European Commission

Directorate-General for Economic and Financial Affairs

Economic Adjustment Programme for Ireland

Summer 2013 Review

EUROPEAN ECONOMY

The report was prepared in the Directorate General for Economic and Financial Affairs under the direction of István P. Székely, Director and European Commission mission chief to Ireland, and Martin Larch, Head of Unit for Ireland, Poland and Lithuania.

Contributors:

Davide Lombardo, Quentin Dupriez, Martin Larch, Kristin Magnusson, Danila Malvolti, Jānis Malzubris, Joao Mederios, Marie Mulvihill, Nigel Nagarajan, Wolfgang Pointner, Etienne Sail, Victor Savin, Graham Stull, Stephanie Medina Cas, and Jacek Szelożyński. Input and comments from Servaas Deroose (GE ECFIN), Uwe Boewer (DG ECFIN), Ioana Diaconescu (DG ECFIN), Brigitte Brockmoeller (DG EMPL), Dirk Van Den Steen (DG SANCO), and the financial crisis task force of the Directorate General for Competition are gratefully acknowledged.

Comments on the report would be gratefully received and should be sent, by mail or e-mail to:

Martin Larch

European Commission

Head of Unit responsible for Ireland, Lithuania and Poland

CHAR 14/174

B-1049 Brussels

E-mail: martin.larch@ec.europa.eu

Executive Summary 5

Introduction 7

1. Recent economic developments and outlook 9

1.1. Macro-fiscal and financial developments 9

1.2. macroeonomic outlook 14

2. Policy outlook 17

2.1. Fiscal policy 17

2.2. Financial sector reform 25

2.3. Structural reforms 27

3. Financing issues 35

4. Risks 37

Abbreviations 39

A1. Programme Implementation 41

A2. Supplementary Tables 49

A3. Updated programme documents 53

LIST OF Tables

1.1. Revised macroeconomic framework 15

2.1. Public finances, 2013 18

3.1. Financing requirements 36

A1.1. Compliance assessment 41

A2.1. Use and supply of goods and services (volume) 49

A2.2. Use and supply of goods and services (value) 49

A2.3. Implicit price deflators 50

A2.4. Labour market and cost 50

A2.5. External balance 50

A2.6. Fiscal accounts 51

A2.7. Debt developments 52

LIST OF Graphs

1.1. Recent economic indicators 10

1.2. Banks funding developments 12

1.3. Mortgage arrears 13

1.4. Banks' lending developments 14

2.1. Fiscal stance, Ireland 21

2.2. Labor market developments 30

LIST OF Boxes

1.1. Revisions to national accounts data in Ireland 11

2.1. Protecting the most vulnerable 19

2.2. Ageing costs and long-term fiscal sustainability 22

2.3. Issues in relation with water charges 31

Under the EU/IMF-supported economic adjustment programme, Ireland continues to make good progress towards addressing the crisis legacy of high indebtedness in public and private balance sheets. A number of developments, including European decisions to extend loan maturities, have further reduced market financing needs in the coming years. This, together with confidence in the Irish authorities’ commitment to programme reforms, has supported improved funding conditions for both the Irish sovereign and the banks. Programme implementation remains strong overall: all milestones for 2013 Q2 were met, with the exception of the publication of an e-Health strategy (which is delayed to the third quarter), and some outstanding issues in relation to the medium-term budgetary framework.

Steadfast programme implementation has been rewarded by an impressive turnaround in investor sentiment. The decline in Irish government bond yields since their peak in mid-2011 has been remarkable. Yet, challenges and risks remain on the road to full recovery and sustained growth including a still large government deficit and debt-to-GDP ratio, high unemployment, and banks' growing non-performing loans. As the end of the programme is in sight, Ireland needs to sustain regained market confidence by a steadfast implementation under the programme and by continuing on the path of reform and fiscal consolidation. Discussions on programme exit continue. The authorities have indicated that they are assessing all options.

A gradual recovery for the second half of this year is expected, although the national accounts release of the first quarter 2013 was lower than projected, which has implications for the forecast of annual GDP growth rate in 2013. Near-term real GDP growth forecasts were revised down accordingly. Key factors underlying the changes are the negative statistical carry-over and a reassessment of the buoyancy of exports, which now appear to be more closely linked to foreign demand, the near-term forecast of which has been lowered since the time of the last review. However, more recent high-frequency data are more positive both in Ireland and abroad, and appear to support the expectation of a measured recovery during the second half of the year.

The Commission's revised preliminary 2013 deficit forecast is 7.6% of GDP, just slightly above the programme ceiling of 7.5% of GDP showing the need for careful budget execution. This reflects mostly the effect of lower economic growth and related downward reassessment of tax revenue. Other deficit-increasing risks bear close monitoring, including potential overruns in the health budget in the second half of 2013 due to delayed implementation of certain budgetary measures. The authorities have reiterated their commitment to manage budget execution proactively so as to ensure that overall expenditure will remain within the budget ceilings, including by offsetting any overruns with savings elsewhere. The introduction of the new property tax erepresents key progress towards a broader and more stable tax base, and proved smoother than had been the case with its precursor (the household charge) last year.

The 2014 Budget will be key to secure durable and fair consolidation and put the debt ratio on a downward path. During the July 2013 review mission, the authorities were not yet in a position to discuss their precise intentions as regards the 2014 Budget. The troika reiterated that, in order to underpin the recent improved market confidence, it is essential that the 2014 Budget is in line with the requirements of the EU "two-pack" regulation and be fully consistent with the 2010 EDP Council recommendation. In particular, the recommended structural consolidation effort should be maintained and interest savings should be used to accelerate debt reduction. The authorities have reiterated their commitment to meeting the targets in line with Council recommendation under the EDP. The 2014 Budget should also set out the main contours of structural reforms in key spending areas that could underpin savings while safeguarding access to key services and protecting the most vulnerable.

Progress was made with the recently agreed 2013 bank diagnostic exercise and with fine-tuning the target-based approach of the Central Bank of Ireland (CBI) to deal with mortgage arrears:

· Assessment of banks' balance sheets: progress has been made regarding methodological aspects of this all-important exercise. The Central Bank of Ireland will be assisted in the execution of the exercise by independent third parties, who will also independently validate the exercise.

· Targets for the completion of sustainable mortgage solutions: given the delay in dealing decisively with mortgage arrears there is a need for targets to ensure that banks deal with their arrears in a timely fashion and so devote themselves to new credit extension in support of the recovery. It is important that a balance is achieved whereby the targets are appropriately ambitious but do not result in the banks unduly relying on the legal route as a way to reach them. Moreover, the court system might not be adequately prepared and resourced to deal with the resulting acceleration in legal cases.

· Repossession procedures: Legislation removing the unintended legal impediments to repossession (from the so-called Dunne judgment) was enacted at the end of July 2013. A review of the effectiveness, length, predictability and costs of repossession procedures is to be conducted by end-year by an expert group, based on terms of reference agreed with the troika.

· "Tracker" mortgages: the authorities continue to explore feasible options to lower the drag on banks' profits from "tracker" mortgages.

Structural reforms continue to advance, though sometimes at a measured pace. The authorities had identified the outsourcing of employment services as an option for addressing capacity constraints in mid-2011. However, it will likely be another year until private providers are in operation. In the meantime, some progress is being made in increasing the number of case-workers within the Department of Social Protection, even though the totals are still small. Two key laws to reform the further education and training (FET) system have been enacted in the past quarter. The reshaping of FET institutions and programmes to improve the skills of the unemployed remains to be completed. Collective labour bargaining mechanisms (and the related statute) need to be re-considered as a result of Court rulings and will need additional legal reform to be re-established. The sale of Bord Gaís Energy and two assets of the Electricity Supply Board should be completed by year-end. Progress with water reforms are on track, with the installation of meters having commenced in August and good progress in drafting the Water Services Bill. Some, albeit slow, progress has also been done in moving the Legal Services Regulation Bill closer to enactment. In the healthcare sector, key measures are being taken to reduce the cost to the state of pharmaceuticals. If complemented by wider reforms underpinned by a timely and well-executed e-Health strategy, these could help achieve much needed value-for-money improvements in health spending. This should help to mitigate against medium-term budgetary risks arising from demographics trends.

A successful completion of the 11th review triggers a disbursement of EUR 2.3 bn from the EFSF. The IMF will disburse EUR 0.8 bn and Sweden and Denmark will disburse a combined EUR 0.25 bn in the context of their bilateral loans to Ireland. This will bring the total amount authorised for disbursement under the programme to 97.9% of the overall international assistance of EUR 67.5 bn. On top of the loans from international lenders, the overall programme envelope also includes EUR 17.5 bn of programme funds provided by the Irish authorities. At the end of the second quarter of 2013 the cash balances of the sovereign amounted to EUR 25.7 bn, compared to EUR 12.3 bn at the end of 2010 when the adjustment programme was launched.

A joint European Commission (EC)/European Central Bank (ECB)/International Monetary Fund (IMF) (henceforth, the "troika") mission visited Dublin during July 9-18 2013 for the 11th review of Ireland's EU/IMF‑supported economic adjustment programme. Compliance with the programme milestones set for the second quarter of 2013 remained strong overall though with a few delays—see the compliance monitor in Annex 1 for a detailed account.

The mission discussed recent economic and financial developments as well as the outlook (section 2), the main policy challenges (section 3), and the government funding situation (section 4). ([1]) The updated Memorandum of Understandings on Specific Economic Conditionality (MOU), reflecting exchanges and agreements with the authorities, is included in Annex IV, together with other updated programme documentation.

1.1. Macro-fiscal and financial developments

The first national accounts estimates for Q1 2013 suggest that the economic recovery in Ireland has been more fragile than previously thought, while Q2 data were not available at the time of writing the report. Real GDP is currently estimated to have shrunk by 0.9 % y-o-y in the first quarter, against consensus expectations of positive growth of 0.3-0.5% y-o-y. Growth rates of all expenditure components of GDP fell on annual terms, which especially for private consumption is challenging to square with more positive high frequency data as discussed further below. The large fall of investment (-19.6%) was skewed by the timing of aircraft purchases (investment excluding this category grew by 6.3%). Nominal GDP declined by 2.2% on the year as the terms-of-trade, which has recently supported nominal output measures, turned negative. The diverging developments between GDP and GNP, which measures the income accruing to households and firms resident in Ireland, continued through the first quarter, with the latter measure growing by 6.1%, although the issue of re-domiciled firms outlined in previous reports complicate the assessment.([2]) Large historical revisions to annual national accounts data have also been released, as discussed further in Box 1.

The "pharma cliff" and weak trading partner demand have taken a toll on exports, although the latest external indicators have been more supportive. The volume of merchandise exports (which predominantly consist of pharmaceutical goods) fell by 6.8% during the first six months of the year compared to the same period in 2012, with a fall in the volume of merchandise imports of 1.6% over the same period. Declines in exports growth rates were offset by even larger ones of the import category, and as a result the current account surplus surged to over 3% of GDP in the first quarter, compared to a deficit of 1.8% a year ago. The relatively weak export performance appears to be driven by external demand and structural factors such as expiring patents of pharmaceutical drugs as harmonized competitiveness indicators continue to compare very favourably to the pre-crisis years([3]) and inflation pressures remain muted, with the latest reading of HICP inflation of 0.7% y-o-y in July compared to the euro area estimate of 1.6% y-o-y. Going forward, the impact of the return to positive annual economic growth in the euro area in the second quarter, the upwards revisions to US and UK growth rates for the same period, and the two-year high Purchasing Managers Index (PMI) for the euro area in August should eventually feed through to more robust export performance.

Recent high-frequency data point to a more resilient performance of the domestic economy through the second quarter of 2013. Q1 2013 marked the second consecutive quarter of positive growth q-o-q in the construction sector, though from a very low base, and house prices in Dublin continue to increase, suggesting that the drag on prices from the expiration of mortgage interest rate relief is petering out (house prices remain virtually flat in the rest of the country). The services index grew by about 2.5% during the first half of the year compared to the same period in 2012. The volume of retail sales was virtually unchanged through the first seven months of the year compared to the same period in 2012 (regardless of whether the motor trade category was excluded or not). The Live Register measure of standardised unemployment has resumed its steady downward trend after a period of stability in early 2013 and dropped to 13.5% in July. The quarterly national household survey (QNHS) confirmed this improved performance, with annual employment growth picking up speed to 1.8% in the second quarter, up by almost a full percentage point compared to the first quarter growth rate. The second quarter data also marked the first positive annual growth rate in five years for full time jobs and for the participation rate (as discouraged workers re-entered the labour force). At the same time, nominal wage growth was only 0.1% during the first half of 2013 compared to the same period the previous year, meaning that real wage growth has been negative since the last quarter of 2009. Consumer confidence has however continued to improve, with the three-month moving average in August reaching levels last seen during the autumn of 2007. The most recent survey indicators such as manufacturing and services PMIs also suggest that a relatively modest expansion can be expected going forward.

Graph 1.1: Recent economic indicators

Source: CSO

The 2013 fiscal outturn so far has been broadly in line with plans, in part benefiting from positive timing factors. Local property tax payments came in earlier than expected, suggesting strong compliance (thus alleviating earlier concerns about the implementation of this new tax, based on last year's experience with its precursor, the household charge). Weaker-than-expected VAT revenue (0.1% of GDP below plans) due to softer domestic demand developments is compensated by stronger corporation tax revenue. Non-tax revenue to-date confirms the expectation of higher surplus payment from the CBI and Eligible Liabilities Guarantee (ELG) fee revenue. Current and capital spending was below plans (0.1% of GDP each), but this is largely a timing issue.

Graph 1.2: Banks funding developments

Deposits data covers BOI, AIB and PTSB. Deposit rates data covers all Irish resident banks and refers to deposits with agreed maturity up to 2 years. HH=household; NFC=non-financial corporates; NBFI=non-bank financial intermediaries. Source: Central Bank of Ireland, Department of Finance

Banks continue to make progress towards a more sustainable funding position. Deposit volumes remained stable in July (at EUR 152 billion), in spite of the continued downward trend in interest rates (the rate on outstanding household term deposits stood at 2.69% at end-June 2013, compared with 2.78% at end-May 2013 and 3.64% at end- June 2012 (left panel in Graph 1.2). Funding by the Eurosystem to domestically-owned banks also continued to decline (year on year borrowing declined by EUR 27 billion in July and by more than EUR 59 billion relative to January 2011), and now represents approximately 4.2% of total Eurosystem funding, down from a peak of nearly 19% in early 2011. Total monetary authority funding to domestically-owned Irish banks fell to approximately EUR 34 billion at end July 2013 from a peak of EUR 156 billion in February 2011 (right panel in Graph 1.2).

Nonetheless, lending remains subdued and lending rates high. Credit advanced to households decreased by 4.4% year-on-year (y-o-y) in July 2013 and have contracted every consecutive month since November 2009, with lending for house purchase down 2.2% y-o-y. ([4]) Furthermore, lending to SMEs and businesses continues to be quite constrained (left panel in Graph 1.4) with lending rates remaining higher than euro area average. In terms of new loans to non-financial corporations (NFCs)([5]), at end June the rate stood at 2.48% compared to the euro area 12 month average of 2.28%. There has been considerable month-on-month volatility in lending rates which, according to the CBI, is due to the particularly low volumes of new lending currently being experienced for NFC loans (there was EUR 442 million new lending in June 2013 in this category compared to a peak of EUR 10.2 billion in March 2009).

Graph 1.3: Mortgage arrears

Source: Central Bank of Ireland

While the flow of new arrears continues to slow, the stock and the increased long-term nature of the arrears remain a concern (Graph 1.3). At the end of Q2 2013 there were over 128,000 primary dwelling house (PDH) and buy-to-let (BTL) mortgages in arrears for more than 90 days, representing almost 14% of the total number of mortgages and almost 20% of the outstanding loan balances. Of these, over 76,000 were in arrears for more than one year and almost 30% of accounts (over 39,000) were in arrears for more than two years, representing a quarter on quarter increase of 12.1%. Loan balances in arrears more than 360 days continue to rise, reaching 12.4% of the value of banks' aggregate mortgage book at end Q2 2013 (from 11.7% at end Q1 2013), for PDH and BTL or investment properties.

The majority of restructures in place continue to be of a short term nature. 337 split mortgages, 320 permanent interest rate reductions and 9 trade-down mortgages were in place at end of Q2 2013, whereas there were over 30,000 restructures on interest‑only and over 5,700 on less than interest‑only arrangements. The authorities have recently begun to provide the re-default rates for restructured loans: 76% of restructured PDH accounts were deemed to be meeting the terms of their arrangement. This means that the borrower is, at a minimum, meeting the agreed monthly repayments according to the restructure arrangement. However, as this covers both short-term and longer-term restructures, this is not a clear measure of the sustainability of arrangements in place.

Graph 1.4: Banks' lending developments

1/Data for households includes mortgage loans. Source: Central Bank of Ireland

While considerable resources have been deployed developing sustainable solutions such as split mortgages, application of these remedies has been limited to date. According to CBI published data, there were 337 split mortgages at end Q2 2013. It is envisaged that split mortgage will be used as an effective treatment of arrears by cooperating borrowers where considerable restructuring and adjustment is required on both sides for the mortgage to return to sustainability. According to the banks there has been some additional activity in this area in recent months, with PTSB offering some 1,500 split mortgages to-date, of which roughly 1,000 have been accepted and AIB offering 1,600 split mortgages to-date. The official figures do not fully reflect these numbers as the significant majority of these offers are subject to the satisfactory establishment of a repayment record over a six month period. Upon satisfactory completion of this term the offer of the split mortgage is confirmed.

1.2. macroeonomic outlook

The revised national accounts data have prompted a downgrade of growth forecasts. Real GDP is now expected to grow by 0.6% in 2013 and by 1.8% in 2014, compared with 1.1% and 2.2% at the time of the last review (Table 1 below). A pick-up in economic activity after the first quarter of 2013 is built into these projections, given the Q1 negative carry-over of -1%, and appears to be borne out by the recent high-frequency indicators in Ireland and abroad. The revised national accounts also point to a weaker recovery after the first stage of the crisis, which suggests less scope for a rebound effect going forward. Weaker HICP inflation and worsening terms-of-trade have been reflected in a more subdued outlook for the GDP deflator. Together with the downgrades of real GDP growth, the level of nominal GDP is therefore projected to be somewhat lower going forward than forecast in the previous review.

Growth is still forecast to become more broad-based towards the end of the projection period. Private consumption has been revised down slightly in 2013 on account of the weak performance during the first quarter, weak earnings data and headwinds from the strong performance during the second half of 2012 (on account of one-off effects such as house purchases brought forward to benefit from the expiring mortgage interest rate relief, and the digital switchover). Near-term investment projections have been increased somewhat as momentum in core investment (excluding aircrafts) appears slightly stronger than thought, although it continues to be dominated by the MNE sector. The recent data revisions have shown that Irish exports, including services, are more attuned to trading partner demand than previously thought. Effects of downwards revisions to trading partner demand in the near term ([6]), and more support from trading partner demand in the outer years, have therefore been incorporated more explicitly in the projections. The so-called "pharma cliff" also appears to have somewhat stronger effects than earlier thought, which is especially thought to impact projections in 2013-2014.

There is substantial uncertainty around the baseline scenario. Current export projections rest on an assumption that the nascent recovery in trading partner demand will become more solid, and will be hard to attain if the latter disappoints. The effects of the "pharma cliff" are also expected to gradually peter out, and some new patented pharmaceuticals to come on stream, but the exact magnitude of these effects are still unknown. Risks to domestic demand projections largely remain as in previous Commission Services' reports, i.e. credit constraints curtailing SME investment ([7]) and hiring and relatively rapid household deleveraging amid diverging cohort effects on private consumption posing downside risks. There are however also upside risks to labour market projections, as unemployment continues to fall and the latest QNHS appear to suggest that the post-crisis trend of part-time employment for new job creation could be coming to an end. If future job creation continues to be in the form of full-time and permanent jobs, it would allow for an increase in weak earnings, dispel uncertainty around future disposable income, and support stronger private consumption developments than what is currently projected.

Table 1.1: Revised macroeconomic framework

Source: Commission Services

Risks to the outlook could be substantially reduced by consistent policy implementation, as underlined in a new medium-term study. In their July 2013 medium-term review, the Economic and Social Research Institute (ESRI) formulate three possible different future scenarios and illustrate the role of domestic policies for improving macroeconomic outcomes by means of en estimated general equilibrium model.([8]) They show that for unemployment to return to the vicinity of the levels seen prior to the crisis, a very strong recovery of trading partner demand and decisive financial sector repair is needed. It would also relatively quickly restore public finances, allowing public consumption to support growth from 2015 onwards to reach on average 4% for the last five years of this decade. Another scenario shows that even if these assumptions about the external environment were to be realized, lack of progress on restoring the financial sector to healthy operations would risk not delivering sufficiently high GDP growth to restore the sustainability of public finances, with average growth for 2015-2020 below 1.5%. ([9])

2.1. Fiscal policy

Despite an outstanding track record, there is a risk of slightly exceeding the general government deficit ceiling of 7.5% of GDP for 2013, showing the need for careful budgetary execution.. This is mainly due to the downward revision of growth, delays in the implementation of structural measures in the healthcare sector, and some one-off elements. Turning to the 2014 Budget, underpinning the recent improvements in market confidence requires strictly adhering to Ireland's commitments. Structural reforms in main spending areas and further strengthening of the medium term expenditure ceilings would help ensure that the remaining consolidation is achieved in a durable, fair, and as growth-friendly as possible manner.

The baseline Commission Services forecast for the 2013 general government deficit has been increased to 7.6% of GDP – just slightly above the 7.5% nominal ceiling (which was also the forecast of the previous review). This reflects in broadly equal parts a lower denominator effect, but also some downward reassessment of tax revenue, mainly from a projected continued underperformance in VAT, in line with the downward revision to the forecast for growth in private consumption (Table 2.1 shows updated forecast as compared to the 2013 budget estimates). Other items, such as personal and corporate income tax revenue, non-tax revenue and overall expenditure, have been kept largely unchanged as compared to the 10th review. On the expenditure side, some pressures are expected to emerge in the health sector in the second half of the year, given delayed implementation of certain budget measures. The baseline forecast assumes, consistent with the authorities' reiterated commitment, that contingency measures will be activated if needed to keep overall spending within the aggregate envelope (in this respect, the lower spending to-date may act as a buffer).

The baseline forecast is subject to several risks:

- Pointing to a potentially higher deficit: as mentioned above, the baseline forecast assumes that delayed or partial implementation of some health sector measures ([10]) will be offset by compensatory measures, but both the size of the possible overruns and of the corrective actions is uncertain. Moreover, previously identified risks remain, namely:

- The IBRC liquidation. The state is required to make up any potential difference between the amount paid by NAMA for IBRC's assets and the valuation of those assets made by the special liquidators ([11])

- AIB dividends. The receipt by the government of ordinary shares as a dividend payment from AIB (0.2% of GDP) may be reclassified as deficit-increasing transfer by Eurostat ([12])

Table 2.1: Public finances, 2013

(1) Excludes Sinking Fund transfer from current to capital account and loan/repayment to/from the Social Insurance Fund which are the Exchequer deficit neutral. (2) The government balance excludes one-off deficit-increasing financial sector measures. Revised GDP forecast since the budget affects deficit ratio. Source: Commission services; Department of Finance.

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Box (continued)

- The so-called Waterford Crystal case. The European Court of Justice ruled that the state needs to have mechanisms in place to ensure in excess of 49% of employees' pension benefits are protected in a double insolvency situation – the bankruptcy of a company and its pension fund. The case is back in the Commercial Court for hearing before the end of 2013 and its judgment will determine the public finance implications. While the net present liabilities to the state could amount to some 0.2% of GDP, it is likely that this amount would be spread out over the lifetime of the pensions. The case could possibly still set a precedent for few other instances of double insolvencies and expose the state to further claims.

- Possible shortfalls in the wage-bill savings from the negotiated agreement with the unions. It is not yet possible to determine whether the Haddington Road Agreement will deliver in full the planned savings of EUR 300 million for 2013 (0.2% of GDP)([13]).

- Pointing to a potentially lower deficit: spending pressures in areas other than health seem to be under control and the improving labour market situation should alleviate demand for welfare services.

Ireland's fiscal stance has not been overtly pro-cyclical since the beginning of the crisis. Using conventional metrics, discretionary fiscal policy has been clearly leaning against the wind in 2008 and 2009, and did not move openly or blatantly into the wind in 2010 and after, in spite of the significant budgetary adjustment efforts put in place by the Irish government (Graph 2.1). ([14]) Fiscal policy remained, and is expected to remain broadly in line with the stabilisation function of discretionary fiscal policy , or at least not to run counter that function. In the early years (2008-2009) when fiscal policy was incontrovertibly counter-cyclical, the fiscal policy strategy mainly consisted of correcting previous policy commitments built on optimistic growth projections accompanied by the fact that in a deflationary environment, nominal expenditure freezes implied increases in real terms. Since 2011, the improvement of the structural deficit has taken place in an environment of slightly improving economic conditions.

Graph 2.1: Fiscal stance, Ireland

Source: Eurostat for real GDP growth 2007-2011; Irish Stability Programme 2013 for real GDP growth 2012-2015

The latest official deficit targets for the coming years were outlined in the budget 2013 package and the 2013 Stability Programme. In April this year the government adopted the 2013 Stability Programme which, for 2014 and 2015, features deficit targets of 4.3% of GDP and 2.2% of GDP targets, respectively. The stability programme essentially restated previous commitments to fiscal adjustment presented in the November 2012 Medium-Term Fiscal Statement, as part of the budget 2013, and allocated the dividend from the replacement of the promissory notes with longer-dated government bonds to faster debt reduction. If fully implemented, these commitments would be consistent with the requirements under the programme and the Council recommendation under the EDP.

During the July review mission, the authorities were not in a position to discuss the 2014 budget, as preparations were at an early stage. In order to underpin the recent improvements in market confidence and put the debt ratio on a declining path, it remains crucial for Ireland to adhere strictly to the commitments undertaken under the programme and the EDP, thus enhancing prospects for a sustained return to affordable market funding. The fiscal adjustment presented in the 2013 Stability Programme is estimated to be consistent with the nominal and structural adjustment recommended under the EDP (see Box 1 of the previous review report). The Stability Programme restates the commitment to the fiscal adjustment presented in the November 2012 Medium-Term Fiscal Statement of EUR 3.1 billion (1.8% of GDP) in 2014 and EUR 2 billion (1.1% of GDP) in 2015, as well as demonstrates that savings from the replacement of the promissory notes with longer-dated government bonds are used to accelerate debt reduction. To ensure that the remaining adjustment is achieved in a sustainable, fair and growth-friendly matter, the 2014 budget should also spell out the key elements of reforms in the main spending areas that increase efficiency while protecting access to services for the most vulnerable. The remaining consolidation options identified in the 2011 Comprehensive Expenditure Review represent a good starting position in this respect.

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Box (continued)

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Box (continued)

Significant progress has been made from the beginning of the programme to strengthen Ireland's medium-term fiscal framework. As highlighted in previous Commission reports under the programme ([15]) and more recently by the IMF Fiscal Transparency Assessment (FTA)([16]), several important reforms have been introduced in recent years, including the passage of the Fiscal Responsibility Act (FRA), the establishment of a new Fiscal Advisory Council (IFAC), the introduction of a medium-term expenditure framework (MTEF), and enhanced reporting (e. g. quarterly government finance statistics and alternative presentation of Exchequer returns).

Despite important improvements, the multi-annual expenditure framework is not yet fully consistent with the EU Fiscal Framework Directive, the recommendations of the Economic Policy Committee, and international best practice([17]). In particular, the recently legislated Ministers and the Secretaries (Amendment) Act does not identify the specific circumstances and modalities in which the multi-year expenditure limits can be changed by the government. Moreover, the Irish multi-year expenditure ceilings cover a different aggregate than that defined by the SGP's "expenditure benchmark" ([18]).

These remaining issues in the framework could be addressed through appropriate legislative reforms. This would enhance the capacity of the expenditure ceilings to serve as medium-term policy anchors, subject of course to well defined escape clauses, and foster transparency and accountability and especially in light of the experience with fiscal policy making in the years preceding the crisis. From this perspective, the authorities' intention to specify the escape clauses in an administrative circular may leave leeway for ad-hoc modifications of the ceilings in the future.

The authorities consider that the existing audit arrangements and reporting satisfy the EU requirement for a comprehensive audit of public finances for Member States under a macroeconomic adjustment programme ([19]). Existing annual audits of public finances by the Office of the Comptroller and Auditor General ensure legality and regularity of public finances. Also, public finance data reporting has been continuously improved by more comprehensive publications, streamlined data collection procedures and quality checks. Dedicated reports by Regling and Watson (2010), Honohan (2010) and Nyberg (2011) have analysed policy and market failures leading to the Irish financial crisis. This satisfies one of the objectives of the comprehensive audit, going beyond the traditional audit activities and assessing broader functions of the public institutions, including government, and supervisory and regulatory bodies. Moreover, the budgetary framework has been strengthened under the EU-IMF programme with a move towards multi-annual budget planning and the establishment of the Irish Fiscal Advisory Council.

2.2. Financial sector reform

Progress has been made regarding the resolution of mortgage arrears but, given the increasingly long-term nature of arrears, more needs to be done. Appropriately ambitious targets are required to ensure the vast majority of arrears cases are effectively dealt with by end 2014. The recent regulatory and system changes (remedying of the legal lacuna created by the "Dunne" judgment, updating of the Code of Conduct on Mortgage Arrears), and the roll out of key reforms such as the Personal Insolvency regime are welcome. The authorities now need to ensure that the legal system is fully equipped to deal with the expected increases in case loads, including by deploying additional resources if required. Progress continues to be made regarding the methodology for the f diagnostics of the Irish banking sector that will be completed in Q4 2013.

Prompted by the CBI target-based approach implemented in March 2013, banks have begun to offer proposals to restructure mortgages in arrears, but the mix has not been ideal. All banks report that they have met the end June target of offering sustainable solutions to 20% of customers in arrears for more than 90 days. The CBI will monitor and audit the banks' progress, assessing the sustainability of offered solutions and will report the findings of this review to the troika in November. It appears that the approach being undertaken by the banks is to deal with the extreme arrears firstly i.e. the very early arrears through such options as arrears capitalisation and appropriate lifestyle adjustment, and to deal with longer dated arrears, where there has been no engagement for a sustained period, by initiating legal proceedings.

The authorities need to set ambitious targets for concluding sustainable solutions for a substantial proportion of loans in arrears by end 2013. During September, the CBI will set public targets for the principal mortgage banks to conclude sustainable restructurings for a significant share of problem loans by year end to achieve the objective that the vast majority of loans in arrears greater than 90 days will be sustainably treated by end 2014. It is important that a balance is achieved whereby the target is appropriately ambitious but does not result in the banks unduly relying on the legal route as a way to reach the targets. A sustainable solution which does not include legal action is usually in the best interest of both parties as legal actions are costly for both sides and the revised payment terms under the new arrangement can in most instances be more affordable than renting for the customer. Any further delays in dealing decisively with mortgage arrears are a considerable drag on the recovery of the domestic economy.

Regulatory and legislative reforms should facilitate the legal process with repossessions, but there are concerns that the judicial system may be unprepared to deal with an increase in cases. There have been several key advances on the regulatory framework, such as the revision of the Code of Conduct on Mortgage Arrears, which now provides greater clarity regarding non-cooperative borrowers and allowable contact, and the enactment of the Central Bank (Supervision and Enforcement) Act 2013, giving more supervisory powers to the CBI and of the Land and Conveyancing Law Reform Act 2013([20]), which removes unintended obstacles to repossessions. Furthermore, work continues on ensuring the first personal insolvency applications are accepted from early September. While all these steps are welcome and reflect the culmination of work under the programme, there are concerns regarding the ability of the courts' system to deal with the expected increase in work load arising from the various policy initiatives. While safeguards have been put in place to keep co-operating borrowers in their homes, given the number of non-cooperating borrowers, particularly in investment properties, an increase in the number of repossessions from the very low levels experienced in recent years is likely ([21]).

The authorities have committed to examine by end October the merits of assigning additional functions to the Specialist Judges dealing with personal insolvency cases, which will enable them to deal with repossession cases as needed. Furthermore, an expert group will be established to review by end-2013, the length, predictability and cost of proceedings, including relative to peer jurisdictions, and propose measures to deal with any problems arising. It is important that there is a clear distinction between the family home and pure investment properties; this distinction is evident with regards to the Code of Conduct on Mortgage Arrears (CCMA), which only protects the family home, but should also be made also more clearly in respect to legal proceedings. In light of this, the authorities will examine the possibility of introducing expedited proceedings, based on the experience of the Commercial Court ([22]), for repossession cases relating to investment properties and will report to the troika by end October. The introduction of such a fast-track scheme would reduce the costs of BTL repossessions and would allow the banks to focus their resources on working with co-operating borrowers to find sustainable solutions.

A framework to facilitate multiple-creditor debt for borrowers with both secured and unsecured loans will commence in September on a pilot basis. The scheme for 750 multiple creditor will run for 3 months. This aims to achieve sustainable and fair outcomes without the need for the borrower to enter the statutory insolvency process. To be eligible for the framework, a borrower must be cooperating with their lenders and have taken steps to adjust their expenditure to established norms. The focus of the pilot is a protocol to enhance cooperation between lenders of secured and unsecured debt at an early stage. While the establishment of this protocol is welcome, banks report that some customers in mortgage arrears continue to access new unsecured credit from other lenders, which they then prioritise over their mortgage payments. This acts as a disincentive for borrowers to engage with banks' efforts to restore payment discipline, and could indicate that the financial system is not allowing banks to recycle their capital efficiently. Restoring debt-servicing priority is an essential condition for a well-functioning mortgage market and is vital for ensuring that the strategy of addressing mortgage arrears can ultimately succeed.

Going beyond mortgages, SME loans in arrears also need to be addressed with greater urgency. The authorities have set restructuring targets for the two main banks involved in SME lending, consistent with ensuring a migration from short term forbearance measures to sustainable solutions. In order to ensure these restructurings are sustainable, the CBI's on-site reviews in the second half of the year will focus on the banks’ operational restructuring capabilities and strategies, the durability of the solutions, and the appropriateness of collateral valuations. The authorities are progressing with the necessary legal provisions to grant the option for SME examinership to be considered by the Circuit Court, which would reduce the associated costs. However, these provisions are provided for in an extensive bill reforming the Company Law, which is not expected to be passed until 2014. Given the importance of the issue, the authorities are seeking to accelerate the adoption of the relevant provision by year-end. In addition, the authorities are considering additional legislative amendments to enhance the SME examinership legal framework to reduce costs and achieve efficiency gains, drawing on experience with the operation of the Insolvency Service in the personal insolvency reform and recommendations in the Company Law Review report. One key policy option is the potential for an administrative body to facilitate SME restructuring out of courts, which would reduce the costs and allow for a more efficient timely process.

The credit guarantee scheme for SMEs([23]) and the microfinance fund([24]) should be reviewed, in light of low levels of take-up([25]). As regards the former, an external review of the scheme is due to be completed by end August, and if legislative changes are recommended every effort should be made to advance these through the legislative process. As regards the second, the authorities have committed to reviewing this scheme. After two years of operation and given the disappointing low levels of engagement, the authorities should consider bringing forward the review. The recent Government decision to dissolve the thirty five County Enterprise Boards and transfer their functions, assets, and liabilities to Enterprise Ireland should enhance the delivery of State support to micro and small businesses and thus should be implemented soon.

Separately, but importantly, progress continues to be made in terms of banks' diagnostics:

· Progress has been made regarding methodological and practical elements of the forthcoming assessments of the banks' balance sheets. In particular, external consultants will have an active role in both aiding the CBI in executing the exercise and in independently validating the exercise and the results. Furthermore, a roadmap for the delivery of the exercise has been agreed with programme partners who will be consulted regularly on progress and results.

· The authorities continue to explore feasible options to lower the drag on banks' profits from "tracker" mortgages.

2.3. Structural reforms

Important steps have been taken recently that will pave the way for additional reforms in activation policies and further education and training. These steps are strategic, and will still need to develop into operational strides to ensure that improved services and support are provided to the unemployed as quickly as possible. Further ground has been laid for the reorganisation of the water sector and the introduction of domestic charges during the final quarter of 2014, and the Legal Services Regulation Bill is t moving somewhat closer to enactment. Further reforms should be pursued to reduce costs and increase efficiency in the provision of health care, such as introducing a system of e-prescriptions, lowering the cost of drugs, promoting the use of generics, and increasing the recovery of costs from private patients in public beds.

2.3.1. Labor market activation

The Government has decided to outsource some activation services to private providers. The shortfall in activation resources has been evident for a long time and the outsourcing option had been considered as early as mid-2011. In late 2012, the Government commissioned a study by external experts to assess the options and suggest a contracting model. The study, completed in early 2013, confirmed the feasibility of outsourcing in Ireland and proposed key features for contract design and the tendering procedure, including a focus on the long-term unemployed, a payments-by-results approach, a four-year duration, and a sub-division of the country in five areas with contractual exclusivity. Many suggested features are expected to be maintained, but the Government indicated that it intended to modify others in order to guarantee a high-level of service delivery, appropriate coverage of different categories of unemployed and adequate cost competition.

In spite of recent measures, it will likely be at least a year before private activation services are in place. A Prior Information Notice (PIN) was issued in early July that specifies that the contracts could encompass the provision of activation services (e.g. job searching, coaching, personal action plans and preparation of CVs) to between 50,000 and 100,000 unemployed people. The authorities indicated that they received significant expressions of interest, and a formal request for tenders will be issued before the end of November following final Government decision on the scope and structure of the outsourcing contracts. Although the issuance of the PIN should accelerate the procedure, the authorities expect that the procurement process and establishment procedures will be such that service delivery will not start until late 2014, in line with recommendation of the external experts

There is scope for increasing the targets to engage the long-term unemployed in the activation process. Three hundred public service staff members are expected to be redeployed as case managers as targeted by end-2013, with an additional 200 redeployments as soon as possible in 2014. These redeployed officers will need to receive adequate training to take on their new functions. The authorities intend to allocate a significant share of these additional resources to provide activation support to the long-term unemployed. They are committed to provide group engagement sessions for 15,000 long-term unemployed people per quarter starting in Q4 2013 and to integrate 10,000 long-term unemployed people in the process of regular one-to-one interviews each quarter. They also intend to review these targets as the redeployment and training of case workers progress; increasing them would be desirable given the scale of the long-term unemployment problem and the amount of resources that have been mobilised. In addition, these targets do not appear compatible with the objective announced in August under the Pathways to Work 2013 to provide one-on-one interviews to 185,000 for 2013([26]).

Strict adherence to the roll-out targets for Intreo offices is essential. Despite the outsourcing of some activation services to private providers, the Department of Social Protection's (DSP) Intreo offices will remain the backbone of Ireland's activation services. Additional delays in rolling-out Intreo offices should therefore be avoided so as to provide an even level of services across the whole country, and the targets of having 43 offices opened by end-2013 should be adhered to. The authorities' willingness to consider redeployments of staff beyond the DSP as case officers is a positive development that could enhance the level of activation services and should translate into prompt action.

Reforms of the further education and training (FET) system are set to move to the operational phase. The recent enactment of the Education and Training Boards Act 2013 and Further Education and Training Act 2013 means that the new institutional landscape for the FET sector is now formally in place. No benefit will be reaped, however, until vocational education centres (VECs) and FÁS training centres are consolidated into the 16 Education and Training Boards (ETBs), a process that is projected to be finalised by the end of 2014 and that should be speeded up.. In addition, the most critical aspects of FET reforms lie ahead as training programmes and courses still have to be reviewed to ensure their relevance for the needs of jobseekers and employers. A seamless process between Intreo offices and ETBs will also need to be established to ensure appropriate referrals and effective participation in training programmes. SOLAS – the new institution tasked to channel funds to ETBs, and monitor and guide their FET work – needs to lay out a credible strategy for the sector quickly and make use of its powers to allocate funds among ETBs to ensure efficiency and the relevance of programmes. The work to prepare the strategic review of the training and education provision offered by ETBs by end-September, a programme requirement, should guide and accelerate the preparation of SOLAS' strategic plan, which is due by end-March 2014.

2.3.2. Wage setting mechanisms

Collective bargaining mechanisms have suffered some setbacks despite recent reforms. Employment Regulation Orders (EROs) and Registered Employment Agreements (REAs) were struck down by two Court rulings in 2011 and May 2013. The Industrial Relations (Amendment) Act 2012 aimed to put in place a stricter legal framework for the setting of the terms and conditions defined under EROs and REAs([27]), but now appears inadequate to address the unconstitutionality of the two mechanisms stemming from the excessive delegation of legislative powers to Joint Labour Committees, labour Courts or the Minister. While the terms and conditions of employees recruited prior to the Court rulings are not affected, as their individual contracts remain valid, employers are not bound by the terms of past EROs and REAs when it comes to new recruitments.

Further legal reforms are needed to re-establish collective bargaining mechanisms. The authorities aim to fill the legal vacuum by preparing a new Bill to further reform EROs and REAs, potentially before end-2013. While employers strongly oppose the Joint Labour Committees that underpin EROs, they are keen to maintain the system of REAs as a channel for negotiations with trade unions in sectors where labour representation is strong. Fast action on the new framework is needed to reinstate a proper industrial relations management mechanism. Many aspects of the 2012 reform ought to be preserved, including the increased flexibility and consideration given to international competitiveness and relative wage levels in the EU, while the scope of REAs ought to be reduced. The authorities also aim to avail of the new reforms to reduce the number of sectors subject to EROs, with some falling under the scope of REAs in the future([28]).

Nominal wages have been sticky across all levels of skills, allowing for a gradual adjustment of real wages. The reforms introduced under the Industrial Relations (Amendment) Act 2012 do not appear to have had an impact on e.g. nominal wages so far. In part, this can be attributed to the continuity of individual contracts and nominal wage rigidity due to efficiency wage and skill-retention policies among firms([29]). The legal uncertainty and recent vacuum on EROs and REAs, however, is also likely a contributing factor, as firms may be unwilling to re-negotiate wages and benefits in light of new labour market conditions in an uncoordinated manner, and new collective agreements at the sectoral level cannot be concluded. This phenomenon is likely to be more prevalent at the low-end of the skills range and in selected sectors subject to EROs and REAs, where nominal hourly wages have either fallen only marginally in the post-crisis period or increased slightly, despite the sharp increase in unemployment (Graph 2.2). Given accumulated inflation, this however translates into falling real wages as outlined earlier in the report. Composition effects and rising productivity have also generated improvements in unit labour costs relative to most other EU countries.

Graph 2.2: Labor market developments

Source: CSO

2.3.3. Reform of water sector

The definitive legal basis for reforming the water sector is being introduced. The authorities are on target to publish the Water Services (No. 2) Bill 2013 by the end of September, having prepared a General Scheme of the Bill and published a summary of it in July. The Bill, which the authorities aim to have enacted before the end of 2013, will achieve several key objectives, including: (1) the transfer of water services functions from local authorities to Irish Water; (2) the transfer of assets and liabilities related to water services; (3) the imposition of charges to domestic and non-domestic users in accordance with the cost-recovery principles set in the EU Water Framework Directive; (4) the assignment of economic regulatory powers, including the approval of tariffs submissions by Irish Water, to the Commission for Energy Regulation (CER); and (5) the delivery of water services by local authorities on behalf of Irish Water and under service level agreements for an initial period of 12 years, with reviews after 2 and 7 years.

Operational milestones are being reached in view of reforming the sector and introducing domestic charges. Irish Water was incorporated in July, and all contracts for the installation of water meters have been awarded, with work commencing in mid-August. The company has put together a two-step communication campaign in order to foster social acceptance of the metering programme and minimise disruptions in the process. In addition, the Irish Water customer contact centre was established in July and the company is in the process of recruiting about 300 workers, mostly from local authorities and Bord Gáis Eireann.

Key decisions on the funding model remain to be made.. The authorities are committed to make Irish Water self-funded over time, which implies the gradual phasing-in of charges at a level sufficient to cover operating and capital costs. They are making progress in developing the funding model for Irish Water and are keen to ensure that Eurostat classifies the company outside the general government sector from the onset, which would require that a credible plan be presented to guarantee that the company covers over 50% of operating costs from water charges. Definitive plans on the level of Exchequer support to Irish Water, the level of charges and the precise timeframe under which the company will become self-funded still have to be drawn and communicated to the public. These decisions will be part of the budgetary process, but CER-led consultations on the structure and level of charges (Box 2.4) ought to start sooner rather than later to prepare the ground for the announcement of a definitive time-plan for the introduction of domestic water charges, an end-year commitment under the Memorandum of Understanding. The finalisation of the funding model is also needed to ensure that the reform of the sector is in compliance with EU State-aid rules.

2.3.4. Asset disposals

Privatisation proceeds will soon become available for debt reduction and growth-enhancing projects. The sale of Bord Gáis Energy is the largest and closest forthcoming transaction, with short-listed companies involved in the final bidding stage. The disposal process of two of the Electricity Supply Board's overseas power plants is slightly less advanced, although transactions are expected to be completed before the end of 2013. While proceeds will at first accrue to the parent companies, the authorities should already draw up their strategy on how to use at least half of the revenue for eventual debt reduction and start identifying specific growth-enhancing projects of a commercial nature. As far as Coillte (the State-owned company operating in the forestry sector) is concerned, the authorities have determined that appropriate conditions for the sale of harvesting rights are not currently met, and that the priority should be on restructuring the company. The privatisation issue will be re-considered at a future date, and it is important that adequate measures be put in place to refocus the company on its core functions and business and to avoid the further build-up of contingent liabilities.

2.3.5. Legal service reforms

Legal services reforms have progressed but still need to be completed. The Legal Services Regulation Bill 2011 moved to Committee stage in July, following the completion of proposed amendments to Parts 1 to 4 of the bill. These included amendments that address concerns about the independence of the Legal Services Regulation Authority and were approved by the Committee. Proposed amendments to Parts 5 to 12 of the bill remain to be completed, however, even though it was initially planned that they would be published by early July. The critical issues dealt with in Parts 5 to 12 of the bill are: (1) complaints and disciplinary hearings; (2) alternative business structures; and (3) legal costs. The proposed amendments will determine the effectiveness of the bill in reducing legal services costs and therefore need to be considered carefully and without fear of confronting narrow vested interests. In particular, alternative business structures should not be victim of the amendments, and careful consideration should be given to the concerns raised by the Competition Authority of Ireland regarding how legal fees are to be determined. It is also essential that the Committee stage resume as quickly as possible after the summer recess to avoid further delays in enacting the bill.

2.3.6. Healthcare sector

Several important reforms are being implemented, though more work is still needed:

· The new "Health (pricing and supply of medical goods)" Act ([30]) affords the authorities significant new scope to achieve important savings on the state's pharmaceutical bill. In particular, as recommended by the recently published ESRI study ([31]), significant savings could be obtained by, for example, setting the maximum ex-factory price of in-patent pharmaceuticals at the lowest price of the current basket of nine EU Member States, rather than at the average (as is the case at present) and update these prices more frequently, i.e. every six or at maximum twelve months. The authorities have undertaken by end-October 2013 to: (i) provide a plan for the mid-term review of the IPHA agreement to be conducted by mid-2014 at the latest, under which they will carry out a comprehensive pricing re-alignment exercise, including in the hospital sector; and (ii) conduct a comprehensive exercise to realign downwards the prices of off-patent listed items.

· A national e-Health strategy, originally due by end-June, is now expected to be submitted by the authorities at end-September. Legislation necessary to allow for the introduction of health identifiers for individuals and professionals is being finalised and will be introduced to the Oireachtas in the autumn ([32]).

· Work to enable the cost recovery for private use of public hospitals has started. Progress is being made on the HSE enhanced financial and accounting framework and the case-based payment system linked to the principle of cost recovery for private use of public hospitals. Work has also started to develop a new IT platform (through external consultants) enabling the break-down of the full hospital budget, including outpatients, by clinical cost drivers.

Improving prescriber and dispenser practices would complement important work underway to reduce pharmaceutical costs. Two important needed reforms in this area are the compulsory use of active ingredient names (so called International Nonproprietary Name, or INN) by prescribers, and clear rules for the display of retail drugs prices by pharmacists. Both these measures would help ensure consumers gain the full benefits of greater generic penetration. The authorities have, however, committed to make arrangements for compulsory prescription by INN, where appropriate, and this should be in place by the end of 2013. The regulatory body for pharmacists has also been asked to examine how greater price transparency can be achieved at the retail pharmacy level.

The programme remains well financed. Earlier in the year the authorities have issued some EUR 7.5 bn in medium-to-long term bonds. The authorities sustained their T-bill programme by selling EUR 500 mn of 3-months bills on a regular basis, at low yields and high bid-to-cover ratios([33]). Cash balances have been further strengthened by some asset sales (e.g., the state's holdings of convertible contingent bonds in Bank of Ireland).

The Irish sovereign debt market also weathered well recent negative events, although short-term volatility is indicative of limited liquidity. Despite recent bouts of higher volatility in international bond markets, yields on Irish sovereign bonds have stayed low. After falling steadily through April to record lows of around 3.4% in the 10-year maturity, Irish sovereign yields rose somewhat over the summer in line with international market dynamics on heightened concerns that the US FED could taper its quantitative easing over the next few quarters, as well as specific factors such as poor liquidity and lack of domestic buying. By the end of the summer 10-year yields appeared to have stabilized around 4%, while spreads to German bond yields had narrowed to around 200 basis points (less than half of the spreads prevailing a year ago). These developments are in line with recent research suggesting that developments in euro area bond yields are beginning to return to pre-crisis patterns, as opposed to the broad-based systemic concerns dominating the market up the summer of 2012. ([34]) Standard and Poor's upgraded its outlook on Ireland's credit rating to positive from stable on 12 July 2013, noting that Ireland’s general government debt may decline faster than previously expected.

The authorities are on track to achieve their funding objectives by the end of the programme. By the end of 2013, Ireland is expected to have accumulated a cash buffer of EUR 22.8 billion, sufficient to cover the total financing needs for 15 months. This includes disbursements of EUR 2.3 billion from the EFSF, EUR 0.8 billion from the IMF and EUR 0.25 billion from Sweden and Denmark following the completion of this 11th review. ([35]) This sizeable cash reserve has been a stable feature of the authorities' funding strategy as a key tool to underpin market confidence. Compared to the 10th review, cash reserves are now larger, because contingencies did not materialize and the retail bond sales were stronger than expected. In July 2013, the authorities redeemed EUR 750 million of the 4% Treasury bond due to mature on 15 January 2014, which together with the maturity extensions of official EU loans agreed earlier in the year will reduce future funding needs considerably. For 2014, the cash buffer at the end of the year is also forecasted to cover the financing needs for the following 15 months.

Table 3.1: Financing requirements

1/ Includes promissory note payments 2/ Includes long-term bonds, T-bills, commercial paper and others 3/ Include contingencies 4/ UK, Sweden and Denmark. Source: Sources: Commission services; NTMA.

As underscored also in previous reviews, and discussed above, Ireland continues to face important challenges and risks, which require close monitoring and determined policy action:

· On the real side, weak growth remains a key risk. The latest revisions of the recent export performance underscore that Ireland's prospects are closely linked to those of its key trading partners. These remain uncertain, and thus represent a key source of risks in the short term. Domestic demand could also fail to produce the envisaged support to economic activity, especially if financial sector reform stalls and unemployment remains high. In the latter respect, there is a risk that, barring a marked increase in activation resources and a timely reform of the training programs, the large cohort of long-term unemployed could find it difficult to return to the labour market, which would have serious adverse consequences for long-term potential growth and the sustainability of public finances.

· Fiscal risks persist. Commission services' best forecast at present is that the programme ceiling on the 2013 general government deficit might be exceeded, albeit by possibly small amounts. Although data through June suggest that expenditure is being contained below the budgeted profile, some pressures are expected to become apparent in the health sector. Additional risks are linked to the IBRC liquidation, the reclassification of AIB shares received by government as a dividend payment and difficulties to achieve full savings from the new public service wage agreement (Haddington Road Agreement). As the more lumpy expenditure (mostly in the capital budget) are completed by the end of the year, these pressures—unless proactively managed—could result in overruns. Moreover, at around 7½% of GDP, the deficit remains high, implying that considerable further fiscal consolidation is necessary going forward to bring public debt firmly back on a sustainable path, even if real economic growth returns to around 3% per year in the medium to long term. It is important that the authorities maintain the set policy course, and that they identify measures that are as much as possible equitable, durable and growth-friendly.

· Financial sector risks remain prevalent. On the one hand, an overly lengthy and protracted resolution of banks' still growing non-performing loans could hinder banks' capacity/willingness to extend new loans which would threaten a sustained recovery, and undermine their profitability and attractiveness to private funding. On the other hand, a speedier resolution could run into administrative and system bottlenecks, especially as far as the court system is concerned, unless procedures are appropriately streamlined and additional resources timely mobilized. Thus, there is a need to mobilize additional resources for the judicial system. It is also essential to preserve and, where possible, improve on the basic institutional framework underpinning the local credit market, to avoid costlier and/or scarcer credit in the post-crisis steady state. From this perspective, reports that unsecured debt is effectively serviced prior and in detriment of secured debt are concerning. Similarly, a functional credit registry, enabling a system-wide picture of a borrower's total indebtedness, should be established without further delays.

AIB Allied Irish Bank

BOI Bank of Ireland

BGE Bord Gáis Energy

BTL Buy-to-Let

CBI Central Bank of Ireland

CCMA Code of Conduct on Mortgage Arrears

CER Commission for Energy Regulation

CPI Consumer Price Index

CSO Central Statistics Office

dpd Days Past Due

EBA European Banking Authority

EC European Commission

ECB European Central Bank

EDP Excessive Deficit Procedure

EFSF European Financial Stability Fund

EFSM European Financial Stabilisation Mechanism

ELG Eligible Liabilities Guarantee

ERO Employment Regulation Order

ESRI Economic and Social Research Institute

ETB Education and Training Board

FAS Foras Áiseanna Saothair

FET Further Education and Training

GDP Gross Domestic Product

GNP Gross National Product

GP General Practitioner

GVA Gross Value-Added

HICP Harmonised Indices of Consumer Prices

HSE Health Service Executive

IBEC Irish Business and Employers' Confederation

IBF Irish Banking Federation

IBRC Irish Bank Resolution Corporation

IMF International Monetary Fund

LTV Loan-to-Value ratio

ma Moving average

MEFP Memorandum of Economic and Financial Polities

MOU Memorandum of Understanding

MTFS Medium Term Financial Statement

NAMA National Asset Management Agency

NBFI Non-Bank Financial Intermediary

NFC Non-Financial Corporation

PDH Primary dwelling house

PCAR Prudential Capital Assessment Review

PTSB Permanent TSB

qoq Quarter-on-quarter

REA Registered Employment Agreement

REER Real Effective Exchange Rate

sa Seasonally Adjusted

SGP Stability and Growth Pact

SOLAS An tSeirbhís Oideachas Leanúnaigh Agus Scileana (Further Education and Training Authority)

SME Small and Medium Enterprise

SSM Single Supervisory Mechanism

y-o-y Year-on-year

WHO World Health Organisation

Table A1.1: Compliance assessment

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Source:

Table A2.1: Use and supply of goods and services (volume)

Source: Commission services

Table A2.2: Use and supply of goods and services (value)

Source: Commission services

Table A2.3: Implicit price deflators

Source: Commission services

Table A2.4: Labour market and cost

Source: Commission services

Table A2.5: External balance

Source: Commission services

Table A2.6: Fiscal accounts

Source: Commission services

Table A2.7: Debt developments

The projections assume no borrowing for precautionary contingencies foreseen in the programme's financing plan. Stock-flow adjustments include a reduction in cash balances from around 14% of GDP at end-2013 to around 4% by end-2016 and other and other financial transactions. Source: Commission services

([1]) This report reflects information available as of 31 August 2013.

([2]) See discussion in the Commission Services' Compliance Report for the 10th review building on the work available at http://www.esri.ie/UserFiles/publications/RN20130102.pdf

([3]) Appreciation of the euro vis-à-vis the GBP might however have adverse effects on Irish exports to the UK.

([4]) Some positive signs are offered by the July 2013 Euro Area Bank Lending Survey, available here: http://www.centralbank.ie/mpolbo/mpolicy/Documents/Comment%20on%20Results%20July%202013.pdf. This shows that loan demand from households for house purchases increased during Q2 2013, for the fifth successive quarter. According to the survey the increase in mortgage demand was linked to more favourable housing market prospects and higher levels of consumer confidence. An increase in loan demand in respect of household lending is also expected during Q3 2013.

([5]) New NFC loans refers to loans above €1 million with floating rate and up to one year fixed

([6]) Downgrades to expected euro area demand for Irish exports dominate upgrades to the corresponding U.S. forecasts.

([7]) The magnitude and timing of effects stemming from the new lending vehicles formed by the National Pensions Reserve Fund and Blue Bay Asset Management in July 2013 are still to too uncertain to be factored into the forecast.

([8]) http://www.esri.ie/UserFiles/publications/MTR12.pdf. Assumptions regarding the external environment were generated by the NiGEM model from the National Economic and Social Research Institute, London.

([9]) It should be noted that while the forecasting performance of the model in question has been very good, it has tended to overestimate growth and underestimate unemployment since the crisis, and there growth numbers quoted above should therefore be seen as an upper bound.

([10]) Certain 2013 budget saving measures have been delayed or only partially implemented. These mainly relate to the reduction of professional fees, pay-bill savings under the Employment Control Framework and the introduction of charges to private patients for the use of public hospital beds.

([11]) Work continues on the liquidation of IBRC, but the volume of loans that may ultimately transfer to NAMA is still unclear. The Special Liquidators of IBRC have been directed to complete the valuation of IBRCs assets by 30 November 2013. This valuation is being undertaken by independent third parties. For the purposes of the valuation, loan assets are valued using discounted cash flow analysis applying a specified discount rate (4.5%). In line with the approach announced in February 2013 there is an obligation on the Special Liquidators to ensure that the assets of IBRC are sold at a price that is equal to or in excess of the independent valuations that are being obtained. Should a bid not be received that is in excess of the independent valuation obtained, the loan asset will transfer to NAMA at the independent valuation price. Any shortfall between the valuation of these assets and NAMA's claim on IBRC will be made up by the State. Any possible such compensation to NAMA is likely to be treated as a financial sector measure, given its one-off nature and the viability of NAMA, and would thus be excluded the EDP and programme deficit target. The statistical treatment of the operations continues to be discussed between the CSO and Eurostat.

([12]) In April 2013, Eurostat decided that the ordinary shares received by the government from AIB as dividends in 2012 (0.2% of GDP) do not represent a financial investment by the state in AIB, but rather an equivalent capital transfer from the state to the bank. This transfer offset the deficit-reducing impact of the dividends. The baseline forecast for 2013-16 assumes only the deficit-reducing effect of the dividend payments, i.e. acquisition of the ordinary shares is assumed as a financial transaction. This is based on an assessment by the CSO that the one-off higher-than-expected AIB losses last year, which triggered the 2012 Eurostat reclassification, are likely not to emerge this year. The statistical treatment of the 2013 dividend payment continues to be discussed with the Irish authorities.

([13]) For example, longer working hours should allow reducing agency and overtime costs in the heath sector, but there has been some resistance from the unions of the affected medical personnel.

([14]) The structural changes of the economy during the economic crisis are beyond normal business cycle fluctuations. Therefore, potential growth and structural government balance estimates need to be treated with caution.

([15]) See http://ec.europa.eu/economy_finance/publications/occasional_paper/2013/pdf/ocp127_en.pdf, p. 29

([16]) The Fiscal Transparency Assessment (FTA) report for Ireland was carried out by the IMF at the request of the Irish Government. The FTA highlighted several weaknesses in the Irish fiscal reporting system. In particular: (i) cash-based budget execution reports are published monthly but cover only the Exchequer and use a classification which does not correspond to the ESA95 rules; (ii) fiscal statistics cover all general government entities, but still exclude public corporations; and (iii) multiple and inconsistent charts of accounts are used by different general government entities. It therefore recommended a series of actions over five years to: (i) expand the institutional coverage of budgets, statistics, and accounts; (ii) recognize all assets, liabilities, and associated fiscal flows in fiscal reports; (iii) modernize and harmonize accounting standards across the public sector; (iv) accelerate the timetable for submission and approval of the annual budget and financial statements; and (v) improve the analysis forecast changes, long-term trends, and fiscal risks. (See http://www.imf.org/external/np/sec/pr/2013/pr13258.htm)

([17]) This has been pointed out in previous reports, see for example: http://ec.europa.eu/economy_finance/publications/occasional_paper/2013/pdf/ocp131_en.pdf, p. 21 and http://ec.europa.eu/economy_finance/publications/occasional_paper/2013/pdf/ocp127_en.pdf p. 27

([18]) Specifically, “government expenditure” in the context of the abovementioned Act is defined as the expenditure voted by the Dáil each year and excludes: (i) debt service costs; (ii) non-voted expenditure financed directly from the "central fund" (judges' pay, and the budgets of the Houses of Oireachtas and the Fiscal Advisory Council); and (iii) expenditure by local governments and non-market public corporations. In contrast, the EU expenditure benchmark is set for general government sector excluding interest expenditure, non-discretionary changes in unemployment benefit expenditure and discretionary expenditure increase fully offset by discretionary revenue-increasing measures.

([19]) Art. 7(9) of Regulation (EU) No 472/2013: "A Member State subject to a macroeconomic adjustment programme shall carry out a comprehensive audit of its public finances in order, inter alia, to assess the reasons that led to the building up of excessive levels of debt as well as to track any possible irregularity."

([20]) The Act removes the unintended constraints on banks' ability to realise the value of loan collateral in certain instances while providing additional new safeguards for the family home in repossessions proceedings.

([21]) The bank took possession of approximately 1300 residences in the period Q1 2012- Q2 2013 with the vast majority of these coming through voluntary surrender.

([22]) The Commercial Court is a division of the High Court that was established in 2004 to provide efficient and effective dispute resolution in commercial cases. The court deals with disputes of a commercial nature between commercial bodies where the value of the claim is at least EUR 1 million. The Court uses a detailed case management system that is designed to streamline the preparation for trial, remove unnecessary costs and stalling tactics, and ensure full pre-trial disclosure.

([23]) The scheme was introduced in October 2012 and provides a Government guarantee to the lender of 75% on individual loans to viable businesses, which is paid to the lender on the unrecovered outstanding balance on a loan in the event of an SME defaulting on the loan repayments.

([24]) The Microenterprise Loan Fund was introduced in October 2012 to provide loans of up to EUR 25,000 to businesses and sole traders employing up to ten people who have been refused credit by the banks.

([25]) The intention was for the credit guarantee scheme to provide EUR 150 m in additional credit to companies per year for a three year period and it was intended to benefit 5,600 businesses. However at end August only 59 loans have been granted, worth a total of EUR 8,6 m. Similarly, for the microfinance fund, only 280 applications were received, with a 44% approval rate. This limited take-up is particularly disappointing, given that 96% of SMEs in Ireland employ less than 10 people and the average lending to SMEs is EUR 40,000.

([26]) See http://www.welfare.ie/en/downloads/Pathways-to-Work-2013.pdf.

([27]) See Economic Adjustment Programme for Ireland, Autumn 2012 Review, page 37.

([28]) The authorities recently published a review of all Joint Labour Committees, with the view to streamlining them where necessary.

([29]) A survey of Irish firms indicates that 87% invoke reduced effort or morale as a reason not to cut nominal wages, with 83% indicating a fear of seeing their best staff leave as another reason. This survey was conducted during late-2007 and early-2008, however, a period during which only 1% of Irish firms reported having cut wages.

([30]) See: http://www.dohc.ie/press/releases/2013/20130624.html

([31]) The report, titled "Ireland: Pharmaceutical Prices, Prescribing Practices and Usage of Generics in a Comparative Context", was an MoU commitment. It finds that drugs prices remain high in comparative terms (including for generic drugs), despite the recent realignments, and generic penetration low.

([32]) The relevant provisions were originally included in the Health Information Bill—which dealt with a wider range of issues—but will now be introduced separately to ensure the roll-out of the identifiers is not unduly delayed.

([33]) The yields of the T-bills were at 0.2% at the latest auction on 18 July, with a cover ratio of 3.6.

([34]) Conefrey, Thomas and Cronin, David (2013) "Spillover in Euro Area Sovereign Bond Markets", CBI Research Technical Paper 05/RT/13, http://www.centralbank.ie/publications/Documents/Research%20Technical%20Paper%2005RT13.pdf

([35]) This will bring the released disbursements to EUR 66.1 billion, representing 97.9% of the total international assistance of EUR 67.5 billion available under the programme.