Public Information Notice No. 04/122

Public Information Notice: IMF Concludes 2004 Article IV Consultation with Ireland

November 4, 2004

On October 29, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Ireland.¹

Background

Over the last half of the 1990s, incomes in Ireland converged quickly to the EU average owing to sustained expansions in output and employment. In the 1995-2000 period, growth averaged 10 percent a year while unemployment declined from almost 13 percent to below 4 percent. The fiscal position also strengthened considerably and the ratio of government debt to GDP fell from over 80 percent in 1995 to less than 40 percent in 2000. Strong export performance kept the current account in surplus or close to balance. Toward the end of the boom period, resource constraints tightened sharply and inflation accelerated to a peak of 6 percent in 2000.

In 2001, growth slowed sharply following the global downturn. Growth in GNP, which best reflects domestic economic activity because it excludes multinational profit flows, fell from 10 percent in 2000 to 1½ percent in 2002. While goods market activity slowed considerably, unemployment rose modestly to a peak of 4.8 percent in mid-2003. Inflation, although moderating slightly from its peak, remained well above the euro area average during the slowdown.

In 2003, the economy rebounded with GNP growing by almost 3 percent. Recent indicators suggest that activity has continued to strengthen in 2004. During 2003, inflation decelerated and is now close to the euro area average. Most recently, however, oil price increases have led to a mild pickup in inflation.

Monetary conditions have been accommodative for a sustained period as nominal interest rates declined considerably in the run-up to EMU. Further, with inflation in Ireland exceeding the euro area average until just recently, real interest rates declined even more. Low interest rates and financial market liberalization have resulted in a rapid expansion in household credit which combined with rapid growth in disposable incomes fuelled a boom in the housing market. Real house prices have risen by 187 percent since 1995.

The rapid economic expansion of the late 1990s increased fiscal revenues sufficiently to allow for substantial budget surpluses in spite of significant expenditure increases and tax cuts. Expenditure increases, however, failed to moderate as growth slowed in 2001 and the fiscal balanced slipped into deficit by 2002. In 2003, expenditure growth was lowered considerably and indirect taxes were increased, leading to a surplus of 0.2 percent of GDP.

Going forward, staff project that the economic recovery will gain momentum with GNP growth of 4½ percent in 2004 accelerating slightly to 5 percent in 2005. Core inflation is forecast to stay close to 2 percent. Although monetary conditions are expected to continue to be supportive, it is anticipated that interest rates will increase toward more normal levels as the global recovery firms. Over the medium term, real growth is expected to be in the 4 to 5 percent range.

Executive Board Assessment

Executive Directors commended the continued impressive performance of Ireland's economy, which is based on sound economic policies, providing useful lessons for other countries. Growth remained remarkably resilient in the face of substantial global shocks over the last few years. Flexibility in the labor market limited increases in unemployment, and inflation slowed rapidly, converging to euro area rates, after running well above trading partner country rates for several years. Looking ahead, as medium-term growth prospects are expected to be less buoyant than during the Celtic Tiger era of the 1990s, the key challenge for Ireland will be to manage the transition to slower growth.

In the near term, Directors expected the economic recovery to become stronger and broad-based, supported by external demand and a continued rebound in business investment. Core inflation is expected to remain moderate. The main risks to this outlook stem from the potential for further euro appreciation in response to global imbalances and the possibility of an abrupt unwinding of the housing boom.

In the medium term, Directors expected growth to be markedly lower than that experienced in the second half of the 1990s, as many of the factors that accounted for the 1990s boom were one-off in nature. However, at around 4-5 percent, growth will still remain high by international standards. The transition to slower growth will require adjustments in expectations in labor and housing markets, and also in fiscal policy. Directors stressed that while the global downturn helped initiate such adjustments, these should be viewed as required for longer-term structural reasons rather than for cyclical reasons only, and clear communications will remain important in this regard.

Directors concurred that safeguarding competitiveness should be a key priority of Ireland's economic policy and social partnership. Although inflation in goods and labor markets has decelerated-suggesting that expectations have adjusted to lower growth-the level of competitiveness has deteriorated. The outcome of the wage negotiations of the latest round of the social partnership, in line with prospective core inflation and productivity developments, is welcome. Nevertheless, Directors noted that the agreed increases do not take into account past erosions in the level of competitiveness or the risks of further euro appreciation. To address this potential source of vulnerability, Directors called for an extended period of wage restraint as well as for increased wage flexibility within the social partnership. This could be achieved by shortening the duration of national wage agreements from three years. Directors also noted that improving domestic competition, especially in the services sector, would help to contain input costs in the export sector.

Directors underscored the importance of achieving a soft landing of the housing market, given that recent house price increases continue to exceed medium-term growth prospects. While in the event of an abrupt unwinding of the housing market boom, financial stability would likely not be a concern, Directors cautioned that the impact of such an unwinding on employment and private consumption could be significant. They therefore welcomed the central bank's communications to curb expectations in credit and housing markets, and encouraged further efforts to increase borrower and lender awareness of the prospects for interest rate increases and their implications for debt-servicing costs. Many Directors also viewed the strong preference in Ireland for owning property as a compelling reason not to provide additional incentives in the form of subsidies to home ownership. Steps, which the authorities were advised to consider in a medium-term context, included removing the interest-deductibility of mortgage payments on primary dwellings, and introducing a market-value-based wealth tax on property, graduated to tax second homes at higher rates. Directors welcomed the authorities' continuing efforts to strengthen financial supervision, including by implementing the FSAP recommendations.

Directors concurred that fiscal policy has adjusted well to slower medium-term prospects. To avoid a procyclical fiscal policy, they called for a modest, front-loaded tightening in the structural fiscal balance in the next budget, in line with the authorities' commitment to achieve a structural balance over the medium term. Although the overall outturn for 2003 and early returns in 2004 have been better than expected, Directors noted that this performance is in part due to one-off receipts from changes in the capital-gains tax regime and successes with anti-fraud measures, and the buoyancy of the property market. It will therefore be important to resist political pressures for increased spending as a result of this improvement in public finances, as such an easing would be procyclical, raise inflation, hurt competitiveness, and limit value for money.

Directors shared the authorities' view that concerns about the level and quality of public services and infrastructure should be addressed by improving delivery rather than by raising tax and expenditure ratios. Directors welcomed the introduction of multi-year spending envelopes for departments' public capital spending. Ireland's government capital spending of 5 percent of GNP is already high by international standards and further increases would risk running up against bottlenecks and inefficiencies. The new framework should safeguard capital spending from procyclical pressures, improve planning and predictability, and encourage efficiency. Given these potential benefits, most Directors saw merit in extending the multi-year spending envelopes to cover current expenditures, as well. Directors supported the fundamental reforms begun in the health sector and the modernization of public service delivery, and encouraged a shift in focus across public services from inputs to outputs. They welcomed the ongoing efforts to strengthen budget controls and monitoring and to improve management and appraisal of capital projects. Directors considered Ireland well-placed to deal with the impact of population ageing, through both its sound fiscal position and the high degree of pension funding.

While commending the authorities' support of multilateral trade liberalization, Directors encouraged Ireland to adopt a more supportive stance within the EU in favor of further reform of the Common Agricultural Policy. They welcomed the authorities' commitment to raising official development assistance to attain the UN target of 0.7 percent of GNP by 2007.

Directors encouraged the authorities to continue their efforts on improving the provision of statistics.