02.12.2016 - Staff from the European Commission, in liaison with staff from the European Central Bank, visited Dublin from 29 November to 2 December to conduct the sixth post-programme surveillance (PPS) review for Ireland. This was coordinated with the International Monetary Fund's sixth post-programme monitoring mission. Staff from the European Stability Mechanism also participated in the meetings on aspects related to its Early Warning System. The main objective of PPS is to assess the country’s capacity to repay loans granted under the former EU-IMF financial assistance programme and, if necessary, to recommend corrective actions.
Ireland’s economic prospects remain bright, but some clouds are on the horizon. In recent years, rapid economic growth has provided tailwinds for policy efforts aimed at financial sector repair and the restoration of sustainable public finances. Most recently, on top of robust underlying growth, the level of GDP surged in 2015 driven primarily by changes in the global operations of some multinationals. This added further to the fall in the headline deficit and debt-to-GDP ratios but had only limited benefits for the domestic economy in terms of household income and employment. While GDP is expected to continue to grow at robust rates, the future evolution of the activities of multinational enterprises remains uncertain and the external environment has become increasingly unpredictable especially after the UK 'leave' vote.
Ireland's fiscal adjustment has been remarkable but slowed in 2016. While broadly compliant, the Draft Budgetary Plan implies a risk of some deviation from the required adjustment towards the medium-term objective in both 2016 and 2017. The government used a large part of the over-performing, but partly volatile, tax proceeds to fund additional current spending in 2016. While the corporation tax increase is recognised as a level shift, this is not fully in line with the June 2016 EU Council recommendations, which encourage Ireland to use windfall gains to accelerate deficit and debt reduction. Looking forward, a continued decline in the still high level of public debt remains sensitive to fluctuations in economic growth and is dependent on the size of fiscal adjustment. In this context the government announcement of a debt-to GDP target of 45% of GDP by the mid to late 2020s is to be welcomed. In this context, compliance with the EU fiscal framework provided under the Stability and Growth Pact remains of the essence.
Increased external uncertainty puts an even greater premium on prudent fiscal policy and a reorientation of public spending toward investment. Efforts to enhance the budgetary process are commendable. Yet, the reliability of multi-annual expenditure planning remains weak, leading to repeated changes to expenditure ceilings. If correctly designed, changes to the fiscal framework would reduce the risk of pro-cyclical fiscal policy in the future. Ongoing spending pressures call for a strengthening of public spending reviews, including in the healthcare sector. The 2017 budget aims to exhaust the available fiscal space and little has been done to broaden the tax base in this budget, leaving the public finances vulnerable to shocks. Further current spending increases and tax cuts could narrow the scope for public investment in infrastructure, making it difficult to address bottlenecks and boost the long-term productive capacity of the economy.
Despite significant progress in recent years, there is ample scope for further vigilance for the banking sector. A number of factors will continue to drag on bank profitability in the near to medium term. These include the elevated stock of non-performing loans (NPLs) and low-yielding tracker mortgages, weak credit demand, difficulties in accessing collateral, and a risk that net interest margins begin to decline. Domestic banks' capital levels have improved, even though the results of the recent European Banking Authority stress test signalled remaining vulnerabilities, mostly stemming from the legacy of their weak asset quality. The resolution of NPLs needs to maintain momentum and efforts to ensure that accounts are sustainably restructured should continue. In particular, the focus should remain on mortgage loans that have long been non-performing. Despite the recent pickup in new lending volumes, both households and firms continue to repay more than they borrow, resulting in a still largely credit-less economic recovery. Market uncertainty persists, including in relation to the longer-term impact of the UK ‘leave’ vote on the banks, especially those with significant UK exposures.
Banks will need to carefully balance the push to boost credit volumes with maintaining prudent lending standards. The opposition Bill enabling the Central Bank of Ireland (CBI) to cap interest rates on variable rate mortgages, if enacted, could interfere with the smooth transmission of monetary policy. By impinging on the generation of sustainable profits by banks, it could also have implications for banking supervision and financial stability. Moreover, a decision to direct lenders as to the interest rate they can charge could lead to a decrease in competition and have a deterrent effect on potential new entrants to the market, thereby inhibiting credit extension at sustainable market rates.
Developments in real estate markets need to be closely monitored. While there is little evidence of house price overvaluation so far, recent price and rent increases have drawn attention to persistent housing supply bottlenecks. The government has repeatedly intervened in the housing market to support the recovery in the residential construction industry, but it will take time to restore an adequate supply of new homes. Although commercial property purchases are largely funded by foreign equity, close supervision of commercial real estate financing should be maintained. Since the CBI macro-prudential measures were announced in late 2014, house price expectations have moderated. Their review, published in November, resulted in several refinements, while at the same time leaving the macro-prudential framework – and in particular the loan-to-income ratio – intact. Looking forward, the framework should be maintained to prevent the potential re-emergence of a vicious circle between house prices and bank lending.
The next PPS mission is planned to take place in the first half of 2017.
The mission would like to thank the Irish authorities for the helpful and open discussions.