European Commission Directorate-General for Economic and Financial Affairs
(European Economy. Occasional Papers. 76. February 2011.
Brussels. Paper and internet. 186pp. )
KC-AH-11-076-EN-N ISBN: 978-92-79-19326-2 ISSN: 1725.3209
Ireland experienced strong growth from the early 1990s, after decades of poor economic performance. Initial success was attributable to sensible fiscal policies, an export-oriented industrial policy and the benefits of closer European economic integration and broader globalisation in a context of strong productivity enhancements. However, domestic demand increasingly took over from exports as growth driver. The strong economic expansion in the years immediately before the current crisis masked an over-reliance on construction as the engine of activity.
Boom-related windfall fiscal revenues were largely spent, contributing to overheating and loss of competitiveness. Amid intense competition for profits in the booming economy and property market, the pace of credit expansion accelerated sharply. Light-touch macro-prudential regulation and supervision did little to stem the swelling banking sector imbalances.
From late 2007, investor confidence in Ireland's property sector evaporated amid concerns about oversupply and a price bubble. This left Ireland facing the twin problems of a sharp decline in cyclical construction-related revenues and the sudden appearance of very large losses in the domestic banking system. The global financial crisis and the severe worldwide recession which it caused exacerbated the problems. From 2008, policies to address budgetary and financial stability concerns included fiscal consolidation as well as a range of banking support measures such as guarantees, capital injections and regulatory reforms. However, by 2010 GDP had fallen from peak by an estimated 17% in nominal terms and the underlying government deficit had increased to over 11%. Unemployment ratcheted upwards.
By the autumn of 2010 the loss of investor confidence in Ireland triggered a vicious cycle. Deposit outflows from the banking sector accelerated and the cost of government borrowing reached unsustainable highs. As financing costs increased and renewed banking losses were revealed, investors were increasingly concerned about the capacity of the government to deal with the dual challenge of a large fiscal deficit and the state's commitment to finance the growing cost of supporting a severely damaged banking sector. The credibility and thus the effectiveness of the government guarantees in the banking sector faded. More outflows and increasing borrowing costs further damaged confidence.
These challenges led the Irish authorities to request external help on 21 November 2010. A programme of €85bn financial assistance was agreed at staff level with the European Commission and the IMF, in liaison with the ECB; and approved by the ECOFIN Council and the IMF Board in December 2010. The programme provides for up to €50bn in fiscal needs and up to €35bn in banking support measures between 2011 and the end of 2013.
Funding from the programme partners is conditional on speedy action to clean up Ireland's financial sector, to put the public finances on a sustainable path and to implement a structural reform package. The banking sector will become smaller to suit Ireland's needs and credit institutions will have to increase capital adequacy standards as well as improve funding profiles to lower market perceptions of risk. Rigorous stress testing of the system is necessary, unviable institutions will need to be wound down and financial regulatory reform must be advanced. Fiscal consolidation of €15bn (9% of GDP) by 2014 – frontloaded and weighted towards expenditure reduction – is required to put the debt-to-GDP ratio on a firm downward trajectory after peaking in 2013. This will also put Ireland on track towards meeting its 2015 Excessive Deficit Procedure deficit target of 3% of GDP. In turn, reform to the budgetary process will help to ensure adequate safeguarding of the public finances. Although price competitiveness has improved, a sustainable economic growth path from 2011 onwards requires further relative price and wage adjustment and shifts of production capacity across sectors. Structural reform measures to boost competition and avoid unemployment traps are an important part of this strategy.
This report provides background to the programme and builds on the documents agreed with the Irish authorities.