Mission Concluding Statement 

Ireland: Staff Concluding Statement for the 2023 Article IV Consultation Mission

November 3, 2023

Dublin, Ireland: Ireland’s economy has shown remarkable resilience in the face of recent consecutive shocks, achieving one of the highest growth rates in the euro area in 2021-22. Growth is projected to moderate in 2023-24 albeit remaining solid. Inflation is expected to ease further. The fiscal position has strengthened considerably on the back of strong tax revenues, but the headline numbers mask some underlying vulnerabilities. The large and complex financial system has remained resilient so far and will continue to be tested by tighter financial conditions. Ireland’s positive outlook is clouded by considerable external risks. Policies should focus on maintaining macroeconomic and financial stability and strengthening resilience in a shock-prone world. This will require: (i) maintaining fiscal prudence to support disinflation and building buffers for future shocks and spending pressures from aging and climate change; (ii) continuing heightened vigilance of financial stability risks; and (iii) advancing structural reforms to boost housing supply, strengthen productivity, and accelerate the green transition.

Growth is expected to moderate, from a very high base. Tighter financial conditions, supply side constraints, and weakening external demand are expected to weigh on the domestic economy. At the same time, a strong labor market, a recovery of real incomes as inflation recedes, and a rundown of excess household savings accumulated during the pandemic should support private consumption in the near term. Staff projects real GNI* growth to moderate to 2½ percent in 2023-24. GDP growth is projected to decelerate to 1½ percent in 2023 and 2⅔ percent in 2024, from an average of 12 percent during 2021-22. Inflation is expected to average 5⅓ percent in 2023 and 3.2 in 2024 before converging to 2 percent in late 2025, reflecting the impact of ECB’s monetary tightening and the moderation of growth and labor market tightness.

The outlook is clouded by considerable external risks. Further weakening of external demand, a renewed surge in commodity prices, an intensification of Russia’s war in Ukraine or the Israel-Gaza conflict, and tighter-than-expected global financial conditions pose risks to the outlook. Furthermore, Ireland’s highly open, small economy would likely be significantly affected by deepening geoeconomic fragmentation in the coming years and changes in international taxation could have more consequences than currently envisaged. Activities of multinational enterprises (MNEs) entail risks on both sides—a retrenchment (expansion) of the MNE sector would lead to lower (higher) employment growth, tax receipts, and confidence.

Fiscal policy should continue to support disinflation and avoid adding to aggregate demand. Despite signs that inflation pressures are abating, capacity constraints in the economy have become increasingly binding, amid a still tight labor market and elevated core inflation. Well-targeted fiscal policy can support disinflation at a lower cost to growth and inequality, by reducing the tension between price and financial stability, while protecting the most vulnerable. Prudent fiscal policy to build adequate buffers is also warranted, given Ireland’s large exposure to external shocks and future spending pressures from aging and climate change. Given the uncertain and volatile nature of corporate income tax (CIT) revenues, excess CIT collections should not be used to fund permanent spending.

The 2024 budget entails a slightly expansionary stance. Budget 2024 responded to elevated levels of inflation through a package of permanent and one-off cost of living measures. A smaller and better targeted package would have been less costly while still protecting the most vulnerable. As inflation continues to recede, one-off cost of living measures should be phased out. In the event downside risks materialize, automatic stabilizers should be allowed to work fully, while any additional discretionary support needs to be temporary and targeted to the most vulnerable while preserving price signals. Any fiscal overperformance should be saved.

Strengthening public investment efficiency and ensuring timely execution of the capital budget will be critical to deliver on the government’s ambitious goals in the National Development Plan while ensuring value for money. Ireland has large and growing investment needs. More efforts need to be directed towards expediting the planning permission process and modernizing regulations. Streamlining the judicial review process is also critical to address large investment needs while reducing uncertainty for projects.

Broadening the revenue base should remain a key policy objective. With a relatively low, narrow, and concentrated revenue base, there is scope to expand and diversify tax revenues, including by improving the personal income tax (PIT) system, reducing its administrative cost, and simplifying the VAT system.

Staff supports the authorities’ decision to save part of excess CIT revenues in two savings funds. This would help de-risk public finances from the excessive reliance on a temporary, narrow revenue source and build buffers in good times while partly pre-financing future spending needs. It is important to operate the funds within a strong fiscal policy framework. With the EU fiscal rules unlikely to be binding for Ireland, the authorities should reflect on an appropriate anchor for their longer-term fiscal framework, beyond the current spending rule for 2022-26, and how the operation of the new savings funds can be integrated within this framework. General principles following international best practices should also be considered to ensure the funds are appropriately structured and sufficiently large to effectively mitigate the impact of shocks and meet future spending pressures.

Systemic financial risks have increased, although there are mitigating factors. Tighter financial conditions, persistent inflation, and rising vulnerabilities in the commercial real estate market (CRE) and its linkages with leveraged non-banks are key contributors to the higher risks. At the same time, households have remained resilient to higher interest rates and cost-of-living, and insolvency rates of domestic firms have increased only modestly. Residential housing markets remain vulnerable to further increases in interest rates, but the long-standing mismatch between housing supply and demand is expected to mitigate the impact.

Ireland’s banking ecosystem is in transition, with a growing presence of international banks. Domestic banks have continued to strengthen their balance sheets, with sound capital and liquidity indicators. Still, intensified supervision of credit and liquidity risks should remain, given a possibly delayed impact from high inflation, tighter financial conditions, and vulnerabilities accumulated during a decade of low interest rates. Progress in reducing the government’s shareholding in domestic banks is welcome. As recommended in the 2022 Financial Sector Assessment Program (FSAP), it is important to recognize the need for the domestic banks to retain talent and ensure a level-playing field for them in the face of more nimble non-banks. Large international banks rely on wholesale funding and have large off-balance sheet liabilities with material inter-linkages with foreign non-banks. Their vulnerabilities to funding stress and shocks from nonbanks warrant continued close monitoring.

Staff encourages continued close monitoring of credit conditions and financial stability risks to assess the need for future adjustment of macroprudential policy settings and agrees that mortgage measures should not be used to address broader housing affordability issues. The Central Bank of Ireland’s (CBI) gradual increase of the counter-cyclical capital buffer to 1.5 percent is welcome. Despite the slight increase in loan-to-income (LTI) for first-time buyers (FTBs), the limit remains restrictive and would unlikely lead to irresponsible borrowing. However, the relaxation of the loan-to-value limit for second and subsequent buyers is not advisable because they are riskier than FTBs, even if the loosening effect may be constrained by the LTI limit and changes to the allowances. These measures could be counterproductive from a housing-affordability perspective were they to increase housing demand and prices. The CBI should continue to carefully monitor the impact of the changes to the measures to ensure they are achieving their objective of ensuring sustainable lending standards in the mortgage market.

Links between the market-based finance (MBF) sector and the Irish economy have been growing and need to be closely monitored. Notwithstanding considerable progress, work should continue to fully elucidate the interlinkages between parts of the MBF sector and the rest of the financial system, and with the domestic economy. As recommended in the 2022 FSAP, closing still significant data gaps in the “other financial institutions residual” sector and conducting risk analysis at a granular level remain a priority, which will require intensified international collaboration. Furthermore, despite the authorities’ active efforts, data gaps in direct cross-border exposures to CRE, which can only be closed through international coordination, prevents a complete accounting of potential financial stability risks.

Commendably, Ireland is at the forefront of developing and operationalizing a macroprudential framework for non-banks. We welcome the CBI’s introduction of a leverage limit and liquidity management guidance on property funds in November 2022 and issuance of a Discussion Paper laying out an overarching approach to macroprudential policy for investment funds. As recommended in the 2022 FSAP, the authorities should continue to closely monitor developments in the CRE market and property funds and recalibrate the macroprudential measures as needed in case of material shifts, leakages, or unintended procyclical effects. They should also continue to work with regional and international institutions and other countries to develop macro-prudential tools targeting risks from non-banks. Staff also welcome the ongoing extensive review of the funds sector which, as part of its terms of reference, will consider the financial resilience and sustainability of the industry in Ireland.

An improved understanding of cross-border money laundering risks remains important to guide policy priorities at the national level. The increases in supervisory resources and efforts to develop a quantitative risk assessment framework are welcome. The authorities should consider exploring potential impacts of money laundering events on the stability of the financial sector.

Policies to increase housing density, remove rent caps, and improve productivity in the construction sector are crucial to sustainably boost housing supply, and in turn support sustainable growth. To address affordability concerns and more durably manage housing market imbalances, measures under the Housing for All plan need to be further complemented by a broader set of supply-side policies that increase urban density, improve land use, and enhance construction productivity. Measures providing greater certainty to developers, such as improving the transparency and certainty about approval processes, as well as accelerating the process are also required. Furthermore, reducing the complexity and restrictiveness of rent legislations, notably replacing rent caps with more targeted housing support for poor households, would help increase rental housing supply. Increased housing supply would help relieve labor shortages and facilitate labor mobility, hence supporting long-term growth.

There is scope to further the MNE sector’s inward linkages to the Irish economy. Facilitating links between MNEs and domestic small-medium enterprises (SMEs) via supply-chain linkages, labor mobility, and innovation cooperation could help raise productivity levels of SMEs. Supporting the digital transformation of SMEs, promoting innovation through expansion of government support for SME-driven R&D, and providing infrastructure to foster industrial clusters could also help bridge the productivity gap.

Progress in achieving key climate commitments needs to speed up. The government has rightly adopted ambitious emission reduction targets for 2030 and 2050. However, Ireland will likely fall short of the 2030 target. The introduction of sectoral limits was welcome, but compliance is proving challenging and almost all sectors are projected to exceed their emission ceilings. The authorities have legislated an annual increase in carbon tax to 2030, with revenues committed to be fully recycled to address the cost of climate change. They will also need to implement additional policies that deliver emission reductions across all sectors faster than expected. >Ahead of theFit-for-55 package rollout in 2027– 28, options could include reduction/removal of implicit fossil fuel subsidies, expansion of the national carbon tax to sectors currently not covered by a form of carbon pricing (e.g., agriculture), higher and unified carbon taxation, and introduction of sectoral feebates. Vulnerable households should be protected using part of revenues from carbon taxation.

The mission would like to thank the Irish authorities and all other stakeholders for their hospitality, productive collaboration, and candid and open discussions. We are especially grateful to the Department of Finance and the Central Bank of Ireland for assistance with meetings and logistical arrangements.