Public Information Notice No. 00/61

Public Information Notice: IMF Concludes Article IV Consultation with Ireland

August 10, 2000

On August 2, 2000, the Executive Board concluded the Article IV consultation with Ireland.¹

Background

Over the past six years, Ireland's economic performance has been spectacular. Real GNP has expanded at an average rate of 8 percent, raising per capita GNP to about 90 percent of the EU average. This strong growth has been accompanied by rapid increases in employment, with the unemployment rate falling to historic lows. The public finances strengthened markedly, as the general government balance moved from deficit into sizable surplus, and the public debt ratio was cut in half. The external current account balance also remained in surplus. More recently, however, strains associated with this rapid growth have become more pronounced. Inflation has accelerated sharply, labor shortages are widespread, and property prices have been rising rapidly for four consecutive years.

Economic activity remained very buoyant in 1999, with real GNP rising by almost 8 percent. Growth was driven mainly by domestic demand, as private consumption was boosted by strong gains in disposable incomes and wealth, and investment remained extremely buoyant. However, external demand also strengthened during the year, reflecting the global economic recovery. Inflation remained subdued until mid-1999 but has since risen to over 5 percent, by far the highest rate in the euro area. This increase reflects both temporary factors associated with higher fuel prices and a tax increase on tobacco, as well as a rise in underlying inflation, particularly for services. Wage pressures have also intensified as the unemployment rate dropped to 4.7 percent in the first quarter of 2000. However, at least until very recently, the adverse effects of higher wage and price inflation on competitiveness have been outweighed by Ireland's relatively strong productivity growth in the tradable goods sectors and the weakness of the euro. Monetary conditions are clearly expansionary from Ireland's point of view, contributing to robust demand growth as well as rapid increases in house prices and private sector credit. Buoyant tax revenues have enabled the government to implement sizable tax cuts and increases in real spending over the past three years, while still achieving an increase in the overall general government surplus.

Near-term prospects are for continued buoyant growth. Real GNP is projected to rise by almost 8 percent in 2000, before moderating to about 6 percent in 2001. Consumer spending growth is likely to remain strong while investment will be boosted by increased government outlays under the National Development Plan. External demand is expected to remain robust, fuelled by the ongoing pick-up in activity in European trading partners. However, limits on available capacity are likely to exert an increasing constraint on Ireland's ability to meet this demand in the short-run, and the current account balance is projected to weaken moderately in 2000. With the economy already operating above estimated potential, the strength of domestic demand is being reflected in upward pressures on domestic prices, most notably in sectors that are not fully exposed to competition. Headline inflation is projected to peak during the second half of 2000 and decline late in the year as the effects of higher fuel prices and the tobacco tax rate hike begin to fade. However, services and non-traded goods price inflation may remain high or increase further. Macroeconomic policies are generally set to be supportive of demand in 2000. While nominal interest rates have increased since late 1999, real rates remain very low in Ireland given its higher inflation rate. Also, the 2000 budget contained further sizable tax cuts and spending increases, implying a net addition to demand. The latest national wage agreement envisages sizable increases in disposable incomes over the next three years that are likely to add to demand growth going forward.

Executive Board Assessment

Executive Directors commended the authorities for the performance of Ireland's economy over the past decade. Output and employment growth have been remarkably buoyant, the public finances have strengthened considerably, and the external current account balance has remained in surplus. While many factors accounted for this performance, Directors stressed the roles played by sound and consistent macroeconomic policies, a generally flexible labor market, a favorable tax regime, and the long-standing outward orientation of Ireland's trade and industrial policies. Directors considered that the economy should be well placed to continue to perform strongly in the future, taking account of its well-established positions in several high-growth sectors.

Directors noted, however, that signs of overheating had become more pronounced since the last consultation. Headline inflation had accelerated sharply since mid-1999, and now exceeded the euro area average by a considerable margin. While this increase reflected higher fuel prices and a tobacco tax hike, underlying inflation had also picked up markedly owing to rapid price increases in the non-traded sector, particularly services. Labor shortages were widespread, physical bottlenecks had worsened, property prices continued to increase rapidly, and private sector credit was still growing at a very high rate.

Directors considered that these developments were indicative of a growing imbalance between demand and supply that posed a risk to Ireland's otherwise favorable medium-term outlook. They noted that higher inflation would place a strain on the latest three-year national wage agreement that had been ratified only a few months ago. Persistent, rapid property price inflation added to these strains. These developments gave rise to the concern that the social consensus underlying the wage agreement could erode, undermining the stability that has been central to Ireland's economic success. While competitiveness remained relatively strong at present, in part reflecting the weak euro, rising wage and price pressures could set the stage for a difficult adjustment later, if the euro were to appreciate substantially.

Directors agreed that the policy responses to address these concerns should include measures on both the demand and supply side. On the supply side, Directors welcomed the Government's plans to increase public investment outlays aimed at addressing infrastructure bottlenecks under the 2000 to 2006 National Development Plan, to pursue further tax reforms aimed at encouraging increased labor force participation, and to foster greater competition through deregulation and privatization. Directors considered that demand-side measures were also needed to contain overheating risks in the short run. Given that monetary conditions, now determined on a euro area-wide basis, were excessively accommodative for Ireland's cyclical position, Directors called for a tightening of fiscal policy to help dampen excess demand and contribute to the moderation of inflation.

Against this background, Directors urged the authorities to save any dividend from stronger-than-expected tax receipts in 2000 and to adopt a budget for 2001 that would imply an improvement in the structural primary balance. Directors stressed that, while the commitment to further moderate tax cuts under the national wage agreement should be respected, pressures for larger tax reductions should be resisted because such reductions would add to, rather than ease, the risks of overheating in the near term. On the spending side, Directors supported the authorities' plans to increase public investment in priority areas to relieve supply constraints, but noted that the desired fiscal tightening in 2001 would imply a need for tight control over growth in other public spending.

To help keep temporary factors from feeding through into higher wage settlements, the government also had an important role to play by ensuring that the increases in public sector wages agreed under the latest multi-year national accord are strictly adhered to. Directors also encouraged the authorities to use the period of this accord to explore alternative mechanisms for public sector wage determination that would reduce the rigidities inherent in the current process. The planned benchmarking exercise offered the prospect of addressing entrenched relativities, but Directors emphasized that this should not come at the expense of overall public sector wage restraint. It would also be desirable to reduce the reliance on wage-tax trade-offs, which tend to impart a pro-cyclical bias to fiscal policy and are likely to be increasingly constrained in the future by medium-term fiscal sustainability considerations. More generally, Directors noted that maintaining discipline over public sector spending is likely to pose an increasing challenge during a period of buoyant tax revenues and sizable budget surpluses. Directors encouraged the authorities to proceed with their earlier plans to implement a multi-year budgeting framework, which could play a useful role in helping preserve fiscal discipline.

Directors welcomed Ireland's participation in the Financial Sector Assessment Program, which had been timely in view of the recent rapid credit growth and significant changes in the financial sector. They agreed that Ireland had a sound and highly developed financial system that has been very stable, even during periods of international financial turmoil. The overall framework of prudential regulation and supervision is well developed with a high degree of observance of international standards and codes. Nonetheless, risks to financial sector and macroeconomic stability could arise from rapid lending growth, in particular related to the domestic property boom. Directors, therefore, welcomed the efforts of the supervisory authorities to ensure that credit institutions follow prudent lending criteria and take adequate account of the potential impact on their portfolios of an adverse macroeconomic shock, which could include a downturn in the property market. Directors encouraged the authorities to continue to monitor the situation closely, and use the full range of prudential tools at their disposal. Directors also considered it desirable that the authorities implement expeditiously their plan to establish a single supervisory agency.

Directors expressed concern that, after several years of rapid property price increases, housing demand may increasingly be driven by expectations of further price increases—a trend that could be abruptly reversed. Given these concerns, Directors welcomed the government's latest initiatives to promote a better balance in the property market through steps to alleviate supply-side constraints and discourage speculative demand. Directors encouraged the authorities to keep the situation under review and address any remaining distortions that may be contributing to excess demand pressures in the property market.

Directors commended the authorities for their ongoing efforts to promote greater competition in the economy, particularly in those sectors that to date have been relatively insulated from competitive forces. They stressed that such policies can be expected to lead to an improved quality of services and help dampen the current strong inflationary pressures in the non-traded sector. Directors urged the authorities to continue and, where possible, accelerate their efforts in this regard.

Core macroeconomic data provided to the Fund were adequate for surveillance purposes. Directors welcomed the authorities' ongoing efforts to improve the quality of economic statistics, but stressed the need for further improvements in the coverage and timeliness of several key indicators.

Directors encouraged the authorities to make greater progress toward achieving the United Nations' target of 0.7 percent of GDP for official development assistance.