, new guidelines to improve the management and appraisal of capital projects, and better contractual arrangements for construction projects that shift risks to contractors. The authorities noted the fundamental reform of administrative structures begun in the health sector which would foster accountability and rationalize service provision, and the program for the modernization of public service delivery. Staff argued for shifting the focus in public services delivery from inputs to outputs. In particular, an emphasis on quantified performance targets would motivate efficiency gains, while demonstrable improvements in the quality of public services will be necessary over time to reduce pressures for additional spending increases, arguing for better monitoring and measurement of public outputs.

A01ufig18

Nominal Growth Rates in Spending on Education, Health, Transport and Communications in 1999-2001

Citation: IMF Staff Country Reports 2004, 348; 10.5089/9781451818765.002.A001

Source: CSO

E. Other Issues

30. Ireland’s statistics are being improved to meet international requirements. Staff welcomed the newly-introduced data on external debt and stressed the need to improve fiscal reporting at the general government level and to publish a national earnings index as well as sectoral balance sheets. The authorities are extending the scope and consistency of earnings data and compiling sectoral balance sheets, which should be completed by 2005.

31. Ireland has been a strong supporter of trade liberalization in the context of the EU. On the CAP, however, the authorities noted that having agreed to two reforms in preparation for the WTO they were unlikely to agree to further reforms. They noted that the priority is to ensure a balanced agreement in agriculture across the three pillars of domestic support, market access and export subsidies. They feel agriculture is one element of the negotiation of a new WTO round that should not be sacrificed as the price for an overall agreement.

32. The authorities remain committed to reaching the UN target of 0.7 percent of GNP for official development assistance (ODA) by 2007. As in 2003, ODA is budgeted at 0.4 percent of GNP in 2004.

III. Staff Appraisal

33. In the face of substantial global shocks over the last few years, the economic performance of Ireland has been enviable. Despite being one of the most open economies in the world, growth proved remarkably resilient to the global downturn. Contrary to concerns, flexibility in the labor market limited increases in unemployment. After running well above trading partner country rates for several years, aided by the euro’s appreciation, inflation slowed rapidly, converging to euro area rates.

34. The near-term prospect is for stronger and broader-based growth and for inflation to remain moderate. Growth will be supported by external demand and a continued rebound in business investment but private consumption will be restrained by increases in debt servicing costs as interest rates begin to normalize and residential investment should slow from unusually high rates. Underlying or core inflation should remain in the vicinity of 2 percent though headline rates will be buffeted by oil prices. The potential for further euro appreciation in response to global imbalances and an abrupt unwinding of the housing boom represent key risks to the outlook.

35. Medium-term growth prospects are markedly lower than experienced in the second half of the 1990s. Many of the one-off factors that accounted for the 1990s boom have raised the level of output rather than imparted a lasting influence on growth prospects and staff forecasts medium-term growth of 4½ percent in GNP. Such rates remain amongst the highest in the world but are less than half the average experienced in 1995-2000.

36. The key challenge for both the private and public sectors is managing the transition, in particular of expectations, to slower growth. Indeed, the external downturn helped initiate a necessary adjustment of expectations and policies to lower growth. However, with medium-term growth prospects significantly lower and the economy not operating far from potential, it is important that these adjustments be viewed as required for longer-term structural reasons rather than as having been necessary for cyclical reasons only. From this vantage point, there are varying degrees of concern about the adjustments to date across sectors.

37. Safeguarding competitiveness must be a key priority of economic policy and the social partnership. In goods and labor markets, the deceleration of inflation indicates expectations have been adjusting but the lagged response means the level of competitiveness has deteriorated significantly. Wage and goods-price inflation rates persistently in excess of those in partner countries represented in part a warranted catch-up as incomes and productivity rose. This process has to, however, be near completion if it has not already overshot. Ireland’s price level has risen well above that in its main trading partners and wages are now amongst the highest in the world. The wage increase negotiated recently by the social partnership is in line with prospective core inflation and productivity developments. It does not, however, take into account past erosions in the level of competitiveness or the risks of further euro appreciation. An extended period of wage restraint is therefore warranted. The desirability of increased wage flexibility also provides a case for shortening the duration of national wage agreements from three years. The costs of more frequent negotiations can be reduced by separating wider social partnership issues from the wage negotiation process.

38. At this conjuncture, public policy should aim to engineer a soft landing in the housing market, but over the medium-term reforms will need to improve the stability of the sector. As house price increases continue to exceed reasonable prospects for medium-term growth, the Central Bank’s communications to tame expectations in both the credit and housing markets are appropriate and welcome. In the event of an abrupt unwinding of the housing market boom, though financial stability is likely not a concern, there is a likelihood of a protracted slowdown in private consumption. With variable rate mortgages predominant and household debt levels having risen, more can and should be done to increase borrower and lender awareness of the prospects for interest rate increases from current cyclical lows and their implications for debt-servicing costs. The strong preference in Ireland for owning property is a compelling reason for not providing additional incentives in the form of subsidies to home ownership. Removing the interest-deductibility of mortgage payments on primary dwellings and introducing a market-value-based wealth tax on property is therefore important. Given still scarce infrastructure, second homes should be taxed at higher rates.

39. Fiscal policy has adjusted well to slower medium-term growth prospects, but cyclical considerations argue for frontloading the remaining necessary longer-run consolidation. The 2003 Budget began the process of adjusting to the new growth realities and the 2004 Budget has held the line, with planned expenditure growth within typical ranges of medium-term potential nominal GDP growth. The overall outturn for 2003 and early returns in 2004 have exceeded expectations, but this reflects in part windfall receipts from changes in the capital-gains tax regime and successes with anti-fraud measures, as well as higher-than-expected revenues from the buoyancy of the property market. Excluding these one-off effects, there is an underlying deficit in 2004 of ½ percent of GDP. With limited slack in the economy and growth picking up, the required adjustment to the medium-term objective of balance should begin in Budget 2005. Political pressures to spend the improvement in the public finances should be resisted as such an easing would be procyclical, raise inflation, hurt competitiveness, and limit the value for money from such expenditures.

40. Concerns about the level and quality of public services and infrastructure in Ireland should be addressed by improving delivery rather than by raising taxes and expenditures. At its present levels of 5 percent of GNP, government capital spending is well above levels elsewhere, and faster increases would risk running up against bottlenecks and inefficiencies. The introduction of multi-year spending envelopes for department’s public capital spending is particularly welcome because it should safeguard such spending from procyclical pressures, improve planning and predictability, and encourage efficiency. There is a strong case for extending such envelopes speedily to encompass current spending. The fundamental reforms begun in the health sector and the modernization of public service delivery hold promise. There should be a shift in focus across public services from inputs to outputs.

41. Scope remains for improving the provision of statistics. Ensuring the timeliness of general government accounts and developing a national earnings index should be priorities.

42. The authorities should adopt a more supportive stance within the EU in favor of further CAP reform, particularly in view of the adverse impact of this policy on developing countries and EU consumers. This would complement the welcome commitment towards achieving the UN’s ODA target by 2007.

43. It is proposed that the next Article IV consultation be held on the standard 12-month cycle.

APPENDIX I Fund Relations

(As of June 30, 2004)

I. Membership Status: Joined 8/08/57; Article VIII

II. General Resources Account:

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III. SDR Department:

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IV. Outstanding Purchases and Loans: None

IV. Outstanding Purchases and Loans: None

V. Financial Arrangements: None

VI. Projected Payments to the Fund

(SDR Million; based on existing use of resources and present holdings of SDRs):

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VII. Exchange Arrangement

As of January 1, 1999, the euro became the currency of Ireland and the irrevocably fixed conversion rate between the euro a