John Hurley: Current state of the Irish economy
Opening statement by Mr John Hurley, Governor of the Central Bank and Financial Services
Authority of Ireland, to the Joint Committee on Finance and the Public Service, Dublin,
15 July 2008.
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Good afternoon Chairman and members of the Joint Committee and thank you for the
invitation to speak with you today on the current state of the economy and the
banking/financial services sectors. I am accompanied by Tony Grimes, the Director General
of the Central Bank and Tom O'Connell, Assistant Director General, Economics.
Earlier this year, I outlined to the Committee our unitary organisational structure and I
emphasised, in particular, how the Central Bank and Financial Regulator work closely
together in response to the market turbulence. I don't intend today to describe those
arrangements again except to say that the structure continues to work very well and there
continues to be the closest cooperation.
It is worth reminding ourselves that we have a very different economy now as compared to
20 to 25 years ago. Since then, Ireland has transformed itself from being a country with a
relatively low standard of living to one where average income per head is now well above the
EU average. Not only are living standards much higher, employment has grown rapidly and
we have seen strong development in manufacturing, business and financial services sectors,
helped by the fact that we have been hugely successful in attracting foreign investment.
Clearly, the economic situation has changed significantly, but in terms of where we are
starting from, the position is very different from the 1980s.
As you know, we published our Annual Report last week and, in my statement today, I will
outline the rationale behind our latest forecasts for economic growth. In our earlier forecasts,
it was always emphasised that there were many downside risks and vulnerabilities that could
push growth lower. These risks related to the potential for interaction between global
financial market turbulence, rising global energy and food prices and the slowing of activity
within the economy, which was already underway.
In recent months, almost all of these downside risks have materialised and this has led to a
greater-than-expected slowdown in growth and higher-than-anticipated inflation.
Notwithstanding the more challenging short-term outlook, we continue to believe that growth
in the economy should gradually recover and inflation moderate. However, this recovery is
not guaranteed and the evolution of the economy will be very much influenced by how we
respond to the current challenges we face. As a country we have benefited considerably
from the prudent, stability-focussed policy approach we have followed in recent decades.
This has helped to deliver domestic economic stability, has contributed significantly to
attracting foreign investment and has greatly facilitated growth. To ensure a sustainable
recovery, it is very important that we maintain this approach and focus on key policy areas
under our control. These include the public finances, the efficiency and effectiveness of
public spending, particularly in relation to increasing the productive capacity of the economy,
and overall competitiveness.
The updated assessment
While the emergence of a slowdown in the economy was not unanticipated, the loss of
momentum has been greater than expected this year. This has arisen from a
sharper-thanexpected adjustment in the housing sector alongside a deterioration in the international
environment. Our current forecasts are that both GNP and GDP growth will remain positive
this year, albeit significantly less than 1 per cent. It will be the end of July before we finalise
our forecasts, but a ballpark estimate, at this point in time, would be around 0.5 per cent
growth this year and about 2 per cent in 2009.
In common with other developed economies, Ireland is facing significant inflationary
pressures arising from very elevated levels of energy and other commodity prices. We are all
conscious of the experiences of the 1970s, when the response to the oil price increases of
the time resulted in persistently high inflation. This undermined growth and employment in
the economy and was especially damaging to those on fixed incomes. While the current
situation is not identical, there are some similarities. It is important to accept that economic
conditions here have weakened and we cannot compensate ourselves on an economy-wide
basis for commodity price increases over which we have no control. As we know from past
experience, if we attempt to do so, recovery inevitably becomes delayed. Ireland's
competitiveness position has weakened in recent years because wage and broader cost
inflation has been higher than in our main trading partners. It is vital for our growth prospects
to ensure that our competitiveness position improves rather than deteriorates further.
Based on the potential for future growth in productivity and the labour force, the medium-term
outlook for the economy remains favourable and growth will return to stronger levels, if the
appropriate corrective action is taken. Growth should pick up next year on the basis of a
bottoming out in domestic housing output and some improvement in the external
environment.
Residential housing market
The housing market weakened significantly during 2007 with sharp declines in both output
and prices. Most economic commentators had envisaged an adjustment in the housing
market because, for a number of years, housing output was well above the sustainable rate
taking account of underlying housing needs. Housing investment peaked at around 13 per
cent of GDP in 2006, which was well in excess of international norms. This is likely to reduce
to about 71⁄2 per cent of GDP in 2008, which represents a very substantial scaling back of
activity. The significant weakening in the housing sector is going to detract considerably from
growth this year.
Housing output should broadly stabilise during the course of next year, but clearly risks are to
the downside. In general, however, the declines in both output and prices represent a
movement towards a more sustainable position in the long term. Unfortunately the
adjustment process is a difficult, if unavoidable, one.
The external environment
Two fairly distinct sets of events are driving global economic developments at the moment.
Firstly, housing market adjustments are taking place in a number of the major developed
economies alongside associated difficulties in financial markets. Secondly, a sharp rise in
commodity prices is placing upward pressure on global inflation and causing a transfer of
income from countries importing these commodities to those producing them. The
combination of these events is having a negative impact on output growth globally.
Unfortunately, this slowdown is affecting the US and UK economies disproportionately, two
of our major trading partners. Economic activity has remained stronger in the euro area,
although an easing in the growth rate is expected in the short-term before a recovery towards
its potential growth rate of about 2 per cent. The risks to the growth outlook are probably on
the downside, however, in all of these economies.
Another negative outcome of these events is, of course, the sharp upward pressure on
headline inflation rates globally. Central banks are very focussed on this issue and are
particularly concerned that the rise in commodity prices does not spread out into higher
inflation generally. In order to counter these risks within the euro area, the ECB Governing
Council decided to raise its interest rates at its last meeting. Price stability is a vital
foundation for sound economic performance and prosperity over the longer term and
preserves the purchasing power of incomes and savings. Inflation, in contrast, creates
uncertainty for savers and investors and undermines confidence in an economy in a way that
ultimately damages the welfare of its citizens.
I would like to turn now to financial market developments. Over the past year, there has been
a generalised disruption in normal money market operations between banks. This resulted
mainly from uncertainty regarding the extent of losses on complex financial instruments
linked to sub-prime mortgages in the US. Central banks responded quickly to counteract
these adverse conditions in money markets. The ECB, in particular, was in a position to take
strong action in the light of the pre-existing arrangements whereby banks had an extensive
range of collateral that could be used to access central bank liquidity. These arrangements
effectively addressed the problems at the short-end of the money market. However, with
questions of transparency and asset valuation remaining, term interest rates continue to be
elevated with higher than normal spreads remaining between longer-term rates and official
rates. This will only change when confidence is restored among financial market participants.
Domestic banking sector
The Irish financial sector is not immune to these international financial developments which
are persisting for longer than expected. Term funding is not as readily available on wholesale
markets and this has increased the need for banks to concentrate on liquidity management.
Internationally, share prices of financials have fallen significantly and Irish shares have also
suffered. It is important, however, to point out that Irish financial institutions have negligible
exposures to impaired US sub-prime and related structured credit products, and loan arrears
remain historically low. Accordingly, the banking sector here has not experienced the
writedown of assets that has required several other international banks to raise additional capital.
In line with the results of previous exercises, the preliminary results of our latest
macroeconomic stress tests on the banking sector, which are designed to test the financial
position of banks in the face of a serious economic downturn, suggest that the banking
sector's financial buffers remain strong. This strength is an essential prerequisite for the
more challenging times that have arisen.
A recovery to medium-term potential growth
Growth should pick up somewhat next year as the fall in domestic housing output levels off.
Thereafter, growth in the Irish economy could begin to return towards its long run sustainable
potential rate of close to 4 per cent. However, this recovery is not guaranteed and, as I have
said earlier, will be influenced by how we respond to the current challenges we face. To
ensure a sustainable recovery in growth back towards potential, it is important to focus on
some key areas under our own control. These include the public finances, the efficiency and
effectiveness of public spending, particularly in relation to increasing the productive capacity
of the economy, and overall competitiveness.
The slowdown in economic activity is impacting significantly on the fiscal position. Exchequer
data indicate a sizeable decline in tax revenue in the first half of 2008, primarily reflecting a
marked slowdown in property related taxes, but also indicative of a slowdown in consumer
spending. On the expenditure side, the weakening of the labour market is increasing social
expenditure. This points to significant deterioration in the fiscal deficit for 2008 relative to
earlier projections. I note that the Department of Finance has revised its estimate for the full
year General Government Balance to a deficit of about 23⁄4 per cent of GDP. Our own internal
estimates are broadly in line with this assessment.
The slowing of growth coupled with the risks facing the economy presents significant issues
for fiscal policy. On the basis of current trends, it will be a major challenge to remain within
the terms of the Stability and Growth Pact next year. It should be emphasised, however, that
the targets set under the Stability and Growth Pact represent a prudent approach to the
management of the public finances.
Within these constraints, it will be necessary to carefully manage the allocation of scarce
public funds and to focus on measures to increase the efficiency and effectiveness of
government spending, both current and capital. A particular priority within the capital
programme should be the maintenance of expenditure on key infrastructural projects, which
can enhance productivity and improve the potential for the economy to grow in the future.
Policies that promote productivity and competitiveness can help the economy to weather the
effects of adverse developments and of lower growth in the global economy. They also serve
to increase the medium-term performance of the economy, protect employment and allow for
sustainable increases in living standards. For these reasons, in addition to my earlier
remarks about the need to improve competitiveness, boosting productivity growth and
promoting flexibility in response to short-term shocks are particularly important. In addition to
enhancing the efficiency of public spending and continuing to address the country's
infrastructure deficit, a number of other measures can be identified which would promote this
goal. These include greater competition in the more sheltered sectors of the economy,
continuing to encourage innovation and R&D activity and enhancing the skill level of the
labour force.
To conclude, we are now in a more challenging environment. This makes it particularly
important to ensure that policy remains focussed on sound economic management and that
timely decisions are taken to redress the unfolding situation. As I have said earlier, we have
benefited considerably from following such an approach.
It has underpinned domestic economic stability, helped us to attract substantial foreign
investment and greatly facilitated growth. It is vital for our prospects for a sustainable
recovery in growth that we continue to follow such a path.