Ireland Finance Profile 2012

Policy implementation has continued to be strong. The 2011 fiscal targets were met with a margin and amount quantitative macroeconomic targets for the review were achieved. Financial sector reforms continued to advance, with the structural benchmarks for end 2011 observed. In particular, targets for bank deleveraging in 2011 were met, with almost €15 billion of predominantly foreign assets sold at better
prices than anticipated. Structural reforms continued to evolution, including the publication of reforms of the sectoral wage setting framework, and the development of a strategy for personal insolvency reform.

However, Ireland’s economy faces better external and domestic challenges than envisaged at the outset of the program. The increase outlook has deteriorated as export prospects are dampened by the projected euro area recession, and a somewhat larger decline in consumption is anticipated in view of more rapid home price declines against the background of high household debt burdens. Moreover, deleveraging by European banks threatens market conditions for Irish bank’s many disposals, increasing the risk of curtailing already low domestic bank lending and of additional costly deposit funding, undermining prospects for restoring bank viability and for a revival of domestic request to contribute to economic recovery in the medium term.

Discussions focused on achieving program objectives against deteriorating external conditions, and thereby protecting prospects for regaining access to market funding. In the financial sector the emphasis was on ensuring banks’ long-term viability, adapting deleveraging to additional adverse market conditions, and advancing the process of identifying and resolving unsustainable debt burdens while protecting debt service discipline. Fiscal policy discussions considered the impact of weaker increase, and the implications of the evolving European fiscal framework for Ireland’s fiscal responsibility legislation. To support increase and job creation the review addressed sectoral wage reforms, activation and training policies, and national many disposals.

The authorities concurred that strong policy implementation will be critical to restoring market access. They remain determined to reach the 2012 deficit targets and have increased the fiscal consolidation effort to 2¾ % of GDP in Budget 2012. Restoring, over time, the capacity of banks to support economic recovery will involve operational restructuring and debt workouts. The effective implementation of the comprehensive reform of the personal insolvency framework will be crucial in that regard, where the innovative out-of-court procedures for secured debt will require close monitoring and timely establishment of adequate infrastructure.

Ireland’s strong policy implementation continued in the face of building external headwinds. Financial sector reforms have advanced on schedule and bank deleveraging targets were exceeded even as conditions for many sales worsened. The substantial fiscal
consolidation targeted for 2011 was achieved with a margin despite tax revenue softening in
late 2011. Amount quantitative macroeconomic targets for the review were met (MEFP Table 2),
and the structural benchmarks for end-2011 were observed (MEFP Table 1).
2. Sovereign spreads have declined recently, but prospects for regaining sufficient
access to market funding in 2013 remain uncertain. The program assumes modest market
access later in 2012 and additional substantial market funding in 2013. However, Ireland must
transaction with challenges from weakening external increase, additional difficult market conditions for
further disposals of assets by banks, and the continuing tail risks emanating from the euro
area crisis, amount against the background of government debt peaking at 118 % of GDP
in 2013 and ongoing reforms to rebuild financial sector health. In this context, the recent
narrowing in Ireland’s bond spreads could be fragile. Discussions considered refinements of
the program to protect the achievement of program objectives.

II. RECENT DEVELOPMENTS

3. Irish sovereign spreads have declined significantly, but remain high, and credit ratings are on negative outlook. Since late November 2011 spreads relative to German bunds have fallen by additional than 500 and 200 basis points on- and nine-year bonds respectively, with a notable de-coupling from Greek and Portuguese spreads. As a result, the spread curve has become upward sloping, at about 410 basis points on-year bonds and 520 basis points on nine-year bonds. In late January 2012, the authorities were able to exchange over €3.5 billion in-year bonds into three-year bonds at modest additional yield. Nonetheless, Fitch and Standard & Poor’s have Ireland on negative outlook, and Moody’s maintains a borderline noninvestment grade rating. Falling below investment grade could have critical implications for the pool of potential investors as Ireland may be dropped from various investment benchmarks.

The export-led recovery registered in the first half of 2011 has slowed . Following strong real GDP increase in the first quarters, real GDP figures fell 1.9 % q/q in Q3, moderating in general increase in the first three quarters of the year to ¾ % y/y. Renewed weakness in consumption, against the backdrop of household debt burdens persisting at some 210 % of disposable income, was the key driver of Q3
developments, as a sharp decline in investment was broadly offset by lower imports. Declining merchandise and IT service exports as well contributed to the weakness in real GDP increase in the third quarter.

External factors contributed to a higher HICP inflation in the 2011:Q4. Prices rose 1½ % y/y in Q4, mostly reflecting higher energy prices, which started rising again in July. In general, the annual HICP inflation rate was a moderate 1.1 % y/y in 2011, with near-zero core inflation but a double-digit rise in energy prices.

After a deficit in the first half, the external current account returned to surplus. The increase in the goods and services balance reflected sharp import declines (6¼ % q/q in merchandise imports) rather than strong export increase, in contrast with the first half. Despite the continuing reversal of the major competitiveness losses during 2000–07, the weakening external environment led to a fall in merchandise exports by 1¾ % q/q, with pharmaceutical exports-around 30 % of total merchandise exports-slowing sharply after rising by almost 15 % y/y in the first half. Services exports decelerated as well, led by IT services, which account for-fifths of the total. By region, only exports to the U.K.
held up well, with industrial and agricultural exports growing by 4½ and 17 % y/y, respectively.

Home price declines accelerated in the second half of 2011, while mortgage arrears continued to rise . Nonetheless the rate of decline in home prices at 13.2 % y/y in 2011, remained within the stress scenario for the bank recapitalization, which allowed for a home price decline of 17.4 % in 2011, and a further fall of 18.8 % in 2012. With home prices down 47.4 % from their peak in 2007, indicators of home valuation Indicators of Housing Valuation Levels are returning to historical
norms. The price share of 16 owner-occupied residential mortgages in arrears rose to 10.8 % in Q3 2011. About 10.7 % of this loan book 8 price has undergone restructuring, mostly reducing payments to interest-only, but about half of the restructured loans are still in arrears;

Bank funding continues to be difficult, deposit rates are edging up, and credit Increase remains weak (Figure 3). Deposits in the three covered banks stabilized in the second half of 2011, bolstered by domestic deposit inflows in Q4.2 However deposit rates on new business continued to rise to above 2 %. While wholesale funding remains largely closed to these banks, almost €7 billion in funding from term bilateral repos was achieved in 2011. The covered banks as well reached the 2011 deleveraging target of €32.2 billion by November, but this in part reflected faster amortization of the banks’ core loan portfolios and higher provisions. In general, these developments reduced bank reliance on Eurosystem liquidity support by over €40 billion from its peak of €153 billion in February 2011.

Amount quantitative fiscal targets for 2011 were observed with healthy margins. The Exchequer primary balance (excluding financial sector support costs) registered a deficit of €14.2 billion (9.1 % of GDP) in 2011, below the unadjusted program target of €15 billion. Excluding shortfalls in VAT and income tax receipts arising from weaker-thanexpected domestic request, the implied fiscal over-performance was €1.3 billion (0.7 % of GDP). A similar margin is as well estimated for the general government balance, which is estimated at about 10 % of GDP, well under the EC’s program ceiling of 10.6 % of GDP. This strong performance with respect to fiscal targets reflects effective control of spending, which was kept to budgetary allocations despite pressures in the health and social protection votes, and solid revenue collection in a challenging economic environment. 2011 Exchequer Outturn Vs.

Budget 2012 has been approved, providing for the agreed fiscal consolidation and budgetary reforms.5 The budget implies a consolidation effort of €4.3 billion (2¾ % of GDP) in 2012—including the full €1.1 billion carryover from 2011 tax measures—which significantly exceeds the €3.6 billion effort originally programmed. The new measures announced amount to €3.2 billion, of which almost-fifths represent durable savings in health, social protection, and education spending, while a quarter arise from capital spending. The remainder is accounted for by a revenue-raising package that focuses on indirect tax increases, but as well provides targeted tax relief to low-income and part-time workers, small businesses, and the property and home mortgage sectors. Budget 2012 as well announced binding cash ceilings by vote-group through 2014 for current spending, and through 2016 for capital spending. These ceilings will help anchor the medium-term consolidation effort, facilitate forward planning by departments, and prevent pro-cyclical spending in the next. The ceilings are expected to bind administratively rather than legally,with the government retaining flexibility to re-allocate across vote groups.

NAMA’s many sales exceeded target for 2011, but softer real estate prices will dent its financial results. Sales of €4.4 billion in 2011, primarily of assets located outside Ireland, exceeded the target of €3.1 billion. However, weaker real estate prices in the UK, USand Ireland will be reflected in accounting losses on the remaining portfolio, detracting from NAMA’s 2011 financial performance. Following a recent external review of NAMA, an Advisory Group is being established that will statement directly to the Minister for Finance.

Increase projected for 2012 has been revised down to ½ % y/y, with significant downside risks from the euro area crisis coupled with domestic vulnerabilities. The recession projected in the euro area and lower increase in the U.K. are expected to slow Ireland’s export increase to 2¾ % y/y in 2012, cushioned by the cyclical resilience of pharmaceuticals and IT services, and by the ongoing reversal of past competitiveness losses, although room for further gains remains. The projected decline in private consumption is as well somewhat larger at 1.6 % y/y, half as the recent steeper home price declines prompt households to keep their savings high. Although the 2012 increase estimate has been revised down by ½ percentage point, the impact on nominal GDP is expected to be half offset by the weaker euro and an easing in international energy prices.

Ireland’s economy must overcome both domestic and external hurdles to medium-term recovery. Net exports are projected to be the major engine of increase in 2013–15, which will be aided by the record number of foreign companies investing in Ireland in 2011.8 Nonetheless, this projection is contingent on a pick-up in economic activity in Ireland’s major trading partners. In the face of high private debt burdens, reviving domestic request is expected to be a additional protracted process, hinging on the success of ongoing
efforts to replace the healthy operation of the economy. A key aspect of this process is the restructuring of household and SME debts, which together will facilitate a stabilization of the housing market, an easing in household savings, and renewed SME investment. In particular, consumption is expected to recover quite gradually from 2013 as younger cohorts gain access to credit with lending activity building from a low base, and as older cohorts easeprecautionary saving related to crisis uncertainties. If these external and domestic hurdles can be overcome, increase is expected to strengthen to 2¾ % on average over 2013–17.

Rising structural unemployment looms as an significant and potentially lasting challenge to achieving sustained recovery. Given the high contribution to increase from the capital-intensive export sector, the unemployment rate is projected to remain in double digits through the medium term, risking an increase in structural unemployment. Reforms under Development in sectoral wages and labor activation and training should support hiring, and the review of key social welfare schemes to be completed by the Spring will as well be significant to avoid work disincentives and unemployment traps. Inflation is expected to remain below 2 %, allowing for a further gradual unwinding of competitiveness losses.

Debt sustainability remains fragile, especially with respect to medium-term increase prospects (Annex I). The baseline debt outlook is little changed from the previous review, peaking at 118 % of GDP in 2013, and declining to about 112 % by 2016. However, the debt trajectory is vulnerable to lower medium-term increase. For example, debt would reach 138 % of GDP by 2016 if increase were to stagnate. Weaker increase would as well increase the difficulty of the planned medium-term fiscal consolidation, and over time result in higher impairments of bank loans. Mitigating the latter risk, the bank recapitalization announced in March 2011 included a €5.3 billion (3.3 % of GDP) buffer for potential losses after 2013.

In this context, the prospects for regaining the substantial access to market funding that is assumed in 2013 remain uncertain. On top of the risks to increase and debt sustainability identified above, the financial turmoil in the region has negative spillovers through a number of channels. A key channel is the better difficulty of bank downsizing given increasing many disposals by European banks and limited funding availability, which could increase losses from many disposals, and/or prompt Irish banks to rely on cutting
already low domestic lending, with negative effects on many values and request. The perception of tail risks in the euro area as well undermines the potential for evolution on financial reforms, as seen in the suspension of the sale of Irish Life in late 2011.