Public Information Notice No. 01/86

Public Information Notice: IMF Concludes 2001 Article IV Consultation with Ireland

August 13, 2001

On August 1, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Ireland.¹

Background

The past six years have witnessed an acceleration of output growth in Ireland. Boosted by participation in EMU, sound macroeconomic and regulatory policies, and strong labor force and employment growth, real GDP expanded at an average annual rate of 9.7 percent in 1995-2000. GNP growth was commensurately rapid, with per capita income rising above the euro area average in 2000. Substantial surpluses on the general government balance and strong output growth helped to reduce dramatically the public debt ratio to an estimated 39.3 percent of GDP at end-2000 from 90.5 percent of GDP at end-1994, and to build a pension reserve fund of over 6 percent of GDP. Although signs of potential overheating appeared during 1999-2000, recent developments point to a moderation in growth to a more sustainable, albeit still high, rate.

In 2000, GDP growth surged to an estimated 11.5 percent. Domestic demand was driven mostly by private consumption and, although less so than in previous years, investment. Due in part to the buoyancy of domestic demand, the current account of the balance of payments shifted from surplus to a small deficit. Inflation also picked up and peaked at 6 percent on a harmonized basis in November reflecting the sustained weakness of the euro and temporary factors, including higher energy prices and increases in indirect taxes. House prices grew strongly before slowing somewhat toward the end of the year. The labor market continued to tighten, with the rate of unemployment falling further and the employment rate remaining well above the euro area average. Reflecting this tightening, wage growth picked up somewhat, but unit labor costs remained subdued, given strong productivity growth.

The economic expansion has continued to benefit the public finances. Despite tax cuts and spending initiatives in 2000, higher-than-expected output growth and unusually high automobile sales boosted revenues substantially, yielding a record budget surplus of 4.6 percent of GDP. Fiscal policy shifted to an expansionary stance in 2001, reflecting a continuation of the structural tax reforms in progress for several years and measures taken in the context of the ongoing national wage agreement. Despite the projected fall in the actual and cyclically-adjusted budget balances, the general government finances remain in significant surplus.

The new national wage agreement, the Programme for Prosperity and Fairness (PPF), came into effect in March 2000 and envisaged nominal increases in basic pay in both the public and private sectors of 15 percent over 33 months, together with tax cuts designed to yield a 25 percent increase in disposable income during the agreement. Against the backdrop of rising inflation through most of 2000, the social partners agreed in December to an additional 2 percent pay increase in April 2001, and a once-off payment of 1 percent of each worker's annual wage in April 2002. Overall, wages are projected to grow by about 10 percent this year.

Developments thus far in 2001 point to a moderation of economic growth. With consumer and producer confidence dampened by the global economic slowdown—notably in the information technology sector—and restrictions on mobility associated with the threat of foot and mouth disease, the expansion slowed during the first half of the year. Partly reflecting these conditions, inflation decelerated to 4.1 percent (year-on-year) on a harmonized basis in May while the 12-month increase in house prices slowed to 18.4 percent in April from 21.3 percent in December 2000. Credit growth to the private sector also decelerated sharply to 18.7 percent (year-on-year) in May 2001 from a peak of 35 percent in March 2000. Labor market conditions, however, remained tight with unemployment falling to a historic low of 3.7 percent in the three months ending February.

The outlook is for GDP growth to decelerate to 7 percent in 2001 as the growth of net exports and business investment slows down reflecting global demand conditions. However, easy monetary conditions, strong growth in disposable income, and low unemployment should support private consumption and residential investment growth and cushion the slow-down. With labor force growth expected to decelerate significantly from the high rates observed in recent years and unemployment at low levels, output growth should continue to slow in 2002 and beyond as the maturing expansion converges to a more sustainable rate.

Executive Board Assessment

Executive Directors commended the authorities for Ireland's outstanding economic performance over the past decade and a half, during which income and employment grew rapidly and unemployment declined to very low levels. A substantial strengthening of public finances, a welcoming policy environment for foreign direct investment, and sustained improvement in competitiveness have contributed to these remarkable achievements.

With resource utilization at high levels, Directors welcomed the moderation in demand and output growth in 2001. They noted that the inflation differential vis-à-vis the euro area average has declined and that house price inflation has abated somewhat. Directors viewed the recent acceleration in wage increases as largely reflecting a catch-up with earlier productivity gains and, therefore, unlikely to harm competitiveness in the near term. However, they warned that if wage increases were to continue to exceed productivity growth, competitiveness could decline and growth could slow over the medium term—though Directors observed that, in the monetary union, some relative wage adjustment was to be expected since it was a mechanism to help bring output growth back to a sustainable path.

Directors observed that the economic outlook remains broadly favorable, but the authorities face a number of challenges in ensuring a smooth transition to a lower, more sustainable rate of growth. Given Ireland's openness and the importance of foreign direct investment in high technology, the deterioration in the global outlook—especially for the technology sector—poses considerable downside risks. Wages and prices will have to respond flexibly to any new adverse external shocks, and the authorities should remain alert to potential stresses in the financial system, although any possible stresses appear manageable at this stage.

Directors agreed that the fiscal stance in 2001 should have been neutral rather than expansionary. Hence, public expenditures should be held tightly to budgeted levels and any underspending saved to mitigate the fiscal easing. Most Directors considered that, provided serious overheating or recession remain unlikely, the authorities should aim at a neutral stance in 2002, and allow the full play of automatic stabilizers. They stressed the difficulty of managing a counter-cyclical fiscal policy in a small open economy. Directors recommended that any stimulative effects from improving the structure of taxes or expenditure be curtailed through offsetting measures elsewhere in the budget.

Directors welcomed the authorities' efforts to improve the tax structure. They noted that cuts in marginal tax rates and the broadening of the rate bands have contributed to reducing labor supply distortions. They suggested that there may be scope for further rationalizing of certain taxes. In particular, the social security tax regime could be reformed so as to take into account its interaction with income taxes, and the base of the VAT could be broadened and its rates standardized.

With regard to expenditures, Directors underscored the need to keep public sector wages under control. They welcome the benchmarking of public pay to private sector pay, but cautioned that offsetting budget measures may be needed if this leads to large increases in the public sector wage bill. They agreed that increased capital expenditures on physical infrastructure are clearly needed, but in view of the short-term capacity constraints, rigorous appraisal and prioritization were essential.

Directors recommended the introduction of a medium-term fiscal framework, building on elements already in place, to help clarify medium-term policy objectives and increase the transparency and predictability of fiscal policy. They stressed that any increases in public resources to specific sectors, such as health and education, should flow from a comprehensive analysis of alternative means of addressing public needs, including through greater private sector provision of such services. In addition, Directors suggested that medium-term budget plans should be accompanied by a strengthening of administrative mechanisms to hold spending departments publicly accountable for the delivery of agreed services within budgeted amounts. To identify areas where transparency can be further improved, Directors suggested that the authorities undertake a Report on the Observance of Standards and Codes on fiscal transparency at a suitable time.

Directors urged the authorities to be vigilant regarding systemic stresses in the financial sector due to slower growth and the softening of the housing market. They welcomed the efforts to implement the recommendations of last year's Financial Sector Assessment Program report and supported further strengthening of the supervisory framework by focusing on forward-looking assessments of systemic stability. Directors noted that draft legislation establishing the single regulatory authority should be approved quickly and the specialized personnel needed to strengthen insurance supervision increased as soon as the single regulator becomes operational. In view of the changing macroeconomic environment and the introduction of the single regulator, many Directors suggested that an update of the Financial System Stability Assessment (FSSA) may be useful next year, but others consider that this should not be a priority given resource constraints in the context of the overall FSAP program.

Directors observed that a number of structural reforms are desirable to help secure continued vigorous growth over the medium term. They agreed that the national wage agreements had facilitated wage moderation in the past, but considered that, in a tight labor market, such agreements may become less effective and may even act to set a floor, rather than a ceiling, on wage increases. Many Directors felt that such agreements could be a source of inflexibility in the event of an adverse shock. Directors also questioned the appropriateness of trading tax cuts for wage moderation in a tight labor market and in the face of increasing demands for public spending. While seeing the value of social dialogue on such issues as working conditions and job flexibility, most Directors suggested that the national partnership approach be reformed to allow private sector wages to be fully market determined, and public sector pay to be aligned with wages in comparable private sector jobs. They stressed the need to develop, over time, a broadly accepted and comparator-based system for determining public sector pay that would allow for greater pay differentiation.

Directors urged the authorities to strengthen competition through privatization and deregulation. They noted that greater competition, especially in sectors traditionally characterized by public monopolies such as utilities and mass transport, would also increase wage discipline. They noted that scope exists for further deregulation and stronger enforcement of existing regulations in the retail food and beverage sectors.

Directors noted the recent improvements in data reporting but called for further progress in improving the coverage and timeliness of data necessary for monitoring short-term developments—notably wages, productivity, and balance sheets, and some aspects of budget presentation.

Directors welcomed the increasing Official Development Assistance and encouraged the authorities to make further progress toward achieving by 2007 the U.N. target of 0.7 of GNP.