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The following OECD assessment and recommendations summarise chapter 1 of the Economic Survey of Ireland published on 4 November 2009.
The economy is experiencing a severe contraction
The Irish economy has slowed very sharply and a severe contraction both by international and historical standards is underway. Housing investment has fallen precipitously. Consumption and business investment are shrinking. The sharp fall in demand results from the unwinding of large domestic imbalances, compounded by the effect of the global downturn in reducing exports and by the international financial crisis. The overall fall in economic activity since the beginning of the downturn will be very large and some of the reduction in living standards is likely to be permanent. The downturn will continue for some time and the recovery is projected to be slow. Just as the boom had an impact on many aspects of the economy, the necessary economic adjustment will have wide ranging and painful consequences. Reductions in wages appear to be taking place and prices are currently falling. Substantial fiscal consolidation, which has begun, is required to bring government revenues and spending into line. In the absence of changes to policies towards the unemployed, high current unemployment creates the risk of sustained high rates of joblessness. Policies are required in the longer term to avoid domestic imbalances on this scale from building up in the future. Without the boost from credit and asset prices, appropriate policies to encourage long-run sustainable growth will be more important for raising living standards.
A major rebalancing of the economy is underway
The sharp slowdown in activity contrasts with the rapid expansion from 2002 to 2007. Although output and employment grew at a fast pace, underlying developments were less robust than during the 1995 to 2000 expansion, with weaker growth and much heavier reliance on domestic demand, as well as a slowing in the rate of productivity improvement. The recent expansion was driven in large part by easier and cheaper credit, and rapidly increasing property prices. Increasing indebtedness was encouraged by low interest rates and an easing of credit conditions. Irish banks expanded their balance sheets at a heady pace, increasing their reliance on wholesale market funding and becoming heavily exposed to property related lending. The strength of demand, particularly house building, induced a rise in labour costs and a loss of competitiveness, while the public finances became heavily dependent on housing related tax receipts.
The housing cycle began to turn in early 2007. The effect on the wider economy was aggravated by financial market turmoil from mid 2007, which led to a tightening of credit conditions, and the sharp slowdown of the world economy from the autumn of 2008. While euro area monetary policy has eased substantially, the effect has been blunted by financial market conditions and it is insufficient to address the build up in slack that Ireland faces. The effective exchange rate has appreciated, in part due to the depreciation in sterling. A substantial retrenchment in the household sector is taking place, reflecting falling wealth and a weaker economic outlook, and the savings ratio is rising very quickly. This is adding to the negative impact on demand of fiscal consolidation and weaker trade prospects. The necessary fiscal consolidation, which has begun, should proceed, although there is a balance to be struck with economic activity. As a result of the large amount of slack in the economy, prices are falling and a mild deflation is likely. A reduction in nominal wages appears to be taking place. This is contributing to improving competitiveness. There are, however, risks that prolonged deflation would increase the real burden of outstanding debts and may more generally add to the weakness of the recovery. Although Ireland has experienced tough economic circumstances before, the challenges are different within monetary union and more difficult in the context of a weak global economy and current financial conditions. The scale of imbalances built up during this cycle is also unusually large.
Measures are in place to restore the financial system to health
A normal flow of bank credit is necessary for economic recovery. Credit conditions for households and firms have tightened as the result of conditions in international financial markets and the severe difficulties of Irish banks. As liquidity in financial markets declined, the Irish system was heavily exposed due to its reliance on this source of funding. More fundamentally, Irish banks expanded their balance sheets at an extraordinary pace during recent years, allowing Irish households and firms to become highly indebted and leading the banking system to be heavily exposed to residential and commercial property-related lending. As a result, banks face large losses on their loan portfolios.
A range of policy actions has been taken to stabilise the banking system. A government guarantee has been extended to banks covering most liabilities, while deposit insurance has been made more generous and effective, although consideration should be given to increasing the speed of pay-out further. The provision of liquidity by the European Central Bank (ECB) has also been important in sustaining bank funding. To restore the health of bank balance sheets, the Irish authorities have injected capital in the form of preference shares into the major banks and one institution has been nationalised. As part of this process, the state of the banks was assessed, although the results of these “stress tests” have not been published. Ireland has gone further than most other countries in resolving uncertainty about losses on banks’ assets by creating the National Asset Management Agency (NAMA), to hold property development related loans. This should be implemented swiftly and assets should be transferred to NAMA at the appropriate price with risk-sharing mechanisms to protect the taxpayer. Sound and professional management of these assets to maximize value will be important. Further recapitalisation may be necessary as assets are being purchased below book value. Banks should explore all options to raise capital. This could involve greater public ownership. Public capital injections should be provided in the form of common equity. While it cannot be ruled out, nationalisation would carry significant costs and risks and should only be undertaken with the utmost reluctance. Any publicly-owned institution should be run on a commercial basis with the objective of maximising the return to taxpayers. To deal with any problems that arise in the banking system in the future, a special resolution regime should be introduced for banks, giving the authorities the full range of options to deal swiftly and effectively troubled institutions.
Financial regulation and supervision should be strengthened
Banks’ heavy reliance on market financing and heavy exposure to property related lending have added to the severity of the downturn, while the rapid expansion in bank balance sheets contributed to the earlier build up of debt and imbalances in the economy. Like elsewhere, it is now clear that banks should be more tightly regulated and supervised to ensure that excessive risk taking does not arise in the future. Many of the required changes in regulation need to occur at international and European level, but there is discretion at national level to ensure that standards are set appropriately. Additional resources should be allocated to banking supervision and the ability of the supervisor to monitor major institutions should be enhanced, as well as improving the analysis of developments in the banking and financial markets as a whole. The financial regulator has already made some progress in these areas and further measures are underway. There has been a move away from principles based supervision to a more intrusive regime. The emphasis on rules should be increased, including use of quantitative indicators, as in some other countries, as triggers for more intensive supervisory involvement. Banks should be required to hold more capital. The regulation of funding was improved in 2007 and provided some protection for Irish banks during the financial turmoil. This should be kept under review in the light of developments and the evolution of international best practice.
More effective macro-prudential policy instruments need to be developed to promote economic stability
There is a need for effective macro prudential policies to avoid economic imbalances re emerging, given that these are more likely to emerge in the context of a monetary union and there is less flexibility to deal with the consequences of asset price reversals. Although a number of measures were taken during the expansion to “lean against the wind” of the rising house price and credit cycles, these were insufficient to dampen the effects substantially. Measures were often limited in scope or introduced too late. The Central Bank should be given a more explicit macro prudential mandate. The Financial Stability Report (FSR) should continue to be published annually. To ensure that the tensions identified in the FSR are addressed, consideration should be given to the development of more effective macro-prudential instruments. These could include an overall leverage ratio and either dynamic provisioning or counter cyclical capital requirements, as well as tools regarding liquidity rules and risk management practices.
Reforming housing policy would contribute to stability
The housing market played a key role in building up the economic imbalances. The immediate challenge is in dealing with the consequences of the correction in the housing market: negative equity is a growing problem and there is a risk that Ireland faces an increase in the number of home repossessions, albeit from very low levels. The new Mortgage Arrears Code will help, but banks should be encouraged to allow portability of mortgages, while support for the unemployed to meet mortgage payments should be made more effective. The aftermath of this housing cycle should be a good time to deal with the poorly designed policies towards housing that contributed to the over heating of the economy. The tax system is biased towards property, housing and homeownership. This leads to more expensive housing and greater volatility. A path towards the reduction of mortgage interest tax relief, beginning with new borrowers, should be set out. The introduction of a property tax would help to ensure that housing is adequately taxed, together with providing a tax base for funding local services. Policy to provide housing for those in need should be made more effective: more support should be provided through meeting the cost of accommodation in private housing rather than the construction or subsidised sale of public housing. The housing downturn may create good opportunities to use private housing to meet public needs.
How to obtain this publication
The complete edition of the Economic Survey of Ireland is available from:
The Policy Brief (pdf format) can be downloaded in English. It contains the OECD assessment and recommendations.
For further information please contact the Ireland Desk at the OECD Economics Department at firstname.lastname@example.org.
The OECD Secretariat's report was prepared by Sebastian Barnes under the supervision of Patrick Lenain. Research assistance was provided by Annette Panzera and Joseph Chien.