Public Information Notice No. 99/79

Public Information Notice: IMF Concludes Article IV Consultation with Ireland

August 20, 1999

On August 4, 1999, the Executive Board concluded the Article IV consultation with Ireland.¹

Background

Ireland's economic performance in recent years has been exceptionally strong. Output and employment have been growing much faster than in the rest of Europe. Real GDP growth averaged 7.5 percent per annum in 1993-98 reflecting a sharp increase in capital accumulation--fueled in part by foreign direct investment--and an expansion of the skilled labor force due to young entrants, increasing female participation, and a reversal of net emigration. Inflation has remained subdued. Public finances have improved significantly and the external current account has remained in surplus.

Economic activity continued to expand robustly in 1998. Business and consumer confidence was boosted by the final advance to EMU. Real GDP is estimated to have grown by almost 9 percent and real GNP by more than 8 percent. Demand has been driven mainly by private consumption, although investment also grew rapidly. The sharp increase in employment was met both by a substantial increase in the labor force and further declines in unemployment. The external current account appears to have weathered the turbulence in world markets relatively well. Although exports continued to grow robustly, strong import growth and a decline in net EU transfers caused the external current account surplus to narrow significantly to 0.9 percent of GDP from 2.5 percent of GDP the previous year.

With the economy expanding above trend for a sixth year in a row, wage and price pressures have begun to mount. Consumer price inflation picked up to 2.4 percent in 1998 (2.2 percent on an HICP basis), well above the average in the EMU area. The pickup was driven by exchange rate factors and by service price increases reflecting strong wage growth across a broad cross-section of sectors. Although 12-month inflation slowed to 1.3 percent in June 1999, this was mainly due to a sharp fall in mortgage interest rates, rather than to an easing of underlying pressures. Service price inflation continued unabated during the first half of 1999. Asset prices, particularly of houses, have also increased sharply. Rapid increases in housing and equity market wealth are likely to have contributed to strong private spending.

During 1998 and the first half of 1999 monetary conditions eased significantly--initially on the heels of the short-term interest rate convergence to EMU levels and, subsequently, as a result of the interest rate reduction by the European Central Bank (ECB) and the euro's nominal effective depreciation. Private sector credit growth, which has been strong since early 1997, picked up markedly starting in October 1998, coinciding with the decline in short-term interest rates.

Although discretionary fiscal policy measures have tended to impart stimulus to economic activity, the fiscal position continued to improve. The sizeable general government surplus last year reflected mainly the cyclical strength of the economy and lower interest payments. Buoyant tax receipts of the first half of 1999 underpinned by vigorous economic activity are likely to raise the fiscal surplus in 1999 to about 2.7 percent of GDP, notwithstanding reductions in personal and corporate tax rates.

The government's active labor market policies have contributed to lowering the long-term unemployment. A minimum wage is expected to be introduced early next year. The proposed hourly rate of IR£ 4.40 appears high in relation to minimum wage rates in other industrialized countries.

The outlook for 1999 and over the medium term is for output to gradually slow down, as capacity constraints become increasingly binding and labor force expansion tapers off. Rates of economic growth and consumer price inflation, however, would remain higher than elsewhere in the euro area reflecting stronger productivity growth in Ireland.

Executive Board Assessment

Executive Directors commended the authorities for Ireland's impressive and sustained economic performance, which has been marked by vigorous growth and rapidly declining unemployment. The fiscal position has strengthened substantially and the external current account is in surplus. Ireland is well placed to continue its ongoing integration with the economies of the euro area and with global markets.

Directors agreed that the Irish economy was likely to continue to grow rapidly in the short term. They noted that the extent of structural changes added particular uncertainty to estimates of the rate of growth that was sustainable in the long run. Some Directors also noted that some degree of wage and price inflation higher than in the rest of the euro area was acceptable, given a possible initial undervaluation of the Irish pound and faster productivity growth in Ireland. However, Directors generally agreed that capacity constraints were likely to become more binding than they had been, and that indications of inflationary pressures--in goods, labor, and asset markets--had grown. Against this background, they broadly agreed that a shift of policy emphasis toward containing inflationary pressures was appropriate so as to ensure a basis for the continuation of Ireland's remarkable record of noninflationary growth.

Directors considered that, notwithstanding its long-term benefits, Ireland's membership in the euro area created additional difficulties regarding demand management in the short run. The sharp fall in interest rates associated with joining the euro area had come at a time when demand and wage pressures were already intensifying. Ireland's business cycle was not synchronized with that of the rest of the euro area, resulting in monetary conditions that were not contributing to the containment of inflationary pressures. In these circumstances, most Directors considered that fiscal policy would take on a greater role in stabilizing aggregate demand. Directors agreed that any relaxation of fiscal policy would be inappropriate. A number of Directors went further, and considered that some tightening of fiscal policies would be appropriate in the near term, if inflationary pressures continued unabated. Some other Directors, however, believed that policy adjustments to lower the level of aggregate demand were not called for at the moment. They saw the need, rather, for any measures to be addressed to reducing overheating in particular markets, notably with regard to credit expansion and the real estate market.

Directors generally agreed on the importance of wage restraint in controlling demand pressures. In this connection, most Directors emphasized the importance of restraining public sector wage increases, given the signaling effect on the private sector. Directors noted the contributions which agreements among social partners had made to wage moderation in the past. However, a number of Directors considered that changes in the provisions of national pay agreements may be appropriate given the tightening of the labor market, and specifically that the authorities should be careful not to secure agreements at the price of procyclical tax reductions. Directors encouraged more extensive use of performance-related pay provisions to foster greater relative wage flexibility and to reduce the risk of excessively high across-the-board wage increases.

Directors agreed that a number of issues for fiscal policy need to be considered in the immediate and medium term. In light of current demand pressures, Directors were of the view that further net tax reductions should not be included in the 2000 budget. They also saw a need to place tax reform in a medium-term context and, in this regard, noted that tax rates could be reduced in a revenue-neutral manner if tax bases were increased. Directors also emphasized the need for a fiscal plan to take realistic account of the need for infrastructure spending and its alternative sources of financing; of the declining level of net transfers from the EU; and of future pension commitments. Regarding the latter, Directors encouraged the authorities to seize the opportunity created by the present fiscal surpluses to fund public service and social welfare pensions. They welcomed, in this regard, the authorities' recent decision to make a sizeable annual set aside to partially fund the government's future pension liabilities. Directors also welcomed progress in developing a multiyear budgetary framework, and encouraged the authorities to strengthen this framework further, particularly through the tightening of expenditure control mechanisms and the incorporation of the recently announced multiannual investment program.

Directors commended the authorities for their active labor market policies, which have contributed to the significant reduction in the unemployment rate. They noted, nonetheless, that challenges remained in tackling the high rate of long-term unemployment. Directors cautioned against setting the proposed minimum wage too high or indexing the minimum wage to earnings in order not to jeopardize efforts to reduce unemployment, particularly among the young and the long-term unemployed.

In light of the rapid growth in credit and strong housing price increases, a number of Directors expressed concern about the risks of an asset price bubble and the potential vulnerability of the banking system. Directors stressed the need to enhance the forward-looking aspects of regulatory policy and, in this regard, welcomed the supervisory authorities' recent initiative to assess the financial system's vulnerability to specified macroeconomic shocks. They felt that a peer review, particularly by supervisors from a country that had undergone a real estate boom, might be helpful.

Directors praised Ireland's continued commitment to raise official development assistance spending, and encouraged the authorities to accelerate progress toward achieving the U.N. target of 0.7 percent of GDP, particularly in view of Ireland's strong fiscal position. Directors welcomed Ireland's support for the HIPC Initiative.

Directors welcomed the authorities' continued efforts to improve the comprehensiveness and timeless of Ireland's statistics, which were broadly adequate in the context of the Article IV consultation and for the purposes of ongoing surveillance.