Ireland
Request for an Extended Arrangement-Staff Report; Staff Supplement; Staff Statement; and Press Release on the Executive Board Discussion.
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The economic and financial pressures facing Ireland are intense. The banking sector is at the fulcrum of Ireland’s problems. The program, therefore, aims to restore the banking system. It will address structural problems and restore confidence. A leaner and more robust banking sector is the major objective. The program provides support in the transition through additional capital to banks. The credibility of the banking system will be bolstered by stringent stress and diagnostic tests. The substantial risks to the program will need to be actively managed.

Abstract

The economic and financial pressures facing Ireland are intense. The banking sector is at the fulcrum of Ireland’s problems. The program, therefore, aims to restore the banking system. It will address structural problems and restore confidence. A leaner and more robust banking sector is the major objective. The program provides support in the transition through additional capital to banks. The credibility of the banking system will be bolstered by stringent stress and diagnostic tests. The substantial risks to the program will need to be actively managed.

I. Context and Objectives

1. The economic and financial pressures facing Ireland are intense. At the heart of the problem is Ireland’s banking sector, which is over-sized relative to the economy and holds sizeable vulnerable assets despite major support measures taken by the authorities. These deep-rooted structural problems have resulted in a marked erosion of confidence, leading to a loss of deposits and market funding, almost all of which in recent months has been replaced by ECB funding. These concerns have come to a head, as the banking sector’s woes have eroded the sovereign’s credibility at a gathering pace.

uA01fig01

The widening of sovereign spreads is reminiscent of the Greek crisis

Citation: IMF Staff Country Reports 2010, 366; 10.5089/9781455212897.002.A001

Source: Bloomberg.

2. With the banking sector at the fulcrum of Ireland’s problems, low growth, fiscal sustainability concerns, and banking vulnerabilities are feeding on each other.

  • The economic outlook is uncertain. The economy is undergoing a profound adjustment as the imbalances from the boom years unwind. Following a sharp fall in output in 2008–09, the pace of recovery is projected to be modest. Downside risks are significant, stemming from deflationary tendencies, overstretched balance sheets, and adverse fiscal and financial feedback loops.

  • The authorities have taken major measures to strengthen the banking sector but vulnerabilities remain acute. The National Asset Management Agency (NAMA) is taking over banks’ land and property development assets; substantial capital has been injected, and sovereign guarantees have been provided to reassure banks’ creditors. However, market pressures continue to pose challenges to the large rollover needs, threatening banking system solvency and placing a severe burden on the sovereign’s finances.

  • Continued large fiscal consolidation is needed to secure debt sustainability. Moving early, the Irish authorities implemented sizeable fiscal consolidation over 2009–10. However, public finances have been weighed down by a deep structural deficit, bank support, and weak growth. Public debt is, as a result, projected to end up close to 100 percent of GDP by end-2010. To help stabilize public debt, the authorities’ consolidation plan includes another €15 billion in consolidation measures over 2011–14, equivalent to 9 percent of GDP.

3. The program therefore aims to restore the banking system to health and, thus, snap the pernicious feedback loops between growth, fiscal, and financial instability. This requires a multifaceted approach:

  • A fundamentally restructured banking system that downsizes the banking sector (while addressing market perceptions of weak bank capital positions).

  • Safeguarding the fiscal consolidation plan to lower the deficit and debt over the medium term, with the burden of consolidation distributed fairly.

  • Institutional reform to improve the shock-absorbing capacity of the economy: a special resolution regime for banks, stronger supervision, and greater budgetary oversight.

  • Further reforms to improve the economy’s efficiency to enhance growth potential.

  • Large external financial assistance to manage the transition and reestablish much-needed policy credibility.

The stability thus generated—along with improved competitiveness and increased credit flows—would underpin a return of confidence, and, hence, brighter employment and growth prospects.

4. By restoring financial stability to Ireland, the contagion threat to other countries would be contained. The contagion threat from Ireland is significant. This risk arises principally because of the market’s perception that Ireland’s vulnerabilities are similar to those of other euro area peripheral economies. In contrast, the direct exposure of international banks to the Irish banking sector is much less salient than is sometimes inferred from the often-cited Bank of International Settlement statistics, which report aggregates that include Ireland’s sizeable international financial services (IFSC) industry. The largely self-contained IFSC has limited links to domestic banks and has not been a source of instability. The international exposure to domestic banks, particularly those covered by the Irish government’s guarantee, is, according to the Central Bank, a small fraction of the aggregate numbers. The contagion risk nevertheless is significant since banks across the periphery are perceived to face common vulnerabilities. Stress in the domestic banks also tends to weaken the sovereign’s credit. The evidence is that the Irish sovereign and banks’ weaknesses have been transmitted to other peripheral economies (Box 1). Looking ahead, the risk is that under high stress conditions, spillover effects to other peripheral euro area economies could be large and extend beyond the euro area. Also, while the Irish correlations with the U.K. and U.S. markets have not been notable recently, a disorderly eruption of financial pressures in Ireland could have wider implications through connections to those markets.

Spillovers from Ireland

Country-specific spillover risks from the Irish sovereign are significant. Ireland has strong financial linkages to the rest of the world and the contagion threat from Ireland could be significant. Given market perceptions, spillover effects to other peripheral euro-area economies could be large. Greece, Portugal, and Spain are the most vulnerable to volatility spillovers from an event in Ireland. Other euro-area sovereigns show negative country-specific cross-correlations, while Italy and Belgium appear like borderline cases.

Systemic tail risks from the large Irish banks are also elevated. Distress in both Allied Irish Bank and Bank of Ireland—the two largest Irish banks—would very likely be followed by distress in other European banks. The estimated conditional probability of distress in at least another European bank given distress in Irish banks is over two-thirds. This would particularly be the case for Greek and Portuguese banks.

uA01fig02

Country-specific conditional cross-correlations vis-á-vis Irish sovereign spreads

(June-September 2010)

Citation: IMF Staff Country Reports 2010, 366; 10.5089/9781455212897.002.A001

uA01fig03

Conditionnal probability that at least one European bank falls in distress given all Irish banks falling in distress

Citation: IMF Staff Country Reports 2010, 366; 10.5089/9781455212897.002.A001

Disorderly eruption of financial pressures in Ireland could have wider implications through foreign banks’ exposure to Ireland. German and U.K. banks have the largest exposure to Ireland (€113 billion and €107 billion, respectively), followed by U.S. (€47 billion), French (€36 billion), and Belgian (€24 billion) banks. As a percent of home country banking system assets, banks from Belgium (2.2 percent), Germany (1.8 percent), and the U.K. (1.3 percent) are the most exposed. However, global banks’ direct exposure to Irish sovereign debt remains very limited.

Portfolio investments are another potential channel of financial contagion. The countries with the largest portfolio investments in Ireland are the U.K. (€134 billion), Germany (€112 billion), France (€95 billion), and the U.S. (€83 billion). Relative to home country GDP, the most exposed countries are Portugal (18.8 percent), the U.K. (8.9 percent), Belgium (8.1 percent), the Netherlands (6.2 percent), Switzerland (5.9 percent), France (5.2 percent), and Germany (4.8 percent). The largest part of foreign portfolio claims on Ireland is generally in the form of long-term debt securities, with the exception of the US, Switzerland and Sweden where equity securities are more important.

II. Recent Economic and Political Developments

5. Following a precipitous fall, the economy is stabilizing. The economy contracted by 11 percent in real terms and 16 percent in nominal terms during 2008–09. Growth in the first half of 2010 was modestly positive but, with a large negative carry-over from 2009 and recent market turmoil, the 2010 GDP is projected by staff to be ¼ percent lower than in 2009. Recent concurrent and leading indicators show weak retail trade and sentiment measures. Consumer prices are expected to fall by a further 1½ percent this year, bringing the cumulative price decline to 6 percent. The fall in housing prices—36 percent since their peak—continues, but at a slowing pace.

uA01fig04

The correction in private sector credit continues

Citation: IMF Staff Country Reports 2010, 366; 10.5089/9781455212897.002.A001

Source: Central Bank of Ireland.
uA01fig05

Consumer sentiment and retail sales have fallen again in recent months

Citation: IMF Staff Country Reports 2010, 366; 10.5089/9781455212897.002.A001

Source: Central Statistics Office Ireland. ESRI

6. The domestic banking sector liquidity crisis remains acute. Banks have been unable to rollover large maturing bank obligations and deposit outflows—mainly commercial deposits—have continued. As a result, the banking system—at 500 percent of GDP—has become almost fully dependent on continued ECB liquidity support.1 Moreover, the Central Bank of Ireland provides emergency liquidity assistance (ELA) to banks where that is judged necessary.2

uA01fig06

Irish banks’ use of ECB liquidity support is eqiuvalent to 83 percent of GDP

Citation: IMF Staff Country Reports 2010, 366; 10.5089/9781455212897.002.A001

Source: Central Bank of Ireland and staff estimates.
uA01fig07

Banks’ debt issuance has come to a halt

Citation: IMF Staff Country Reports 2010, 366; 10.5089/9781455212897.002.A001

Source: Bloomberg.
uA01fig08

But remaining debt repayments are relatively small in 2011

Citation: IMF Staff Country Reports 2010, 366; 10.5089/9781455212897.002.A001

Source: Bloomberg.

7. The fragile banking system remains the key threat to public finances. The Irish authorities have taken strong and repeated action to counter the large structural deficit (Box 2). But while large adjustment needs remain, bank support has added to the fiscal burden. The deficit is expected to reach 32 percent of GDP in 2010, reflecting bank recapitalization of 20 percent of GDP. Government debt will reach 99 percent of GDP by end-2010. The government’s obligations to the financial sector have pushed spreads on government bonds to historic highs and significantly reduced market access for the sovereign.

8. Tackling the crisis has taken a political toll. Until recently, deep consolidation has been implemented in a remarkably socially-cohesive manner. This reflects a tradition of social partnership that has served well despite the difficult choices that have had to be made. However, with continued upward revisions of the consolidation needed and of the costs of supporting the financial sector, frustration has mounted. The government has announced it will call early elections. The ruling party, Fianna Fáil, is trailing in the opinion polls. The mission met with opposition parties and the main ones indicated broad support for the program objectives of achieving financial sector and fiscal stability, but indicated their interest in revisiting some of the policy approaches to achieve these objectives.

Government Support of the Financial Sector, September 2008–October 2010

The authorities’ extensive support has been vital to address financial stability concerns. The measures have been guided by the European Union framework for state aid. Also, access to ECB liquidity support has been an important stabilizing factor.

  • Government guarantees of domestic banks’ liabilities. A guarantee on the liabilities of seven banks was put in place in September 2008 under the Credit Institutions Financial Support Scheme (CIFS), which expired in September 2010. The CIFS covered all existing and new bank liabilities, excluding retail deposits covered by the statutory deposit guarantee scheme. A new scheme was put in place in December 2009, the Credit Institutions Eligible Liability Guarantee (ELG) Scheme, replacing the CIFS in covering newly issued bank liabilities. The ELG scheme covers senior debt and deposits with maturities of less than five years. The scheme has been extended through end-December 2011, and the EC has approved the extension through end-June 2011.

  • The National Asset Management Agency (NAMA) was established in late 2009, to take over banks’ distressed land and property development assets. The participating banks receive government-guaranteed securities in return for the assets. By August 2010, NAMA had acquired assets with a nominal value of some €27 billion, at an average discount of over 50 percent. NAMA is expected to complete its acquisitions by January 2011, in a total amount of €73 billion. The transfer of assets by the banks at a price below their book value implies that these banks will need additional capital.

  • Financing to boost banks’ capital ratios. In March 2010, the Financial Regulator determined a target capital ratio for banks of 8 percent for Core Tier 1 capital, of which 7 percent is to be equity capital, taking into account losses from NAMA transfers as well as expected losses on non-NAMA assets until 2012. Required capital injections also were set to ensure that banks Core Tier 1 capital remains above 4 percent in a stress scenario. During 2009–10, the government has provided capital injections of €45 billion.

III. Overall Strategy

9. The authorities’ program addresses head on Ireland’s key challenges:

  • Restoring the banking system to health. The banking system needs to be restructured and recapitalized. The program’s key objectives are, therefore, to reduce the size of the sector to a manageable level, separate good assets from bad, and reduce dependence on wholesale funding. The capital position of banks will also be bolstered under the program. These measures should help restore confidence in the system over time and allow for renewed access to market funding at reasonable costs. Once the process takes hold, the banking sector will be in a better position to meet the credit needs of the economy.

  • Underpinning fiscal sustainability. The program builds on the authorities’ own National Recovery Plan. This calls for large further frontloaded fiscal adjustment, with two-thirds of the adjustment coming from spending, and the remainder from revenues. This will in turn support Ireland’s medium-term public debt prospects. At the same time, important structural fiscal reforms will play an important role, including a new budget formation process, which comprises a new Fiscal Responsibility Law (medium-term spending framework), and a new Budget Advisory Council (independent budget assessment).

  • Securing sustainable economic growth. Ireland already has a competitive business environment. That said, the mutually-reinforcing problems of government (high deficit and debt), private sector (weak balance sheets), and the financial sector suggest that the economy will go through a prolonged structural adjustment phase that may lower growth prospects. The program aims to snap the pernicious feedback loops between these vulnerabilities by restructuring the banking system, restoring fiscal sustainability and putting in place new fiscal processes, as described above, and implementing other structural reforms (including reducing trade restrictions) that will copper-fasten Ireland’s growth prospects.

10. Substantial external financial assistance will provide support for these strategies. Ireland is expected to have a large balance of payments need over 2011–13, in particular, to finance the buildup of reserves to improve banks’ ability to meet their large external debt rollover needs and prevent substantial capital outflows. The program aims at gradually restoring market access, ensuring that any financial account shortfall is temporary. At the same time, the ECB would need to continue providing liquidity support to the domestic banking sector, as needed, over the course of the program.

11. The Fund-supported program has been formulated in close collaboration with the EC and the ECB. The EC and ECB have been involved in all aspects of the discussions, and helped contribute to a truly joint program with the authorities.

IV. Macroeconomic Framework

12. The economy is expected to stabilize and begin to recover in 2011. Staff projects growth to recover from -¼ percent in 2010 to 1 percent in 2011. Growth in trading partner countries, though moderating from 2010, will support a continued recovery of exports. Investment spending is projected to continue contracting—albeit at a moderating rate—reflecting the planned reduction in public infrastructural investment and the overhang of unsold residential and commercial properties. Unemployment is likely to persist at about 13½ percent in 2011 contributing, along with fiscal consolidation to a reduction of real disposable income. Offsetting these contractionary tendencies, the savings ratio, having reached record-high levels in 2010, could decrease as the limits of precautionary savings are reached. Despite this cushioning effect, private consumption is projected to fall by 1½ percent of GDP. However, these judgments are necessarily imprecise. The authorities expect smaller headwinds from fiscal consolidation and a greater fall in savings rate: hence, they project private consumption to remain flat through 2011. On this basis, they project growth to reach 1¾ percent in 2011.

uA01fig09

The savings ratio has reached a historical peak

Citation: IMF Staff Country Reports 2010, 366; 10.5089/9781455212897.002.A001

Source: Department of finance and staff projections.

13. Looking further ahead, the pace of economic recovery is likely to be modest. Compared to 6 percent over 2000–07, in the baseline program scenario, growth would average 2¾ percent over 2012–15. Even this modest recovery is subject to downside risks.

  • Exports will continue to lead the recovery helped by improved competitiveness and world trade growth. However, spillovers from the largely enclave exports sector to the domestic economy will be limited because of their heavy reliance on imports, their tendency to employ capital-intensive processes, and the sizeable repatriation of profits generated by multinational exporters. But to the extent that the domestic sector participates in the export recovery—and signs of this are emerging as traditional sectors exports are picking up—the spillover to domestic demand could be greater.

  • The large fiscal adjustment will remain a drag on consumption, as will the unwinding of home-grown imbalances from the boom years—leading to weak credit growth, continued weakness in property prices and wages, and high real debt burdens. A sizeable structural component will likely keep the unemployment rate above 10 percent to 2015.

  • Private investment could bottom out at 7 percent of GDP in 2010, compared to a historical average of 20 percent. While lower public spending will keep investment low, with the recovery of exports and the normalization of domestic demand, a modest rebound is expected in the private investment ratio to 10 percent of GDP by 2015.

uA01fig10

Domestic demand has fallen sharply and is likely to take time to recover

Citation: IMF Staff Country Reports 2010, 366; 10.5089/9781455212897.002.A001

Source: Statistics Office Ireland. and staff projections
uA01fig11

The unemployment rate has become high, with a substantial share of long-term unemployment

Citation: IMF Staff Country Reports 2010, 366; 10.5089/9781455212897.002.A001

Source: Statistics Office Ireland.

14. The authorities share staff’s view on the pattern of the recovery, but are somewhat more optimistic about the magnitudes. The divergence from staff’s projections continues through 2012 and then narrows in subsequent years. Again, the authorities see a larger scope for a fall in the private savings rate, as consumer confidence returns and labor market conditions improve.

15. Subdued inflation, below the euro-area average, will help competitiveness but act as a short-term drag on the recovery. Staff and the authorities agree that with substantial spare capacity in the economy and modest external price pressures, inflation rates are expected to be low over the coming years. However, with a continued contraction in consumer spending in 2011, staff projects a further fall in consumer prices of ½ percent. The authorities noted that exchange rate movements and energy price increase would prevent further price falls in 2011. Wage incomes fell on an annual basis by 2½ percent in the first half of 2010, and, looking ahead, are expected to increase more slowly than prices in the medium term, generating a real wage adjustment.

uA01fig12

Consumer prices are falling, despite a pick-up in inflation in other euro area countries

Citation: IMF Staff Country Reports 2010, 366; 10.5089/9781455212897.002.A001

Source: Eurostat.
uA01fig13

Both goods and service prices continue to fall on an annual basis

Citation: IMF Staff Country Reports 2010, 366; 10.5089/9781455212897.002.A001

Source: Statistics Office Ireland.

16. Staff expects that the positive impact on the current account of higher net exports will be partly offset by profits repatriation by multinational companies. The current account deficit has fallen sharply from 5½ percent of GDP in 2008 to 2 percent in 2010, largely reflecting a correction of the boom in domestic demand. Going forward, the correction is expected to continue as net exports lead the recovery. However, since much of Ireland’s exports are produced by multinationals, for which the value-added is to a large extent repatriated, factor income outflows will dampen the current account improvement. Furthermore, with high government and private sector debt, which is to a large extent held by foreigners and carries elevated interest rates, debt interest payments will represent a substantial current account outflow.

Ireland - Macroeconomic Projections

(Percentage change, unless otherwise indicated)

article image

Contributions to growth.

V. Returning the Banking System to Healthy Functionality

17. Banking sector vulnerabilities are concentrated in three key areas:

  • Low asset quality. The oversized domestic banks (text figure) are heavily exposed to the Irish property market, which has yet to stabilize. In September 2010, nonperforming loans were 12.9 percent of all loans and this ratio is expected to rise. Given the high levels of unemployment, cuts in real wages, and the heavy exposure to “tracker” and variable interest rate mortgages, investors are concerned that there may be unaddressed losses on non-NAMA assets, especially in residential mortgage lending (25 percent of private sector credit). Although official estimates suggest that only 10 percent of residential mortgages are either in arrears or have been rescheduled, banks’ loan portfolios might be impacted by a high level of forbearance (Box 5). Provisioning levels have also declined sharply in recent years (offset in part by bolstered capital). Finally, current low policy rates will, when raised, exert considerable pressure on variable rate mortgage holders.

  • Constant funding concerns. The cliff effect of maturing loans in last quarter of 2010 following the expiry of the original CIFS guarantee, uncertainties about the renewal of guarantees, and concerns about restructuring strategies of unsecured creditors have escalated problems with rolling over large wholesale funding needs.

  • Prolonged Anglo-Irish bank resolution. Although the bank was nationalized almost two years ago, it has sucked in ever-increasing public funds, and has served as a nagging reminder of the severe banking supervision deficiencies in Ireland and the poor state of Irish banks.

uA01fig14

18. In this context, the authorities and staff agreed that a comprehensive bank restructuring program is critical. There was a shared view that the objectives of this process would be to:

  • Isolate the viable banks and return them to healthy functionality by substantial downsizing and reorganization.

  • Support the transition to a downsized banking sector through recapitalization to reduce perceptions of weakness and encourage deposit inflows and market-based funding.

  • Reduce systemic risk and increase shock-absorbing capacity through stronger supervision and a special resolution regime for banks.

A. Downsizing and Reorganization

19. Comprehensive measures were agreed to achieve a substantial downsizing of the banking system over time. Banks will start taking several actions as they will be required to:

  • Unwind noncore assets (including operations abroad).

  • Quickly transfer the remaining vulnerable assets (land property and development loans) to NAMA (about €17 billion). This would require amendment to existing legislation to permit the transfer of assets in a block rather than on individual basis as presently required by law. Alternatively, the authorities are also considering speeding up the process to allow immediate asset transfers to NAMA at the current average haircut and then adjusting the price through ex-post single valuation.

  • Promptly and fully provision for all nonperforming assets as needed.

  • Deleverage additional specified portfolios as feasible, supported by credit enhancements. For example, particular portfolios of assets could be packaged for clean sale to third parties (i.e., not a government sponsored entity).

  • Distressed institutions, including Anglo-Irish Bank and Irish Nationwide Building Society will be resolved without compromising the interests of protected or secured creditors.

To ensure progress made, banks will be required to submit business plans demonstrating their explicit commitment to deleverage and restructure operations through clear periodical targets, which will be defined on the basis of criteria developed by the central bank in consultation with the EC, ECB and IMF.

B. Raising Capital Standards

20. The transition to a leaner and more robust system is to be navigated by setting higher capital standards and ensuring availability of financing to achieve them. In this regard, the following strategy is planned:

  • Promptly increase capital buffers. The central bank will enforce recapitalization of viable banks to achieve a capital ratio of 12 percent Core Tier 1 by end-February 2011.3

  • Stringent forward-looking assessment of capital needs. Stress-tests based on adverse scenarios (PCAR 2011) and a diagnostic of current asset valuations (Boxes 3 and 4) will be initiated to thoroughly review the capital needs of banks over a horizon of three years. All key details of these new stress tests will be communicated transparently to enable market participants to assess the results. Following this assessment, a capital ratio of 10.5 percent Core Tier 1 would become the new regulatory minimum. This ratio would place the banks in the league of well-capitalized peers and would be a move towards Basel III standards.

  • Taking into account the overall resources available to the authorities, including from the EU-IMF financing, the authorities will have adequate funds to meet needed recapitalization. Under the program, the authorities have a notional buffer of about €35 billion to support the banking system. The actual amount used is expected to be less than this buffer. In the first instance, up to €10 billion would ensure the immediate recapitalization of banks up to 12 percent in Core Tier I capital and the remaining €25 billion would be available on a contingency basis to maintain a capital ratio of 10.5 percent of Core Tier I capital under a stress scenario.

21. Banks’ funding risk is currently alleviated by the extension of the government guarantee until December 2011, but markets may require a longer period of security. The ECB has endorsed the authorities’ view that extending the guarantee is needed for financial stability purposes and the EC has agreed that stability would be given precedence over competition considerations. Currently, the extension has been approved by the European Commission through the end of June 2011. The need for further extension of the guarantee, perhaps on a more limited basis, will need to be assessed in due course. The strengthening of banks’ balance sheets under the program would also facilitate Eurosystem liquidity support for banks with improved solvency prospects and collateral.

Methodology to Conduct a Second Stress Test Exercise (PCAR 2011)

Phases: The stress test will take place in two phases. The first stage, planned to be completed by the end of March 2011, will involve the 6 largest domestic banks. Credit unions and subsidiaries of foreign banks will be considered in the second phase, planned to be completed by the end of June 2011.

Definition of parameters and scenarios. The central bank will define the detailed criteria to run the revised stress test by end-December 2010, in consultation with EC, ECB, and IMF staff. Staff and the authorities have agreed to include interest rate and exchange rate risks as additional criteria to ensure banks will hold sufficient capital to absorb losses stemming from banks’ maturity gaps.

Capital targets. Banks will have to meet a minimum Core Tier 1 ratio of 10.5 percent under the baseline scenario (compared to the 8 percent under PCAR 2010) and a minimum Core Tier 1 ratio of 6 percent under the stress scenario (compared to 4 percent under PCAR 2010). The time horizon of the exercise will be 2011–13.

Approach. The stress-test will include a top-down component and a bottom-up component. The top-down component will consist of a macroeconomic scenario developed by the Irish central bank aimed to be consistent with the EU-wide stress test conducted by CEBS/EBA, with additional specifications to adapt the framework to the local economic conditions including, as feasible, taking into account special features of the credit union model. The bottom-up analysis will also include targeted loan reviews, benchmarking of collateral valuations, reviewing provisioning methodologies and approaches to workout/liquidation. The final assessment will be based on the most conservative results from the top-down and bottom-up approaches.

Probability of default. The probability of default for different portfolios and loss given default will be estimated based on both the top-down and the bottom-up components of the stress test.

Liquidity risk. The exercise will review the funding mix and related costs, also through benchmarking across institutions. An analysis of the impact of possibly higher funding costs will be carried out by the authorities. In this context, elements such as credit rating downgrades, contingent liabilities management, contingency funding plans, impact of divestments and restructuring will form part of the analysis.

Transparency on results. Disclosure of the final results and methodology are important elements to enhance market confidence about the robustness and comprehensiveness of the overall exercise. Proper communication of any needed related action would also need to be addressed.

Initial Terms of Reference for Data Quality and Asset Quality Diagnostic Review

Objective: Support the new PCAR with a thorough and in depth due diligence of the integrity of the banks’ financial reporting and the quality of banks’ assets.

Principles. The exercises will be conducted in line with four principles: (i) the diagnostic study should not be conducted by an audit or consultancy firm that has provided such services to the bank in the last three years. The central bank should also contract a specialized firm to help staff to oversee the consistency and integrity of the exercise; (ii) these examinations should cover all relevant assets, liabilities and off balance sheet items, including foreign subsidiaries when relevant. They should provide a thorough assessment of the adequacy of monitoring and reporting of all relevant risks (credit, market, foreign exchange, liquidity and operational risks); (iii) strict benchmarks should be used similar to those regularly used to assure the quality of the due diligence processes; and (iv) to ensure transparency, the third party independent reports should be made public on the website of each individual institution as well as on that of the central banks as soon as the PCAR 2011 process is completed.

General scope and benchmarks of the review

Data validation

The validation process would seek to ensure that data is properly compiled, processed and reported. In particular, this exercise will verify the integrity of the banks’ internal process in the following fronts: (i) information technology, (ii) accounting of earnings; and (iii) reporting and disclosures.

The review should be comprehensive and conducted on the basis of internationally accepted methodologies. It should adequately cover bank’s activities (assets, liabilities, off-balance sheet, and reporting of bank risks) including those of their subsidiaries and affiliates.

Asset quality validation

This component includes an assessment of asset quality in accordance with a methodology that seeks to identify the recoverable value of assets through the economic cycle, in net present value terms.

The asset diagnostic process would assess the quality of assets and the effect on the bank’s capital of any related adjustment. It would cover not only loans but all other material exposures of banks’ (on and off-balance sheet) and their investment portfolios.

Review of terms of reference and asset valuation methodology. The development of the terms of reference by the central bank and of the asset valuation methodology by the consulting firms will be carried out in consultation with EC, ECB and IMF staff.

Reporting and disclosure. The assessors’ report should provide to the central bank (i) a factual summary of their findings and recommendations to address existing operational and data integrity weaknesses; (ii) the necessary adjustment based on the verification process and the effect of these adjustments on the bank’s reported regulatory capital. The main findings will also be made public.

C. Reducing Risk and Increasing Shock Absorption Capacity

22. Steps are also being taken to address institutional weaknesses that were uncovered at the onset of the crisis. They will contribute to make the overall financial system more robust:

  • The government remains firmly committed to strengthening banking supervision, a critical failing in the lead up to the crisis. Staffing levels and budget allocations will be substantially increased. Top level management at the supervisory authority has been changed. In addition, the authorities have announced an enhanced risk assessment framework, strict corporate governance standards, and the reorganization of the supervisory board structure. An independent assessor will take stock of progress as well as compliance with Basel Core Principles for effective banking supervision.

  • The authorities are preparing legislation to establish a comprehensive bank resolution framework, drawing on proposals under discussion at the European level and recent legislative reforms such as in the U.K. and Germany. The authorities share staff’s view that broader resolution tools with stronger powers for the central bank will enhance their ability to deal with distressed institutions in future. In particular, the draft legislation will provide for the appointment of special managers to perform the function of senior management and the bank’s board, the ability to transfer assets and liabilities, and the establishment of bridge banks. Further, the new regime needs to be linked with the liquidation framework.

  • The personal insolvency regime will be substantially reformed. Despite steps taken to eliminate some of the rigidities in the current court-based bankruptcy framework by reducing the discharge period from 12 to six years (at the court’s discretion), the authorities agree that broader legal reform is needed. Once the Law Reform Commission has presented its final report in December 2010 legislative drafting will commence as a matter of priority. The reforms could include the establishment of a new debt enforcement office to administer an alternative non-judicial debt settlement and enforcement mechanism, while minimizing moral hazard. The authorities estimate that initial uptake of the improved in-court and new non-judicial proceedings will be significant given the extent of household financial distress.

Ireland—Residential Mortgages

Irish households are increasingly under pressure to meet their residential mortgage and other debt obligations. Current central bank data indicates that about 40,000 residential mortgages (close to 5.1 percent) are in arrears. Moreover, it is estimated that about 45,000 mortgages have been rescheduled under a voluntary scheme so far, bringing the total of mortgages in distress to more than 70,000, given the overlap between the two categories. The number of mortgages in arrears has been rising steadily, fueled by high unemployment and growing economic stress on households.

Interest rates for “tracker” mortgages linked to the ECB main refinancing rate remain low, but additional pressure may arise should this interest rate increase. About half of the banks’ residential mortgage book are “tracker” mortgages, most of which were originated since 2006. Many mortgages for investment properties are also “tracker” mortgages now reaching thresholds that require the repayment of principal (following interest-only periods during the first five years). Given the significant fall in real estate values, many households are also faced with negative equity, thereby limiting mobility. First time buyers who bought at the height of the real estate boom in 2006/2007 are particularly vulnerable.

Mortgage restructurings are guided by the Central Bank’s Code of Conduct on Mortgage Arrears and the Irish Banking Federation’s voluntary Operational Protocol. The Code of Conduct applies to mortgages on the principal private residence and sets out a restructuring framework for borrowers unable to pay (mostly in the form of a rescheduling), including a moratorium on repossession for 12 months. The Code of Conduct is currently under revision to strengthen procedural protections and is expected to be issued shortly. Under the Operational Protocol, banks are encouraged to reach agreement with borrowers on an affordable and sustainable repayment plan, often assisted by a Money Advice and Budgeting Service advisor (state-funded debt advisory service).

Several financial support programs are in place to assist homeowners, though these should only target the neediest. Mortgage interest supplement (MIS) provides short-term support during periods of unemployment or reduced income and the number of recipients has more than doubled since 2008 to 17,800 in November 2010. MIS appears to facilitate rescheduling arrangements to “interest only” repayment plans. The authorities intend to centralize the administration of MIS to ensure more consistent application of relevant ceilings. Further, the authorities grant mortgage interest tax relief for recent vintage mortgages and affordable housing support by local authorities.

Acknowledging that further measures are necessary, while limiting moral hazard, the authorities seek to implement some of the measures recommended by an expert group. The final report by the Mortgage Arrears and Personal Debt Group recommends the introduction of a Deferred Interest Scheme (DIS) for mortgages deemed sustainable. The DIS would allow the deferral of up to one third of interest payments for up to five years or when 18 months deferred interest has accrued, whichever comes sooner, with no interest accruing on the deferred interest portion. Unsustainable cases would require trading down or voluntary surrender of the residence. However, should more households seek access to social housing the demand will likely exceed supply. Moreover, given the extent of household distress and the remaining personal liability for any mortgage amounts not recovered in a foreclosure proceeding, it seems essential to develop a comprehensive personal insolvency regime, a step also under consideration by the authorities.

VI. Safeguarding Public Finances

23. From the onset of the crisis, the authorities took strong fiscal adjustment measures to address debt sustainability concerns. The structural deficit, adjusted for the impact of asset prices, reached 12 percent of GDP in 2008. As the financial crisis unveiled Ireland’s large underlying imbalances, the authorities immediately implemented large deficit-reducing measures and set out strong medium-term consolidation targets. Overall, the measures implemented during 2009–10—a time when most Euro zone countries were providing fiscal stimulus—amounted to 6.3 percent of GDP (8 percent of GDP in full year terms).

24. Weak growth and banking distress have, however, placed a greater burden on public finances than previously anticipated. Large, post-boom deficits and major bank support have added substantially to the debt stock, leading the government to rightly conclude that additional deep fiscal consolidation is critical.

uA01fig15

Ireland moved early to consolidate, while most euro area countries were providing stimulus.

Citation: IMF Staff Country Reports 2010, 366; 10.5089/9781455212897.002.A001

Source: IMF Fiscal Monitor, November 2010.

A. Consolidation Strategy

25. The program aims to preserve fiscal sustainability while mitigating adverse effects on growth. The planned consolidation over 2011–14, laid out in the authorities’ National Recovery Plan, is broadly appropriate. However, staff expects GDP growth outcomes to be weaker than those currently foreseen by the authorities and hence the deficit ratio to fall more slowly than envisaged under the plan. Reflecting this reality, the European Commission recently extended by one year the deadline for meeting the Stability and Growth Pact deficit threshold of 3 percent of GDP to 2015. This helps defer the authorities’ obligations to the Stability and Growth Pact. However, under staff’s current projections, achieving the new target is likely to need further measures in the medium term.

General Government Finances 1/

(In percent of GDP)

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Sources: Department of Finance and staff estimates.

The general government numbers fully incorporate IMF/EFSF financing, including bank recapitalization under the program.

26. The envisaged consolidation is necessary to put the debt-to-GDP ratio on a downward path. The combination of low growth and inflation, and a high fiscal deficit are likely to continue to push up the debt ratio in the coming few years. However, the comprehensive structural measures under the program will yield a permanent reduction in spending and a more stable revenue base in the medium term. The debt ratio is expected to start declining by 2014 on account of an improvement in the structural primary balance (by more than 8 percent of GDP between 2010 and 2015) and the convergence of nominal GDP growth rates to the implied average interest rate on public debt.

uA01fig16

Debt is expected to stabilize at a high level

Citation: IMF Staff Country Reports 2010, 366; 10.5089/9781455212897.002.A001

Source: Department of finance and staff projections.

27. Debt dynamics would improve if the recapitalization requirement remains contained. Staff estimates suggest that it is unlikely that bank capitalization needs will exceed €35 billion. If that amount is needed, the authorities would use their own resources of up to €17.5 billion and €17.5 billion would be added to sovereign debt. In this conservative baseline scenario, the debt ratio would peak at 125 percent of GDP in 2013. If the needs are lower, as is currently anticipated, less financing under the overall program will be required. In this case, the government can use its liquid assets to cover the budgetary financing needs, also reducing the debt. In a scenario where capitalization needs are €25 billion, debt would peak at 119 percent of GDP in 2013, and if only the initial €10 billion is required, debt would peak at 109 percent of GDP.

uA01fig17

The baseline scenario is based on a cautious assumption of need for bank support

Citation: IMF Staff Country Reports 2010, 366; 10.5089/9781455212897.002.A001

Source: Staff projections.

28. The sovereign’s obligations will also be lower if the debt owed by banks is restructured. For Anglo Irish, which is a nationalized bank, a debt exchange at a discount of about 80 percent is ongoing. This operation reflects the view that subordinated debt is designed to be loss absorbing and where a bank has lost substantial value—and, indeed, insolvent—the debt holders should share in the losses. Further such action is contemplated for banks that have received substantial state assistance, and would help reduce the need for fresh injections of capital by the government. Both the authorities and the staff noted that the decision to share losses with creditors should, in principle, be based on the extent of the banks’ overall losses and the need to return the bank to a more stable funding structure, while keeping in view the knock-on effects on others.

B. The National Recovery Plan and Program Targets

29. The authorities’ National Recovery Plan forms the basis of the fiscal program. The plan provides for €15 billion (9 percent of GDP) in budgetary savings over 2011-14, almost twice the level envisaged in the December 2009 Stability and Growth Pact Update. The adjustment is front-loaded—with €6 billion (3.5 percent of GDP) in savings expected in 2011 alone, and focused on expenditure reductions, which account for about two-thirds of the effort through 2014.

uA01fig18

The consolidation is front-loaded and expenditure-based

Citation: IMF Staff Country Reports 2010, 366; 10.5089/9781455212897.002.A001

Source: Staff projections.

30. Budget 2011, including adjustment measures of €6 billion, is set for parliamentary approval on December 7. Although about €0.7 billion worth of measures are of a one-off nature, and despite the reliance on capital expenditure cuts in 2011, the measures are broadly durable and of high quality. One-third of the adjustment (€1.8 billion) will come from capital spending, including due to better value-for-money infrastructure procurements. The current spending effort will be led by savings of €1.2 billion in payroll and discretionary expenditure, reflecting (voluntary) public service numbers reductions of about 8,000 (2¼ percent of the payroll); a 10 percent salary reduction for new entrants; an average 4 percent cut in public service pensions, graduated according to pension level; and other efficiency savings.4 On social welfare, the authorities intend to reduce universal and, hence, nonprogressive benefits, and reform working age payments and associated job search conditionality to lower the risk of poverty and inactivity traps for the long-term unemployed. These measures are expected to yield €0.9 billion, about one-sixth of the planned 2011 consolidation. As such, the adjustment takes due regard of Ireland’s strong system of social protection.

31. A revenue package—sized at €1.4 billion—widens the base for income tax and raises its progressivity. Through a 10 percent reduction in personal income tax bands and credits, and an integration of the health and income levies, budget 2011 will seek a positive contribution from part of the 45 percent of households that were hitherto exempt from income tax, while removing non-progressive exemptions enjoyed by certain groups. The remaining measures will build on the progressive packages already implemented in 2009–10. In particular, the authorities intend, inter alia, to withdraw various tax reliefs on private pension contributions, lower the tax-allowable ceiling for such contributions, eliminate other income tax expenditures, and further strengthen capital taxation. These include the withdrawal of various tax reliefs on private pension contributions, a lowering of the tax-allowable ceiling for such contributions.

32. The 2011 program targets allow accommodation of risks to growth. Staff and the authorities agreed that the traditional budgetary aggregate—the exchequer balance (excluding net interest payments and costs arising from bank support operations in the context of the program) should serve as the performance criterion. The authorities were confident about meeting the end-2010 target, based on revenue and expenditure outturns through November. For 2011, the targets are derived from the measures approved in budget 2011 and staff’s macroeconomic projection. If growth is lower than projected by staff, the program does not require spending cuts to offset underperformance from prudent revenue projections, which would otherwise further weaken demand. In parallel, and to secure debt sustainability, the program requires that any revenue over-performance be saved. It will be critical that the tax administration has continued adequate funding and technical capacity to effectively implement the planned tax policy changes and counteract lower compliance pressures due to the recession.

Fiscal Consolidation Measures in 2009–10 and in the National Recovery Plan

(Announced net yields in € billions, relative to pre-budget positions)

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33. The plan details a number of high-quality fiscal measures over the medium term. A major reform on the revenue side is the planned introduction, by 2014, of a site-value tax on residential property that will provide a stable source of local government revenue. Indirect taxation is to be strengthened through phased increases in VAT and carbon tax rates, starting 2012-13, and a tightening of VAT subsidies. On the expenditure side, the plan envisages progress toward full cost-recovery in the provision of water services and tertiary education, while protecting lower-income groups through means-tested support schemes. Indicative ceilings by Vote Group have been set to anchor further efficiency savings in payroll, capital and discretionary current spending; while welfare reductions are expected to obtain via a reform of child and disability benefits, and the introduction of a single means-tested social assistance payment for working age people.

34. In sum, the plan strikes a reasonable balance between several competing considerations and thus provides a good basis for the fiscal program. First, the size and phasing of the package has resonated well with market anticipation of its debt reduction effect. Second, the inclusion of labor market activation measures is growth friendly and ameliorates concerns about the impact of the consolidation on domestic demand. Third, the plan achieves a suitable balance between equity and efficiency: proposed spending efficiencies of €7.1 billion are complemented by relatively progressive direct tax increases of €4.1 billion, while planned welfare cuts are focused on universal and employment-inhibiting benefits. Finally, the focus on expanding the tax base and cultivating new sources of revenue is appropriate given that volatile revenues were a key contributor to fiscal stress during the crisis.

C. Institutional Reforms for Fiscal Sustainability

35. To entrench fiscal credibility, the authorities are preparing a fiscal responsibility law (FRL). In line with staff’s earlier advice, the law will provide for:

  • A medium-term budgetary framework, including binding multi-year expenditure ceilings by department. A formal multi-annual budgetary framework enshrined in the FRL can lend greater credibility to these ceilings, and thus, reduce the uncertainties associated with consolidation.

  • A fiscal institutional framework. To reinforce the commitment to sustainable public finances, the authorities will adopt a fiscal rule to provide a post-consolidation anchor for fiscal policies. Staff welcomed the proposal, and noted that the fiscal rule should have broad coverage and be easy to monitor. The authorities are also establishing a budget advisory council to assess fiscal policies and forecasts, and highlight long-term risks to public finances. These mechanisms would further enhance policy credibility.

36. The authorities are planning to reform key pensions parameters to avert potential risks to long-term debt sustainability. Ireland’s ageing-related spending profiles compare well vis-à-vis other OECD economies. However, the surge in spending on public service and state pensions in recent years has alerted the authorities to move early and decisively on this front. Consistent with the National Pensions Framework (published in March 2010), the authorities are planning to introduce legislation in 2011 to increase the pension retirement age from 65 to 66 by 2014, 67 by 2021, and to 68 by 2028. For new entrants into the public service, pension entitlements will be linked to average career earnings and annual increases indexed to consumer prices. Over the medium-term, the authorities also intend to review the indexation regime for state pensions.

uA01fig19

Projected Increases in Government Spending on Health and Spending are Low Relative to Advanced Economies

(change in relevant expenditure in percentage points of GDP, 2010–30)

Citation: IMF Staff Country Reports 2010, 366; 10.5089/9781455212897.002.A001

Source: IMF Fiscal Monitor Database.

VII. Structural Reforms to Raise Efficiency and Growth Potential

37. The key fiscal and financial structural reforms described above are essential to improving the prospects of economic recovery and raise the medium-term growth potential. The financial sector measures—improved banking supervision, a new bank resolution framework, and a new personal insolvency regime—will strengthen the resilience of the financial system and improve its capability to handle the challenges associated with the crisis. The fiscal reforms—medium-term budgetary framework and institutional reforms—should help to strengthen the credibility of public finances.

38. Other reforms will also help the reorientation of the economy and address the large medium-term adjustment needs. Ireland consistently ranks among the top 10 countries for ease of doing business. As such, there are no “low-hanging” fruit for reforms with quick and easy dividends. Nevertheless, the National Recovery Plan includes a strategy to remove remaining structural impediments to competitiveness and employment creation. Building on this Plan, the program focuses on measures relating to competition in product and services markets, labor market reform, and the management of government assets and liabilities (Box 6).

Reducing Impediments to Competitiveness and Employment Creation

The government will introduce legislative changes to remove restrictions to trade and competition, especially in sheltered professions. The scope of competition law will be broadened to encompass all sectors; and legislative amendments proposed to enable the imposition of financial and other sanctions in civil law cases relating to competition. An independent ombudsman to promote and oversee competition in sheltered sectors will be established. In addition, for the legal profession, a package of measures will aim to reduce legal costs; and for the medical profession, restrictions on the number of qualifying general practitioners (GPs) and on the number of patients that newly qualified GPs can treat will be removed. For the pharmacy profession, it would be important to fully enforce the recent elimination of the 50 percent mark-up paid on medicines under the State’s Drugs Payments Scheme.

Labor market reforms will aim to reduce the unemployment rate. The authorities are considering reforms of unemployment benefits with a view to reducing inactivity and unemployment traps, especially for unskilled workers. In particular, the reforms are likely to seek an adjustment in the replacement ratios facing the long-term unemployed; and an improvement in activation procedures to strengthen job search conditionality. These improvements would occur via better identification of jobseekers’ needs, and increased counseling activities at the beginning of the unemployment spell; more effective monitoring of jobseekers’ activities with regular evidence-based reports; and a mechanism for credibly sanctioning noncompliant beneficiaries. Concurrently, the authorities also intend to lower by €1 (to €7.65) the national minimum wage, which remains high by OECD standards, followed by a review of sector-specific minimum wage agreements, with a view to their elimination.

Other reforms aim to support the expansion of domestic businesses and aim for convergence toward cost recovery for public services. The authorities intend to improve efficiency by ensuring that investment is better targeted at key strategic road projects and maintenance which, inter alia, should have cost-reducing knock-on effects on the retail sector. A 15-day payment rule for goods and services received by public administrations will be extended beyond government departments to the wider public sector, which should help small businesses. Among public services: domestic water will be metered and charged by 2014 and the industry overseen by a water regulator; for the energy and gas sectors, the government will undertake an independent assessment (building on the forthcoming report of the Review Group on State Assets & Liabilities), with a view to enhancing their efficiency, including through possible privatization of state-owned assets.

VIII. Program Modalities

A. Access and Conditionality

39. The Irish authorities have requested a sizeable financing package to support their efforts to get their economy back on track. The overall size of the financing package is €85 billion (about US$113 billion). Of this, the European Union and bilateral European lenders have pledged a total of €45 billion (about US$60 billion). The Irish authorities have decided to contribute €17.5 billion to this effort from the nation’s cash reserves and other liquid assets. The Fund’s contribution would be through a three-year SDR 19.5 billion (about €22.5 billion; or US$30 billion) arrangement, representing 2,321.8 percent of quota. The European disbursement and repayment terms would be aligned to those under the EFF.

40. Staff proposes a three-year Extended Arrangement under the Extended Fund Facility. Ireland’s balance of payments need is medium-term in nature and will not be resolved within the repurchase periods provided for under the credit tranche policies. It will require medium-term structural reforms to complete financial sector restructuring and unwind a private and public sector debt overhang, which would be more appropriately dealt with through the EFF. However, the program would be anchored by a strong fiscal adjustment process, and a sovereign return to market would be expected in due course. If market spreads were to decline faster than envisaged, program assumptions will be reviewed as part of the quarterly reviews. The proposed structural conditionality would focus on measures to safeguard financial stability, ensure an adequate bank restructuring process, and enhance the fiscal framework.

41. Ireland is facing a balance of payments need comprising of: (i) a financial account deficit arising, in particular, from rollovers of external government debt and outflows from Irish banks; (ii) a smaller current account deficit reflecting the legacy of lost competitiveness, which will only gradually be regained; and (iii) the need for the authorities to strengthen their reserve holdings in order to meet the government’s external debt obligations as they come due and, through shoring up confidence, improve banks’ ability to meet their large external debt rollover needs (by attracting deposits and market funding) and prevent substantial capital outflows.

42. Conditionality is focused on key vulnerabilities and aimed to shore up confidence in the short run and strengthen the policy framework in the medium term.

  • Quantitative targets. The quantitative conditionality includes a performance criterion on the central government cash primary balance and an indicative target on central government net debt. In line with Fund policies, a continuous performance criterion on the non-accumulation of external payments arrears is also included. These performance criteria are described in Table 1 attached to the MEFP.

  • Structural benchmarks. The structural conditionality is focused on measures to strengthen the fiscal framework, safeguard financial stability, and ensure an adequate bank restructuring process and the design of a comprehensive bank resolution framework. On the fiscal front, the government will introduce a fiscal responsibility law providing for binding multi-annual expenditure ceilings by area, and establish an independent budgetary council. These measures are described in Table 2 attached to the MEFP.

B. Exceptional Access Criteria

43. Exceptional access would be required under the program in light of the large projected financing gap. Staff’s assessment is that Ireland meets all four criteria for granting exceptional access, namely:

  • Criterion 1: Exceptional balance of payments pressures in the capital account: The member is experiencing or has the potential to experience exceptional balance of payments pressures on the current or capital account resulting in a need for Fund financing that cannot be met within the normal limits. Ireland is experiencing substantial capital account pressures arising from acute liquidity pressures. Heightened market concerns have prompted rating downgrades and sharp increase in sovereign spreads which, in turn, have restricted market access to an extent that would make it impossible to cover financing needs within normal limits. The banking sector’s rollover requirements on maturing external obligations and an accelerated deposit outflows could result in further pressures on the capital account. Absent the necessary backstopping of exceptional financing from the euro area and the Fund, the authorities have limited scope to stem additional flights of capital.

  • Criterion 2: Sustainable debt position: A rigorous and systemic analysis indicates that there is a high probability that the member’s public debt is sustainable in the medium term. However, in instances where there are significant uncertainties that make it difficult to state categorically that there is a high probability that the debt is sustainable over this period, exceptional access would be justified if there is a high risk of international systemic spillovers. Prior to March 2009, Ireland had an AAA rating on its sovereign debt. But the financial crisis exposed vulnerabilities (overstretched private sector balance sheets, outsized banking sector, high dependence on foreign financing) and led to large banks’ losses, thereby increasing the need for government support for recapitalization and placing the public debt-to-GDP ratio on an unsustainable path. However, the development of a comprehensive bank restructuring strategy, the potential for asset recoveries, and a resolute medium-term adjustment program, should all help reduce the government debt back to sustainable levels in the medium term. Even though uncertainties around such a debt path make it difficult to state categorically that this is the case with a high probability, Fund support at the proposed level is justified given the high risk of international systemic spillover effects (see also paragraph 4).

  • Criterion 3: Access to private capital markets: The member has prospects of gaining or regaining access to private capital markets within the timeframe when Fund resources are outstanding. Ireland’s impaired access to capital markets reflects heightened sustainability concerns linked to acute funding pressures in the banking sector. A broad restructuring strategy for the banking sector should limit the fiscal burden and restore the banking sector to health, while the exceptional financing provided by European partners and the Fund is expected to drastically reduce debt default risks and normalize access to capital markets within the maturity of EFF resources.

  • Criterion 4: Strong policy reform program: The policy program of the member country provides a reasonably strong prospect of success, including not only the member’s adjustment plans but also its institutional and political capacity to deliver that adjustment. The program risks are substantial, not least because of the sheer scale of the banking crisis and the large uncertainties about its resolution. At this juncture, it is extremely difficult to gauge the potential for further capital outflows. The program is designed to mitigate these risks by concentrating conditionality on the banking sector, while launching an ambitious medium-term program of economic and fiscal reforms. Ireland’s sound institutions and consensus-based approach should underpin the proposed program and staff’s judgment is that the program has reasonably strong prospects of success.

C. Capacity to Repay the Fund and Risks to the Program

44. Ireland’s capacity to repay the Fund will remain satisfactory under an Extended Arrangement. Given this is Ireland’s first drawing of Fund resources, Fund’s cumulative exposure will remain high but manageable by the end of the program. Outstanding credit to the Fund is expected to peak in 2013-14 at about 2,320 percent of quota, and peak debt service to the Fund as a ratio of exports of goods and services will be 2.0 percent in 2017. Government debt could peak at an elevated level (125 percent of GDP) and the combined repayment for Fund/EFSM/EFSF financing will be large. However, fiscal adjustment and the resumption of growth are expected to place the debt on a declining path from 2013 onwards. Lower bank capitalization needs than projected in staff’s conservative baseline scenario would also lower the peak debt ratio.

45. That said, the risks to the program remain high:

  • Growth may be weaker than projected. The gradual recovery of the economy might not materialize as envisaged. Although the debt sustainability analysis indicates that a moderate shock could be accommodated, a prolonged period of deep recession could weaken loan repayment capacity of households and businesses and increase bank losses beyond current projections, leading the economy into a negative spiral. Analogously, wage and price deflation—coupled with contraction in activity—could have a powerful negative effect on debt dynamics.

  • The fiscal outlook might deteriorate, opening a larger financing need. The side effects of the adjustment could make fiscal consolidation more difficult than currently envisaged and lead to sharp reductions in tax revenue.

  • Reversing the financial sector deterioration might be difficult. Low growth, deteriorating asset quality, and higher funding costs could all weigh on the banking sector. There is also a real risk of a disorderly disruption of financial pressures, which might delay the expected recovery.

  • Political risks are considerable. Adhering to the fiscal targets and restructuring the financial sector require strong political will and public support. Despite the consensus-building approach toward the program, the likely change in government in early 2011 increases the political risks. In this context, the mission met with a range of social partners and political to outline key elements of the program and obtain their views.

  • Access to capital markets might take longer than expected. Ireland’s access to private capital market might be even more delayed than what has been assumed under the program, particularly under any of the adverse shocks shown in the debt sustainability analysis.

46. In accordance with Fund policy, staff has initiated a safeguards assessment of the Central Bank of Ireland, expected to be completed by the first review. IMF funds will be deposited in the government account at the Central Bank of Ireland (CBI). The CBI publishes its annual financial statements, which are independently audited in accordance with international standards. The most recent audit opinion for 2009 was unqualified.

IX. Staff Appraisal

47. The program is designed to address deep-rooted structural problems and, concurrently, restore confidence in the Irish economy’s future. The critically-weakened banking sector can be returned to health only at a calibrated pace. That is also the case for reversing the structural fiscal problems. While it is essential that the authorities move ahead with continued resolve, too rapid a speed could either undermine the process or create heavy short-term costs. The structural challenges for raising growth are less daunting. But growth is held back by the weakness of the banking sector and public finances. The interacting vulnerabilities create feedback loops that place the economy in a low-growth equilibrium, and hence especially susceptible to domestic and external shocks. By addressing the core structural challenges, the expectation also is that confidence will gradually return—and place the economy on a more dynamic path with better shock-absorbing capacity.

48. A leaner and more robust banking sector is the first major objective of the program. The tools to do so are clear—disposal of noncore assets, further transfer of land and property development loans to NAMA, and sale of asset portfolios (possibly through credit enhancements). Also, the banks that are evidently nonviable need to be wound down while transferring their deposits to safer, viable banks. Achieving this objective will require an orderly process—skillful execution will be essential to success.

49. Because this process will be drawn out—and entails short-term risks—the program provides support in the transition through additional capital to banks. The additional capital will be used to raise and maintain higher bank capital-asset ratios. These higher ratios are to be guided by those achieved by peers in other countries, but with an eye to the higher standards under Basel III. These higher standards are being increasingly seen as the norms by financial markets.

50. The credibility of the banking system will be bolstered by stringent stress and diagnostic tests. To account for the deterioration of the economy since the last stress tests, new tests will be complemented by a careful diagnostic of the underlying asset values. Bank capitalization based on this analysis should reassure markets that banks are adequately capitalized to deal with the further risks that they face. By thus credibly achieving the capital standards, ahead of the schedule demanded by Basel III, the expectation is that financial markets will acquire greater confidence in those Irish banks that are deemed to be viable. As such, while the program does not directly provide liquidity to banks, the confidence generated should enable over time banks to attract deposits and market funding. Meanwhile, liquidity support from the ECB will be an essential component of the program.

51. The fiscal strategy is based on the authorities’ recently published National Recovery Plan. The plan makes a number of pragmatic choices. These should help achieve sustainability of public finances, while paying appropriate regard to a social safety net. The Plan balances the need to press ahead with consolidation but without unduly damaging short-term economic prospects. It emphasizes expenditure reductions to increase the likelihood that the consolidation is durable; but recognizes the need for tax increases, with a special emphasis on broadening the tax base. These overarching compositional choices are reinforced with efforts to increase expenditure efficiency and support equity considerations.

52. While there are no “low-hanging” fruit on structural reforms for enhancing growth, the program incorporates several measures with this objective. The authorities will pursue reduction of restrictions on trade and competition. In addition, several supportive measures are directed at increasing the level of employment. Finally, based on the report of the Review Group of State Assets and Liabilities, an assessment will be made of the scope for increased efficiency of state-owned assets. Following that assessment, the possibilities of asset privatization will be explored, especially in the electricity and gas sectors.

53. The substantial risks to the program will need to be actively managed. The key risk is that implementation will be delayed or faced with unanticipated challenges. This execution risk is particularly salient given the extreme technical delicacy of the many tasks that lie ahead. Execution is also subject to market and political developments. The principal risk mitigation strategy is to proceed in an adaptive and deliberate manner with appropriate consultation with the relevant constituencies.

54. In view of Ireland’s balance of payments need and the comprehensive package of adjustment measures already taken and proposed by the authorities, the staff supports the authorities request for an Extended Arrangement in an amount equivalent to SDR 19.5 billion.

Table 1.

Ireland: Selected Economic Indicators, 2005–11

(Annual change unless otherwise stated)

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Sources: Department of Finance; Central Bank of Ireland; IFS; Bloomberg; and Fund staff calculations.

Contribution to growth. However, the data for exports and imports of goods and services are annual growth rates.

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.

Table 2.

Ireland: Medium-Term Scenario, 2007–15

(Percentage change, unless otherwise indicated)

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Sources: CSO; Department of Finance; and IMF staff calculations.

Contributions to growth.

In percent of GDP.

In percent of potential output.

Table 3.

Ireland: General Government Finances 2006–15 1/

(In percent of GDP)

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Sources: Department of Finance; and staff estimates.

The general government numbers incorporate the full amount of prospective IMF/EU financing.

Central government net debt is defined as National Debt -- the conventional measure of net debt -- less liquid assets of the NPRF. These are defined as the sum of cash, listed equities and bonds. The figure for 2010 is the end-November provisional figure.

Table 4.

Ireland: Indicators of External and Financial Vulnerability, 2003–10

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

Data for 2010 refers to end-September 2010.

Data for 2010 refers to end-June 2010.

Data for 2010 refers to end-March 2010.

Including securitisations.

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. The M3 compiliation methodology has been amended in line with Eurosystem requirements.

Nongovernment credit/nongovernment deposits ratio.

Table 5.

Ireland: Summary of Balance of Payments, 2008–15

(In billions of euros)

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Sources: National authorities, and staff estimates and projections.

The increase in reserves includes unused amounts of program disbursements in the government’s account at the central bank, including in euros.