John Hurley: International economic and financial developments and
prospects for the Irish economy
Address by Mr John Hurley, Governor of the Central Bank & Financial Services Authority of
Ireland, to the Irish Association of Pension Funds Annual Dinner, Dublin, 28 February 2008.
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Introduction
I would like to thank your chairman for the invitation to address you this evening on the
occasion of your annual dinner. In my speech tonight, I will comment on international
economic and financial market developments as well as prospects for the domestic
economy. I will also briefly address the issues of population ageing and pensions.
International economic developments
Prior to the recent slowdown in economic growth, the global economy had, over the previous
four years, experienced its strongest period of expansion since the early 1970s. While this
might not have been apparent in the euro area, where growth only started to pick up in the
second-half of 2005, the evidence from the rest of the global economy is clear. Not only was
there robust global growth during this period, a number of other features were also striking.
In particular, increasingly global growth was spread more widely, with emerging market and
developing economies accounting for a higher share of growth. An important factor behind
these developments has been globalisation, which has had both a significant real and
financial dimension.
The economic impact of these developments has meant that the emerging market
economies now account for a greater share of world economic activity. Integration, however,
works both ways. As a result, I would not expect that these economies can remain immune
from the current slowdown in global economic activity. The main sources of this slowdown
are rooted in the US economy and, in particular, its housing sector. The adjustment in that
sector is having a significant effect on the US economy and also on other major economies.
This reflects the fact that a range of complex financial products linked to housing, in
particular in the area of sub-prime lending, has amplified the impact on the real economy of
what were not large changes in themselves. This, in turn, reflects the way in which these
products were distributed and valued within the financial system.
The actual scale of the slowdown in the US remains rather uncertain. There has been a
significant monetary and fiscal policy response, but it is still unclear how deep or how long
the slowdown may be. It is apparent, however, that growth will slow substantially.
The second area of uncertainty is the impact on other economies. Given the weight of the US
in the global economy and its extensive linkages with other economies, there will certainly be
some impact. As regards the euro area, possible spillover effects on growth are one of the
downside risks to activity that have been identified by the Governing Council, although the
upside risks to inflation at present are also very clear.
Financial markets
Turning to financial markets, it is clear that these too have become much more integrated
over time. From a position where sectors like your own have tended to have a "home bias" in
asset allocation, portfolios have become much more international in nature. One
consequence of this is that it has made possible the financing of ever growing global current
account imbalances. This may have facilitated the rise of these imbalances, and the national
spending and savings behaviour that lies behind them by, for example, a tendency to keep
the cost of borrowing lower than it might otherwise be in countries with savings deficits.
It has been argued that financial globalisation and, in particular, the scale and speed with
which it has developed, has played a part in generating some of the excesses in financial
markets which have crystallised over the past six months. However, there have also been
other factors at work. I would like to turn now to comment on some of these.
At this stage, the events of the past six months are well known. After a long period during
which financial market conditions were extremely buoyant, global markets have witnessed a
substantial and warranted repricing of risk. This follows a prolonged period when asset prices
were driven to exceptionally high and unsustainable levels in many parts of the world, and
inadequate attention was paid to risk. The unwinding of these excesses has generated
significant turbulence in financial markets and strains in money markets. These problems
reflect vulnerabilities which have been uncovered about the way risks have come to be
assessed, valued and distributed in today's markets. Once they surfaced, these
vulnerabilities have led to a substantial degree of financial reintermediation and
deleveraging.
Central banks have responded in a determined manner to counteract disorderly conditions in
money markets. The actions undertaken since August have alleviated problems at the
shortend of the interbank market. They have also helped to encourage a narrowing of the wide
spreads that had opened up between longer-term rates and policy rates. While having eased
back, however, concerns about credit quality and asset valuations persist. International stock
markets have also been affected by the turbulence, particularly financial sector stocks. Irish
bank shares, which are a significant part of the Irish equity market, did not remain unaffected
by these events, although another factor was the rebalancing of growth away from the
construction sector in the domestic economy. These recent developments, however, have to
be placed in the context of previous substantial increases in Irish bank shares.
During this period of exceptional turbulence, Irish banks, like their international peers, faced
an environment where medium to long term funding was not as readily available on
wholesale money markets as heretofore. However, adequate overnight liquidity was
available at all times and, since the end of the year, conditions in the interbank markets have
eased, and term funding is now more freely available and at lower, if not normal, interest
rates.
The current situation and outlook for the stability of Irish banks, based on an assessment of
developments so far, is positive. The sector's shock absorption capacity has been largely
unaffected by the turbulence in international financial markets. The domestic banking system
reports no significant direct exposures to US sub prime mortgages and only negligible
exposures through investments and links with other financial companies or special purpose
vehicles. In addition, our stress-testing of the banking system indicates that Irish banks are
solidly profitable and well-capitalised.
As far as drawing conclusions at the global level in relation to the turbulence is concerned,
there needs to be a careful and balanced assessment made of the lessons to be learned
from recent events. Indeed, we must also be conscious that this turbulence may persist for
some time yet. The elements which came together to generate the recent turbulence
involved a weakening of credit discipline, a build-up of leverage, with risks transferred in an
opaque way through the global financial system. Added to this was a degree of investor
complacency, encouraged by benign economic conditions and a long period of low market
volatility. All of these together led investors to focus heavily on return while under-weighting
risk. It will be important, as the lessons of recent experience are absorbed, to improve risk
management, in particular in relation to liquidity issues, market transparency, and valuation
standards of complex financial instruments and vehicles. The management, assessment and
monitoring of credit risk, the assessment of counterparty risk and the role of credit rating
agencies are also issues which require consideration. These are all areas identified in the
roadmap of actions endorsed by EU Finance Ministers last October. Work on this roadmap is
on track and a detailed report on these issues is due to be considered by ECOFIN in April.
The domestic economy
I should say that, at times like this, the protection afforded to a small country by membership
of the euro area comes sharply into focus. It is undoubtedly the case that our ability to cope
with recent challenges has been greatly enhanced by our membership of economic and
monetary union.
Before commenting further on the domestic economy, I would like to make a few remarks
about monetary policy. As you may be aware, the most recent assessment of the Governing
Council was that, as the reappraisal of risk in financial markets continues, there remains an
unusually high degree of uncertainty over its impact on the real economy. It is clear that the
risks to the outlook for economic activity in the euro area lie on the downside; however, risks
to price stability over the medium-term are on the upside. The latest data have tended to
confirm this assessment of risks. At our next meeting in March, we will, of course, have the
benefit of new macroeconomic projections.
The prospects for the Irish economy this year are for some moderation in economic growth
following the strength of recent years. Nevertheless, growth is expected to remain relatively
favourable by international standards. The Bank projects GDP growth of around 3 per cent
this year, with GNP growth expected to be somewhat lower at about 2.6 per cent. This
represents a significant deceleration, as the economy enters a phase where domestic
demand will lose much of its recent buoyancy, with exports playing a more significant role.
Export growth is expected to grow broadly in line with export market growth, although this will
mean a somewhat slower pace than last year, given current external headwinds. A further
rebalancing of economic growth, with less dependence on domestic demand and a stronger
external performance, is therefore envisaged. Indeed, such a rebalancing is required in order
to maintain a satisfactory overall performance and to put the economy on a sustainable path.
This underlines the importance of preserving and improving the economy's competitiveness
position. The linkages between our economy and the US and, indeed, the UK, suggest that
there will inevitably be some effect from developments in these economies through various
channels such as trade, financial flows and even perhaps foreign direct investment. The
scale of the impact is difficult to assess. Although it is likely to be significant, it may not be
perhaps quite as great as some commentators have recently suggested.
In relation to fiscal policy, the somewhat expansionary stance this year will provide some
support to domestic activity. It will partly offset the slowing of domestic demand, albeit within
the limits of prudence and without an excessive deterioration in the underlying budgetary
position. It will be particularly important to reduce the rate of increase in current spending to
what can be financed by more moderate revenue growth, while continuing to focus public
capital resources on improving the country's infrastructure, in line with the National
Development Plan.
As regards domestic demand this year, the most notable adjustment relates to the
construction sector. Its weight in overall output growth is set to decline to a more sustainable
level due to a sizable reduction in residential construction output. This had reached levels in
recent years that were well beyond the economy's medium-term requirements. The
moderation in output growth and, in particular, the adjustment in the labour-intensive
construction sector suggest that employment growth is set to decelerate significantly this
year. While employment gains in other sectors of the economy are likely to more than offset
the decline in construction sector employment, the overall increase in employment is likely to
be quite modest. Employment growth seems set to fall short of the increase in labour supply
and, as a consequence, some limited rise in the unemployment rate, perhaps to an average
of about 51⁄2 per cent, is in prospect this year. Less robust output and employment growth
will, however, contribute to an easing in inflationary pressures in the domestic economy. The
average HICP inflation rate is expected to fall to around 21⁄2 per cent this year, and perhaps
further to about 2 per cent next year, bringing inflation in Ireland broadly into line with the
euro area average.
Following substantial price increases over an extended time-period, house prices have
declined reflecting an easing of demand. As prices have eased, housing output has also
fallen back from recent record highs, adjusting to meet the new demand conditions. As a
result, the supply of new houses is projected to decline to a level in line with the
mediumterm requirements of the economy, or possibly even somewhat below it. This combination of
housing output and price developments has resulted in a significant and welcome
deceleration in credit growth since mid-2006.
Turning to the medium-term, the economy has the potential to grow by around 4 per cent, a
healthy rate of expansion by the standards of other developed economies. Assuming no
adverse external developments and a broad levelling off in housing output, growth should
recover in 2009, approaching its medium-term potential. As I have already stated, however,
this outcome is contingent on the maintenance of a strong competitive position. This will
require a sensible approach to pay determination and continuous improvements in
productivity in both the private and public sectors of the economy.
I would like to particularly stress the important role of productivity for the future of the
economy. In the long run, only productivity improvements can bring sustainable increases in
the standard of living for individuals. If we try to compensate ourselves for terms of trade
losses, such as those caused by oil price increases, then the results will be damaging. We
know that this is the case from past experience. It took us many years to recover from
inappropriate responses to similar developments in the past. Policies that promote
productivity and competitiveness can, on the other hand, help the economy to ride out the
effects of adverse developments and of lower growth in the global economy. They will also
serve to increase the medium-term performance of the economy, protect employment and
allow for sustainable increases in living standards.
Population ageing and pensions
I will now turn to the issue of pensions and ageing. While it is obviously good news on an
individual level that life expectancy is increasing, population ageing more generally poses
significant macroeconomic and fiscal challenges for most developed countries, including
Ireland, during the decades ahead. The projected increase in the old-age dependency ratio
will have negative implications for economic growth, while simultaneously placing a
significant burden on public finances and on the sustainability of privately funded
occupational and private pensions.
Population ageing will place considerable pressure on the public finances by driving up
agerelated expenditure. In the European context, the most acute fiscal pressures are faced by
those countries where - unlike in Ireland - occupational pensions are mainly funded on a
pay-as-you-go basis within public social insurance systems. A number of European countries
have already adopted pension reforms aimed at controlling the projected increase in public
pension expenditure. These include a considerable restructuring of contribution or benefit
rules, increasing the effective retirement age and linking pension benefits in an actuarially fair
way to life expectancy. In some cases, where these types of reforms have proved to be
insufficient, more systemic reforms have been adopted, changing the financing structure of
pension provision with increased reliance upon funded pension arrangements.
In the Irish case, the flat rate structure of the basic state pension, together with our current
relatively favorable demographic structure, has so far resulted in a much smaller fiscal
burden from age-related expenditure. Nevertheless, on the basis of current policies,
agerelated public expenditure in Ireland is set to increase significantly in the decades ahead.
Total pension expenditure by the state is set to increase from 4.6 per cent of GDP in 2005 to
7.9 per cent in 2030 and further to 11.1 per cent of GDP in 2050, according to the latest
Department of Finance estimates.
As you will be aware, some pension reforms have already been adopted in Ireland. The most
notable has been the establishment of the National Pensions Reserve Fund (NPRF). In
addition, the parameters of the public service occupational scheme have been adjusted, with
an increase in the minimum retirement age for new entrants. While the projected
pensionrelated burden represents a significant challenge, careful planning will help to counteract the
long-term pressures emanating from population ageing. In this regard, the Government's
recently published Green Paper on Pensions presents a range of measures that might be
undertaken to address future pension expenditure pressures. The four options considered
were - a gradual increase in the current social welfare pension combined with a longer
working life, enhancements to the current voluntary pension system, the adoption of a soft
mandatory pension savings scheme and a fully mandatory pension savings scheme. Another
issue worth considering is whether tax incentives or direct contributions by the Exchequer, as
in the SSIA scheme, are the better approach. As you will also be aware, the National
Pensions Review, published by the Pensions Board in 2006, provides a further set of
recommendations.
Ireland has the advantage of starting from a healthy fiscal position, with one of the lowest
debt-to-GDP ratios in the EU. Furthermore, Ireland's demographic profile is expected to
remain favourable for some time. The country has a window of opportunity to move towards
a more sustainable position. It is important, however, that considerable practical progress is
made in good time in dealing with a problem, which, while not imminent, is nevertheless
unavoidable and needs to be addressed sooner rather than later.
There are two key issues that need to be addressed.
First, measures are urgently required to bring funding into line with the cost of state
pensions. Without this, the long term funding gap for the state pension system that already
exists will be exacerbated.
Second, private occupational and personal pension coverage is particularly low among
lowincome workers and this must be addressed. While 800,000 people are covered by
occupational pension schemes and about EUR90 billion worth of assets are under
management, at present nearly half of Irish workers are not covered by occupational or
private pension schemes. As a result, these workers face a substantial fall in living standards
when they reach retirement.
The challenge for the pensions industry itself is to mobilise private savings and to deliver
investment returns that can provide adequate pensions when they fall due. An important
factor in this is to ensure that pension products are sold in as transparent a way as possible.
In recent times, a much wider range of investment outlets for pension funds has become
available, but recent experience indicates that the risks associated with new and innovative
products need to be prudently assessed.
Conclusions
In conclusion, therefore, while both the international and domestic economies are in
somewhat of a down phase at the moment, this has followed a protracted period of strong
economic growth. A very welcome feature of this has been the rapid economic progress of
regions of the world that did not enjoy the substantial improvements in living standards
experienced by OECD countries since the second world war. Improved living standards and
levels of health care have led to very significant increases in life expectancy in both
developing and developed countries. The pensions industry and national exchequers
worldwide are faced with the challenge of coping with these profound changes. With our
relatively young population, Ireland is facing these pressures somewhat later than most other
advanced countries.
An important response, both to these longer-term challenges as well as the shorter-term
difficulties caused by a weaker external climate and adjustments domestically, will be to
continue to improve our productivity performance. There can be no doubt that we will be in a
better position to cope with challenges such as population ageing and with changes in
economic circumstances generally in a situation in which our economic performance
continues to remain robust.
As I have already mentioned, it is important that we face the longer-term challenges of
ageing without undue delay. Estimates suggest, for example, that, from a position at present
where there are six people at work to every retired person, by mid-century this ratio will fall to
two people at work to every pensioner. The various discussion papers, including the recent
Green Paper, set out the various options for us to choose as a nation. It is important that we
move ahead soon to deal with these issues, so that it will not be necessary to take more
drastic action at some stage in the future.