Public Information Notice No. 05/146

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Ireland

October 17, 2005

On October 5, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Ireland.^{1 1}

Background

Macroeconomic performance in Ireland was extraordinary during the 1990s and has remained impressive in recent years, due in significant measure to good policies. Real GNP growth averaged 4½ percent in 2003-04, reflecting strong domestic demand and healthy net exports. Rapid employment growth was supported by sizable immigration. With the appreciation of the euro since 2002, HICP inflation has fallen to about 2¼ percent. House price appreciation has continued to slow gradually, but house prices remain high on various measures.

Ireland's public finances are strong, but fiscal policy has been procyclical in recent years. Gross public debt is about 30 percent of GDP, among the lowest in the EU; taxes on labor and business income are relatively low; and the general government fiscal position has been either close to balance or in surplus since 1996. However, fiscal policy was expansionary during 2001-02, when economic activity was somewhat higher than potential, and contractionary during 2003-04, when the output gap was negative. The 2005 budget implies considerable fiscal stimulus, at a time when the economy is widely regarded as being close to full employment.

Labor market flexibility is Ireland is good, as reflected in rapid employment growth and low unemployment. This is largely due to reforms of the tax and benefit systems, which has produced one of the lowest tax wedges among industrial countries. However, labor costs are high compared to euro area partners. National wage agreements and public sector benchmarking exercises play important roles in the wage setting process.

Banking system profitability and capitalization are strong, and nonperforming loans are low. However, vulnerabilities exist: credit growth—while slowing—remains high, property-related lending accounts for more than half of the stock of bank lending, and net interest margins have declined as reliance on more expensive wholesale funding has increased. Household debt has risen sharply and amounted to 120 percent of disposable income at end-2004.

The elderly dependency ratio in Ireland will rise considerably over the coming half century, though the increase is back-loaded compared to the rest of the euro area. Incentives to keep older people in the workforce are relatively strong, so that the effective retirement age is one of the highest among industrial countries. The state-funded old-age pension provides a flat share of average earnings, which helps the elderly avoid poverty but provides only a low replacement rate for the majority of workers.

Executive Board Assessment

The Executive Directors commended Ireland's continued impressive economic performance, the result of sound economic policies, including prudent fiscal policy, low taxes on labor and business income, and wage moderation. Directors welcomed the authorities' intention to keep these policies in place, allowing Ireland to maintain its competitiveness and sustain its remarkable performance going forward.

Directors expected economic growth to be strong in the short term, driven by an acceleration of consumption and continued robust business investment, though—with the gradual cooling of the housing market—residential investment will likely decline modestly starting next year. The main risks to the outlook are a further rise in oil prices, an abrupt slowdown in global growth, and a sharp decline in the housing market. While acknowledging uncertainties about supply potential, Directors viewed the economy as now being close to full employment. With inflation projected to rise next year, rapid growth of aggregate demand could give rise to wage pressures, which would undermine external competitiveness, especially as labor costs are already high.

Directors welcomed Ireland's low level of public debt and generally prudent fiscal policy. However, they noted that the 2005 budget is imparting considerable fiscal stimulus, adding to cyclical pressures. With euro area monetary policy very accommodative from Ireland's perspective, fiscal policy needs to help relieve potential overheating. Directors called for prudent budget execution and saving any revenue windfalls in the remainder of 2005, and for underlying fiscal tightening in 2006, in line with the authorities' medium-term fiscal objective of close to balance or surplus. In addition, Directors underscored the importance of building a fiscal cushion in good times, such as now, in the event that downside risks materialize. If aggregate demand were to weaken abruptly, Directors agreed that automatic stabilizers should be allowed to operate fully and that specific measures to prop up the housing market should be avoided.

Regarding the composition of fiscal adjustment, Directors recommended that the growth of current spending be restrained and that the tax base be broadened. Moderating the steep escalation in current spending would limit the risk of inefficiencies. The tax base could be broadened by limiting property-related capital allowances, preserving the nominal ceiling on mortgage interest tax relief, and introducing a property tax.

Directors supported the authorities' objective of improving value for money in the delivery of public services. They suggested that five-year envelopes could be introduced for current spending, that fiscal projections could be extended to five years, that government procurement practices could be strengthened further, and that a focus on quantified performance targets could help motivate efficiency gains. Separately, Directors noted that—to improve fiscal neutrality and reduce the risk of procyclical fiscal policy—it could be desirable to introduce automatic indexation of tax credits and bands, excise duties, and social welfare payments to developments in consumer prices.

While the conduct of fiscal policy in Ireland has been laudable over the years, Directors shared the authorities' view that it would be useful to deepen public understanding of fiscal issues. As pressures to raise spending are longstanding and could increase, an enhanced public debate could help clarify both short- and longer term constraints and requirements. However, many Directors did not see a case in Ireland's circumstances for the creation of a fiscal council to provide third-party assessments.

Directors commended the openness and flexibility of Ireland's labor market, and the low labor tax wedge, which have enabled Ireland to benefit from enhanced intra-EU labor mobility and contributed to faster growth and low unemployment. They underscored that keeping wages in line with productivity is essential to maintaining competitiveness, noting that wages are high relative to those in the euro area. With the slowdown in productivity growth and the entrenchment of low and stable inflation, Directors recommended that wage increases under the forthcoming national wage agreement and the next public sector benchmarking exercise be moderate. In addition, Directors noted that the wage agreement needs to preserve flexibility, given differential productivity developments across firms, and that the next benchmarking exercise should be as transparent as possible, continue to promote verifiable modernization in the public sector, and avoid putting upward pressure on wages elsewhere in the economy.

While recognizing the banking system's strong profitability and capitalization, Directors noted that vulnerabilities exist and therefore welcomed the authorities' efforts to increase awareness of risks. They highlighted, in particular, the need to monitor carefully trends in the housing market, given the high exposure of banks to this market. Directors underscored that continued supervisory efforts are essential to limit excessive risk-taking by lenders and borrowers: stress-testing could be enhanced and conducted more frequently, credit standards could be strengthened, and interim updates to the Financial Stability Report could be prepared. Directors welcomed the FSAP update planned for 2006.

Directors considered Ireland well placed to cope with the fiscal impact of population ageing, given the low debt ratio and the accumulation of reserves in the National Pensions Reserve Fund. Nevertheless, they shared the concern that households are on the whole not saving enough for retirement, and welcomed the authorities' consideration of further policy responses. Directors noted that Ireland's effective retirement age is one of the highest among industrialized countries, and concurred that encouraging longer active participation in the labor force is important. Beyond that, the appropriate role of government in addressing inadequate household saving depends crucially on the tradeoff between the risk of forcing some people to save more than they wish and the risk of some people not saving enough and falling back on the government in the future. In general terms, the solution should be clearly sustainable over the long run and provide the right incentives to work and save.

Directors agreed that strengthening competition in the domestic economy is crucial to maintaining strong productivity growth and external competitiveness. In the banking system, codes of conduct to promote competition could usefully be extended, with the eventual objective of removing the regulation of certain fees. In the non-life insurance sector, greater disclosure of aggregate information on claims histories would be desirable. Better regulation is also needed in retail and professional services to stimulate competition and reduce prices.

Directors encouraged the authorities to continue their efforts to improve the timeliness and reliability of statistics.