Public Information Notice No. 02/83

Public Information Notice: IMF Concludes 2002 Article IV Consultation with Ireland

August 7, 2002

On July 31, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Ireland.¹

Background

Sound economic policies and favorable circumstances supported Ireland's sustained economic expansion over the last decade. Real GDP growth averaged above 7 percent in 1991-2001 reflecting: robust external demand; strong labor supply growth based on a young, educated population and rising female labor force participation; membership in EU and, subsequently, EMU; substantial foreign direct investment, attracted by policies such as a favorable business tax regime and wage moderation; and substantial fiscal consolidation. Unemployment plummeted and per-capita income rose above the EU average. High growth and fiscal consolidation brought the public debt ratio down to 36½ percent of GDP by end-2001.

GDP growth declined in 2001 to almost 6 percent from 11½ percent the year before, reflecting the global slowdown and the Information and Communications Technologies (ICT) shock as well as foot-and-mouth disease-related restrictions. However, the current account remained broadly stable and unemployment only edged up to 4.2 percent (on a claimant count basis) by May 2002. Moreover, after a sharp decline in the third quarter of 2001, output rose again in the fourth quarter. Other—as yet uneven—signs of a recovery have been evident in recent months, including rising manufacturing output, retail sales (excluding automobiles), and consumer and business confidence. The economic slowdown contributed to a reduction in inflation in 2001 and house prices fell for five consecutive months during September-January. However, inflation spiked up again in early 2002, mainly due to indirect tax increases, and house prices rebounded.

The outturn for the general government balance in 2001 of a small surplus (corresponding to broad structural balance) was significantly weaker than budgeted, in marked contrast to previous years. Cyclical effects on revenue of the growth slowdown and temporary factors, such as animal diseases and September 11, contributed to the deterioration as did expenditure overruns and unexpectedly strong revenue effects from past income tax cuts. The resulting fiscal expansion in 2001 is estimated at some 2.2 percent of GDP. The path for medium-term structural balances was also shifted down sharply in the 2002 Stability Programme to a deficit of some 1 percent of GDP in 2003-04 from a surplus of about 4 percent of GDP in 2003 in the previous Programme. This deterioration reflected both higher expenditure growth and lower structural revenues.

The Fund's outlook is for GDP to rise by 3.2 percent in 2002, supported by steady growth in private consumption. Exports are projected to accelerate by mid-year, although the recovery in private investment would take somewhat longer. Given negative short-term real interest rates, monetary conditions are expected to remain easy, even if the ECB tightens monetary policy or the euro appreciates moderately. Nevertheless, price and wage inflation are expected to ease somewhat this year due to ebbing demand pressures. Following a rebound in the latter part of 2002 and 2003, output growth over the medium term is projected to trend down as labor force growth slows reflecting demographics and already low unemployment, and as labor productivity declines with income convergence and the return of foreign direct investment to more normal levels after the bursting of the ICT bubble.

Executive Board Assessment

Directors commended the authorities for Ireland's impressive economic performance, reflected in sustained gains in income and employment over the last decade, and rooted in sound economic policies, a skilled workforce and flexible labor market, and an investor-friendly environment. They observed that the economy appears to have weathered the global slowdown relatively well—partly due to the combination of a weak euro, supportive macroeconomic policies, and a high level of resource utilization prior to the shock.

Directors noted that, notwithstanding the weakness in the domestic technology sector, the economic outlook is broadly favorable, with growth expected to pick up in the second half of 2002, in line with a recovery in world demand. However, they cautioned that there are significant downside risks to the global recovery, and that the continued appreciation of the euro combined with relatively high inflation and labor costs could adversely affect Ireland's competitiveness—particularly in the traditional employment—intensive industries—and the strength of the recovery. These factors could also pose a risk—albeit likely a manageable one—to the financial sector.

Directors expressed concern about the sharp deterioration in the structural fiscal balance in 2001, and the indicators that pointed to an expansionary fiscal stance in 2002, after adjusting for one-time measures and given the risk of revenue underperformance. Directors would have preferred a neutral fiscal stance, that is, an unchanged structural fiscal balance, in 2002, particularly against the background of the easy monetary conditions, but agreed that measures to unwind the stimulus are not advisable at this time in view of the uncertainty of the recovery and the still-sound fiscal position. However, they stressed that public expenditure, particularly wages, should be held to budgeted levels, and that fiscal policy should, at a minimum, be neutral in 2003.

Directors expressed concern over the marked deterioration in the medium-term fiscal outlook, which, unless checked, could risk Ireland's growth prospects. They recommended that the general government position be in structural balance over the medium-term, compared with the projected deficits of about 1 percent of GDP. Such a policy would help sustain investor confidence and provide a margin against possible lower structural revenues or higher fiscal costs. Moreover, in the event of adverse shocks, it would permit the full operation of the automatic stabilizers without breaching the 3 percent deficit limit of the Stability and Growth Pact.

In the discussion on measures to achieve structural balance, Directors—while welcoming the authorities' efforts to develop multi-year departmental spending envelopes—considered that a formal medium-term fiscal framework would serve to improve policy predictability. Such a framework could include an overall fiscal constraint, multi-year spending limits, and safeguards to protect capital spending from budget pressures. In this connection, Directors cautioned against rapidly increasing public spending, and recommended that rigorous value for money criteria, with clearly defined, monitorable outputs, be applied to all spending programs. They welcomed the use of Public Private Partnerships and encouraged further private sector involvement in the provision of public services. Directors emphasized that greater fiscal transparency will be key for the success of a medium-term framework, and some suggested that the authorities undertake a fiscal Report on Standards and Codes.

In considering policies on the revenue side, and, in particular, should a case emerge for additional spending, Directors noted that it would be necessary to find efficient sources of additional tax revenue. There was broad agreement that measures to widen the tax base are preferable to increasing tax rates, and that there is greater scope for user fees. Targeted transfers could offset any adverse effects of these measures on the poor. Directors cautioned against excessive increases in marginal taxes on labor, given possible adverse effects on labor supply and competitiveness.

Directors underscored the risks to the medium-term fiscal position as well as to competitiveness from public sector wage pressures. They urged a cautious approach in phasing in the pay increases agreed under the recent benchmarking agreement and many Directors suggested that any future national wage agreement be divorced from reliance on fiscal concessions—noting that negotiating expenditure commitments could run counter to needed improvements in public expenditure management. Directors noted that continued dialogue among the social partners could be helpful for maintaining social consensus and establishing wage norms, but underscored that wages should be permitted to reflect market forces, including on the downside and across skill categories.

Directors agreed that strengthening competition through regulatory reform and privatization is key to securing high growth over the medium term. They welcomed the strengthening of the Competition Authority and emphasized the importance of further efforts to liberalize regulatory restrictions, limit the influence of vested interests, and reduce anti-competitive practices, including in the professions and the public services.

Directors noted that the capitalization of the banking system appears to provide an adequate cushion against possible risks to asset quality. Nevertheless, they emphasized that supervisory authorities should ensure that capital and provisions remain adequate in the event of a deterioration in unemployment, company finances, or property prices. Close monitoring of systemic risks and the speedy unification of financial sector regulation will also be important. In addition, Directors encouraged the new, single regulatory authority—when it is established—to give priority to strengthening insurance supervision.

Directors commended the progress made in the provision of statistics. They suggested that the priority should now be to further improve the timeliness and coverage of certain data, particularly on earnings, national accounts, and sectoral balance sheets. Directors welcomed the steps being taken by Ireland to curb money laundering and combat the financing of terrorism.

Directors welcomed the increase in the allocation for official development assistance and the authorities' commitment to achieve the U.N. target of 0.7 percent of GNP by 2007.