COMMISSION STAFF WORKING DOCUMENT Macroeconomic Imbalances - Ireland 2014
Date: 2014-03-05
Institutions: European Commission
Subjects: Euro Group (euro area), Ireland, competitiveness, economic growth, financial institution, indebtedness, labour market, macroeconomics, public debt, stability pact













EUR-Lex - 52014SC0079 - EN











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52014SC0079

COMMISSION STAFF WORKING DOCUMENT Macroeconomic Imbalances - Ireland 2014 /* SWD/2014/079 final */









Results of in-depth reviews under
Regulation (EU) No 1176/2011 on the prevention and correction of macroeconomic
imbalances
Ireland: The recently completed macroeconomic adjustment
programme was instrumental to manage economic risks and reduce imbalances.
However, the remaining macroeconomic imbalances require specific monitoring
and decisive policy action. In particular, financial sector developments,
private and public sector indebtedness, and, linked to that, the high gross and
net external liabilities and the situation of the labour market mean that risks
are still present. The Commission will put in motion a specific monitoring of
the policy implementation, and will regularly report to the Council and the
Euro Group. This monitoring will rely on post-programme surveillance.
More specifically,
starting in 2007, Ireland experienced a collapse of the property market, and
measures to address losses in banks and a fall in government revenues gave rise
to severe budgetary problems. On the back of a loss of market access, Ireland
sought international financial assistance at the end of 2010. Ireland
maintained a strong track record of implementation throughout the programme,
which was completed in 2013. The fiscal consolidation targets under the
programme have been met, and Ireland has improved domestic fiscal rules and
institutions. Moreover, the headline deficit is projected to meet the targets
in 2013 and 2014. Bank deleveraging targets have been met and capital adequacy
ratios have improved. Financial supervision and regulation have been
strengthened. Households have increased their saving rates to reduce their
indebtedness. Labour market reforms contributed to a reduction in unemployment.
House prices have also stabilized and shown signs of recovery. Nonetheless,
more progress is needed as public debt remains very high, as does external
debt, the financial sector is vulnerable with a high amount of non-performing
loans and long-term and youth unemployment remains elevated.
Excerpt of country-specific findings on Ireland, COM(2014) 150 final,
5.3.2014
Executive Summary and Conclusions 7
1.       Introduction  9
2.       Macroeconomic
Developments 11
3.       Imbalances
and Risks 17
3.1.     Private
sector indebtedness 17
3.1.1.  Enterprise
indebtedness trends largely driven by the activity of multinationals 17
3.1.2.  Household
balance sheet repair continues and net worth growth has resumed   20
3.2.     General
government debt 26
3.3.     Financial
sector challenges 30
3.3.1.  The build-up
of imbalances in the Irish financial system   30
3.3.2.  Programme
achievements and remaining challenges 31
3.3.3.  NPL resolution
and bank capital 34
3.3.4.  Bank
profitability  36
3.3.5.  Access to
finance  37
3.3.6.  The non-bank
financial sector 38
3.4.     Competitiveness
and sustainability of the external position  38
3.4.1.  Imbalances
build up fast at the peak of the boom   38
3.4.2.  The crisis and
rebalancing  41
3.5.     Labour
market issues and skills mismatches 48
3.5.1.  Boom times,
imbalances build up   48
3.5.2.  The crisis and
rebalancing  51
5.       Policy
Challenges 57
References 59
LIST OF Tables
2.1.     Key
economic, financial and social indicators - Ireland   16
3.1.     SME credit
policy initiatives 37
LIST OF Graphs
2.1.     Components
of GDP growth show the recovery has been export led   11
2.2.     Private
sector deleveraging has mirrored the change in domestic demand   11
2.3.     Unemployment
has declined while participation increased   11
2.4.     Core
inflation in Ireland has remained below the Euro Area   12
2.5.     Average
residential property prices have stabilised   12
2.6.     Bank
lending to households and firms remains subdued   13
2.7.     Long term
unemployment is now declining, though still very high  14
3.1.     Private
sector indebtedness considerably exceeds the euro area average  17
3.2.     Private
indebtedness in IE continued to grow in 2009-2012  17
3.3.     Large
inter-company loans inflate non-consolidated debt figures 19
3.4.     Large part
of total NFC debt relates to non-resident MNC liabilities 19
3.5.     Net credit
to NFCs declining as firms repay debt and some NPLs are written-off 20
3.6.     NFC debt
sustainability gradually improving  20
3.7.     Despite
falling DI, IE HH debt-to-GDI declined more than in most other MS  22
3.8.     HH debt
sustainability improving amid continued deleveraging  23
3.9.     Debt
service burden in IE lower than EA average and other MS with indebted HHs 23
3.10.   Households'
savings continue to be used to repay debts 23
3.11.   HH net worth
increases due to rising housing asset values 26
3.12a.                                                                                                         Gross government debt projections 27
3.13.   Contribution
to change in gross government debt 27
3.14.   Composition
of the gross government debt 28
3.15.   Maturity
profile of long-term debt (at end-January 2014) 28
3.16.   Government
guarantees have declined   29
3.17.   General
government balance and real GDP growth  29
3.18.   Ireland's
Structural Primary Balance (SPB) compared to other Member States, 1998-2013  30
3.19.   Fuelled by
cheap credit, household (HH) indebtedness increased sharply  30
3.20.   The growth of
the Irish banking system outpaced the euro-area average  30
3.21a.                                                         IE banks capital ratios are among the highest in the euro area   32
3.21b.         IE bank
LDRs are below other programme countries and trend to the euro -area average  32
3.21c.                                                                                                             IE banks' liabilities are normalising  32
3.21d.                                                                          Eurosystem borrowing is below pre-programme levels 32
3.22.   Improving
profitability momentum but the outlook remains challenging  34
3.23.   Early
stabilisation in total arrears but NPL stocks continue increasing  35
3.24.   The current
account rapidly turns into large deficits 38
3.25.   Goods exports
experience structural changes 39
3.26.   Real unit
labour costs surged in the mid-2000s) 40
3.27.   The REER
appreciated through most of the first part of the 2000s 40
3.28.   IFSC's net
creditor position initially hides the deterioration of the non-IFSC NIIP  40
3.29.   Real
gross-value added per hour worked rises independently of the collpase of the
construction sector 41
3.30.   Recent
productivity gains have exceeded those in the euro-area   41
3.31.   The current
account turns to large surpluses 42
3.32.   Services
exports increase sharply  42
3.33.   Ireland gains
significant global market shares in exports of services, but loses them in
goods 43
3.34.   Services
exports overtake goods exports 43
3.35.   Ireland ranks
highly in business climate indicators 43
3.36.   FDI inflows
regain momentum   44
3.37.   Wedge between
exports and imports has increased significantly  44
3.38.   Demand
composition of GDP has shifted   45
3.39.   The official
sector drives the deterioration of the NIIP  45
3.40.   The NIIP of
domestic banks balances as they deleverage  46
3.41.   Non-bank
financial companies (non-IFSC) and non-financial companies have compensating
net positions 46
3.42.   Pharmaceutical
exports are affected by the patent cliff 47
3.43.   Most
home-grown manufacturing firms are very small 48
3.44.   Manufacturing
value-added is concentrated in large firms 48
3.45.   Participation
in the labour force rose sharply, particularly among women  48
3.46.   Unemployment
remained low while active population surged   48
3.47.   Employment
rose across all sectors, with a sharp increase in construction  51
3.48.   The share of
construction in employment rose to unprecedented levels 51
3.49.   Tight labour
market conditions put pressure on wages 51
3.50.   LT
unemployment rises in parallel with the increase in unemployment rate  52
3.51.   Employment at
low skills levels has declined markedly  53
3.52.   Current and
prospective active age population with low skills level far exceeds current
labour demand   53
3.53.   Nominal wages
have been stagnant in the private sector and fell in the public sector 54
3.54.   Private
sector employment recovers 54
3.55.   There is
relatively little labour market slack at high levels of education  55
LIST OF Boxes
3.1.     Tracker
mortgages – a structural challenge for Ireland's banks 18
3.2.     Housing
market imbalances have dissipated   21
3.3.     Improvements
in the fiscal framework  25
3.4.     Reform of
the Irish regulatory and supervision frameworks during the programme  33
3.5.     Policies
reforming the labour market 50
LIST OF Maps
No table of contents entries
found.
Under the three-year EU-IMF financial
assistance programme which ended in December 2013, Ireland implemented an
impressive macroeconomic adjustment programme. The
government launched a consolidation programme which reduced the general
government deficit from 10.6 % of GDP in 2010 (excluding bank support measures)
to 7.2% in 2013, and significantly improved fiscal rules and institutions.
Banks embarked on an impressive deleveraging process with loan-to-deposit
ratios falling from 210% in 2008 to 119% in 2013. Bank capital adequacy ratios
rose on the back of stress tests followed by further government capital
injections. The supervisory and regulatory role of the central bank was
significantly strengthened through numerous reforms. The authorities undertook
a series of labour market reforms, including a reshaping of activation
policies. The unemployment fell steadily from a high of 14.9% in late 2011 to
12.1% at end-2013 as labour costs declined. Private households increased their
saving rates significantly to reduce their indebtedness, while house prices,
after falling by more than 50% compared to the 2007 peak, have recovered
especially in Dublin. As a result, real GDP posted low but positive growth in
2011-13, on average higher than euro-area growth.
Nonetheless despite these achievements,
imbalances remain important. In particular: 
·       Private sector debt is about three times the level of aggregate
economic activity, though it has started to decline recently. The high level of private sector indebtedness is related in part to
Ireland's significant multinational corporation sector that maintains high
levels of foreign-funded investment. Smaller domestic firms' and household
debt, in part a legacy of the housing boom, is also comparatively high but has
declined from late 2008.
·       The government debt-to-GDP ratio is estimated to have peaked at 122%
in 2013. This high level of debt reflects, amongst
other factors, sizeable government banking support measures and the impact the
decline in the property market had on government revenues. Contingent
liabilities, though declining, are also large. Still, the fact that government
debt is largely long-term and at low interest rates improves its
sustainability.
·       The financial sector remains vulnerable.
Non-performing loans are high at nearly 27% of total loans for the three main
domestic banks as of mid-2013 and they continue to increase, albeit at a
reduced pace. The profitability of banks is also challenged due to the
structure of their assets, which is linked to the large amount of tracker
mortgages (low-yielding legacy assets) they hold. In the medium term, Irish
banks are also susceptible to a weakening of their capital positions after the
Basel III accord on regulatory standards for bank capital adequacy, stress
testing and market liquidity risk is implemented.
·       The external accounts show a large negative international investment
position (NIIP), though this is essentially due to high government debt. The latter is a direct result of the government bailout of the
banks and the debt inflows under the EU/IMF financial assistance programme.
There are also some competitiveness concerns that the tradable sector remains
too dominated by the large multinational corporations and not enough by smaller
domestic firms.
·       Long-term unemployment is high at more than 60% of total
unemployment and youth unemployment is elevated.
This reflects the decline of the construction sector and the difficulty of
transferring these skills to other types of employment sectors. The substantial
number of long-term unemployed raises the risk that these workers may lose the
skills necessary to re-enter the workforce.
This In-Depth Review (IDR) also discusses
the policy challenges stemming from these imbalances and the possible avenues
to reach balanced growth. Further correcting imbalances would require taking
forward the adjustment process started under EU-IMF financial assistance
programme. The authorities' positive track record under the programme bodes
well for future adjustment. A number of elements can be considered:
·       The sustainability of government debt largely hinges on a further
reduction of the still high fiscal deficit. The
2013 government deficit is estimated at above 7% of GDP. Under the Excessive
Deficit Procedure (EDP) Ireland is required to reduce the fiscal deficit to
under 3% of GDP by 2015. To achieve this, the planned budgetary adjustment for
2015 would have to be underpinned by high quality structural measures. Beyond
2015, the Irish authorities will be subject to the requirements of the
preventive arm of the Stability and Growth Pact (SGP). The government’s latest
fiscal targets are consistent with this, and if fully met, would achieve the
medium-term budgetary objective (MTO) of a balanced budget in structural terms
by 2018. This would also ensure the government debt-to-GDP ratio continues to
decline and be consistent with the debt rule under the SGP. In terms of
multi-annual budgetary planning, limiting discretionary changes to the
government expenditure ceiling to a predefined and restricted set of conditions
would help in the consolidation process. A careful monitoring of contingent
liabilities would also be called for.
·       To sustain economic growth beyond the short term financial sector
repair needs to progress further so as to restore the credit channel and reduce
the private debt overhang. Further pursuing
mortgage arrears restructuring targets would reduce the high stock of
non-performing loans and improve the profitability of banks. Arrears
restructuring, in combination with private insolvency arrangements, would
further aid the reduction of private and household debt. Improving access to
finance for small and medium sized enterprises (SMEs) is also a priority, as
lending to enterprises in particular can boost growth. Market-based options to
lower the profitability drag from tracker mortgages on banks could also be
investigated. Without these reforms the financial sector will not be able to
fully support the economic recovery process.
·       The ongoing rebalancing of the Irish economy and the reduction of
the high proportion of long-term unemployed could be stepped up by addressing
existing labour market issues. There have been
significant advances with labour market activation reforms but additional
efforts would be necessary, particularly to boost the delivery of government
support services to the unemployed. More progress with further education and
training (FET) would also be needed for the reskilling of the unemployed, in
particular to ensure that the needs of both employers and jobseekers are
satisfied and that the offer of training programmes is underpinned by a
strategic plan for the sector. 
·       To alleviate the highly negative NIIP, recent competitiveness gains
need to be advanced and public finances further adjusted. A full implementation of fiscal consolidation plans will improve
the external position as public external debt declines. Labour market reforms
would enhance competitiveness through improving skills while on-going wage moderation
is also crucial. A reallocation of resources to the tradable sector would be
supported by financial sector schemes that improve financing to domestic SMEs
as they export little. 
On 13 November 2013, the European
Commission presented its second Alert Mechanism Report (AMR), prepared in
accordance with Article 3 of Regulation (EU) No. 1176/2011 on the prevention
and correction of macroeconomic imbalances. The AMR serves as an initial
screening device helping to identify Member States that warrant further in
depth analysis to determine whether imbalances exist or risk emerging.
According to Article 5 of Regulation No. 1176/2011, these country-specific
in-depth reviews (IDR) should examine the nature, origin and severity of
macroeconomic developments in the Member State concerned, which constitute, or
could lead to, imbalances. On the basis of this analysis, the Commission will
establish whether it considers that an imbalance exists in the sense of the
legislation and what type of follow-up in terms it will recommend to the
Council.
In the AMR the Commission briefly discussed
the case of Ireland and indicated that its situation in the context of the MIP
would be assessed after the end of the EU-IMF financial assistance programme,
which coincided with the end of the availability period under the European
Financial Stability Facility (EFSM) on 8 February 2014. On the external side,
the AMR highlighted the negative net international investment position (NIIP)
though this is partly compensated by large inward FDI stocks and driven by
government debt levels. On the internal side, high levels of private and
government debt remain a concern, along with significant levels of unemployment
though this has been declining. 
On 18 February 2014 the Council considered
that Ireland should be fully integrated in the European Semester framework,
including the MIP, and invited the Commission to consider preparing also an IDR
for Ireland. This document responds to the invitation of the Council.
Against this background, section 2 first
gives an overview of general macroeconomic developments. Section 3 looks more
in detail into the main imbalances and risks, focusing on private sector
indebtedness (3.1), general government debt (3.2), financial sector challenges
(3.3), competitiveness and sustainability of the external position (3.4), and
labour market issues and skills mismatches (3.5). Section 4 discusses policy
considerations.
Growth, labour market, and inflation
The bursting of a large property-market
bubble in 2007 pushed the economy into recession.
The steep decline in property prices weighed heavily on domestic demand as
private households and banks' balance sheets suffered. Moreover, the decline in
the construction sector had negative effects on employment and output. After
real output loss of 9½% between 2007 and 2010, the economy began to recover
thanks to external demand. Domestic demand has remained weak, showing signs of
recovery only in 2013. Still over 2011-2013, average annual real GDP growth in
Ireland was 0.9%, higher than that in the euro area. 
After a sluggish performance in the
first half of 2013, growth began to pick up and is estimated at 0.3% for the
year as a whole. Weakness in exports and the
continuing drag of low private consumption contributed to a year-on-year (yoy)
contraction in real GDP of -1.3% and -0.9% in the first and second quarters
respectively. Export weakness – particularly of goods exports – reflected
difficult economic conditions in key trading partners, as well as the effects
of patent expiry for certain high-value pharmaceutical products manufactured in
Ireland ('Patent Cliff'). As conditions in trading partners began to improve,
and thanks to significant improvements in cost competitiveness, exports
accelerated, particularly services, in the third quarter of the year. High
frequency indicators for the final quarter of 2013 suggest the economic
recovery picked up speed at the end of the year. Early indicators of an
increase in investment activity and a stabilisation of private consumption
suggest more balanced contributions to growth will underpin the nascent economic
recovery.
Growth is expected to pick up further. Average real GDP growth in 2014 is forecast at 1.8%, as economic
recovery in key trading partners is expected to sustain positive export growth,
particularly for services, while further improvements in the labour market and
a modest rise in investment, from low levels, are expected to  support the
domestic economy. In 2015, average GDP growth is projected higher at 2.9%,
largely due to growing net exports. Private sector deleveraging will continue
to dampen the contribution to growth from domestic demand, but to a lesser
extent than in the past (Graph 2.2). 
Labour market developments have outpaced
improvements in GDP growth. The divergence between
stagnant GDP and rising numbers employed was notable in the first half of 2013,
as GDP shrank but employment rose. Employment gains were also supported by
broader improvements in the labour market with employment gains moving from the
part-time sector to the full-time one, while the participation rate has risen
(Graph 2.3). The seasonally adjusted unemployment
rate remains high, but fell to 12.8% in the third quarter 2013 from a peak of
15.1% in the first quarter of 2012. Faster increases in employment than GDP
have led to a decline in productivity, as measured by unit labour costs (ULC).
This 'productivity puzzle' is most likely explained by the falling contribution
to GDP of goods exports from the pharmaceutical-chemical sector in line with
the 'Patent Cliff'([1]). 
Inflation remains below the euro-area
average. Annual core inflation remained subdued in
2013, reflecting low wage pressure and the ongoing process of internal
devaluation (Graph 2.4). At 0.5%, 2013 average annual HICP
inflation excluding energy remained firmly below the average for the euro area
for a fifth consecutive year. This reduction in relative consumer prices
supports real competitiveness gains made by Ireland since the onset of the
crisis. The largest driver of 2013 inflation in the non-traded sector was
higher rents paid by private tenants, which increased by 8.5% in the year to
December 2013.
The housing market has stabilised, with
signs the Dublin market is diverging from the rest of the country. There are indications that following the large adjustment in house
prices, the market is beginning to once again stabilise (Graph 2.5). Some areas of the country,
particularly Dublin, recorded double-digit growth in property prices in recent
months, though the level of transactions remains low and price movements still
appear driven by fundamentals (Box 3.2). Residential rental prices also reflect
the emerging two-tier property market, with Dublin average rental prices
increasing 7.6% yoy in the year to November 2013, against 1.8% yoy for the rest
of the country.
Ongoing fiscal consolidation is expected
to have stabilised government debt. The 2013
deficit is estimated at 7.2% of GDP based on cash data, which were slightly
better than expected. Consumption-related revenue continued to be weak, while
direct tax revenue on labour and corporate income fared better. Overall, the
expenditure outturn was broadly in line with budget plans, while some overruns
in the health sector were offset by savings elsewhere. Under current growth
assumptions, gross government debt as a per cent of GDP is expected to have
peaked in 2013 at 122% and is expected to decline to 120% in 2014.
The 2014 general government deficit is
projected at 4.8% of GDP. This includes the
discretionary measures presented in the 2014 budget of 1.5% of GDP, and
other deficit improving elements, some of which are temporary. Discretionary
measures include tax increases on alcohol and tobacco, on bank deposits, on
pension fund assets and on financial institutions. Expenditure measures include
further public sector wage savings, and tighter eligibility for social benefits
and medical services. 
In 2015, the general government deficit
is projected at 4.3% of GDP on a no-policy change assumption. This means it includes consolidation measures that had been
announced with a sufficient degree of detail at the cut-off date of the
Commission Services' winter forecast. The cyclically-adjusted budget balance
net of one-off and other temporary measures is projected to decline from 6.5%
of GDP in 2013 to 4.7% in 2015 ([2]).
Financial Sector and credit supply
International financial markets have
regained confidence in Ireland. On 7 January 2014,
within weeks of the successful completion of the EU-IMF financial assistance
programme, the Irish sovereign issued a new ten-year bond at a yield of 3.54%
(about 30 basis points below the ten-year bond yield of Spain and Italy) with
high demand from investors. Irish bonds also rallied following the January 2014
announcement by Moody's to raise the long-term credit rating of sovereign debt
to investment grade. Ten-year spreads over Germany stood at around 165 basis
points in early February, near record lows, and much below their high of 1143
basis points in mid-July 2011.
In spite of the nascent economic
recovery, bank credit to households and non-financial companies (NFCs)
continues to fall. December 2013 recorded the
sharpest decline in the annual rate for lending for mortgages since the onset
of the crisis, bringing the average for 2013 down 3% from 2012. Tight credit
conditions, combined with subdued demand, are also reflected in loans to NFCs,
which fell by 6% yoy in December 2013.
Interest rates on new loans remain high. Interest rates on loans to Irish households averaged 3.3% over the
twelve months to November 2013, about 40 basis points higher than the corresponding
figure for the euro-area. For NFC loans under EUR 1 million, Irish rates
averaged 4.6% in 2013, which was even higher than the euro-area average of 3.8%
for the same period. Nonetheless, this figure remained below the 2013 average
for Spain (5.1%) and Portugal (6.4%), but slightly above that of Italy (4.4%).
A slight decline in rates to households in late 2013 was primarily the result
of a cut in the ECB's interest rate.
Social Indicators
Social transfers cushioned much of the
immediate impact of the crisis, but poverty rates are rising, as long-term unemployment has increased. The poverty
reducing impact of social transfers has been higher in Ireland than for most
other EU countries. At-risk-of-poverty (AROP) ([3]) levels initially fell, from 17.2%% in 2007 to 15% in 2009
levelling off at 15.2% for 2010 and 2011. This in part reflected the relative
effect of falling wages on poverty thresholds. AROP are now set to rise again
as non-core social welfare payments (allowances for maternity, bereavement
grants, jobseekers benefit for under 26s and certain allowances for retired
people) have been affected in more recent budgets. Severe material
deprivation ([4]) rates also
rose from 4.5% in 2007 to 7.8% in 2011, but were still below the EU average (of
8.8%).
Income inequality measures have remained
largely stable since the onset of the crisis. The
S80/S20 income quintile share ratio is below the EU average and fell from 4.8
in 2007 to 4.6 in 2011, indicating less inequality in Ireland, against an
increase in the EU over the same period (from 4.7 to 5.1). This may partially
reflect the mildly progressive nature of fiscal consolidation in the first
years of the crisis, which however has been reversed in more recent budgets.
3.1.      Private
sector indebtedness
Private sector indebtedness in Ireland
considerably exceeds the euro-area average but has recently started to decline (Graph 3.1). Between 2009 and 2012 Irish private sector debt-to-GDP
increased while it was stable or declined in most other Member States with
private sector indebtedness above the MIP threshold (Graph 3.2). However more
recently, the Irish private sector non-consolidated debt-to-GDP ratio declined
to almost 317% at end-September 2013, its lowest level since the third quarter
of 2008. Despite falling by about EUR 48 billion (8.4%) from its peak in the
second quarter of 2012, it remains the second highest in the EU. This indicates
that the drag on domestic demand due to ongoing balance sheet repair by
domestic agents is likely to persist.
However, the aggregate indicator masks
important differences in the deleveraging trends of households and enterprises. While households have reduced their debts by about 19 percentage
points from their peak of 121% of GDP in late 2009 through raising savings,
non-financial corporation (NFC) debt increased by about 7 percentage
points over the same period, reaching EUR 350.8 billion (211.6% of GDP) at
end-September 2013. More recently this trend appears to have reversed and NFC
debts have declined by about 10% since their peak in the third quarter of 2012,
though they remain at elevated levels.
3.1.1.   Enterprise
indebtedness trends largely driven by the activity of multinationals
The sizeable imbalance in enterprise
indebtedness is related to Ireland's large multi-national corporation (MNC)
sector. Even though they represent just 2% of
Irish-resident firms, MNCs accounted for almost 56% of total turnover and 57.4%
of the gross value added of all domestic enterprises in 2011. Given that these
firms often finance their activities through intra-group loans, measuring
liabilities on an unconsolidated basis – as is the case in the MIP scoreboard –
overstates the NFC debt-to-GDP ratios in Member States with large MNC sectors,
such as Ireland. On a consolidated basis ([5]) NFC indebtedness relative to GDP in Ireland was more than 25
percentage points lower in 2012 when compared to the non-consolidated level.
However, at 306% of GDP, Ireland's private sector was still the second most
indebted in the EU and considerably above the euro area average for this
indicator (Graph 3.3).
 (Continued on the next page) 
 Box (continued) 
Research ([6]) on the sources of funding of Irish enterprises indicates that
rising debt levels for the sector as a whole over the past three years could
largely be attributed to buoyant MNCs which have maintained high levels of
foreign-funded investment activity despite the domestic economic downturn
(Graph 3.4) ([7]).
While aggregate NFC debt levels have
increased during the crisis due to the activity of multinationals, indigenous
firms have continued to deleverage. Unlike MNCs,
Irish small and medium-sized enterprises (SMEs) are largely reliant on lending
from resident credit institutions (Section 3.3.5). Thus, possible credit supply
constraints during the crisis partly contributed to the declining stock of
credit to the NFC sector, as banks tightened credit conditions in response to
liquidity shortages and increasing funding costs. Subdued credit demand from
firms is also important as over-indebted SMEs – many of which are still
reeling from distressed property exposures – have reduced investment and
stepped up loan repayments: since September 2008 Irish enterprises have repaid
about 9.6% of credit institution loans in net terms (Graph 3.5). In parallel,
banks are working through a high stock of non-performing SME loans (Section
3.3.3), which has resulted in increased provision charges and some debt
write-downs, leading to a further reduction in outstanding net lending to the
sector. Nonetheless, the declining stock of bank credit to NFCs has been more
than offset by growing international borrowing by Irish multinationals. As the
MNC sector is less exposed to a deterioration in domestic economic conditions,
the degree of vulnerability for the whole economy caused by the corporate debt
overhang in Ireland is perhaps less acute than in other Member States with high
private sector debt-to-GDP ratios.
Alternative measures of NFC debt
relative to balance sheet size reveal that the imbalance is also declining. NFC debt as a percentage of total NFC financial assets and of total
liabilities has been on a downward trend recently (Graph 3.6). Debt as a
percentage of financial assets fell to 50.7% in the third quarter of 2013
largely driven by an increase in NFC financial assets. Debt to total
liabilities also decreased further, falling to 37.3% as firms turned to
alternative sources of funding including equity issuance and trade finance,
which resulted in an increase in total liabilities. In summary, while overall
NFC indebtedness in Ireland remains high as a share of GDP, the aggregate debt
sustainability of firms is gradually improving.
3.1.2.   Household
balance sheet repair continues and net worth growth has resumed
Irish households are still among the
most indebted in Europe though deleveraging is
easing debt burdens despite the fall in disposable income. By end-September
2013, household debt declined by more than 17% from its peak in the fourth
quarter of 2008. Still, at 101.7% of GDP, Irish household indebtedness was the
second highest in the EU and as a share of gross disposable income (GDI) it was
the third highest at 203.7%. Despite a 13% contraction in disposable income,
Irish households reduced their debt-to-GDI ratio by 7 percentage points since
the start of 2008, more than in most other Member States with household
debt-to-GDP ratios above 100% (Graphs 3.7 and 3.8). 
 (Continued on the next page) 
 Box (continued) 
As employment gains support disposable
income and deleveraging continues household debt sustainability should improve
further. Irish households' debt service burdens
compare favourably with those in other Member States (Graph 3.9). This is
partly due to "tracker" mortgages (Box 3.1), which account for over two thirds of
all Irish mortgage loans. As they are priced at a low fixed margin over central
bank policy rates they are protecting borrowers from rate increases passed
through from higher bank funding costs. In addition, recent initiatives from
some banks to achieve sustainable arrears resolution through partial debt
relief offers to distressed mortgage holders should also contribute to reducing
household indebtedness.
Higher household savings are being used
for debt reduction and thus entail a drag on future consumption. Central bank analysis ([8]) indicates that the largest share of household savings continues to
be used for liability transactions reflecting net debt repayments (Graph 3.10).
Household savings have slowly declined since 2009. However, they are now about
50% lower relative to their peak in the third quarter of 2009.
Household net worth has resumed its
upward trend as the value of housing assets has started increasing and
liabilities have declined ([9]). Housing assets recorded an increase
of 3.5% during the third quarter of 2013, the largest quarterly rise since the
third quarter of 2006. This helped push up household net worth to about EUR 485
billion or over 290% of GDP (Graph 3.11). While these positive developments may
continue in the near term, it remains unclear whether the nascent recovery in
residential property prices will be sustained, particularly with potential
increases in supply in the context of ongoing mortgage arrears resolution (Box 3.2). 
To conclude, Irish private sector
indebtedness, though high, is less problematic when considered in the context
of country-specific characteristics and the improving debt sustainability of
domestic agents. As regards the corporate sector,
the large share of multi-national firms in Irish economic activity inflates the
aggregate debt-to-GDP figure without necessarily increasing associated
vulnerabilities for the domestic economy. On the contrary, buoyant MNC
investment during the downturn, supported by non-resident funding, has
continued to cushion the adverse impact on growth caused by ongoing balance
sheet repair by indigenous enterprises. The household sector has been
deleveraging since the onset of the crisis and debt burdens are gradually
easing, supported by low average mortgage interest-costs, falling debt levels
and recent increases in employment. At the same time, household net worth
continues to rise due to a gradual recovery in property prices.
3.2.      General
government debt
Irish gross government debt has
increased from 25% of GDP in 2007 to an estimated 122% of GDP in 2013. This sharp increase reflects the severe impact the collapse of the
property market and the ensuing economic and financial crisis had on public
finances. Public debt rose due to sizable banking support measures, the large
drop in property-related government revenues and rising interest servicing
costs (Graph 3.13). An additional factor contributing to
the increase in the gross debt-to-GDP ratio was the increase in precautionary
cash balances. However, partial use of the government's rainy day fund – the
National Pension Reserve Fund (NRPF) for bank support alleviated some of the
borrowing needs. 
A gradual and balanced fiscal adjustment
path has been followed in order to restore sustainability of public finances. Fiscal consolidation began mid-2008, and from the beginning it
sought to strike the appropriate balance between fiscal sustainability and
growth concerns by giving, to the extent possible, priority to growth-friendly
consolidation measures. The fiscal adjustment was more expenditure-based,
including through wage reductions and better-targeting of welfare spending.
Property taxation has been shifted from taxing transactions to recurrent
revenue streams based on the value of housing. Environment-friendly taxation was
expanded and the income tax base was broadened, while maintaining the overall
progressivity of the measures, which has contributed to the social acceptance
of the overall adjustment. The authorities have also implemented a series of
reforms to improve the domestic fiscal framework (Box 3.3).
Government debt is projected to decline
from its peak in 2013 as primary surpluses are achieved and economic growth
picks up. In 2014, the primary fiscal position is
expected to be in balance, though the reduction in debt-to-GDP ratio will
mostly be due to a decline in the high precautionary cash balances (from around
11% of GDP at end-2013 to 6% of GDP by end-2014)([10]). The Commission Services' baseline scenario for debt
sustainability (based on the 2014 winter forecast) implies a steady reduction
of public debt to 103 % of GDP by 2020 (Graph 3.12). The baseline scenario is predicated
on a relatively quick acceleration of economic activity with real GDP growth
returning to 2.9% per year as of 2015 (Graph 3.17). Debt sustainability analysis reveals
that the government-debt-to GDP ratio is most sensitive to a combined shock of
lower economic growth and lower fiscal consolidation. Specifically, if economic
growth was 1 percentage point lower than the baseline and the deficit about 0.6
percentage points higher, the fiscal deficit would be 4.1% of GDP in
2015 and it would decline to below the 3% of GDP threshold only in 2018. This
would raise the government debt to GDP ratio to 123% in 2016-17 before
declining. The sensitivity of government debt to a rise in interest rates on
new borrowing is estimated to be low, given low future refinancing needs.
Government debt is largely long-term and
at low interest rates ([11]). Long-term debt comprises some 90% of
gross debt, of which around 38% of long-term debt is from official loans from
the EU-IMF programme partners (graph 3.14). The lending rate margins on the EFSM
and EFSF debt were eliminated and the average maturity extended from 7.5 to
12.5 years in 2011 and again to 19.5 years in 2013, enhancing the
sustainability of Ireland's public debt. Moreover in 2013, long-dated
government bonds with low floating interest rates replaced
the shorter-dated promissory notes at the time of the IBRC liquidation.
The interest rate on these bonds is linked to euribor plus a spread of
250 basis points and they will mature between 2038 and 2053 ([12]). These bonds are held by the CBI and will be sold to the market.
Consequently, the average maturity of long-term debt stood at about
12 years at end-2013 ([13]). The average interest on government debt is estimated at
around 4% at end-2014. Its low level is related to the high proportion of
official debt and the long-dated government bonds with floating interest rates.
While interest rates on these bonds may rise, the effect on the government
balance would be mitigated through the repayment of part of the income back to
the sovereign. 
Contingent liabilities assumed during
the financial crisis have declined, but remain sizable. The blanket guarantee of bank liabilities (including large
deposits) was an emergency measures introduced unilaterally by the Irish
government in 2008 with the aim to prevent a systemic crisis in the Irish
banking sector. This guarantee expired after two years and was succeeded by the
Eligible Liabilities Guarantee (ELG) scheme. This guarantee, though still
significant, has been declining (graph 3.16). The ELG scheme was closed to new
liabilities in March 2013 and the outstanding amount will fall further as
guaranteed liabilities mature. Exceptional Liquidity Assistance (ELA) was the
central bank's policy instrument, under which loans guaranteed by the
government were provided to credit institutions for liquidity support. After
the IBRC's liquidation, ELA is no longer used. Government guaranteed bonds
issued by the Special Purpose Vehicle of the National Asset Management Agency
(NAMA) were used to acquire commercial property loans from the domestic banks.
The NAMA guarantees are expected to persist in the medium term.
Other Irish non-crisis related
contingent liabilities are significant, but also common to other EU countries. Other government guarantees include the Deposit Guarantee Scheme ([14]) (around 50% of GDP in 2011), callable capital in the European
Financial Stability Facility (EFSF), the European Stability Mechanism (ESM) and
the European Investment Bank (totalling around 13% of GDP in 2012). There are
also other open-ended commitments, as the Insurance Compensation Scheme for the
insurance industry ([15]).
Off-balance sheet Public-Private Partnership (PPP) projects amount to some 3%
of GDP in contractual value in 2013, but more projects are in the pipeline. The
use of PPP projects reduces short-term financing needs of the government and
spreads the public costs over a longer period of time. 
Ireland's fiscal adjustment is on track,
though further fiscal effort is needed. Ireland is
required to reduce the fiscal deficit below 3% of GDP by 2015 under the
Excessive Deficit Procedure (EDP). So far, fiscal adjustment has been in
compliance with the EDP recommendation and the procedure has been in abeyance
since August 2011. While the 2014 overall adjustment is in line with the April
2013 stability programme, the somewhat lower discretionary effort in 2014 means
that, at current macro projections, a higher structural effort is required in
2015 to ensure a timely correction of the excessive deficit.
The Commission services estimate that a further fiscal adjustment of
around EUR 2.5 billion is required in 2015 to bring the deficit below
3% of GDP. Further details are expected to be made public in the
2014 Stability Programme (by end-April 2014) and the 2015 draft budgetary
plan (by 15 October 2014). Government's announcements of possible tax cuts in
2015 need to be reconciled with the planned adjustment path.
To keep the debt ratio on a declining
path, fiscal consolidation needs to continue in the medium term. After exiting the EDP, Ireland will be subject to the rules of the
preventive arm of the Stability and Growth Pact (SGP). The authorities plan to
attain their MTO of a structural budget balance by 2018 which would be
consistent with the SGP rules. If this is to be achieved with a constant
revenue-to-GDP ratio it implies a significant reduction of government
expenditure relative to GDP. Under current projections, the balanced budget in
2018 would imply a structural primary surplus of 4.8% of GDP. This is quite an
ambitious plan relative to past experience across Member States (only 3% of observations
for other Member States had higher structural budget balance in the past; Graph
3.18). 
3.3.      Financial
sector challenges
3.3.1.   The
build-up of imbalances in the Irish financial system
Fuelled by low-cost market liquidity in
the run up to the crisis, significant imbalances built up in the Irish banking
sector ([16]). Amid intense competition for profits and market shares in an
overheating economy and property market, the pace of credit expansion
accelerated sharply. This was accompanied by loosening credit standards, and
'light-touch' macro-prudential regulation and supervision did little to stem
the swelling banking sector imbalances. The annual growth rate of loans to
Irish households was close to 30% in 2004-2006 (Graph 3.19). As a result of the credit boom
concentrated in the construction sector Irish banks accumulated large property-related
exposures – their share in total bank assets increased from less than 40% in
2002 to over 60% in 2006 ([17]). This led to a sharp deterioration in banks' asset quality after
the burst of the housing market bubble. 
The rapid expansion of the banking
sector reflected the build-up of large external liabilities. Domestic banks' total assets reached around 500% of GDP in 2009
(Graph 3.20), having increased by almost 200
percentage points since 2006. This growth rate by far outpaced the inflow of
deposits and average loan-to-deposit ratios peaked at about 210% in late 2008
(Graph 3.21b). The emerging funding gap was closed through increasing reliance
on market liquidity: Irish banks' net indebtedness to non-resident entities
grew from about 10% of GDP in late 2003 to 60% of GDP in 2008. This exposed the
vulnerability of Irish banks' funding structure to rapid changes in market sentiment.
3.3.2.   Programme
achievements and remaining challenges
Under Ireland's programme the domestic
banking sector was restructured, downsized and recapitalised. Since end-2010, two banks have been merged and two others resolved.
After one of the largest recapitalisations by the general government in terms
of share of GDP in advanced economies ([18]), Irish banks continue to have some of the highest capital ratios
in the euro area (Graph 3.21). Oversized bank balance sheets have
been deleveraged with loan-to-deposit ratios (LDRs) gradually converging to the
euro-area average. 
 (Continued on the next page) 
 Box (continued) 
As a result, banks' funding profiles began
normalising, with stable deposits despite falling rates, growing market funding
at favourable yields and Eurosystem borrowing back to pre-crisis levels. The
regulatory system and prudential supervision were also substantively reformed
(Box 3.4). Thus, the programme underpinned
financial stability and helped Ireland emerge from a severe banking crisis.
However, financial sector repair is not
yet complete and challenges remain. The stock of
non-performing loans (NPLs) continues to increase, albeit at a reduced pace,
with the average NPL ratio for the three domestic banks at almost 27% - the
highest in the EU. In response, banks have increased loan-loss provisions, and
are stepping-up efforts to address mortgage and SME loan arrears, with performance
against targets monitored by the CBI. While impairment losses have likely
peaked as the flow of new arrears slows, and despite positive margin momentum
for 2014 (Graph 3.22), Irish banks' profitability is
challenged by the structure of their assets in a low-policy rate environment
(Box 3.1). Though Ireland's economic recovery is
not reliant on lending in the near term, weak bank profitability could present
a supply constraint to credit which will be necessary to sustain growth. In the
medium term, Irish banks are also exposed to regulatory vulnerabilities as
after Basel III ([19]) is fully
implemented their common equity tier 1 (CET1) ratios are estimated to be among
the lowest in Europe, due to sizeable deductions from capital related to
deferred tax assets (DTAs) and preference shares ([20]).
3.3.3.   NPL
resolution and bank capital
The Irish authorities have established a
robust institutional framework enabling banks to tackle the high stock of NPLs. As to residential mortgages, which account for about 50% of
domestic banks' NPLs, the CBI has established a three-tier targeting system,
which mandates lenders to treat increasing shares of their over 90-day arrears
cases through implementing sustainable loan restructurings ([21]). Other regulatory measures addressing distressed mortgages include
personal insolvency and bankruptcy reforms, and changes to the repossession
regime and consumer protection rules. These have also contributed to increased
levels of engagement between debtors and lenders, resulting in more arrears
cleared by borrowers and durable loan restructurings. The pace of arrears
formation continues to slow and in the third quarter of 2013 total home-loan
mortgage arrears declined for the first time since the series began in 2009
(Graph 3.23). Resolution of distressed SME loans,
accounting for over 19% of total impairments, is also monitored against bank
key performance indicators and targets though these are not public. More time
is likely required for some banks to durably restructure these loans, many of
which have links to property.
The authorities should set increasingly
ambitious bank targets to ensure that the bulk of NPLs are durably restructured
during 2014. The targets for agreed mortgage
restructurings should reach 100% of arrears cases over 90 days past due, if
possible by end-2014. To monitor the durability of modified loans from the
first quarter of 2014 the authorities have established an ambitious ([22]) 75% target for continued adherence by debtors to the renegotiated
loan terms. Thus, banks need to ensure that agreed solutions are sustainable
and compliant with CBI guidelines. A similar level of ambition should apply to
SME loan restructures and a strategy should be developed for addressing
distressed commercial real estate exposures, a large share of which have SME
connections and account for almost 25% of domestic banks' NPLs.
Capital consumption due to NPL
resolution is not estimated to result in breaches of regulatory capital
thresholds. Domestic banks have increased loan-loss
provisions with their average coverage ratio rising by 10 percentage points to
54% from end-2010 to September 2013. The recent CBI balance sheet assessment
(BSA) concluded that adjustments in risk-weighted assets and significantly
higher provisions are warranted. However, the exercise also found that, on a
point-in-time basis at end-June 2013, capital buffers were sufficient for
banks' capital ratios to remain above the then CT1 regulatory threshold of
10.5% and the 8% CET1 floor to be used in the ECB comprehensive assessment.
However, some uncertainty remains regarding the outcome from the
forward-looking stress test element of the comprehensive assessment.
The consumption behaviour of only about
10% of Irish households is estimated to be directly affected by mortgage
arrears resolution. CBI research indicates that
households in mortgage distress spend 18% less on average as compared to the
general household population ([23]). However,
in the third quarter of 2013 only about 8% of households were in arrears
including below 90 days.  In addition, 2% of primary-dwelling home loans that
are not in arrears were restructured possibly also indicating cases of borrower
distress. Thus, the consumption of a maximum of about 10% of households could
be directly affected by the mortgage arrears resolution process ([24]). Arrears formation is also expected to slow further, while durable
restructures gradually replace short-term forbearance.
The direct impact of mortgage arrears
resolution on consumption is likely to be small.
Assuming that the same share of households in debt distress has the same share
in consumption, and that re-instating debt service at an affordable level would
reduce their expenditure somewhat even in cases where some debt relief has been
provided, no growth in consumption for these households could be estimated.
Assuming that consumption increases for other households at the same rate as in
the last Commission forecast, it is estimated that mortgage arrears resolution,
if fully implemented, could reduce consumption by roughly EUR 0.4 billion, or
by 0.5% cumulatively during 2014-2015. Moreover, part of this drag could be
offset by some distressed households increasing spending due to receiving some
debt relief. Thus, resolving mortgage NPLs is unlikely to have a large direct
impact on household consumption.
However, associated confidence effects
could be considerable in the medium term and NPL resolution could support
banks' capacity to increase productive lending to the economy. As durable loan restructurings are implemented restoring debt
service at affordable levels, financial uncertainty will be reduced and the
debt sustainability of households reinforced. Perceptions about banks' asset
quality should also improve, as would those of property prices after banks work
through a possibly sizeable housing inventory, thus underpinning future demand
for property. These factors can translate into considerable confidence effects
in the medium term. In addition, given the already high asset encumbrance of
Irish banks ([25]), their high
NPL ratios entail limited available collateral for additional secured market
funding ([26]). Thus, as
arrears are resolved over time and new credit extension continues thereby
improving banks' overall asset quality, their capacity to raise market
liquidity would be strengthened, supporting lending to the real economy.
Moreover, once arrears resolution nears completion, banks would be gradually
able to re-allocate resources and re-focus their operations from arrears
management and collections to their core business. 
3.3.4.   Bank
profitability
Restoring profitability is necessary to
sustain new lending and return banks to private ownership, and while prospects
have recently improved important challenges remain.
As funding costs declined and new credit was extended at higher rates, banks'
net interest margins (NIM) continued to increase in the second half of 2013.
Despite expected higher provisions to reflect updated provisioning guidelines
and the recent BSA findings, prospects for some banks to return to
profitability in 2014 have improved. In their Interim Management Statements
providing a mid-year update on their financial performance Ireland's largest
domestic banks, Allied Irish and Bank of Ireland, signalled continued
improvements in operating profitability due to positive expansion of NIM and
cost management initiatives. This was confirmed by a CBI review of operating
profits which indicated that both banks forecast a return to post-provision
profitability in 2014, though this is highly sensitive to new lending
forecasts. In addition, in an environment of low policy rates Irish banks are
particularly challenged due to the large share of tracker mortgages in their
balance sheets (Box 3.1). 
Market-based options to reduce the drag
from trackers on bank profitability could be explored. As demonstrated by the continued tightening in market spreads for
covered bonds collateralised by Irish mortgages ([27]), secured market issuance involving trackers could soon be priced
at funding costs eliminating their negative carry. However, liquidity
advancement rates using these securities would likely still be punitive for
banks given market collateralisation requirements ([28]). In addition, such issuance could only be placed in the market if
there are no delinquent assets in the collateral pools, and recent analysis by
the authorities has confirmed that in order to offer meaningful benefits to
banks, any solution should also include non-performing trackers. 
Possible national solutions could
involve credit enhancement using high-quality uncorrelated assets. These could be repoed in the market to source liquidity at lower
funding cost and better advancement rates, which could then be on-lent to the
banks against new own-use bonds secured on tracker portfolios ([29]). However, a number of challenges to such an approach including
applicable state aid rules would need to be explored further.
3.3.5.   Access
to finance
Lending to Irish enterprises remains
weak, though this is more likely driven by subdued credit demand than supply
constraints. Bank credit to resident NFCs and SMEs
decreased by 3.9% and 4.8% yoy, respectively, at end- September 2013.
Nonetheless, survey evidence suggests that an increasing number of SME loan
applications are being approved in full by banks and the success rate in
obtaining financing for Irish firms is trending to the euro-area average ([30]). Despite strongly improved trading performance, Irish SMEs' demand
for credit reportedly declined by 36% during the six months to September 2013.
Factors behind this could include tight credit conditions reflecting efforts by
Irish banks to improve profitability, or a perception by firms that banks are
not lending. However, latest survey evidence suggests that gradual demand
substitution may be ongoing: improved trading performance has contributed to a
lower overall level of demand as funding requirements for working capital from
weaker firms declined. This has so far not been offset by higher demand for
investment and growth as SMEs remain cautious about future trading performance.

Improving access to finance includes
more non-bank financing options. Although the
amount of bank financing has decreased, due to constraints on both the demand
and the supply side, Irish companies, and SMEs in particular, remain highly
exposed to the bank sector and its vulnerabilities: more so than their average
EU counterparts ([31]). Thus,
there is room for the development of the Irish equity and debt financing
providers that could help SMEs diversify their risk. However, technical
capacity within many Irish small firms may be limited, which would explain the
low take-up of more complex non-bank funding schemes so far.
State-backed funding initiatives are
supporting SME credit and employment, though additional effort is needed to
increase take-up. Schemes established during the
programme included direct government funding, private debt and equity financing
with state participation, loan guarantees and credit mediation. These have
witnessed some modest initial successes in generating extra credit and helping
create and protect jobs in the sector (Table 3.1), though take-up so far has been low and
needs to be increased. A new programme to help build technical capacity in SMEs
should support the development of skills necessary to use more complex funding
schemes available. Nonetheless, repairing the bank credit channel will be
important to improve access to finance more appreciably. A comprehensive
strategy for SMEs should be developed to address both funding and debt
restructuring issues, and to implement the recommendations of the High Level
Expert Group on SME and Infrastructure Finance published in December 2013.
Lending, particularly to enterprises, is
necessary for sustained economic growth. Research
has highlighted that at high levels of financial development, as measured by
the ratio of private sector credit to GDP, the relationship between financial
development and economic growth becomes negative. This could be partly
explained by the large share of lending extended to households, which evidence
suggests has an insignificant effect on GDP growth ([32]). A study has found that the level of private sector credit in
Ireland is higher than the level predicted by a range of socio-economic factors
([33]). This may
suggest that limited future growth could be derived in Ireland through
financial intermediation. Economic growth in Ireland in the near term is not
reliant on new lending, as output is forecast to be largely driven by net
exports in 2014-15 and employment gains boost consumption. Nonetheless, other
research identifies a positive and significant relationship between enterprise
credit and GDP per capita growth, also implying that the source of that funding
does not matter. ([34]) Hence,
enterprise credit initiatives in Ireland should be pursued via both bank and
alternative finance sources.
3.3.6.   The
non-bank financial sector
The asset management industry could contribute
to the growth of the financial sector, provided that it is adequately
supervised ([35]). Recent analytical work by the CBI discusses a potential
relaxation of loan origination prohibition rules to the asset management
sector ([36]). The work
nevertheless also highlights the contagion risk that investment funds may
transmit to the traditional banking system under some circumstances. Still, the
potential impact of this sector to Ireland’s overall macroeconomic stability is
limited as it is not integrated into the domestic economy and the assets under
management are foreign-owned.
3.4.      Competitiveness
and sustainability of the external position
3.4.1.   Imbalances
build up fast at the peak of the boom
Ireland's external accounts deteriorated
sharply and rapidly during the property bubble. The
current account had remained in surplus or close to balance during the Celtic
Tiger years, and it is not until 2004 that Ireland's current account tuned into
a large deficit. The construction boom fuelled by large financial inflows from
abroad induced a reallocation of resources towards the non-tradable sector and
a surge in imports. Between 2004 and 2005, the current account deficit rose 3
percentage points to 3.5% of GDP, before further rising to around 5.5% of GDP
in 2007 and 2008.
Global trends in manufacturing
negatively affected Ireland's exports already in the early 2000s. Foreign computer manufacturers like Gateway and Dell started
closing plants in Ireland in 2001 as manufacturing centres were delocalised to
cheaper production locations in Asia, to such an extent that exports of office
machines and automatic processing equipment collapsed back to their 1990 levels
by 2010. In contrast, the pharma-chemical sector, also led by FDI from global
companies, continued to develop throughout the 1990s and 2000s to the point
where exports of pharmaceuticals represented close to 60% of total goods
exports in 2013. The pharmaceutical sector is also subject, however, to rapidly
shifting patterns in global production, including the emergence of low-cost
production centres in countries like China, India or even Bangladesh and the rising
importance of generics.
Ireland's share in world goods exports
halved to 0.64% from the early 2000s to 2012.
Merchandise exports were broadly at their pre-crisis level in 2013 as rising
exports of pharmaceuticals just about compensated for vanishing computer
exports. Overall, Ireland nevertheless remains a very open economy, with total
merchandise trade representing around 80% of GDP, similar to the EU average.
Ireland's decline in relative terms as a
global manufacturing centre was most likely inevitable. As they are driven by FDI flows and foreign multinationals,
Ireland's exports are particularly susceptible to changes in global patterns of
product specialisation and shifts in the structure of value chains.
Rising unit labour costs nevertheless
accelerated an ongoing phenomenon. Real unit labour
costs tended to decline in line with developments in the euro area in the first
few years of the 2000s, but went on a gradual rising trend from 2003 onwards
before surging around 2007. In turn, the real effective exchange rate (REER)
evolved alongside that of the euro-area as a whole until around 2005, a period
during which structural reforms in Germany induced productivity gains and wage
restraint. Higher inflation and wage growth thereafter decoupled Ireland's REER
developments from those in the core of the euro-area and Germany in particular.
More than many other countries, Ireland
was vulnerable to losses of competitiveness. Given
the sheer contribution of the FDI sector and multinationals in exports, GDP and
employment, Ireland's economy is very reactive to losses of competitiveness
through wage and/or productivity developments that are out of line with those
in the euro-area and beyond. It is also vulnerable to developments that affect
the locational choice of major multinationals, including in terms of corporate
taxation, the business climate in general, the quality and cost of
infrastructure services and the availability of skills (see also
section 3.5).
Private financial flows comfortably
covered the rising current account deficit. As the
current account deficit widened, much of the financing came in the form of
bonds, money market instruments, loans and deposits. To a significant extent,
these flows were intermediated by Irish domestic banks whose loan to deposit
ratios surged. In contrast, and reflecting structural shifts in the economy,
net FDI flows turned sharply negative.
Ireland's net international investment
position (NIIP) nevertheless took time to deteriorate. Rising current account deficits did not at first translate into an
increase in Ireland's negative NIIP. By 2007, the negative NIIP represented
about 20% of GDP, around its level for most of the 2000s. Ireland's NIIP is
somewhat unusual, however, in that it is affected by the uncommonly large size
of the FDI sector and by the flows generated by the International Financial Services
Centre (IFSC). ([37]) During the
early 2000s, rising equity injections, reinvested earnings, intra-company loans
and external borrowing by the affiliates of multinational companies followed by
rising bond issuances by domestic banks led to an increase in the negative NIIP
excluding the IFSC from minus 4.6% of GDP in 1999 to minus 63% in 2007.
Overall, this deteriorating trend was hidden by the large positive net position
generated by the IFSC, but pressures were mounting already.
3.4.2.   The
crisis and rebalancing
The burst of the real-estate bubble led
to a rapid and sharp adjustment in the current account. The collapse of the economy was at first driven primarily by
plummeting investment and a steep drop in private consumption, followed
somewhat later by a significant contraction in public expenditure. The
contraction in domestic demand and the rapidly drying up of sources of external
financing forced the current account deficit to contract from
EUR 10.1 billion in 2008 to EUR 3.8 billion in 2009 and to swing
into a surplus of EUR 1.8 billion in 2010. The structure of Ireland's
economy, its large export-orientation and its ability to run significant
current account surpluses prior to the excesses of the real-estate bubble made
such a rapid correction possible.
The rebalancing process has been rapid
and effective. The onset of the crisis has in part
forced the rebalancing from the non-tradable to the tradable sector upon the
Irish economy through a destructive process, i.e. the collapse of domestic
demand and the loss of employment and output in the non-tradable economy,
particularly but not exclusively the inflated construction sector. This "destructive
adjustment", however, has also been met by a "constructive"
process that has enabled Ireland to regain the competitiveness it lost during
the 2000s and to grow its tradable sectors.
Improvements in competitiveness have
been significant. Over the past few years and in
the context of the EU-IMF programme of financial assistance, Ireland has
stepped up its efforts to rein in labour costs in the public and private
sectors (see section 3.5), increase labour productivity and improve cost
and non-cost competitiveness.
Significant productivity gains have been
achieved in the past few years. Whether measured by
real labour productivity per hour worked or by real gross valued-added per hour
worked, gains appear to have been not only sizeable, but also larger than in
the euro-area as a whole or in Germany. Composition effects resulting from the
loss of construction output (with traditionally low productivity) appear to
account for relatively little of the overall productivity gains. This is not
particularly surprising given that productivity gains have been sustained for
several years even though construction output came to a virtual halt in a
matter of months and now represents a very small fraction of total output.
Shifting patterns in the composition of manufacturing output and in the
structure of overall output do influence, however, overall measures of
productivity and competitiveness. The rising weight of high-productivity
sectors such as the pharmaceutical industry means that productivity gains for
the economy as a whole are likely somewhat overstated by aggregate
indicators ([38]).
The correction in the real effective
exchange rate (REER) has preceded that in other euro-area Member States and
also been sharper. While the appreciation of the
REER in the first part of the 2000s was higher in Ireland that elsewhere in the
euro-area, the depreciation over the past five years has also been more
significant. Using 2005 as the base year, the REER index has again fallen below
that of Germany and the euro-area as a whole, with a cumulative depreciation of
about 25% from peak (Q2 2008) to trough (Q2 2013).
The current account has swung to a large
surplus. The rebalancing over the past few years
has been such that the current account shifted from a deficit of 5.6% of GDP in
2008 to a surplus of 4.4% in 2012, which is expected to have risen further to
7.0% in 2013. The trade surplus increased over the past few years despite the
broadly stable level of exports, which indicates that local value addition has
also been on the rise. This rising trend appears to be tapering off, however.
The second largest driver of adjustment in the current account has been the
balance on services, which turned into surplus for the first time in 2012 at
EUR 3.2 billion, in sharp contrast with deficits in excess of EUR 10
billion in the first half of the 2000s. The services surplus further increased
to EUR 4.4 billion in the first nine months of 2013, highlighting a
further structural change in Ireland's economy and its position vis-à-vis
foreign investors.
Ireland's trade is shifting towards
services. As it consistently lost export market
shares on the merchandise side with the delocalisation wave in the computer
industry, Ireland also developed as a services hub for multinationals,
including software and other ICT sectors and business services. In the first
three quarters of 2013, computer services represented 41% of services exports,
with another 39% accounted for by business services and 17% by insurance and finance.
Ireland's market shares in services
exports have surged. Similarly to what happened
with goods exports in the 1990s, the development of Ireland as a services hub
has been led by the investment decisions of major multinational companies. Net
inflows of FDI have become large again since 2010 and are now directed mostly
to the services industry. Although global trade in commercial services
represented only about a quarter of global merchandise trade in 2012, it has
also tended to increase somewhat faster on average since the 1980s. Ireland's
share of this growing global market, in turn, increased more than six-fold from
0.41% in the first half of the 1990s to 2.66% in 2012.
Services exports have surpassed goods
exports and have been resilient through most of the crisis. The increase in services exports has been such that they overtook
merchandise exports in Q4 2011 and have been higher ever since. In addition,
they have been quite resilient through the Irish and global crisis as they only
experienced a short-lived stagnation in 2008 and 2009 before resuming their
rising trend.
Ireland's regained cost competitiveness
and structural rebalancing have been supported by the general strength of its
business environment. The attractive and
investor-friendly nature of Ireland's investment climate has underpinned its
ability to attract large FDI inflows during the past decades. It is recognised
by a number of public and private institutions, including the Commission
itself, the OECD, the World Bank or the World Economic Forum. ([39]) Under the World Bank's Doing Business Indicators 2014,
Ireland ranked better than the EU-average for all but three categories, and it
placed among the top countries in the world for six of them.
Renewed momentum in FDI inflows reflect
regained competitiveness and reinforce the rebalancing of the economy. Net inflows of FDI decelerated well before the onset of the crisis
and turned negative for several years before turning positive again in 2010.
The momentum has been maintained since then and the pipeline of projects
announced by the Industrial Development Agency (IDA), which is in charge of
promoting Ireland as an investment destination, attests to the renewed level of
confidence by the international business sector in Ireland's potential as a
regional or global hub. New projects and additional investments by existing
affiliates are also set to further contribute to the rebalancing of the economy
and the expansion of the tradable sector.
The demand composition of GDP has
significantly shifted over the past few years as the economy rebalanced. The reallocation of resources towards the tradable sector and the
"destructive adjustment" are further evidenced by the large shift in
the relative contributions of domestic demand and net exports of goods and
services in total output. Although Ireland has been a very open economy for
decades, the adjustment of the past few years has boosted the share of net
exports in GDP to around 23%, double the level previously sustained in the
early 2000s. This has been achieved as the share of imports of goods and
services in GDP remained constant while the share of exports of goods and
services rose markedly, which is indicative of the rising value added and lower
import intensity of exports. It must be noted also that, even though there has
been a significant degree of "destructive adjustment", domestic
demand has now stabilised and is expected to rise in 2014.
Ireland has accumulated a large negative
NIIP as a result of the crisis. As indicated
earlier, it is important to distinguish between the IFSC NIIP and the non-IFSC
NIIP in order to disentangle the underlying drivers and potential imbalances.
While the IFSC had a net creditor position of 43% of GDP at the end of 2007, it
dropped to near-balance by end-2008, including as a result of large (negative)
valuation changes, and has remained there since then. Gross credit and debit
positions do remain very large, however, at around 14 times GDP, which means
that the net position could easily swing back to significant credit or debit,
including through valuation effects as a large proportion of these positions
are held in the form of equity.
The bailout of domestic banks has driven
the deterioration of the NIIP. In stark contrast
with the balanced IFSC NIIP, the non-IFSC NIIP deteriorated sharply over the
past few years from a net debit position of 63% of GDP at the end of 2007 to
104% of estimated GDP in September 2013. The negative position peaked at
EUR 196 billion at the end of 2011 but fell since to
EUR 172 billion at end-September 2013. The operations linked to the
government bailout of domestic banks and the credit flows under the EU-IMF
programme of financial assistance that ensued have been the driver of Ireland's
deteriorating NIIP. The provision of emergency liquidity assistance (ELA) by
the Central Bank of Ireland, the issuance of promissory notes and their
subsequent conversion into long-term bonds, and the EUR 67.5 billion
package of financial assistance from the EU, IMF and bilateral creditors have
all impacted the NIIP over the past few years in significant ways.
The nature of the authorities' net debit
position has shifted in recent quarters. In the
initial stages of the banking crisis, the Central Bank of Ireland (CBI)
accumulated the bulk of the authorities' negative NIIP as it provided funds
under the ELA. At its peak in Q4 2012, prior to the granting of financial
assistance from the EU and IMF, the Central Bank had accumulated a negative
NIIP of EUR 128 billion. The CBI's position has been gradually
unwound over the past few quarters, including as a result of the conversion of
promissory notes into long-term government bonds. The general government's
negative NIIP, however, has concurrently increased as funds were disbursed
under the EU-IMF programme of financial assistance.
The NIIP of domestic banks reflects the
transfer of liabilities to the public sector and the impact of the programme. The downsizing and deleveraging imposed on domestic banks as part
of the crisis resolution strategy and the EU-IMF programme of financial
assistance has had a significant effect on their own NIIP. The foreign
liabilities of domestic banks were divided by a factor of almost three between
end-2009 and September 2013. Their foreign assets, in turn, were reduced by a
factor of 2.5 in the same period as ownership of large segments of the banks'
balance sheets were transferred to the National Asset Management Agency (NAMA),
bringing the NIIP close to balance ([40]).
The FDI sector also has a large impact
on Ireland's IIP. Affiliates of large multinational
companies tend to finance their investments through direct equity injections,
intra-company loans or borrowing outside the Irish banking system and
reinvested /retained earnings have also been large. As a result, the FDI sector
has traditionally generated a sizeable negative NIIP. As of September 2013, the
negative NIIP of non-financial companies represented EUR 87 billion,
or 53% of estimated GDP. The effect of this position on Ireland's overall NIIP
has been compensated, however, by a positive NIIP of EUR 70 billion
from non-bank financial intermediaries, which includes NAMA. Although much
smaller than the IFSC's gross positions, valuation changes in the positions of
non-financial companies and non-bank financial intermediaries can also have a
sizeable effect on Ireland's overall NIIP. Similarly, decisions on earnings
retention or repatriation have a potentially significant impact.
Issues around Ireland's large negative
NIIP are mostly of a public debt sustainability nature. As evidenced above, the scale of the IFSC and the FDI sector are
such that Ireland's NIIP can swing relatively quickly and widely. The negative
net position that has been accumulated over the past few years, however, is
driven by the NIIP of the CBI and general government, as the other parts have
broadly balanced. While the high negative NIIP is a source of concern in
principle, its roots are well understood, as is the policy response needed to
unwind it. Ultimately, Ireland's negative NIIP as it currently stands is a
matter of public sector debt sustainability (see Section 3.2) rather than
the reflection of large imbalances in the current account sustained over a
prolonged period of time.
The nature of the Government's external
debt significantly reduces concerns about the NIIP.
The general government's negative NIIP position is expected to unwind over a
prolonged period as the debt level is reduced in line with the fiscal plans. Also,
the long maturities and the relatively low average interest rate on the public
debt reduce the servicing burden and refinancing risks (see section 3.2).
The economy and tradable sectors remain
dominated by the FDI sector. The bulk of Ireland's
exports of goods and services alike are accounted for by large multinational
corporations using Ireland as one component in their global value chains. As
happened in the 1990s with the computer hardware industry, Ireland is therefore
directly affected by global shifts in trade patterns and the organisation of
value chains. Its cost and non-cost competiveness, benchmarked globally, is
therefore also more crucial than for other EU economies. In this context,
developments in the pharmaceutical sector will have a major impact on Ireland's
external accounts, including on a net basis. Exports fell in 2013 as a result
of the patent cliff. The extent to which this will affect the industry's
medium-term potential in Ireland remains unclear; even though indications are
that the sector remains vibrant with new projects taking over plant closures.
FDI is relatively concentrated. While it has attracted large inflows of FDI over the past decades,
foreign investments in Ireland are relatively concentrated both in terms of
investor base and in terms of sectoral orientation. This implies that decisions
by individual firms and developments in specific sectors can have an unusually
large impact on the economy as a whole.
Domestic companies are little
internationalised. Ireland's home-grown industrial
fabric is dominated by micro, small and medium enterprises, only a small
proportion of which are export-oriented and an even smaller proportion of which
have the potential to grow into large internationalised groups. This further
increases Ireland's reliance on the multinational corporations for exports, the
development of high-valued and productivity sectors and (high-skill) job
creation.
3.5.      Labour
market issues and skills mismatches
The boom and bust cycle had a deep
impact on the Irish labour market and triggered a sharp rise in unemployment. The precise extent to which the increase in unemployment and the
deterioration of labour market indicators are cyclical or structural is
uncertain at this stage. The government has already implemented several
policies to address high unemployment (Box 3.5). The boom and bust cycle has
nevertheless generated challenges that require decisive policy actions to
support the sectoral re-allocation of the labour force in line with the rebalancing
of the economy. 
3.5.1.   Boom
times, imbalances build up
Pre-crisis Ireland displayed impressive
labour market indicators, but imbalances were building up already. Ireland experienced full employment for almost a decade. As the
active population continued to increase quickly during most of the 2000s and
migration inflows accelerated, sustained economic growth generated the level of
job creation needed to maintain the unemployment rate at around 4%.
Employment growth was initially
widespread across sectors, but increasingly hinged upon the construction and
public sectors over time. While overall job
creation continued at a fast pace, employment in some important sectors from a
labour market perspective broadly stabilised or initiated a declining trend as
early as in 2001. In contrast, employment growth in construction gathered
further steam to the point of representing 13.5% of total employment by 2007.
Similarly, employment in the public sector (including education and health)
increased rapidly on the back of the rise in construction-related government
revenue. 
Prolonged tight labour market conditions
induced strong pressures on wages. With
unemployment down to frictional levels and Ireland in the midst of a catch-up
process with the frontier, wage growth was high through most of the 2000s.
3.5.2.   The
crisis and rebalancing
The burst of the real estate bubble and
the ensuing broad-based crisis brought a dramatic reversal in the labour market
situation and revealed severe imbalances. The
reversal of fortunes was stark and abrupt as the unemployment rate more than
doubled in just one year to 10% in early 2009, followed by further increases to
nearly 15% in late-2011 and early-2012. The construction sector bore the brunt
of the adjustment, with employment falling to barely a third of its peak level
by late-2012 and close to 200,000 jobs being shed in a very short time span ([41]). By the time the adjustment had run its course, employment in
construction represented only about 5% of the total from a peak of nearly 14%
in 2006, despite the concurrent fall in overall employment.
The boom-bust cycle has affected
distinct segments of the labour force very differently. The nature of the cycle and the structure of Ireland's economy, including
the prominence of the FDI sector (see section 3.4), mean that certain classes
of workers, in particular those with low or intermediate skills, have been
affected significantly more than others. A number of salient developments in
the labour markets over the past few years need to be highlighted as they
affect the policy responses necessary to address the imbalances and the sharp
rise in unemployment.
Unemployment has become largely of a
long-term nature and severely affects the youth. As
the crisis unfolded and became protracted, unemployment has taken an
increasingly long-term nature. By Q3 2013, just over 60% of the unemployed had
been without a job for over a year, and 45% had been separated from employment
for more than 2 years. Such a high level reflects the specificity of many
construction sector skills and their difficulty to transfer to other types of
employment. It also compares poorly with the EU average, in contrast to
Ireland's position prior to the crisis, when long-term unemployment had come
down to around 25% and well below the EU average. In addition, the high
prevalence of long-term and very long-term unemployment generates high risks of
losses of tangible and intangible skills for the workers affected and a genuine
danger of hysteresis. The crisis has taken a particular toll on the youth at
all skills levels, who have faced difficulties in integrating the job market in
recent years. The unemployment rate among the 15-24 years old peaked above 30%
in late 2012 and early 2013.
The prevalence of low work intensity is
a serious concern. Ireland's share of households
with low work intensity is exceptionally high at 24.1% in 2011, compared with
an EU average of 10.3%. The prevalence of low work intensity has also risen in
recent years with the general increase in unemployment and its long-term
nature. This point to the concentration of joblessness at household level and
raises specific social and policy concerns.
Unemployment and inactivity traps have
emerged. Unemployment benefits are paid under a
dual system of jobseeker's benefit (JB) and jobseeker's allowance (JA). JB is
not means-tested and is provided to eligible jobseekers for a period of up to 9
months. ([42]) Although
the payment is graduated according to previous earnings, it is capped at a
maximum weekly rate of EUR 188 ([43]), which effectively applies to most claimants. If not or no longer
eligible to JB, jobseekers are eligible to JA. JA is paid at the same weekly
rate of EUR 188 for people above 26 years of age and without dependents.
It is means tested but not time-bound. In addition, jobseekers may be eligible
for additional benefits, most importantly the rent supplement (housing support)
and the medical care (free medical care and prescriptions).
Replacement rates are comparatively high
for certain classes of unemployed. The flat
structure of unemployment benefits under the JB and JA system, the unlimited
duration of JA and the availability of supplementary payments have several
implications: (1) replacement rates are relatively low in the initial
phase of unemployment in comparison with EU or OECD countries, particularly for
average and above average income earners; (2) replacement rates are
relatively high for the long-term unemployed, particularly for below average
income earners, which is likely the case for the majority of the long-term
unemployed; and (3) additional benefits, in particular the rent supplement
and the medical card, further increase the replacement rates for certain
segments of the population. ([44])
Skills mismatches have emerged with the
rebalancing of the economy. As indicated in
section 3.3, Ireland's economy has gone through a major rebalancing
process over the past few years, part of which has been of a "destructive
nature" with the collapse of the construction sector and the sharp fall in
domestic demand. The reallocation of resources towards the tradable sector has
also had consequences for the structure of the demand for labour.
A number of factors drive skills
imbalances. First and foremost, the transformation
of the Irish economy provides increasingly less room for low-skilled workers.
Second, while Ireland has the highest tertiary education attainment rate in the
EU, there remains a large number of workers with education level 0-2. ([45]) Aging will not naturally address the labour supply and demand
mismatch at this level of skill. In addition, Ireland's system of further
education provides insufficient room for valuable re-skilling and up-skilling
opportunities.
The imbalances that have led to the high
level of unemployment have been partly reduced or are being addressed, but
challenges remain. Wage developments have been
subdued in the past few years and have cut real labour costs. The high level of
unemployment placed a cap on nominal wages since the onset of the crisis and
put an end to the long rising trend in nominal wage costs. Despite the
relatively high level of labour market flexibility, however, nominal wages in
the private sector have proved sticky as elsewhere. In contrast, public service
wages were cut on several occasions, which has reduced the positive wage
differential between the public and private sector ([46]).
New vacancies are being filled rapidly
and private employment is rising. Recent labour
market developments (see section 2) are indicative that frictions on the
labour markets are relatively limited at this stage: the increase in labour
demand is translating in rising employment as vacancies are being filled
rapidly. This is also indicative that structural unemployment may not have
risen as much as a result of the crisis, as may have been estimated at first
and under standard econometric techniques.
Slack in the labour force is high
overall, but relatively thin for certain categories of skills. Total labour supply remains significantly larger than demand at
this stage, but the degree of slack differs widely across skills levels. While
the slack ratio ([47]) is at
around 30% for education levels 0-2, it at about 20% for education levels 3-4
and down to 8% for education levels 5-6. Although the latter is significantly
higher than in the pre-crisis levels when it hovered around 2%, it is
indicative that relatively little excess capacity exists in the high-skill
segment of the labour market and that pressures and skills shortages could
materialise relatively rapidly if the recovery on the labour market is
sustained. 
The post-crisis level of structural
unemployment remains uncertain. The relatively low
slack ratio at education level 5-6 also highlights the potential risk that
Ireland may soon confront if past trends in employment growth (i.e. a continued
increase in employment at the high-end of the skills spectrum) continue: that
vacancies may increase further without a corresponding rise in employment and
that the unemployment rate may be stuck at a structurally high level. Ireland's
ability to generate job creation at the intermediate skill level and its
capacity to offer re-skilling and up-skilling opportunities to its (long-term)
unemployed population will be critical in this regard.
Significant imbalances started to unwind
in 2007 triggering a major adjustment and rebalancing process. A property market and credit boom in the run up to 2007 was
accompanied by a loss of competitiveness and widening current account deficits.
Property-related lending led to rising levels of private sector indebtedness,
while weak financial regulations further undermined the balance sheet of banks.
The bursting of the bubble and economic downturn eventually led to the
government's intervention in the banks and a transfer of liabilities from banks
to the government. Government borrowing undertaken to rescue banks and under
the EU/IMF-supported programme led to a rise in external liabilities reflected
in the highly negative NIIP. 
Completing the path of macroeconomic
adjustment towards balanced and sustainable growth can only be achieved with
further policy efforts. The economy has undergone a
significant amount of adjustment since 2009. The current account has swung into
surplus, private sector debt started to decline, the fiscal position has
improved, labour costs and unemployment have declined, and financial sector
repair is on-going. Nonetheless, macroeconomic imbalances still exist giving
rise to important policy challenges. 
Lowering government debt through fiscal
consolidation
Government debt reduction is critical to
reducing vulnerabilities and restoring the long term sustainability of public
finances. The current deficit levels are clearly
unsustainable, which makes strict adherence to the adjustment path laid out in
the Council recommendation under the EDP all the more essential. Beyond the
correction of the excessive deficit, it will also be important that the
conditions of the preventive arm of the SGP are met so as to attain a balanced
fiscal position as soon as possible. Strengthening multi-year budgeting rules
would also ensure that discretionary changes to the government expenditure
ceiling are limited to well-defined and a restricted number of conditions.
Certain aspects of fiscal data reporting and analysis could also be improved.
The expected recovery of economic growth will help the fiscal adjustment over
the medium-term but additional efforts could be required if growth surprises on
the downside. In this regard, privatisation revenues are an opportunity to
reduce public debt. Careful monitoring and management of contingent liabilities
is also essential in order to not derail future debt reduction. 
Reducing financial sector vulnerabilities
Financial sector repair is critical to
revive lending and improve the soundness of banks.
Non-performing loans remain high and maintaining or raising mortgage and SME
arrears restructuring targets is crucial to improve bank profitability.
Developing a strategy to restructure commercial real estate arrears would also
help greatly. Further developing schemes to ease SME access to finance is
important as credit conditions for domestic SMEs remain tight and as this would
support growth. Market-based options to reduce the profitability drag to banks
from tracker mortgages could also be explored further. It is also important to
have the recently enacted central credit register operational as soon as
possible as this would improve banks’ risk management. Proactive and careful
implementation of new financial legislation, especially related to the new
personal insolvency regime and facilitating banks’ access to collateral, is
critical. Safeguarding the capital position of banks would also help them
confront challenges linked to the EU-wide stress tests in 2014.
Easing private and household debt
Financial policies that lower private
domestic debt, particularly household debt, are important for supporting future
growth. In the near term, ongoing household
deleveraging is likely to continue weighing on growth, though less so than in
the past. In the medium term, the reduction of financial uncertainty for
individuals and banks through NPL resolution can have significant confidence
effects. Financial sector policies that encourage mortgage debt restructuring
will aid the reduction of household debt as banks propose sustainable arrears
resolution through partial debt relief offers to distressed mortgage holders.
This will also lessen the impact debt deleveraging has on private consumption.
Careful monitoring of other regulatory measures that aid resolving distressed
mortgages is particularly relevant, particularly as concerns recent changes to
personal insolvency and bankruptcy reforms and to the repossession regime and
consumer protection. Effective implementation of these changes would enhance
debt resolution. In addition, labour policies aimed at reducing unemployment will boost disposable income and aid household
debt reduction. Other financial policies that encourage
the restructuring of SME and commercial debt would also help the reduction of
private debt. 
Cutting long-term unemployment through more
reforms
Continued labour market reforms will
facilitate further rebalancing and declines in the unemployment rate. Employment gains will also continue to support household
deleveraging. Labour market activation policies could be strengthened,
especially in the government delivery of support services to the long-term
unemployed and identifying job opportunities. Further education and training
(FET) reforms are important to reduce skills mismatches, especially increasing
the relevance of FET programmes for jobseekers and employers and improving the
assessment of skill needs. It would also be critical to ensure that the new
institutional setup for FET works smoothly, especially with the allocation of
funds to the new education and training boards (ETBs) which would entail an
improved monitoring system to better measure outcomes and channel funds where
best results are achieved.  Policies aimed at maintaining recent wage
moderation and at avoiding inactivity traps are also important to maintain
employment gains.
Consolidating the reduction of external
imbalances
Fiscal, labour and financing reforms
will protect external competitiveness. Government
debt reduction would address concerns over the large negative NIIP as public
external debt is reduced. Policies incentivising resource reallocation into the
tradable sectors could be further explored, particularly for domestic firms as
few are export-orientated. Measures which assist the
development of SMEs, alongside international investment into the economy, would
be in the best interests of Ireland's long-term economic growth. In this regard, on-going initiatives boosting access to finance
for SMEs are important to expand and make more effective. Government policies
that ensure continued wage moderation and the reskilling of the labour force
are also key as they would lock in recent productivity increases and labour
cost reductions. 
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([1])  The effects on headline output from
this sector, which accounted for about 12% of gross value added (GVA) in 2012,
but only 2% of employment , have likely masked underlying improvements in
the more labour-intensive domestic economy. See Enright S and Dalton M (2013).
([2])  One-off measures include guarantee
payments related to the liquidation of IBRC in 2013 (0.7% of GDP), revenue from
the sale of mobile telephone licenses in 2013 (0.4% of GDP), revenue from the
sale of the National Lottery licence in 2014 (0.2% of GDP), as well as
financial sector measures for credit unions in 2014 and 2015 (less than 0.1% of
GDP in each year).
([3])  At Risk of Poverty rates measure the
percentage of the total population whose income is below a set percentage of
median incomes for the country, and here it is 60%.
([4])  Severe Material Deprivation is defined
as the inability to afford at least four items of a list of nine items deemed
necessary to lead an adequate life (for example paying rent, heating or buying
meat).
([5])  The latest consolidated figures from
Eurostat are from 2012 and are only available annually.
([6])  Cussen and O' Leary (2013).
([7])  Consolidated debt figures do not
exclude inter-company loans provided by non-resident entities and securities
issued to international investors.
([8])  Cussen M., O'Leary B. and Smith D.
(2012).
([9])  Household net worth is computed as the
sum of household financial and housing assets minus total household
liabilities.
([10]) Change in the cash balances is
reflected in stock-flow adjustments in Graph 3.12, which account also for other smaller
financial operations including debt management operations.
([11]) Long-term debt is defined as debt with
an original maturity of over one year.
([12]) The long-dated government bonds that
replaced the promissory notes have reduced the government funding needs and
provide interest savings. For full analysis of the impact of this operation,
see Box 1 in http://ec.europa.eu/economy_finance/publications/occasional_paper/2013/pdf/ocp131_en.pdf.
([13]) This does not reflect the extension of
the EFSM loan maturities (see Graph 3.15). Including the EFSM loan maturity
extension, the average maturity of long-term debt is estimated at around 13
years.
([14]) This covers small deposits of up to EUR
100,000.
([15]) For more details see Fiscal
Transparency Assessment: http://www.imf.org/external/np/sec/pr/2013/pr13258.htm.
([16]) The Irish banking sector includes two
distinct components: (i) domestic credit institutions which at end 2010 held
more than 55% of total bank assets and provided about 95% of total loans to the
domestic private sector; and (ii) non-domestic banks from the large offshore
financial centre (IFSC), which focused on lending to non-residents and
purchases of securities.
([17]) Honohan (2010).
([18]) The total bank recapitalisation cost
for the government amounted to about EUR 64 billion, or approximately 41% of
2011 GDP. The EUR 16.5 billion recapitalisation cost determined by the 2011
Prudential Capital Assessment Review (PCAR) stress test was considerably lower
than initial estimates. The private sector shared in the bank rescue cost
through liability-management exercises on subordinated debt and shareholder
losses.
([19]) The new global standard on bank capital
adequacy and liquidity reflecting the Basel III agreement, transposed into the
EU legal framework via the Capital Requirements Regulation and Capital Requirements
Directive IV, which entered into force on 17 July 2013.
([20]) DTAs are recorded to reflect
carry-overs of bank losses if it is deemed likely that they will be used to
reduce tax expense in subsequent periods.
([21]) For details of the CBI Mortgage Arrears
Resolution Targets see: http://www.centralbank.ie/press-area/press-releases/documents/approach%20to%20mortage%20arrears%20resolution%20-.pdf
([22]) Data on re-default rates is limited
though recent experience from the US and the UK suggests that restructured
loans become delinquent in about 30 to 40% of cases in the first 12 months
after renegotiation, though this is less prevalent when permanent principal
and/or interest reductions are provided. Thus, the CBI target of max. 25%
re-default rate in 2014 appears conservative.
([23]) Lydon (2013).
([24]) This calculation reflects arrears balances
data published by the CBI; the number of arrears cases from the same
dataset shows just about 6.5% of households being in any arrears (these figures
refer to primary-dwelling homes only).
([25]) According to the ESRB's "Annex to
the recommendation on funding of credit institutions", Irish banks' total
asset encumbrance (pledged loans/total loans) at end-2011 was 30%, while
mortgage-loan encumbrance exceeded 55%.
([26]) High asset-encumbrance also constrains
the capacity of banks to issue unsecured debt, as investors in such securities
are subordinated to secured creditors (which have recourse to the balance sheet
of the issuer as well as to the pledged asset collateral).
([27]) Asset-swap spreads (versus 6-month euribor)
on all outstanding AIB and BOI asset-covered securities (ACS) were trading in
the 80-115 basis points range at the time of writing this report.
([28]) Net liquidity advancement reflects the
funding provided after a discount is applied on the market value of collateral.
([29]) Own-use bonds are securities issued by
a bank to itself and backed by asset pools (e.g., tracker mortgages).
([30]) For more details see the latest RedC
and ECB
SAFE surveys covering the period April-September 2013.
([31]) Lawless et al.
(2013).
([32]) Arcand et al. (2012) and Beck et al. (2012).
([33]) Beck (2014).
([34]) Ibid.
([35]) From EUR 330 billion at the end of 2008
toEUR1,068 billion at the end of November 2013, the assets under management of
Irish domiciled investment funds have almost tripled in size, according to the
CBI and ECB.
([36]) CBI (2013).
([37]) The FDI sector also has an impact on
the current account through income flows that is both extremely large and at
times difficult to disentangle precisely. Ireland has attracted not only large
foreign companies with a genuine commercial presence in the country, but also a
number of companies that have established small headquarter operations that
channel disproportionately large income streams for tax purposes. These
operations have not only impacted the current account and the NIIP, but also
the measurement GNP. Fitzgerald (2013) estimates that the so-called
re-domiciled Plcs may have inflated the current account surplus by around 5% of
GDP in 2012.
([38]) O'Brien (2011).
([39]) See for example the European
Commission's Member States' Competitiveness and Industrial Performance
Scoreboard 2013.
([40]) This transfer of assets to NAMA is
reflected in the build-up of external assets of "other financial
intermediaries", not in the external position of the general government.
([41]) This loss is equivalent to about 10% of
total peak-time employment.
([42]) Eligibility conditions include prior
contributions to pay related social insurance (PRSI) for a determined number of
weeks, in addition to being available for and genuinely seeking work.
([43]) Excluding additional payments that
might be claimed for dependents.
([44]) Standardised data on replacement rates
are compiled by the OECD Directorate for Employment, Labour and Social Affairs.
([45]) The United Nations Educational,
Scientific and Cultural Organisation (UNESCO) developed the International
Standard Classification of Education (ISCED) for cross-country comparison
purposes. Levels 0-2 correspond to education up to lower secondary level.
Levels 3-4 correspond to education up to post-secondary non-tertiary level.
Levels 5-6 correspond to first and second stage tertiary education.
([46]) A number of studies, including by the
Central Statistics Office (CSO) and the ECB point to a positive wage gap in
favour of the public service, after controlling of variables like education,
experience, age, gender or size of the employer. The gap is most significant
for the lower part of the income distribution and falls for higher income
earners to the point of becoming negative for top percentiles. The gap has been
reduced with the pay cuts of 2009-2010, and will be further reduced for
high-income earners as a result of the Haddington Road agreement.
([47]) The slack ratio is measured as the
number of jobseekers (active population minus employed population) divided by
the number of employed people at a given level of skills.