Ireland
2007Article IV Consultation: Staff Report; Staff Supplement; and Public Information Notice on the Executive Board Discussion

This 2007 Article IV Consultation highlights that economic performance of Ireland remains strong, supported by sound policies. The growth rate of real GNP per capita continues to be one of the highest among advanced economies and the unemployment rate one of the lowest. However, in recent years, economic growth became more reliant on house building, and competitiveness eroded. Rapidly rising housing prices were accompanied by surging bank credit to property-related sectors and strong wage growth. The banking system continues to perform well, but rapid credit growth has led to vulnerabilities.

Abstract

This 2007 Article IV Consultation highlights that economic performance of Ireland remains strong, supported by sound policies. The growth rate of real GNP per capita continues to be one of the highest among advanced economies and the unemployment rate one of the lowest. However, in recent years, economic growth became more reliant on house building, and competitiveness eroded. Rapidly rising housing prices were accompanied by surging bank credit to property-related sectors and strong wage growth. The banking system continues to perform well, but rapid credit growth has led to vulnerabilities.

I. Introduction1

1. Economic performance remains very strong, supported by sound policies. The growth rate of real GNP per capita continues to be one of the highest among advanced economies and the unemployment rate one of the lowest. Higher value-added activities such as financial services, information technology services, and other business services are expanding. Inward foreign direct investment is boosting labor productivity, while outward FDI—and increases in foreign holdings more generally—are allowing Irish households, corporations, and financial institutions to diversify their assets. Ireland’s open door for workers from new EU member states is supporting economic growth and mitigating potential labor-market bottlenecks. In addition to outward oriented policies, key pillars of Ireland’s performance are prudent fiscal policy, low taxes on labor and business income, and labor market flexibility (Box 1).

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Growth and Unemployment

Citation: IMF Staff Country Reports 2007, 325; 10.5089/9781451818857.002.A001

Fund Policy Recommendations and Implementation

Fiscal policy: Fiscal policy has been prudent, with a medium-term fiscal objective of close to balance or surplus, in line with Fund advice. In the past couple years, windfall property-related revenues were saved and the fiscal stance was not procyclical, in line with Fund advice.

Financial stability: The Fund supports the supervisory framework, which aims to prioritize resources across sectors based on risk profile. The regulatory and supervisory framework continues to be strengthened in line with the recommendations of the 2006 FSAP Update.

Wage policies: The present social partnership agreement contained no fiscal concessions, in line with Fund advice, though the wage increases were a little on the high side.

2. However, in recent years, economic growth has become more reliant on house building and competitiveness has eroded. The share of residential investment in economic activity rose to a higher level than in other advanced economies. House prices increased rapidly and the ratios of house prices to rents and to household disposable income rose to historical highs. The construction boom was accompanied by surging bank credit to property-related sectors, strong wage growth and inflationary pressures, and a deterioration in the external current account balance.

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Share of Residential Investment, 2006 1/

Citation: IMF Staff Country Reports 2007, 325; 10.5089/9781451818857.002.A001

Source: AMECO.1/ 2005 data for Australia, Canada, and France.

3. A new government was formed in June following parliamentary elections, but substantial continuity in economic policies is expected. Fianna Fail remained the largest party in parliament and Prime Minister Ahern formed a coalition government with the Green Party, the Progressive Democrats and supported by some independent members of parliament. Brian Cowen was reappointed as Finance Minister and also appointed as Tanaiste (Deputy Prime Minister). Given the comfortable majority of the ruling coalition, parliament is likely to run its full course, with the next general election in mid-2012.

II. Strong Growth in 2006, Though Housing Market Started to Cool

4. Economic growth was strong in 2006, driven by robust domestic demand (Table 1). Private consumption growth remained buoyant, as support from dynamic employment growth and steady wage growth partly offset the adverse effects of higher debt service and energy costs. Business investment growth fell sharply, reflecting the base effect of exceptionally large purchases of aircraft the previous year (and was therefore matched by a decline in import growth). Residential investment growth slowed, but this was partly offset by a pickup in nonresidential building investment. Lost competitiveness contributed to a slower growth of exports of goods and services.

Table 1.

Ireland: Selected Economic Indicators

(Annual change unless otherwise stated)

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

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

As of May 2007.

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.

As of June 2007.

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Real GDP Growth, 2002–06

Citation: IMF Staff Country Reports 2007, 325; 10.5089/9781451818857.002.A001

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Contributions to GDP Growth

Citation: IMF Staff Country Reports 2007, 325; 10.5089/9781451818857.002.A001

5. Strong growth in 2006 diminished economic slack and boosted inflationary pressures. HICP inflation rose to 2¾ percent, above the euro area average, driven by rapid increases in services prices. The unemployment rate was stable, as both employment growth and labor force growth were robust, reflecting high net immigration and increased participation rates, especially among women. For the year as a whole, wage growth was broadly in line with productivity (GDP per employee) growth, suggesting that economy-wide unit labor costs were broadly flat in 2006. In light of rising inflation and low unemployment, the authorities and staff agreed that output was at or slightly above potential in 2006, though such estimates have large margins of uncertainty.

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Unemployment Rate

Citation: IMF Staff Country Reports 2007, 325; 10.5089/9781451818857.002.A001

A01ufig06

Employment Growth

Citation: IMF Staff Country Reports 2007, 325; 10.5089/9781451818857.002.A001

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Real Wage and Productivity Growth

Citation: IMF Staff Country Reports 2007, 325; 10.5089/9781451818857.002.A001

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Inflation

Citation: IMF Staff Country Reports 2007, 325; 10.5089/9781451818857.002.A001

6. Higher-than-trading-partner inflation led to a further erosion of competitiveness. Ireland’s share of industrial country exports of goods and services continued its gradual decline and the current account deficit widened to 4¼ percent of GDP (Table 2). Net FDI was negative but improved relative to 2005, mainly reflecting the passing of the impact of temporary U.S. regulatory changes. The authorities and staff agreed that, while external competitiveness has eroded, the external position is stable (Appendix II) and that Ireland’s real effective exchange rate is close to, but perhaps slightly above, its equilibrium value.2

Table 2.

Ireland: Summary of Balance of Payments

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Sources: The Central Statistics Office; and Fund staff estimates.
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Real Effective Exchange Rate

(24 trading partners, economy-wide)

Citation: IMF Staff Country Reports 2007, 325; 10.5089/9781451818857.002.A001

Source: EuroStat
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Current Account

Citation: IMF Staff Country Reports 2007, 325; 10.5089/9781451818857.002.A001

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Ireland’s Export Share

Citation: IMF Staff Country Reports 2007, 325; 10.5089/9781451818857.002.A001

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Foreign Direct Investment

Citation: IMF Staff Country Reports 2007, 325; 10.5089/9781451818857.002.A001

7. The rise in euro area interest rates since late 2005 has prompted a cooling of the housing market. The growth of residential investment declined significantly in 2006 and house prices have fallen in recent months. The share of residential investment in GDP in Ireland is higher than in other countries, partly reflecting catch-up in Ireland’s housing stock. With the ratio of house prices to rental income above its historical average, house prices were seen as somewhat overvalued by Central Bank officials and staff, though in line with fundamentals by Department of Environment officials.

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Mortgage Lending Interest Rate

Citation: IMF Staff Country Reports 2007, 325; 10.5089/9781451818857.002.A001

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House Price Growth

Citation: IMF Staff Country Reports 2007, 325; 10.5089/9781451818857.002.A001

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House Completions

Citation: IMF Staff Country Reports 2007, 325; 10.5089/9781451818857.002.A001

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Ratio of Average House Price to Gross Annual Rental Income

Citation: IMF Staff Country Reports 2007, 325; 10.5089/9781451818857.002.A001

Sources: CSO; Department of Environment; Quarterly National Household Survey; and staff calculations.

III. Growth Slowdown Ahead, With Risks on the Downside

8. Residential investment is expected to wind down as house completions return to a sustainable level. Although rapid population growth and a relatively low number of dwellings per capita ensure strong underlying demand for housing, the staff consider the sustainable level of house completions to be about 50,000 to 70,000, well below the 88,000 dwellings finished in 2006. Thus, residential investment is projected to contract substantially during 2007–10. The authorities saw a soft landing of the housing market as likely. The shared view is that any overvaluation of house prices would likely diminish gradually over time as rental income and other fundamentals grow more quickly than house prices. The authorities and staff agreed that housing wealth effects on consumption are small.3

9. The growth slowdown in 2007 will be cushioned by strong private consumption and fiscal stimulus (Table 3). In addition to robust employment growth, steady wage growth, and increased government transfers to households, private consumption will be supported by maturing Special Saving Investment Accounts (amounting to about 12 percent of private consumption), a small portion of which will be spent. Nonresidential structures investment is also expected to be strong, in light of continued favorable growth prospects over the medium term and Ireland’s need for public infrastructure. Altogether, staff project that real GDP will grow by about 4¾ percent. Given the strength of domestic demand, the current account deficit is expected to widen further to about 4½ percent of GDP.

Table 3.

Ireland: Contributions to GDP Growth

(In percent)

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Macroeconomic Projections

(Percentage change, unless otherwise indicated)

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Contributions to growth

10. Growth will rebalance further in 2008, as the easing of domestic demand relieves inflationary pressures and helps to narrow the current account deficit. Economic growth is projected to slow further, as the temporary supports to private consumption fade, euro area interest rates continue to rise, and the downturn in residential investment gains momentum. The slowdown in domestic demand growth should increase economic slack and dampen import growth. Over the medium term, assuming the completion of the adjustment in the housing market, GDP growth will likely run at about 4 percent, reflecting employment growth of about 2 percent and labor productivity growth of about 2 percent. The authorities noted that official projections would only be updated in the autumn, but gave a broadly similar characterization of the outlook.

11. The risks to the short-term outlook are tilted to the downside. The housing market could cool more sharply than expected or the external environment could deteriorate (or both). If realized, these risks would further dampen economic growth, reduce government revenue, and increase financial sector stress:

  • Housing market: The prospect of lower capital gains could scare investors in buy-to-let properties. The 2006 census shows that 15 percent of dwellings are unoccupied, though this is in line with the EU average. Another transmission channel is through private consumption, as housing market developments could undermine consumer confidence. A third transmission channel is through the financial sector. The end of rapid house price appreciation could trigger a reassessment of the risks associated with mortgage lending, possibly leading to a tightening of lending standards, which in turn could affect domestic demand. Cross-country, historical evidence presented in the April 2003 WEO suggests that sharp increases in house prices are followed by sharp declines about 40 percent of the time.

  • External developments: Growth in Ireland’s trading partners is projected to remain robust, but risks are skewed to the downside. In particular, a weakening of U.S. growth is an important risk (Box 2). Also, given the relatively high share of exports to the United States, a further appreciation of the euro would undermine Ireland’s competitiveness to a greater extent than for other euro area countries. A reversal of still benign global financial market conditions could lead to a deterioration in investor sentiment toward Ireland.

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Unoccupied Dwellings

Citation: IMF Staff Country Reports 2007, 325; 10.5089/9781451818857.002.A001

Source: Euroconstruct
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Partner Country Growth

Citation: IMF Staff Country Reports 2007, 325; 10.5089/9781451818857.002.A001

Spillovers to Ireland

As a small, open economy, Ireland is vulnerable to spillovers from its main trading partners. Merchandise exports amount to about 50 percent of GDP, of which more than two-fifths go to the euro area and less than one-fifth each to the U.S. and the U.K. Ireland is also vulnerable to swings in its real effective exchange rate.

Staff analysis yields two main findings:1/

  • Spillovers from the U.S. account for a much larger share of the variance of Ireland’s GDP than implied by the U.S. share in Ireland’s merchandise exports. This could reflect a larger U.S. share of services exports or the dominance of U.S. multinationals in inward FDI. Therefore, a further slowdown in U.S. growth could have a large effect on Ireland.

  • The impact of shocks to the real effective exchange rate on Ireland’s GDP increases over time, with their share of the variance decomposition rising to about 12 percent after two years and higher still at a longer horizon. This suggests that past erosion of competitiveness may yet have a more substantial impact on economic activity.

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Share of Irish GDP variance decomposition explained by trading partners

(in percent)

Citation: IMF Staff Country Reports 2007, 325; 10.5089/9781451818857.002.A001

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Share of Irish GDP variance decomposition explained by REER

(in percent)

Citation: IMF Staff Country Reports 2007, 325; 10.5089/9781451818857.002.A001

1/ Daniel Kanda, “Spillovers to Ireland,” Selected Issues Paper.

12. With a rebalancing of economic activity in prospect, the discussions focused on the policies needed to support the adjustment to sustainable growth. Specifically:

  • How is fiscal policy positioned to cushion the slowdown? How will demographic change affect the public finances over the long term?

  • What are the key vulnerabilities and how large are the buffers in the banking system? How will financial stability and growth be promoted over the medium term?

  • How can wage-setting mechanisms help to ensure wage moderation and wage flexibility in response to changing macroeconomic conditions?

IV. Ample Room for Fiscal Stabilizers, but Population Aging Ahead

13. Already-strong fiscal performance improved further in 2006 (Table 4). Following a decade of close-to-balance-or-surplus fiscal positions, the general government surplus surged to almost 3 percent of GDP in 2006 and net debt fell to about 12 percent of GDP. The better-than-expected fiscal outturn reflected mainly the strength of property-related revenues, as stamp duties and capital gains tax benefited from rising house prices. Government expenditure as a share of GDP fell slightly, as a decline in current spending more than offset a rise in investment.

Table 4.

Ireland: General Government Finances

(In percent of GDP)

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Sources: Department of Finance and staff estimates.

Staff projections are based on the 2007 budget, adjusted for staff’s macroeconomic and revenue buoyancy assumptions.

Net debt is defined as gross debt minus the value of the National Pensions Reserve Fund and the Social Insurance Fund.

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General Government Balance

Citation: IMF Staff Country Reports 2007, 325; 10.5089/9781451818857.002.A001

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General Government Debt

Citation: IMF Staff Country Reports 2007, 325; 10.5089/9781451818857.002.A001

14. The budget for 2007 implies substantial fiscal stimulus at a time when the economy may be operating at or above capacity.4 In staff projections, most of the 2 percentage point of GDP deterioration in the fiscal position comes from a rise in expenditure, due to increases in social welfare payments and higher education and health spending. The revenue-to-GDP ratio is projected to fall, reflecting both lower corporate income tax and some weakening of stamp duties and capital gains taxes in the second half of the year. While tax buoyancy could once again surprise on the upside (as it has done in recent years5), housing market turnover (the base for property-related taxes) could slow more sharply than expected. Staff noted that, given inflationary pressures, eroding competitiveness, and a widening current account deficit, substantial fiscal stimulus in 2007 is unfortunate, but the authorities pointed to the need to achieve social objectives.

General Government Finances

(In percent of GDP)

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Sources: Department of Finance and staff estimates.

Staff projections are based on the 2007 budget, adjusted for staff’s macroeconomic and revenue buoyancy assumptions.

Net debt is defined as gross debt minus the value of the National Pensions Reserve Fund and the Social Insurance Fund.

15. On unchanged policies, some cyclical weakening of the fiscal position in 2008 is likely, stemming from the impact of the growth slowdown on government revenue. In staff’s central scenario, the fiscal balance is projected to decline by ½ percent of GDP, with risks to this projection tilted to the downside. However, a faster-than-expected cooling of the housing market could result in a much sharper fall in the fiscal balance, reflecting lower property-related revenues, lower income tax and VAT revenues, and higher spending on unemployment benefits. If external shocks were to occur at the same time, the deterioration in the government balance could be even larger, as illustrated by the large deterioration in the fiscal balance (almost 5 percentage points of GDP) between 2000–02. The authorities agreed with the characterization of risks.

16. Against this background, the authorities and staff shared the view that prudent fiscal policy should be maintained. With the new government’s five-year program containing some potentially costly proposals, such as a reduction in the social security contribution rate, a rise in pension benefits relative to average earnings, and a cut in personal income tax rates, staff cautioned against discretionary measures that would weaken the underlying fiscal position and suggested restraining the growth of current spending to nominal GDP growth. The authorities said that a sound fiscal position would be maintained by reducing current expenditure growth and targeting a balanced budget.

17. Turning to the medium term, the authorities and staff agreed on the importance of further improving the quality of spending and reviewing the tax base. Specifically, while a high level of government investment spending is appropriate given Ireland’s significant infrastructure needs, robust cost-benefit analysis is needed to ensure value for money. In this regard, project sponsors need to ensure that full economic analysis is carried out: compliance with this requirement should be subject to audit by the central unit responsible for oversight and quality control of cost-benefit analysis. Turning to current spending, value for money could be enhanced by introducing multi-year envelopes and requiring efficiency gains in the delivery of public services. On the revenue side, the authorities noted that a Commission on Taxation will be established to review the efficiency and appropriateness of the taxation system. Staff suggested that the Commission could consider, among the other issues, the nature of taxes on property, with a view to establishing whether revenue neutral adjustments might be made which would encourage mobility while ensuring a dynamic tax base and avoiding distortionary effects. Staff also suggested broadening user fees, for example by fully charging for water supply and sewage treatment and introducing a congestion charge in Dublin. The authorities pointed to the political sensitivity of property-related taxes and user fees.

18. Looking further ahead, population aging will put increasing pressure on public finances. While Ireland’s population actually became slightly younger over the past 50 years, the old-age dependency ratio will start to rise quite steeply very soon. As a result, the EC Aging Working Group projects a rise in age-related government spending between 2004–50 of about 8 percentage points of GDP (primarily due to increased pension spending), higher than the average for other EU countries.6 To prepare for this spending, the government is setting aside every year 1 percent of GNP in a National Pensions Reserve Fund. Another partial offset will be an eventual decline in government investment spending as a share of GDP to a level more in line with the industrial country average. Nevertheless, an illustrative scenario shows that government net debt could rise substantially by mid-century. To improve public understanding of the pressures on public finances, staff suggested the regular publication of a report on long-term fiscal sustainability, as is done in some other countries. The authorities noted that the budget documents regularly cover these issues and that work on a longer report is underway.

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Old-Age Dependency Ratio 1/

Citation: IMF Staff Country Reports 2007, 325; 10.5089/9781451818857.002.A001

Source: Eurostat.1/ Defined as the ratio of population aged 65+ to population aged 15–64.
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Increase in Age-related Public Expenditures, 2004–50 1/

Citation: IMF Staff Country Reports 2007, 325; 10.5089/9781451818857.002.A001

1/ European Economy, Special Report No. 1, 2006.
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Government Net Debt--Illustrative Scenario

Citation: IMF Staff Country Reports 2007, 325; 10.5089/9781451818857.002.A001

19. To address long-term fiscal pressures, the authorities and staff agreed that a mix of measures will be needed (Box 3). Staff noted that the state pensionable age (currently 65) could be raised in line with rising life expectancy and that the government’s annual contribution to the National Pensions Reserve Fund could be raised. Staff further observed that some other countries are addressing concerns about the adequacy of private saving for retirement by introducing a national defined-contribution scheme with automatic enrolment and low operating costs. The authorities responded that these and other options would be analyzed in a forthcoming Green Paper on Pension Policy.

Long-Term Fiscal Sustainability

The Global Fiscal Model is used to simulate the macroeconomic effects of different options to restore debt sustainability.1/ Funding the rise in age-related spending through a concomitant increase in social security contributions would require substantially higher contribution rates—up to 20 percentage points by 2055. This policy would have negative effects on labor supply, which would already be shrinking as the population ages. A more growth-friendly option would be a combination of raising the retirement age, broadening the tax base, and increasing less distortionary indirect taxes, the base for which is more resilient in an aging society.

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Effective Social Security Contribution Rate: Illustrative Scenario

Citation: IMF Staff Country Reports 2007, 325; 10.5089/9781451818857.002.A001

1/ Dennis Botman and Dora Iakova, “Policy Challenges of Population Aging in Ireland,” Selected Issues Paper.

V. Banks Have Large Exposures to Property, but Big Cushions Too

20. The banking system continues to perform well, but rapid credit growth has led to vulnerabilities (Table 5). Reflecting the strength of the economy, the banking system is well-capitalized, profitable, and liquid, and nonperforming loans are low. However, bank lending to construction and real estate firms amounts to about 47 percent of GDP (Figure 1). Household debt now amounts to about 160 percent of household disposable income and, with most debt at variables rates, rising euro area interest rates have raised households’ debt burdens. While about ⅓ of the mortgages taken out by first time buyers in 2006 was at a 100 percent loan-to-value ratio, the average loan-to-value ratio is low compared to other countries and households’ financial assets far exceed financial liabilities. At the same time, as loan growth has outstripped deposit growth, banks have become more reliant on wholesale funding, which is more expensive and potentially more volatile than retail funding. However, banks also hold high levels of liquid assets. Looking forward, the slowdown in credit growth associated with the cooling housing market is expected to put some pressure on profits.

Table 5.

Ireland: Indicators of External and Financial Vulnerability

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

Represents non-euro debt of the government sector.

Includes lending for construction and real estate activities.

Credit equivalent values.

Owing to differences in classification, international comparisons of nonperforming loans are indicative only.

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

The methodology used to compile M3 has been amended in line with Eurosystem requirements. Therefore, there is a break in the series.

Nongovernment loans/nongovernment deposits ratio.

Figure 1.
Figure 1.