Bulletin

Winter 1999

 Central Bank of Ireland 1999 Maurice Gerard Moynihan 1902-1999

The death last August of Dr. Maurice Moynihan, former Governor of the Central Bank, is recorded with deep regret. He was predeceased by his wife, American-born Mae Conly, in July 1994. They were married in 1932 and had five children, two of whom predeceased him. The Bank extends its sympathy to his surviving children, Anne, Joan and Martin.

Dr. Moynihan was born in Tralee, Co. Kerry, and educated by the Christian Brothers. He won a scholarship to University College, Cork where he was awarded a first-class honours degree in commerce. His career began in the Department of Finance in 1925. He became Private Secretary to the Taoiseach, Eamon de Valera in 1932.

He was appointed Secretary to the Government and Secretary of the Department of the Taoiseach in 1937, and is acknowledged to have played a central, constructive role in the co-ordination of government policy generally. He was a member of the committee which Mr. de Valera established to draft the new Constitution. During the Second World War he worked closely with Mr. de Valera in his defence of Ireland’s position of neutrality.

Dr. Moynihan was a Service Director of the Central Bank from 1953 to 1960 and Governor from 1961 to 1969. Under his enlightened stewardship the Bank developed in several important areas: the issuing of credit advice to the banks which marked the beginning of monetary policy, the provision of rediscounting facilities, active participation in the market for government securities, the development of clearing systems and preparatory work for a money market. He also oversaw the widening of the fund backing the note issue to include assets other than sterling.

During his tenure the administration of exchange controls was transferred to the Bank; much of the banknote printing was ‘‘repatriated’’ to Dublin and an embryonic banking supervision function was set up. Dr. Moynihan also oversaw the mergers of clearing (Associated) banks and the centralisation of the foreign currency reserves in the Bank. He was also responsible for promoting economic and monetary research at the Bank which, under his guidance, undertook most of the key functions of a modern central bank.

The former Foster Place premises of the Currency Commission, having become inadequate, Dr. Moynihan initiated the building of a new Central Bank of distinctive construction and design in Dame Street.

He was conferred with an honorary doctorate in economic science by the National University of Ireland in 1955 and with a papal title — Knight Commander of the Order of St. Gregory the Great — in 1959. He also became a member of the Commission of Charitable Donations and Bequests for Ireland.

Subsequent to his retirement he wrote Currency and Central Banking in Ireland, 1922-1960, Central Bank and Gill and MacMillan, 1975 and edited Speeches and Statements by Eamon de Valera 1917-1973, Gill and MacMillan, 1980 while also serving as a Director of Trinity Bank.

His contribution to the development of the State was significant and enduring. His achievements were matched only by his modesty and courteous manner. May he rest in peace. Contents

Section 1 5 Comment on the Irish Economy

9 The International Economy

19 The Domestic Economy: Real and Financial Developments

41 Domestic Prices, Costs and Competitiveness

49 An Timpeallacht Gheilleagrach

51 Statement by Governor, Central Bank of Ireland, to Oireachtas Committee on Finance and the Public Service, 13 October 1999

Section 2 57 Monetary Policy in the Euro Area: The Role of National Central Banks — Rafique Mottiar

71 Structural Differences between the US and the Euro Area — John Flynn

Section 3 Statistical Appendix and Explanatory Notes Notes ISSN 0332-2645

1. The permission of the Government has been obtained for the use in this Bulletin of certain material compiled by the Central Statistics Office and Government Departments. The Bulletin also contains material which has been made available by the courtesy of licensed banks and other financial institutions. 2. Unless otherwise stated, statistics refer to the State, i.e., Ireland exclusive of Northern Ireland. 3. Unless otherwise stated, amounts expressed in pounds (£) refer to Irish Pounds. 4. In some cases, owing to the rounding of figures, components do not add to the totals shown. 5. The method of seasonal adjustment used in the Bank is that of the US Bureau of the Census X-11 variant. 6. Annual rates of change are annual extrapolations of specific period-to-period percentage changes. 7. The following symbols are used: e estimated n.a. not available p provisional . . no figure to be expected r revised — nil or negligible Q quarter f forecast 8. As far as possible, data available at end-Sept. 1999 are included in the Statistical Appendix (Section 3). 9. Updates of selected Tables from the Statistical Appendix, concerning monetary and financial-market developments, are provided in Monthly Statistics which is currently published on the first Thursday of every month. Data on euro and Irish- pound exchange rates, Irish Government bond yields and on the Irish equity index are provided daily on recorded telephone message (Telephone: 353 1 6716299). Printed by: Cahill Printers Ltd., East Wall Road, Dublin 3. Designed by: Brendan Matthews and Associates, 9 Upper Leeson Street, Dublin 4. Paper: 100% Chlorine Free Product. Enquiries relating to this Bulletin should be addressed to: Central Bank of Ireland (Publications), P.O. Box No. 559, Dame Street, Dublin 2. Telephone 6716666 Telex 31041 Fax 6716561 www.centralbank.ie Comment on the Irish Economy

Exceptionally strong economic growth has now continued for several years. Growth in 1999 is estimated at about 7 per cent. after a period of economic expansion averaging some 8 per cent. a year in the previous five years.

The task facing economic policy is to manage and facilitate a gradual slowdown in demand to a rate consistent with the estimated medium- term growth potential of the economy and so underpin the objective of price stability. There are pressures in the economy which, if left unchecked, could undermine prospects for continuing stable growth.

Unemployment has fallen steadily for some years and now stands at just over 5 per cent., a very low figure by historical standards. Ireland’s employment rate, on foot of an increase in employment of more than 370,000 or 30 per cent. in the past five years, is now similar to that of the EU as a whole; 61 per cent. of the working-age population is now in employment. Anecdotal evidence of unfilled vacancies in many sectors of the economy has recently been confirmed in a comprehensive survey by the Economic and Social Research Institute. Although there are lags in the availability of data, there has been an acceleration in the pace of wage increases, particularly in the public sector.

Using a common standard, the Harmonised Index of Consumer Prices, Ireland’s inflation rate, at 2·8 per cent. in October, has been over twice the euro-area average, and is currently the highest among the fifteen EU countries. This must be a source of serious concern. The relative cyclical positions of the Irish and euro-area economies in general and, to some degree, price level convergence to euro-area levels may be contributing to this, but strong underlying inflationary pressures are the main driving force. While the Consumer Price Index (CPI) has been 1 registering annual increases of about 1 ⁄2 per cent. for some time, this incorporates the temporary effect of substantial reductions in mortgage interest rates in the run-up to the adoption of the single currency at the end of last year. When this effect is removed, the CPI increase is currently running at a rate of more than 3 per cent. a year. In the 1 services sector, inflation is now of the order of 5 ⁄4 per cent.

Other evidence of pressures in the economy are house prices and congestion problems arising from the demands placed on infrastructure of various kinds. While the rate of increase may have moderated to some degree, house prices have reached unduly high levels. The balance of payments surplus has been reduced and is likely to move into deficit next year.

5 The authorities and social partners now have the task of dealing with problems of success such as the current pressure on resources of various kinds, including skilled labour. It is sometimes argued that the acceleration in the pace of wage increases, for example, is part of the adjustment process in a booming economy. According to this perception, higher wage increases affect international competitiveness; this reduces net exports and the demand for labour, which, in turn, eases the pressures in the labour market. However, this is unlikely to be a smooth process. Firstly, wage developments may be quite slow to respond to new circumstances such as a deceleration in growth. Secondly, the strongest wage pressures, with some exceptionally large increases observed or in the pipeline, are evident in the sectors that operate in more sheltered conditions — health, education and security. These are not exposed to market disciplines or international competition. Besides, services in these areas are, for the most part, provided free at the point of delivery, so that consumers do not have an incentive to curtail demand.

For some years Ireland’s per capita productivity increases have been higher than in the rest of the euro area. There would seem to be a number of reasons for this. There has been a significant structural change in the economy with resources, labour and capital, moving from relatively low productivity sectors into higher productivity industry and services. Ireland has been able to benefit from catching up with the high productivity levels and living standards of more developed economies. Foreign direct investment has been a significant contributor to this progress which has also been facilitated by a benign business environment and high skill levels of the workforce.

It is arguable that higher productivity growth, which is likely to continue for some time ahead, provides scope for Irish wage rates to increase at a higher rate than in the euro area in general. However, this may result in higher inflation which would quickly challenge competitiveness, especially if real wage expectations outstrip productivity growth.

Notwithstanding the recent one-half percentage point increase in official euro-area interest rates, monetary conditions in Ireland remain very easy.1 Real interest rate levels, generally, are unsuited to the Irish situation where inflation is running well ahead of the euro area average. Another indicator of monetary conditions is the effective exchange rate. For the first three quarters of 1999, the real effective exchange rate has been almost 2 per cent. lower than in the corresponding period in 1998; this follows a reduction of about 5 per cent. in 1998. A further indication of easy monetary policy has been the very large increase in the monetary aggregates — of the order of 25 per cent. a 1 year. This is in stark contrast to the 4 ⁄2 per cent. reference value for the growth in the broad money stock set by the European Central Bank for the euro area.

These circumstances underscore the need for fiscal restraint in the current buoyant economic conditions. This has been echoed in recent reviews of the Irish economy by both the OECD and the IMF. 1. Euro-area monetary policy is Assessments of past fiscal policy show that it has been generally pro- outlined later in this bulletin. cyclical with expansionary fiscal actions taken at times of economic

6 strength. This is far from ideal and serves to intensify, rather than alleviate, the business cycle.

As well as its stabilisation role, fiscal policy also has an important function to fulfil in providing essential public infrastructure, possibly in partnership with the private sector, and in facilitating enterprise in order to promote growth potential. However, despite the scale of improvement in the nation’s finances, there is a continuing need for restraint and for the proper ordering of priorities. Provisional data for 1999 indicate that, while the actual budgetary position was in significant surplus, the structural budgetary position (i.e. the budget adjusted to take account of current economic conditions) was in approximate balance. The Budget has provided an expansionary stimulus at an inappropriate time. Decisions taken in relation to public spending and taxation tend to become permanent commitments that cannot easily be reversed. This reduces the scope for discretionary action in the future to soften the effect of any adverse economic shock.

It is necessary that the expansionary effects of fiscal policy be eased by an appropriate evolution of wages and salaries, bearing in mind the substantial personal tax reductions which have been announced. Excessive demand, whether public or private, will undermine the achievement of stable and sustainable growth.

7

The International Economy

Overview Since early Autumn, the view that the global economy is recovering from the effects of the recent crises in emerging markets has become more entrenched. Nevertheless, there are still significant challenges facing the global economy. Although the Asian economies that were the first victims of the crisis are now recovering, the situation in Latin America remains fragile and so does the Russian situation. Ongoing concern about emerging market economies is shown in yield spreads, although they have narrowed since last year. Among the major economies, the key question is whether the US can achieve a soft landing, with minimal dislocation in financial markets. After a series of interest rate rises by the Federal Reserve Board, market expectations of future interest rate increases remain. (The use of interest rates implied by futures contracts as indicators of market expectations is examined in Box 1.) This and evidence of continuing non-inflationary growth suggest that the US may be closer to achieving a soft landing. The expected upturn in euro-area economic activity now appears to be underway. On the basis of the economic outlook and recent developments in monetary aggregates, the European Central Bank also moved to raise interest rates in November to contain medium-term inflationary pressures. Recovery in the Japanese economy also appears to be established, although concerns about the medium-term sustainability of the public finances remains. An immediate issue for the global economy is the impending century date change and the potential for economic disruption if key computer systems experience difficulties in the transition to the year 2000. The so-called Y2K problem is already having effects in financial markets, where the interest rates on contracts spanning the millennium weekend have spiked upwards. This spike reflects the premium which market participants require for dealing over the transition and is, unsurprisingly, greater for uncollateralised instruments. In response to these concerns, the major monetary authorities have put in place measures to alleviate potential risks to the operation of monetary policy and financial markets over the century date change. The euro has weakened markedly against the other major currencies during the period under review, with the euro effective exchange rate experiencing a fall of over 4.5 per cent. between late August and the end of November. However, on the basis of economic recovery in the euro area, internal price stability and a strong current account position, the euro has strong potential for appreciation.

World Economic Developments Revised GDP data show that growth in the euro area picked up in the first half of 1999, after a slowdown in late 1998. Over the first half, however, the composition of growth changed, with domestic demand growth weakening and net exports now making a positive contribution

9 Changes in Key Economic Variables in Various Countries Table 1

Real GDP Unemployment Inflationa Current Balance Growth Rate of Payments as a%ofGDP 1998 1999e 1998 1999e 1998 1999e 1998 1999e %% %%%%%% Belgium 2·9 1·4 9·5 9·2 0·9 1·1 4·8c 4·3c Germany 2·3 1·4 9·4 9·1 0·6 0·4 −0·2 0·0 Spain 4·0 3·4 18·8 15·7 1·8 2·1 −0·2 −0·6 France 3·2 2·5 11·6 11·3 0·7 0·5 2·8 2·6 Irelandb 8·9 7·9 7·4 5·5 2·4 1·5 0·9 0·3 Italy 1·3 1·2 11·8 11·7 1·7 1·5 1·7 1·6 Netherlands 3·8 2·6 4·1 3·6 2·0 2·3 5·5 5·6 Austria 3·3 2·0 4·7 4·3 0·8 0·7 −2·1 −1·8 Portugal 3·9 3·0 5·0 4·6 2·8 2·3 −6·7 −7·5 Finland 5·6 3·6 11·4 10·3 1·3 1·3 5·8 5·3

Total Euro-Area 2·8 2·1 10·9 10·3 1·2 1·0 1·3 1·2

Denmark 2·9 1·3 6·3 6·0 1·7 2·5 −1·4 −1·1 Greece 3·7 3·3 10·1 10·3 4·5 2·3 −2·7 −2·3 Sweden 2·6 3·2 6·5 5·4 −0·1 0·2 1·9 1·1 UK 2·2 1·1 4·7 4·8 2·7 2·3 0·2 −1·4

Total EU 2·7 2·0 9·6 9·1 1·4 1·3 1·0 0·7

US 3·9 3·7 4·5 4·3 1·6 2·2 −2·6 −3·5 Canada 3·1 3·6 8·3 8·0 1·0 1·5 −1·8 −1·0 Japan −2·8 1·0 4·1 5·0 0·6 −0·4 3·2 3·5 a Consumer price index is used for all countries. b Central Bank of Ireland estimates. c Belgium-Luxembourg. Sources: IMF World Economic Outlook, December 1999, estimates and projections.

to growth. The latter development reflects a marked turnaround in export growth. Although consumer confidence survey data weakened slightly earlier in the year, as reflected in slower consumer spending and moderating retail sales growth, confidence remains at a high level. Business confidence continues to improve and is reflected in industrial output data, which has shown an ongoing improvement this year. Nevertheless, the decline in unemployment, evident into early 1999, has stalled in recent months, with the unemployment rate constant at 10.0 per cent. in August and September. Inflation has picked up slightly, with the annual change in the Harmonised Index of Consumer Prices (HICP) rising to 1.4 per cent. in October. This increase reflects the rapid rise in oil prices, which has been partly offset by declining unprocessed food prices.

Euro-area growth is projected to recover during the second half of 1999, due in part to strengthening world demand. Although the European Central Bank raised interest rates in November, euro-area monetary conditions are still relatively favourable and should also underpin growth. The IMF is projecting real GDP growth of 2.1 per cent. in 1999, rising to 2.8 per cent. in 2000. This outlook is consistent with the projections from the OECD and the European Commission.

After slowing in the second quarter, US growth reasserted itself in the third, rising to a rate of 5.5 per cent. annualised. Although consumer

10 spending growth weakened slightly, consumer spending and investment remained the main factors driving growth. Net exports, on the other hand, continued to be a strongly negative influence on growth, reflecting dollar strength and strong import demand. Although recovering world activity strengthened export growth, this was outstripped by import growth. Monthly data, however, have been showing a more mixed picture. Consumer confidence has waned since June, retail sales eased in October from earlier highs and recent housing data show a continuing contraction in housing investment, suggesting that domestic demand growth is weakening. This contrasts with labour market data which shows an ongoing tightening, as the unemployment rate fell to a 30-year low of 4.1 per cent. in October. However, there is little evidence of wage pressures in the economy, with non-farm unit labour costs and the employment cost index moderating in the third quarter and productivity recording the largest increase this year. Underlying consumer price inflation remains subdued, although the annual headline rate picked up to 2.6 per cent. in September and October on the back of increases in oil prices.

On the outlook for the US economy, the Federal Reserve Board raised the target federal funds rate, by a further 25 basis points, to 5.5 per cent. in November. This was a pre-emptive action designed to mitigate future inflationary pressures, as signalled by labour market tightness, and should slow activity in 2000. Weaker consumer confidence, recent falls in new orders and declines in the coincident and leading indicators suggest that growth may be starting to moderate. Nevertheless, manufacturing output continued to expand in October and the NAPM index, despite falling back in October, continues to indicate an expansion in output. The latest IMF forecast is for growth of 3.7 per cent. in 1999, again broadly in line with the consensus estimate. Dampened investment and slowing household wealth growth are expected to slow growth to under 3 per cent. in 2000.

There are now clearer signals that Japan has passed the recessionary trough and that growth has started to recover. Revised second quarter GDP figures show quarterly growth of 0.1 per cent. Although government spending had accounted for over half of the first quarter upturn in growth, the main boost in the second quarter came from consumer spending and private housing investment. Recent monthly data confirm this trend, with a slowing decline in retail sales and industrial output and orders showing increases. The September trade figures, which show strong export growth and sharply weaker imports point to a greater contribution to growth from the external sector. Unemployment continued to fall slowly from 4.9 per cent. in July to 4.6 per cent. in September, although the unemployment data may understate the jobless total as some workers may have given up searching for work. Deflationary pressures appear to be abating, with consumer and wholesale prices recently recording small month-on- month increases and their year-on-year rates of decline showing signs of slowing.

Looking forward, the effects of earlier fiscal packages will be felt in the latter part of 1999 and into 2000, while the Y18 trillion package announced in November 1999 will affect fiscal spending in 2000. As a result of low consumer confidence, however, the tax rebates

11 Three-Month Interest Rates Table 2

Euribor US Dollar Japanese Sterling Yen

%%%% 26 February 1999 3·10 4·95 0·17 5·33 31 March 1999 2·97 5·00 0·19 5·19 30 April 1999 2·58 4·99 0·15 5·19 31 May 1999 2·58 5·07 0·10 5·44 30 June 1999 2·67 5·37 0·14 5·12 30 July 1999 2·69 5·34 0·13 5·22 31 August 1999 2·70 5·52 0·11 5·19 30 September 1999 3·09 6·08 0·28 5·50 29 October 1999 3·49 6·18 0·33 5·94

contained in the fiscal packages appear to be being used for precautionary saving in the light of historically high unemployment. The ability to maintain the current fiscal stimulus will be constrained by the weakening of the public finances, which is an ongoing concern in financial markets. Nevertheless, the Bank of Japan’s Tankan surveys continue to suggest an improvement in economic conditions into 2000. Similarly, despite a weakening in September, the leading indicator index suggests that the economy will expand over the next three to six months. The IMF is forecasting real GDP growth of 1.0 per cent. in 1999, with growth of 1.5 per cent. expected for 2000.

Economic Developments in Europe Although Germany and Italy are projected to see their growth rates increase towards the euro-area average in 2000, the performance of the German and Italian economies in 1999 has fallen short of expectations. The UK has managed to avoid recession and has passed the cyclical trough, with attention turning relatively quickly to the emergence of future inflationary pressures.

After strengthening in the first quarter, real GDP growth in Germany stagnated in the second quarter, with GDP showing no change over the previous quarter. This was driven by falls in consumer spending, government spending and construction investment, which offset the recovery in exports. Export growth has been driven by recovering world demand and the ongoing weakness of the euro. Consistent with stalled growth, the unemployment rate has been static at 10.5 per cent. for six months. Inflation continues to be subdued and the HICP index shows year-on-year increases of less than 1 per cent. each month.

Domestic orders, however, have begun to increase, while export orders are benefiting from the global recovery and the weakness of the euro. This is reflected in industrial production growth and survey data, which show increasing business optimism. The latest recent outlook from the IMF is for GDP growth of 1.4 per cent. in 1999, rising to 2.5 per cent. in 2000.

In France, real GDP growth improved in the second quarter after a weaker first quarter. This was driven by strengthening consumer spending and a recovery in exports. Although investment remained strong, the buoyancy experienced by this category in the first quarter

12 was not repeated. The resurgence in growth is also reflected in industrial output growth, stronger consumer and business confidence, and falling unemployment. The unemployment rate fell to 11.1 per cent. in September, compared to the 11.8 per cent. average for 1998. Inflation remains subdued, with annual HICP inflation of less than 0.5 per cent. being recorded in recent months. Household demand, corporate investment and growing exports are expected to place the French economy in a virtuous circle of GDP growth, low inflation and falling unemployment. This benign outlook is reflected in orders and survey data, with the IMF predicting output growth of 2.5 per cent. in 1999 and 3.0 per cent. in 2000. Outside the euro area, the UK economy now seems to be experiencing a strengthening economic recovery. Preliminary data for the third quarter suggest that GDP grew by 1.8 per cent. year-on-year. There are also indications that growth is now becoming more balanced and, although services remain the dominant sector, manufacturing growth picked up markedly in the second quarter. Although retail sales have continued to grow strongly, consumer spending growth slowed in the third quarter relative to the unusually buoyant performance earlier in the year that reflected earlier interest rate declines and strong consumer confidence. The buoyancy of domestic demand was offset by weak net exports, largely reflecting the appreciation of sterling. However, more recent data suggest that the trade balance may be improving as the lagged effects of the 1997/98 sterling appreciation erode. The labour market remains tight, as reflected in the number of unfilled vacancies, which is 24 per cent. higher than a year ago, and the unemployment rate, which has fallen to 4.2 per cent. in recent months. Annual average earnings growth fell back to 4.7 per cent. (three-month moving average, year-on-year) in September from 4.9 per cent. in August, but remained higher than earlier in the year. The increase in unit labour costs declined over the first half of the year and may reflect increased productivity resulting from the better utilisation of hoarded labour. Despite the tight labour market, inflation remains subdued. The underlying (target) retail price index continues to grow at about 2.2 per cent. year-on-year, while the headline rate has fallen to 1.2 per cent. — the lowest since 1963. In the light of a tight labour market and a recovery in global activity, the Bank of England raised its policy interest rate twice since mid-year in order to cool the economy. Nevertheless, the outlook remains positive; survey data are showing business optimism and continue to suggest an upturn in activity. The IMF is predicting growth of 1.1 per cent. for 1999 and 2.4 per cent. for 2000. On the basis of the outlook for the global economy, growth in Ireland’s main trading partners is projected to be 1.9 per cent. on a weighted basis in 1999, rising to 2.5 per cent. in 2000.

International Price Developments The external inflation environment facing the Irish economy has disimproved somewhat since the publication of the previous Bulletin, but on balance remains relatively benign. Although non-oil commodity prices remain generally weak, oil prices have risen further. Annual producer price inflation, which had been negative in many industrial countries earlier in the year, has picked up significantly. Consumer

13 price inflation has also increased slightly in recent months due mainly to the impact of rising oil prices. The year-on-year increase in HICP in the third quarter averaged 1.1 per cent. in the euro area and 1.2 per cent. in the EU as a whole. In the US, annual consumer price inflation averaged 2.3 per cent. over the same period. In most cases, consumer price inflation is expected to increase in 2000, reflecting the continued recovery in world demand with additional upward pressure coming from the rise in oil prices. In international commodity markets, non-fuel commodity prices were generally weak during the first three quarters of 1999, while oil prices have risen sharply. According to IMF statistics for the third quarter, the composite index of non-fuel commodities was down 5.6 per cent., year-on-year, while the price of Brent crude oil was up by 65.2 per cent. The IMF indices for food and beverages were particularly weak and were down by 12.7 per cent. and 23.5 per cent., year-on-year, respectively. However, the index of metals prices was up by 5.1 per cent. over the same period, with agricultural raw material prices just 0.1 per cent. higher. In summary, concurrent indicators have deteriorated somewhat in recent months but remain relatively benign. In terms of Irish inflation, a modest increase in external inflationary pressures is likely in the year ahead on foot of strengthening economic activity in Europe and Asia. The lagged impact of current euro weakness will add to these pressures as will the effect of the continuing increase in oil prices.

Monetary Developments Concerns about the potential spillovers from crises in emerging markets have been virtually dispelled in recent months. The focus is now firmly on the path of interest rates in the major economies, especially the euro area and the US. Although inflation remained low, interest rate increases were carried out in November in the US, the euro area and the UK, in an effort to maintain non-inflationary growth. The ECB Governing Council raised the key euro-area interest rates by 50 basis points on 4 November 1999, reversing the reductions implemented in April. The rate on the main refinancing facility returned to 3.0 per cent., with the rate on the deposit facility going to 2.0 per CHART 1 cent. and that on the marginal lending facility moving to 4.0 per cent. Euro Area Monetary Aggregates % Prior to the move, the Council had warned of the need to monitor 12 carefully the emergence of upward price pressures, in the context of sustained monetary growth, an improved economic outlook and rising 10 oil prices. Eurosystem monetary policy is based on two pillars; a reference value for euro-area M3 growth of 4.5 per cent. per annum 8 and a broadly based assessment of the outlook for future price developments. Although current inflation remains well within the 6 definition of price stability, the Council concluded that both pillars indicated that the balance of risks to future price stability had moved 4 to the upside and that the downside risks present at the time of the reduction in rates in April were no longer present. 2 In explaining its decision, the Council noted that the continued upward 0 deviation of M3 growth from its reference value indicates that there is APR MAY JUN JUL AUG SEP ample liquidity in the euro area. Year-on-year M3 growth has steadily '99 risen in recent months from 5.1 per cent. in March to 6.0 per cent. in M3 Private Sector Credit October. This growth reflects an ongoing increase in M1 (currency in

14 circulation plus overnight deposits) and a strong expansion in holdings of marketable assets. The low opportunity cost of holding liquid CHART 2 ECB Interest Rates and Money instruments explains both the steady increase in the demand for Market Rates currency in circulation and the growth in overnight deposits. Turning % to the counterparts of M3, total credit granted to euro area residents 4.5 has grown strongly during the year, recording year-on-year growth of 4.0

8.1 per cent. in October 1999. Private sector credit has been growing 3.5 strongly all year, recording year-on-year growth of 10.5 per cent. in October. This reflects the low level of retail lending rates and possible 3.0 front-loading of lending, given borrowers expectations of rises in bank 2.5 lending rates. Over the year to date, however, there has been an ongoing decrease in financial institutions’ net external assets, reflecting 1.5 borrowing by euro-area residents for investment abroad. 1.0

After being relatively stable during September, money market interest 0.5 rates shifted upwards during October on expectations of a rise in 0.0 official interest rates. There was also a steepening of the yield curve APRMAYJUNJULAUGSEPOCTNOV during this period, against the background of stronger expected output '99 growth and possible future inflationary pressures. After the interest rate Marginal lending rate Deposit rate increase of 4 November, however, short-term interest rates stabilised Main refinancing rate and the yield curve flattened as longer-term rates declined. The three- EONIA month EURIBOR rose from 2.7 per cent. at end-August to 3.5 per cent. at end-November, with three month interest rates spanning the year end being slightly distorted by Y2K concerns. Looking further out, futures contracts are predicting a further monetary tightening of about 50 basis points by mid-2000. At a longer maturity, ten-year bond yields initially rose during October, reflecting upwardly revised expectations about euro-area economic performance and rising US bond yields. In late October domestic euro-area factors became more dominant, as the release of strong M3 data reduced market uncertainty about near- term interest rate developments and bond yields fell in anticipation of a rise in official interest rates. Since late-August, euro-area yields have risen by about 30 basis points to stand at about 5.2 per cent. at end- CHART 3 November. As US bond yields have not risen as much, the spread Selected Official Interest Rates % between US and euro-area yields has narrowed slightly, over the 8 period, to about 112 basis points. 7 Monetary policy in the US has been tightened in recent months, with the Federal Open Market Committee (FOMC) raising the target federal 6 funds rate by 25 basis points on 24 August and indicating a 5 symmetrical policy bias. In October the FOMC indicated that it was adopting a tightening bias, before raising the target federal funds rate 4 by a further 25 basis points to 5.5 per cent. on 16 November. Although 3 these actions were forward looking and designed to achieve non- inflationary growth, futures contracts indicate expectations of a further 2 rise in US official interest rates next year. Uncertainty about the course 1 of US policy rates was reflected in bond yields, which were quite volatile during October. Data releases indicating strong economic 0 OCT NOV DEC JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV performance and the announcement of a tightening policy bias pushed '98 '99 bond yields up to 6.3 per cent. by late-October. However, the release United States Note: of data showing lower than expected labour costs and inflation then The rates shown in this chart Japan are the main refinancing rates pushed yields back down towards 6.0 per cent. Although yields fell for the euro-area, discount United Kingdom rates for the US and Japan, further after the latest interest rate increase, they stabilised around 6.2 and the base rate for the UK. per cent. at end-November — about 25 basis points above the end- Euro Area August level.

15 Box 1: Interest Rate Expectations and Futures Contracts Interest rate futures contracts enable a borrower or lender to fix interest costs or earnings for a number of months in the future.1 As they involve fixing interest rates for a future period, they can be used to assess interest rate expectations over that period. Features The most heavily traded short term interest rate futures are for three month maturities, expiring at the end of every quarter. A December short term futures contract purchased in September fixes, in September, an interest rate for three months beginning in December. The futures price is quoted as ‘‘100 minus the interest rate’’; e.g., if the three-month December 1999 contract is quoted at 96.55, then the implied interest rate for three months starting in December is 3.45% (100 — 3.45 = 96.55).2 If participants in the futures market believe that official interest rates will increase in the following six months, the implied rate in futures contracts applying to that period will increase, to reflect the higher money market rates expected to prevail at that time. The amount by which implied interest rates in futures contracts exceed current three month money market rates gives a broad indication of the futures markets’ expectations regarding monetary policy tightening.3 In this way, implied interest rates in futures contracts are used to assess official interest rate expectations. Uses of Interest Rate Futures An interest rate futures contract can be used as a hedging instrument against interest rate changes. As these contracts are traded up to several years ahead, they can be used to fix borrowing costs/earnings for a couple of years. The most frequent traders of futures contracts are, however, speculators, who buy or sell these contracts in order to profit from a view that the market will either go up or down.4 Traders who have a view that interest rates in one year’s time will be less than the rate implied in futures contracts today would buy these contracts, anticipating that the implied interest rate would fall, causing the price to rise. Recent Movements in Implied Interest rates In Table 1, the rates implied in three month interest rate futures contracts at end- August 1999 are compared with end-November, for contracts maturing between end-1999 and end-2000 for the US, euro area and the UK. The normal method of assessing interest rate expectations by comparing three month money market rates with implied interest rates is, at the present time, complicated by the fact that current three month money market rates incorporate some premium for risks perceived to be attached to the changeover to the year 2000 (Y2K). To reflect this uncertainty, some estimates of interest rate expectations are expressed in a small range. • In US dollar futures, the interest rate expected to apply on three month borrowing or lending in mid- to late-2000 was largely unchanged between August and November. By mid-2000, market interest rates are expected to have risen to 6.26%, compared with the three month money market interest rate at end-November of 6.03%. Adjusting the latter for the possible effects of the Y2K risk premium, the tightening in official interest rates is expected to be between 25 and 50 basis points (b.p.) by mid-2000. A comparison of the end-June and end-December 2000 implied rates indicates that a further 25 b.p. increase in official interest rates is expected by the end of next year. • For euro futures, implied three month interest rates during 2000 rose between August and November. This increase in the amount of monetary tightening expected to be undertaken by the ECB during 2000 reflects greater optimism regarding euro area growth, alongside higher inflation figures. Implied interest rates for mid-2000 are 3.9%, while the current three month money market interest rate is 3.4%. As the latter includes a Y2K risk premium, the implied rates point to an increase of between 50 and 75 b.p. in official euro area interest rates by mid-2000. An additional 50 b.p. is then expected before the end of 2000.

1 By definition, a financial futures contract is a legally binding agreement, to buy or sell on an organised exchange, a standard quantity of a specific financial instrument at a future specified date, at a price agreed at the time the contract is made. Although these contracts may be linked to interest rates, equities or currencies, this box deals only with short term interest rate futures. 2 The rate implied in the futures price is an annual rate, but only applies for the duration of the contract. 3 If, however, the current three month money market rate incorporates expectations of a near term increase in official interest rates, this should also be taken into account in assessing the total amount of monetary policy tightening expected to be undertaken. 4 For example, if the price of a US dollar three month contract rose by five basis points, from 93.93 to 93.98 (a movement in the implied annual interest rate from 6.07% to 6.02%), a trader holding ten such contracts, which have a nominal value of $1m. each, would gain $1m x 10 x 0.05% x 3/12 = $ 1,250.

16 • UK futures contracts also show an increase in interest rate expectations over the CHART 4 past three months, as economic growth has strengthened and upside risks to Selected Three-Month Interest Rates inflation have emerged. While three month money market rates are around 5.9%, % End-week data implied rates of around 6.6% for end-June 2000 show that the futures market is 8 discounting monetary policy tightening of between 50 and 75 b.p. by then, followed by an additional 50 b.p. by end-2000. 7

Table 1: Comparison of implied 3-month interest rates at end-August and 6 end-November 1999 5 Future Contracts: US Euro area UK 4 3-mth interest rate Aug. Nov. Aug. Nov. Aug. Nov. December 1999 6.00 6.07 3.33 3.43 5.78 5.95 3 March 2000 5.99 5.99 3.35 3.55 5.97 6.30 June 2000 6.25 6.26 3.58 3.88 6.36 6.63 2 September 2000 6.44 6.44 3.80 4.11 6.69 6.87 December 2000 6.67 6.62 4.15 4.41 7.00 7.11 1

0 Source : Bloomberg SEPOCT NOV DEC JAN FEB MAR APR MAY JUN JULAUG SEP OCT NOV '98 '99

Note: Monetary policy in Japan remained supportive over the period, with US Dollar The rates shown in this chart Japanese Yen are London Market mid-closing the Bank of Japan keeping overnight call rates at close to zero. rates. Although this is designed to improve the profitability of bank lending, Pound Sterling it does not appear to be having a stimulatory effect. Banks seem Euro unwilling to lend and accept the risk of bad loans, a problem which is compounded by the ongoing need to restructure elements of the Japanese financial system. Japanese bond yields fell by about 45 basis points during September, at the same time as the yen was appreciating strongly, and it appears that the decline in bond yields reflected capital inflows. Although these capital inflows were reversed in October, thereby ending the downward pressure on yields, inflows resumed in November. Furthermore, new data provide more support for the view that a gradual economic recovery is taking place — putting a floor under yields. Since end-August ten-year bond yields have been broadly unchanged and stood at 1.91 per cent. at end-November.

The stance of monetary policy in the UK was reversed during the period, on the basis of stronger than expected economic activity and revised expectations for inflation and growth. In order to keep inflation CHART 5 Exchange Rate Changes for the Euro within its medium-term target, the Bank of England raised interest rates % End-week data pre-emptively on 8 September and 4 November. On both occasions the repo rate was raised by 25 basis points, bringing it to 5.5 per 2 cent. Looking forward, futures contracts show an increase in expected 0 interest rates in recent months, as the outlook for growth has improved -2 and upside risks to inflation have emerged. Having risen during -4 September and most of October, in the light of strong data releases, -6 UK bond yields then fell dramatically in early November. Although this -8 may have reflected US developments, UK yields dropped more sharply -10 before recovering to stand at 5.3 per cent. at end-November. -12 -14 Exchange Rate Developments -16 -18 Over the period under review the euro weakened against the other -20 major currencies. Economic developments in the euro area, the US -22 and the UK prompted their monetary authorities to tighten policy in DECJAN FEBMAR APR MAY JUN JULAUG SEPOCT NOV order to prevent future inflation. Given their relative cyclical positions, '98 '99 United States Dollar Note: this has driven a divergence of interest rate expectations across the This chart shows percentage major currencies and, as a result, yield differentials between the US Pound Sterling changes in Euro exchange rates by reference to Yen and the euro area have narrowed slightly. Nevertheless, the euro has 31 December 1998.

17 continued to weaken reflecting a variety of factors, such as technical trading and investment incentives, which are difficult to disentangle. On the second factor, for example, the decline in the net external assets element of the monetary data suggests that investment abroad by euro-area residents may be depressing the value of the euro.

After an initial weakening in late August and early September, the euro strengthened markedly against the US dollar to stand at 1.09 dollars to the euro on 15 October. At this time the dollar was being adversely affected by weak economic data and a warning from the Federal Reserve Chairman on stock market valuations, while euro-area economic data was fuelling expectations of rising interest rates. Later in October and into November, a rebound in US stock prices and data confirming strong US growth and subdued inflationary pressures, underpinned a strengthening of the dollar, which stood at 1.01 against the euro at end-November. As usual, a broadly similar pattern was shown against sterling, which strengthened in early September on strong economic data and the unexpected interest rate increase on 8 September. Sterling rose to 0.64 to the euro on 24 September, before the euro strengthened to bring the rate to 0.65 on 18 October. Thereafter, data pointing to an improved outlook for the UK economy saw sterling resume its upward path against the euro to stand at 0.63 at end-November. The Japanese yen continued to strengthen against the major currencies during the period from end-August to late November. The principal factors driving this strengthening have been an improved outlook for the economy, a significant rise in the Nikkei stock market index and a rise in long-term bond yields. Against the euro, the yen has strengthened from 116 to the euro at end-August to 103 at end-November, an appreciation of over 11 per cent. in three months.

18 The Domestic Economy — Real and Financial Developments12

Overview The growth rate of the domestic economy decelerated slightly in 1999. 1 The volume of GNP is estimated to have increased by about 7 ⁄4 per cent. compared with just over 8 per cent. in 1998. This moderation in output growth was largely as a result of slower export growth due to the less favourable external environment. Domestic demand, particularly consumer spending, continued to grow strongly, although the rate of increase in machinery and equipment investment may have lost some momentum. The outlook for next year is for further strong growth, although the rate of expansion in real GNP may fall back 1 slightly to about 6 ⁄2 per cent. An improvement in external demand particularly within the euro area, is likely to support a modest recovery in export performance, although the possibility of a sharp slowdown in US growth remains a risk to the external environment. The rate of increase in domestic demand, however, may moderate somewhat as the impact of declining interest rates fades. It is important to note that this outlook does not take into account the impact of Budget day changes in taxation and spending which were not available when these forecasts were being prepared. Such changes may have a significant impact on developments. Irrespective of the precise growth rate of the economy next year, however, it seems clear that the continuing strength of demand will maintain upward pressure on wages and prices in the economy, particularly in the non-traded sector. (Developments and prospects in this regard are reviewed in detail in the next chapter.) 1. Data for dates prior to 1 January 1999 have been notionally re- Increases in domestic demand have underpinned overall output denominated in euros using the fixed conversion rate of \1 = £0·787564. growth in recent years. The performance of private consumption has This method of conversion preserves been a particularly striking feature of developments. This reflects the quantity, price and value changes as significant increase in household disposable incomes due to strong previously expressed in Irish pounds employment growth, increased average earnings and sizeable but comparisons of this type of data reductions in personal taxation. In addition, the continuing strength of across countries are not valid. In particular, those relating to wage and economic activity, the sharp fall in unemployment and the decline in cost developments have to take interest rates have combined to improve consumer confidence and account of actual exchange rates for boost spending. The impact of the reduction in interest rates at the end dates prior to 1 January 1999 and of 1998 and earlier this year is now becoming attenuated, however, this is the basis of the relevant and there may be some moderation in the growth of consumption calculations referred to in this and spending next year, although this effect may be substantially offset by the following chapter. tax reductions in the Budget. Investment spending has also grown 2. The forecasts contained in these strongly in recent years, although there seems to have been some chapters were compiled in late deceleration in 1999, possibly reflecting the less favourable external November and do not take account environment. Investment is expected to grow at a slightly slower rate of data published subsequently. They next year, with capacity constraints limiting any further acceleration in also assume that interest and exchange rates remain unchanged. construction output and with labour shortages restraining inward direct

19 Expenditure on Gross National Product 1998, 1999e and 2000f Table 1

1998 % change in 1999e % change in 2000f

\ million Volume Price \ million Volume Price \ million

1 1 1 1 Personal Consumption Expenditure 38,967 7 ⁄2 3 ⁄2 43,304 5 ⁄2 3 ⁄2 47,321 1 1 Public Net Current Expenditure 10,136 4 3 ⁄4 10,889 4 ⁄2 3 11,709 1 3 1 Gross Domestic Fixed Capital Formation 17,012 12 ⁄4 7 ⁄4 20,574 12 6 ⁄2 24,539 of which: 1 1 • Building and construction 10,608 12 11 ⁄2 13,243 12 ⁄2 9 16,239 1 3 • Machinery and equipment 6,404 12 ⁄2 1 ⁄4 7,331 11 2 8,300 Value of physical changes in stocks 1,001 910 680 Statistical Discrepancy −255 −255 −255

1 3 1 Gross Domestic Expenditure 66,861 8 4 ⁄2 75,422 6 ⁄4 4 ⁄4 83,994 1 3 1 3 Exports of goods and services 63,874 12 ⁄2 ⁄4 72,360 13 ⁄4 1 ⁄4 83,369

3 3 Final Demand 130,735 10 2 ⁄4 147,782 9 ⁄4 3 167,363 1 1 1 Imports of goods and services 55,013 12 ⁄2 1 62,505 12 ⁄2 2 ⁄4 71,954

1 3 3 Gross Domestic Product 75,722 8 ⁄4 4 85,277 7 ⁄4 3 ⁄4 95,409 Net factor income from rest of the world 9,465 10,930 12,945

1 1 1 Gross National Product 66,257 7 ⁄4 4 ⁄2 74,347 6 ⁄2 4 82,464

investment. This implies that the projected recovery in demand in the euro area will have a more muted impact in terms of promoting inward investment in Ireland, from the US and other countries, than would previously have been the case.

There was a noticeable slowdown in export growth this year. This deceleration was largely the result of external demand developments rather than any loss in competitiveness. Nominal wage growth has picked up but a continuation of strong productivity growth and the weakening of the euro have effectively ensured that the economy has not suffered a deterioration in competitiveness to date. Export growth is likely to pick up somewhat next year due to improving demand conditions, particularly within the euro area but the re-acceleration is likely to be modest. Import growth has been strong in recent years, although it was comparatively weak in the first part of 1999, given the strength of domestic demand and exports. There also seems to have been a shift towards more services imports relative to merchandise imports. Despite the relatively weak figures for the first part of the year, it seems likely that the final outcome for the year as a whole will be somewhat stronger, and will be maintained into next year. The contribution of net exports to overall output growth is likely to remain modest next year with domestic demand set to remain the main driving force behind growth.

The continuing strength of output growth is likely to lead to further substantial increases in employment. Total employment is expected to 1 expand by 3 ⁄2 per cent. next year, following an estimated increase of 5 per cent. in 1999. The rapid expansion of the labour force over the last five years has been a key factor in Ireland’s growth experience. The natural increase in the population of working age will continue to boost labour supply, while some further modest increase in participation rates, together with inward migration will supplement this growth. There may, however, be a slowdown in rate of growth of labour supply, as the scope for further increases in the female participation rate may be more limited than in the past. The prospects

20 for inward migration are difficult to assess. Proposed changes in immigration regulations may allow greater entry of non-EU workers but there is already some anecdotal evidence that escalating housing costs may be restricting inward migration. The unemployment rate is likely to fall further next year, averaging about 5 per cent. for the year as a whole. This is a level at which increasing labour shortages are likely to put further upward pressure on wages across a wide range of sectors.

Domestic Demand Personal Consumption As already noted, the strength of consumer spending has been one of the main driving forces behind the strong output growth of recent years. This reflects the growth in the disposable income of the personal sector. Average earnings have increased by over 2 per cent. per annum in real terms over the last four years, employment has grown significantly and income tax reductions have been made in successive Budgets. Other factors have been at work as well, including an improvement in consumer sentiment. This means that not only do households have more income to spend but they also feel increasingly inclined to spend, rather than save, this income. Changes in sentiment are rather intangible, but expectations about the future are clearly an important ingredient and these have clearly improved. Increases in asset prices, particularly property prices, also partly reflect improved expectations about future economic growth.

The short-term indicators show that consumer spending continues to grow very strongly. The volume of retail sales was up 9·4 per cent. CHART 1 Index of Volume of Retail Sales year-on-year in the first nine months of this year, while car sales were YEAR-0N-YEAR % — 3 MONTH MOVING AVERAGE (SA) up 19·5 per cent. in the first ten months. Consumer sentiment remains 1990 = 100 very positive according to the results of the EU survey and it seems 11 unlikely that there has been any significant slowdown in spending in more recent months. As a result, the volume of consumer spending is 10 1 expected to have risen by 7 ⁄2 per cent. for the year as a whole. There is also likely to be a further substantial rise in expenditure next year. Employment growth may moderate as increasing labour shortages 9 constrain recruitment, but wage and salary increases are likely to pick up, which will serve to further boost disposable incomes. The impact 8 of the decline in interest rates, will inevitably begin to fade, so that the reduction in the savings rate which appears to have taken place during 7 1999 may not be repeated on the same scale. Overall, it seems likely that consumer spending growth will moderate next year, perhaps to 1 6 about 5 ⁄2 per cent. This does not take into account the impact of any SEP OCT NOV DEC JAN FEB MAR APR MAY JUN JUL AUG SEP Budget day changes in personal taxes, however, which could '98 '99 substantially boost consumer spending and lead to very little deceleration in consumption growth next year.

Public Consumption The volume of government consumption is estimated to have grown by about 4 per cent. this year, on the basis of the available information. A similar rate of growth is expected next year. Budget-day announcements may affect this projection, although most expenditure changes typically relate to transfers rather than government consumption.

21 Investment The volume of fixed investment is estimated to have increased by 1 about 12 ⁄4 per cent. in 1999. This rate of increase, while substantial, is somewhat lower than the outturn for 1998 of 16·8 per cent. This lower increase is mainly accounted for by the estimated decline in the 1 rate of increase in machinery and equipment investment to 12 ⁄2 per cent. from 24·2 per cent. last year. The volume of investment in building and construction is expected to have increased by about 12 per cent. in 1999, compared with the outturn for 1998 of 13·8 per cent.

The deceleration in machinery and equipment investment reflects weaker export growth and an apparent decline in foreign direct investment inflows, with a noticeable deceleration in the output growth of a number of high-technology industrial sectors. Indicators of machinery and equipment investment remain relatively buoyant but less so than in 1998. For example, year-to-date sales of light and heavy goods vehicles were up by 22·3 per cent. and 13·6 per cent., respectively, in October 1999 compared with rates of increase of 38·5 per cent. and 20·6 per cent. recorded in the same period of last year. The value of capital goods imports increased by just over 7 per cent., year-on-year, in the first seven months of the year, while the increase for 1998 as a whole was over 34 per cent.

Indicators of activity in the construction sector remain positive. Private house completions rose by 14·9 per cent. in the first half of the year compared with the same period in 1998, while social housing completions increased by 5·5 per cent. over the same period. Homebond registrations, a proxy for housing starts, were up 11·8 per cent. in the year to October. According to the Quantity Surveyors’ Inquiry, recommended progress payments for non-residential building in the first quarter were up by 54 per cent., year-on year, overall, and by over 95 per cent. for commercial building. Employment in the construction industry continues to increase reflecting the strength of activity. In the first nine months of the year, employment in the construction sector (firms with 5 or more employees) was 7 per cent. higher year-on-year.

1 A slight acceleration to about 12 ⁄2 per cent. is forecast for growth in the volume of building and construction investment in 2000. While demand for building and construction output is likely to remain strong both in the public and private sectors, supply-side constraints, particularly in the labour market, may have a negative impact on the rate of expansion in activity. Growth in the volume of machinery and equipment investment is forecast to decline to about 11 per cent. reflecting a continuation of the deceleration in 1999 due to a weaker trend in foreign direct investment inflows. Overall, investment is forecast to increase by about 12 per cent. in real terms next year.

Stock Changes There was a positive but fairly modest contribution to growth from stock changes in 1998. The prospects for this year are for a very small negative contribution to growth followed by a slightly larger one next year. The continuing growth in the economy is probably contributing to planned inventory accumulation but slightly slower output growth,

22 and a long-term trend towards greater efficiency in controlling inventories may point to a reduction in the scale of stock accumulation. This may occur despite a tendency for some firms to maintain higher than normal stocks at the end of this year, in order to minimise the possible impact of disruption to production due to Year 2000 concerns. The impact of the latter on economy-wide stocks is somewhat uncertain, however, as households may also decide to make advance purchases of goods which could reduce stocks in the distribution sector of the economy. The prospects for next year are for a slightly larger reduction in stock building.

Merchandise Trade and the Balance of Payments Merchandise Trade The pattern of external trade has been quite variable over recent times. CHART 2 Following a very good performance during most of 1998, the output Value of External Trade of the exporting sectors began to decelerate in the latter part of the THREE MONTH MOVING AVERAGE (seasonally adjusted) £ Million year and in the early part of 1999. This was mainly due to relatively weak demand growth, particularly within the euro area. This slowdown 30 seems to have persisted through the first half of 1999, although the indications are that output and exports began to recover again in the 25 latter part of the year, probably assisted by an improvement in the growth performance of the euro area. Much of the evidence for the 20 pick-up relates to export orders and producers’ expectations, but there are now some signs of an improvement emerging in actual output 15 growth in the exporting sectors. In spite of this re-acceleration, it seems unlikely that the volume of merchandise exports will grow by more 10 1 than 12 ⁄2 per cent. this year, which is a noticeable deceleration from 1 24 ⁄2 per cent. in 1998. The outlook for 2000 is for slightly stronger 5 1 export growth of about 13 ⁄2 per cent., reflecting the projected strengthening of external demand, particularly in the euro area. Weaker 0 inward investment, however, due to increasing labour shortages in the JUL AUG SEP OCT NOV DEC JAN FEB MAR APR MAY JUN JUL '98 '99 economy, may serve to limit export growth next year and in subsequent years. The possibility of a sharper-than-expected slowdown Exports in US growth also constitutes a risk to both export growth and inward Imports investment.

The pattern of imports has also been variable in recent times. While import growth was strong throughout much of last year, reflecting the strength of both exports and domestic demand, there was a slowdown in import growth in the first half of this year. This deceleration was not as marked as initial data on merchandise import volumes suggested. In particular, service imports were much stronger than anticipated, so that the overall volume of imports did not decelerate as markedly as the merchandise data suggested. These trends appear to reflect developments in the exporting sectors, with a reduction in overall demand for inputs due to weaker export growth being supplemented by an increasing switch to service rather than merchandise imports. It is likely that merchandise import volumes strengthened again in the latter part of the year, although the shift to service imports may have been an ongoing feature. The prospects for next year are for further strong merchandise import growth, reflecting the continuing strength of all components of demand, although the precise breakdown between merchandise goods and service imports remains somewhat uncertain. Traded goods prices internationally were relatively weak in 1999 but may have come under some upward pressure latterly, due

23 to the relative weakness of the euro. This pressure may persist into next year. Taking all these factors into consideration, it seems likely that the merchandise trade surplus will grow from about \22,695 million (or 1 1 30 ⁄2 per cent. of GNP) in 1999 to about \27,745 million (or 33 ⁄2 per cent. of GNP) next year.

Merchandise Trade 1998, 1999e and 2000f Table 2

1998 Change in 1999e Change in 2000f

\ million Volume Price \ million Volume Price \ million

1 3 1 3 Merchandise exports (adjusted) 57,852 12 ⁄2 ⁄4 65,606 13 ⁄2 1 ⁄4 75,725

1 1 1 Merchandise imports (adjusted) 38,972 9 ⁄4 1 42,911 9 ⁄2 2 ⁄4 47,980

Total balance 18,880 22,695 27,745 1 1 1 (% of GNP) (28 ⁄2) (30 ⁄2) (33 ⁄2)

The deficit on services trade is likely to show a substantial increase for 1999 as a whole, due to the continuing growth of services imports by the foreign-owned multinational sectors. The latter has maintained a lot of its momentum in spite of the more modest growth in merchandise exports by this sector. Factor income outflows from this sector are also continuing to grow significantly, so that the deficit on this item is likely to have increased further this year. Both of these trends seem set to continue next year with further substantial increases in these deficits in prospect. The surplus on current international transfers is also set to diminish next year, as the reduced entitlement to EU structural funds and a higher EU budget contribution begin to have an impact. Overall, the current account seems likely to shift from a surplus of \280 million 1 (or under ⁄2 per cent. of GNP) in 1999 to a deficit of about \365 1 million (or ⁄2 per cent. of GNP) next year for the first time since 1990. Stronger personal consumption as a result of Budget Day changes in taxation and spending, however, could result in higher-than-expected imports and a larger current account deficit.

The Capital and Financial Account There was probably a small surplus on current account of the balance of payments in the first nine months of 1999 and, as a consequence, a corresponding deficit on capital and financial account inclusive of changes in the official external reserves. Developments on capital and financial account were dominated by outflows through the banking sector reflecting a reduction in the net external liabilities of this sector. There were also private capital and official capital outflows. These were associated in part with institutional portfolio outflows and net repayments of Exchequer external debt, respectively. End-September valuation adjustments increased the euro value of the official external reserves by \1,186 million.

Official balance-of-payments data covering the first nine months of the year are expected to be published soon. In October, the official external reserves fell by \59 million ending the month at \4,977 million.

24 Balance of Payments 1998, 1999e and 2000f Table 3

| million 1998 1999e 2000f

Current Account • Merchandise trade balance (adjusted) 18,880 22,695 27,745 • Services −10,019 −12,840 −16,330 • Current international transfers 1,318 1,355 1,165 • Net factor income from rest of the world −9,465 −10,930 −12,945

Balance on current account 714 280 −365 1 1 (% of GNP) (1) ( ⁄2)(−⁄2)

Capital and Financial Account • Capital transfers 839 • Official capital flows −1,594 • Transactions of credit institutions 5,523 • Official external reservesa −2,089 • Private capital/residual −3,398 a Change in reserves on a transactions basis, i.e., excluding valuation adjustments. A minus figure equals a net increase in reserves.

Output Trends and the Labour Market Industry and Services Output Output data for the first half of the year are consistent with a moderation in the growth of manufacturing activity. In the period from January to June, output was 8·3 per cent. higher than in the same period of last year. While this is a strong rate of growth, it does represent something of a slowdown from the growth rates of recent years — total output expanded by 16·6 and 16·7 per cent., respectively, in 1997 and 1998. The main factor underlying the moderation in the growth rate is the deceleration in the rate of output growth in the high-technology sectors, partly reflecting a slowdown in foreign direct investment inflows into the Irish manufacturing sector. For example, in CHART 3 the first half of the year, output in the electrical engineering sector was Volume of Industrial Production just 2·5 per cent. higher than in the same period of 1998, while in the YEAR-ON-YEAR % CHANGE 3 MONTH MOVING AVERAGE other foods sector, output in the first half of the year was 0·7 per cent. 30 lower, year-on-year. In addition, output growth in the pharmaceuticals sector, where the highest growth rates had been recorded in recent 25 years, has decelerated sharply this year. In the indigenous sectors, 20 output in the first half of this year was 0·5 per cent. higher than in the same period of 1998 — relatively strong output growth in some sectors, 15 most notably in some of the foods sectors, was almost fully offset by declines in other areas. 10

5 The IBEC/ESRI monthly industrial survey points to an improvement in overall industrial production during the second half of the year. 0 Buoyant domestic demand conditions and an improving outlook for -5 the UK economy should have supported some increased output in the JUN JUL AUG SEP OCT NOV DEC JAN FEB MAR APR MAY JUN indigenous sector as the year progressed. At the same time, the '98 '99 improved external environment, particularly in the EU, is likely to have Manufacturing supported a re-acceleration of output growth in the high-technology Hi-Tech sector. Overall, manufacturing output is forecast to have expanded by Indigineous around 10 per cent. in 1999.

25 Looking towards next year, the more favourable international environment should continue to underpin output growth in the high- technology sectors. However, some further deceleration in foreign direct investment inflows into the manufacturing sector is expected, reflecting labour shortages in the high skilled sectors. As a result, output growth in these sectors is expected to remain relatively subdued by recent standards. A continuation of buoyant domestic demand should support relatively strong growth in the indigenous sector next year. The decline in the value of the euro against sterling will, if sustained, also help to assist the expansion of output in some of these sectors. In this general environment, the volume of manufacturing activity is forecast to expand by about 9 per cent. next year. It is assumed that any disruption to production due to Y2K problems will be minor and short- lived with little impact on the outturn for the year.

Manufacturing Output, annual percentage change Table 4

Total High-Technologya Indigenous

1994 12·8 18·1 5·3 1995 20·1 28·9 6·3 1996 8·2 10·9 3·3 1997 16·6 21·9 5·7 1998 16·7 22·6 2·7 e 1 1999 10 12 ⁄2 2 f 1 2000 9112⁄4

1 Average 1994-2000 13 ⁄4 18 4

a Pharmaceuticals, office and data processing, other foods, electrical and instrument engineering.

Building and construction investment expanded by an estimated 12 per cent. in 1999, suggesting that output in this sector also grew strongly. Further strong output growth is expected next year. Service sector output also grew strongly this year, reflecting buoyant domestic demand conditions together with robust employment growth. Sustained levels of domestic demand, together with a continuation of good employment growth, should continue to underpin strong output growth in the service sector next year. In line with the trend of recent years, public sector output is expected to remain subdued in 2000.

Agricultural Output All the indications are that 1999 was another difficult year for the agricultural sector. In the beef sector, it is estimated that the volume of output rose this year, partly reflecting a large increase in live exports. In the dairy sector, some increase in the volume of output is expected 1 following a 2 ⁄4 per cent. decline in 1998. In addition, the usage of inputs is expected to have been lower this year than in 1998, reflecting more favourable weather conditions. In these circumstances, it is estimated that the volume of gross agricultural output rose by about 14 per cent. this year. However, the increase in output was largely offset by poor price conditions in 1999, with preliminary price estimates produced by the CSO pointing to a substantial deterioration in the agricultural terms of trade. Output prices were 4·3 per cent. lower than in 1998, reflecting weak prices for a wide range of agricultural commodities. In the two largest sectors — beef and milk — prices were 5·6 and 3·3 per cent. lower, respectively, this year. The

26 data also confirm the continuing difficult conditions in the sheep and pig sectors. Only in the cereals and vegetables sectors were price increases recorded in 1999. At the same time, input prices were slightly higher this year than in 1998. As a result, there was a 5 per cent. decline in the agricultural terms of trade this year. In addition, it is estimated that subsidy payments were lower than in 1998, so that in 3 overall terms, agricultural incomes this year were about 2 ⁄4 per cent. 1 lower than in 1998 (a decline of 4 ⁄4 per cent. in real terms).

Looking towards next year, the outlook is somewhat more benign. Some further increase in the volume of gross agricultural output is expected, partly reflecting favourable prospects for the beef sector. Some marginal increase in the volume of inputs is also expected. In these circumstances, the volume of gross agricultural output is 1 expected to rise by about 3 ⁄4 per cent. next year. Output prices are also expected to be higher next year, partly reflecting the fact that in the more troubled sectors, it is difficult to see prices falling any further. Some improvement in the agricultural terms of trade is expected. It is also expected that subsidies next year will be somewhat higher than in 1999. As a result, the overall level of agricultural income is expected 1 1 to rise by about 3 ⁄4 per cent. (a rise of ⁄2 per cent. in real terms) next year.

Summary of Agricultural Output and Incomes 1998, 1999e and 2000f Table 5

1998 Percentage change in 1999e Percentage change in 2000f

\ million Value Volume Price \ million Value Volume Price \ million

a 3 3 1 Gross agricultural output 4,152 −1 ⁄4 2 ⁄4 −4 ⁄4 4,081 3 2 1 4,202 1 3 1 1 3 Farm materials and services 2,241 −6 ⁄4 −7 ⁄4 2,101 2 ⁄4 ⁄2 1 ⁄4 2,148

1 3 1 1 Gross agricultural product at market prices 1,911 3 ⁄2 14 −9 1,981 3 ⁄4 3 ⁄4 ⁄4 2,053 Subsidies less expenses 458 325 329

3 1 Income from self-employment 2,369 −2 ⁄4 2,306 3 ⁄4 2,382 a Including the value of stock changes

The Labour Market Results of the Quarterly National Household Survey (QNHS) for the second quarter of 1999 confirm that strong economic growth continues to have a positive impact on the labour market. Following a year-on-year increase of 71,900 (4·8 per cent.) in the first quarter of the year, employment growth accelerated to 96,600 (6·5 per cent.) in the second quarter. This latter increase was composed of a 79,700 (6·4 per cent.) rise in full-time employment together with a 16,900 (6·8 per cent.) rise in part-time employment.

While all sectors (including agriculture) recorded positive year-on-year employment growth, it was once again the service sector which accounted for the bulk of the overall increase, with particularly strong gains being recorded in the financial and other business (up 24,000) and transport, storage and communication (up 9,100) sectors. Somewhat surprisingly, there was also a large increase in the number employed in the education and health sector (up 13,500). Outside the service sector, the largest increase was recorded in the construction

27 sector (up 15,900), reflecting the buoyant conditions currently being experienced there.

The data confirm the continuing decline in unemployment. In the second quarter of this year 96,900 people were classified as unemployed, a fall of 29,700 compared to the same period of 1998. Over this period, the unemployment rate (based on ILO definitions) fell from 7·8 per cent. to 5·7 per cent. Of those unemployed, 59,400 were males, the majority of whom (96 per cent.) were seeking full-time employment. On the other hand, a large proportion (38 per cent.) of the 37,500 females who were unemployed were seeking part-time employment. In terms of the duration of unemployment, in the second quarter of this year 41,600 people (2·5 per cent. of the labour force) were unemployed for one year or more, compared to 63,500 (3·9 per cent. of the labour force) a year earlier.

The labour force expanded by 67,000 (4·1 per cent.), year-on-year, in the second quarter of this year, an acceleration from the 1·8 per cent. growth in the previous quarter. These increases in the labour force reflect the demand for labour resulting from the strength of economic activity, which has encouraged higher participation. At the same time, demographic factors continue to enhance the labour supply. In particular, the labour force continues to benefit from the natural increase in the working age population, which in turn is attributable to the peak in the birth rate in the early 1980s. In addition, net inward migration continues to boost the labour force — in the year to April 1999, the net inflow into Ireland amounted to 18,500.

It is now clear that, while the labour force continues to expand, the rate of growth of the labour supply has not kept pace with the demand for labour, so that shortages of labour have emerged throughout the skills spectrum. A survey conducted by the ESRI in the Autumn of 1998 found that 27 per cent. of firms in the private non-agricultural sector had vacancies. Given strong employment growth in the intervening period, it is likely that this figure has increased further more recently.

In overall terms, total employment in the first half of the year was 84,300 (5·7 per cent.) higher than in the same period of 1998. Available data point to further strong growth in the second half of the year. For example, income tax receipts in the year to end-October were 9 per cent. higher than a year earlier, while the downward trend in registered unemployment also suggests further employment growth. In addition, CSO data show that, in the year to September 1999, employment in construction was 7 per cent. higher than in the same period a year earlier. In overall terms, total employment is now estimated to have increased by an average of about 77,000 (5 per cent.) this year. Strong demand for labour is expected to encourage higher participation, which, together with positive demographic changes, should continue to underpin further expansion of the labour 3 force, which is expected to have increased by about 2 ⁄4 per cent. Unemployment for the year as a whole is expected to average around 1 94,000, corresponding to an average unemployment rate of 5 ⁄2 per cent.

28 Employment and Unemployment 1998, 1999e and 2000f Table 6

(annual average ’000) 1998 1999e 2000f

Agriculture 135 135 134 Industry 436 454 469 Services 950 1,009 1,052

Total Employment 1,521 1,598 1,655 Unemployment 125 94 85

Labour Force 1,646 1,692 1,740 1 1 Unemployment Rate (%) 7 ⁄2 5 ⁄2 5

Note: The CSO has revised the sectoral employment breakdown in 1998.

Looking towards next year, the prospect is for further strong employment growth. However, the rate of increase is expected to be somewhat slower than this year, reflecting shortages of labour across almost all sectors. In overall terms, employment is expected to expand 1 by a further 57,000 (3 ⁄2 per cent.) next year, with the private service sector once again being the main engine of growth. The demographic factors which have underpinned the expansion of the labour force in recent years are expected to continue next year, with the labour force 3 forecast to increase by a further 2 ⁄4 per cent. Unemployment is expected to decline further next year, although the magnitude of the decline is expected to be somewhat lower than in the last number of years. For the year as a whole, an average rate of around 5 per cent. is currently expected.

The Public Finances Total current expenditure for the first nine months of 1999 totalled \13,655 million, or 69·8 per cent. of the 1999 Budget estimate. Central Fund Services, at \2,890 million or 66·8 per cent. of the Budget target, was broadly in line with expectations. Net Non-Capital Supply Services expenditure amounted to \10,764 million, up 8·8 per cent. on the same period last year.

Total current receipts in the first three quarters of the year amounted to \17,809 million. Tax revenue, at \17,361 million, was up 15·4 per cent. year-on-year, which compares with a 7·5 per cent. projected increase for the year as a whole on Budget day. It is now expected that total tax revenue in 1999 will exceed the Budget target by about \1,269 million.

Non-tax revenue amounted to \447 million or 88 per cent. of the full- year target. Overall, the difference between current revenue and current expenditure in the first nine months of the year resulted in a current budget surplus of \4,155 million. This compares with a \2,454 million current budget surplus in the same period in 1998.

The Exchequer balance for capital purposes amounted to a surplus of \3,692 million over the first nine months. When the Telecom´ Eireann flotation receipts are excluded, however, there was an underlying deficit of \964 million. Voted capital expenditure amounted to \1,609 million, an increase of 20 per cent. over the same period last year. Exchequer Capital Resources over the first nine months were, excluding receipts from share sales, broadly in line with expectations.

29 Exchequer Returns at End-September 1999 Table 7

1998 1999

Outturn Budget estimate First Three-Quarters

\ million \ million % change \ million % change % of Budget year-on-year estimate

Current Expenditure — Central Fund Servicesa 4,360 4,326 −0·8 2,890 −4·8 66·8 — Non-Capital Supply Servicesb 13,939 15,229 9·3 10,764 8·8 70·7

Total 18,299 19,555 6·9 13,655 5·6 69·8

Current Revenue — Tax revenue 20,481 22,011 7·5 17,361 15·4 78·9 — Non-tax revenuec 475 509 7·2 447 32·3 87·8

Total 20,955 22,520 7·5 17,809 15·7 79·1

Current Budget Surplus 2,655 2,965 4,155

Exchequer borrowing for capital purposes 1,707 1,790 −3,692

Total Exchequer Surplus 948 1,175 7,848

General Government Surplus (% of GDP)d 2·1 1·7 a Debt servicing, judicial salaries and pensions and EU Budget contribution. b Government current expenditure on areas such as Social Welfare, Health, etc. c Central Bank surplus income, National Lottery surplus, interest and dividends, etc. d ESA95 basis.

Taking the current and capital balances together, the Exchequer surplus for the first nine months of the year was \7,848 million. Excluding the Telecom´ Eireann receipts, the underlying surplus amounts to \3,191 million. This compares with a surplus of \1,707 million for the corresponding period in 1998.

The 2000 Abridged Estimates were published on 11 November. Net non-capital spending is projected to rise by \1,047 million in 2000, an increase of 6·8 per cent. over 1999. The outgoings on Central Fund Services in 2000 are projected to fall by about 11 per cent., reflecting lower debt servicing costs. Together, the changes in the Central Fund Services and Net Non-Capital Supply Services expenditures imply that total current spending is forecast to rise by 2·8 per cent. in 2000. Voted capital expenditure is set to rise from \3,088 million in 1999 to \3,847 million in 2000, an increase of 24·6 per cent.

Exchequer Financing In the first nine months of 1999 Government balances increased by almost \5 billion, reflecting the Exchequer surplus of close to \7·9 billion (inclusive of Telecom receipts) less net repayments of borrowings of \2·9 billion. Repayment of medium- and long-term bonds amounted to \2·3 billion, of which \752 million was Irish Government bonds listed on the Stock Exchange and almost \1·6 billion was other bonds. The Government also repaid \266 million of short-term borrowing (commercial paper) and \202 million to ministerial funds. The increase in Government balances was \3·2 billion in the third quarter of the year. In this period, the Government raised

30 Box 1: The Underlying Fiscal Position Buoyant public finance data occurring alongside strong economic growth poses difficulties in ascertaining the true underlying fiscal position. In particular, with above-average economic growth and government budget surpluses, it becomes difficult to identify whether it is the economy’s influence on the budget or a tight fiscal policy stance that is generating the relatively good budgetary position. Strong GDP growth in itself would be expected to generate a better government budget balance through an increased revenue take and lower expenditure. On the revenue side, an increase in GDP growth will, given existing tax rates, tend to generate a higher tax return by increasing the tax base. Moreover, this positive influence on the budget balance will likely be complemented by a fall in certain categories of government expenditure, in particular lower outlays on unemployment-related payments associated with a fall in unemployment.

It is essential, therefore, to attempt to separate out the underlying influence on the budget balance in order to assess the underlying stance of fiscal policy. One means of assessing the underlying fiscal position is to calculate what are termed cyclically- adjusted budget balances. Provisional estimates of the cyclically-adjusted fiscal balance position in Ireland suggest that, when adjustment is made for the influence of the economic cycle, the budget balance is less impressive than indicated by the unadjusted, or raw, general government balance data.1 The cyclically-adjusted budget balance appears to have declined in the years up to 1998, from being in a surplus position in 1995 through 1997 to being in or around balance in 1998 and 1999.

It is important that the underlying fiscal position does not deteriorate further for two reasons. First, the Stability and Growth Pact requires Member States to maintain budgetary balances that over the economic cycle are close to balance or in surplus. Secondly, while not as immediate a prospect as is the case in other EU member states, the Irish public finances will in the next century be faced with the prospect of meeting substantially greater pension outlays. In this context, maintaining an underlying government position close to balance or in surplus at this time is important as a basis for making provision for these long-run burdens on the public finances.2

1 The trend growth rate for real GDP used for these calculations is 5 per cent. which is an estimate considered consistent with a sustainable growth rate over the full cycle. Other estimates, based on fitting statistical trends, put the trend growth rate closer to 7 per cent. This higher rate is influenced more by the high actual rates experienced in recent years. The effect of using a lower trend growth is that more of the fiscal buoyancy over the period 1995 to 1999 is being ascribed to positive cyclical factors. 2 A forthcoming article in the Quarterly Bulletin will examine more comprehensively both cyclically-adjusted budget balances and longer-term issues for the Irish public finances.

\244 million in bonds listed on the Irish Stock Exchange, but otherwise repaid borrowings. Overall, repayments amounted to \2·1 billion.

The contribution of national savings schemes to the Exchequer was negative to the tune of \78 million in the first nine months of the year, compared with \155 million raised in the same period last year.

Monetary Policy and Financial Sector Developments Overview An overview of monetary developments in the euro area is contained in the ‘International Economy’ chapter of this bulletin. The Governing Council of the ECB decided on 4 November to increase the ECB’s three main interest rates by 0·5 of a percentage point, reversing the reductions implemented in April. The Governing Council’s decision was based on an assessment that the balance of risks to future price stability had moved towards the upside and that the downside risks present at the time of the reduction in rates in April were no longer present. Despite the increase in interest rates in November, monetary conditions in Ireland remain lax. Average interest rate levels this year are still relatively low by historical Irish standards. Moreover, with

31 Irish inflation relatively high compared with other euro-area countries, real interest rates are lower here than in other monetary union members. Retail interest rates in Ireland have also been affected by increased competition, notably in the area of residential mortgages. In addition, exchange rate conditions for Irish traders have been relaxed this year, reflecting the declining trend of the euro. An estimate of a trade-weighted average value of the exchange rate for Ireland indicates that it depreciated by around 2 per cent. in real terms in the first three quarters of this year, following a 5 per cent. average decline in 1998.

Money and Credit Ireland’s share of the euro-area broad money stock (M3) increased by \4,077 million in the third quarter to \77,504 million. This figure comprises selected liabilities of resident Monetary Financial Institutions (MFIs) with respect to Irish residents and residents of other monetary union members. On average, Ireland accounted for 1·7 per cent. of euro area M3 in the three months to end-September. Ireland’s contribution to M3 rose in August and September following two consecutive monthly falls. The impact of the privatisation of the State- owned telecommunications company, Telecom´ Eireann, contributed to this development. Of the increase in Irish M3 in the third quarter, \4·8 billion was denominated in euro (including Irish pounds and denominations of other monetary union member countries), while the component denominated in currencies of non-EMU countries fell by \757 million. Total deposits increased by \3·1 billion over the quarter. The largest increase was in deposits with agreed maturity up to two years. In October, Ireland’s share of M3 amounted to \79,922 million, an increase in the month of \2,418 million. The increase was mainly due to Irish resident deposits, principally those with an agreed maturity of up to two years.

As M3 is calculated on a different basis to the old M3E series, which has been discontinued, it is not yet possible to calculate year-on-year

Source and Application of Funds Table 8

\ million January to January to September 1998 September 1999

1. Borrowing (−)/repayments (+) 454 2,893 Irish Government bonds listed on the Irish Stock Exchange 283 752 Other Irish Government public bond issues 98 954 EIB loan 133 108 Medium Term Notes 65 91 Private Placements 89 453 National saving schemes −155 78 Commercial paper 185 266 Miscellaneous debt 21 −13 Borrowing from ministerial funds −264 202

2. Increase (+)/decrease (-) in Exchequer deposits and other balances: 1,252 4,955 Increase (+)/decrease (−) in Exchequer balance 1,093 328 Increase (+)/decrease (−) in foreign deposits 319 4,666 Increase (+)/decrease (−) in other balances −159 −39

Exchequer Surplus (1+2) 1,706 7,848

32 Private-Sector Credit: Annual Rates of Change (%) Table 9

Residential mortgages Total private-sector credita

1998 March 20·7 28·1 June 19·5 24·7 September 18·9 21·3 December 18·8 22·6

1999 January 18·6 24·2 February 19·7 23·0 March 20·7 24·6 April 21·4 30·5 May 23·9 31·1 June 22·4 30·7 July 22·7 32·2 August 23·3 31·1 September 25·3 33·9 October 23·9 34·0 a Not adjusted for transactions between credit institutions and non-bank IFSC companies or valuation effects arising from exchange-rate movements. Since April 1999, the annual growth rate has been inflated by an exceptional item.

growth rates for Irish M3. In the period from end-January to end- October 1999, Ireland’s contribution to M3 increased by 16·4 per cent., implying an annualised rate of growth in excess of 20 per cent. CHART 4 This compares with average annual M3 growth for the euro area of 6 Changes in Private-Sector Credit per cent. for the third quarter and a reference value for euro area M3 % Year-to-year change growth of 4·5 per cent. per annum. 40

35 The annual rate of growth in credit advanced to non-Government Irish residents by credit institutions resident in this country (private-sector 30 credit) accelerated further in the four months to October. At end- 25 October, the annual growth rate was 34 per cent., compared with 30·7 per cent. at end-June and below 23 per cent. at the end of 1998. Part 20 of this acceleration is accounted for by an exceptional item relating to 15 the merger between Irish Life and Irish Permanent in April. Adjusting for this item, the annual growth rate was just below 30 per cent. in 10 October. 5

0 It would appear that part of the pick-up in credit growth this year is DEC JAN FEB MAR APR MAY JUN JUL AUG SEP OCT IFSC related. The credit figures are no longer adjusted for the impact '98 '99 of non-Irish-pound lending to non-bank IFSC entities, as was the case Headline before the start of this year. This is because the information required for this adjustment is no longer available as data are now reported Adjusted on a euro/non-euro basis in monetary union, whereas previously the breakdown was between Irish pounds and foreign currencies. In the past, the great bulk of lending to non-bank IFSC entities - generally in excess of 95 per cent. — was non-Irish-pounds and not directly related to activity in the economy. If all IFSC lending is excluded from private- sector credit the annual growth rate, adjusting for the exceptional item mentioned above, would have been 26·1 per cent. in October, compared with 23·5 per cent. in December 1998. The rate of credit growth is still very high but the level of acceleration may be overstated by the headline figures. The rapid growth in private-sector credit is partly accounted for by the strength of domestic economic activity. However, the exceptionally low level of interest rates, and the expectation that they will remain relatively low by historical standards

33 Change in Credit Institutions’ Non-Government Credit by Sectora Table 10

End-August 1998/ End-May 1999/ End-August 1999 End-August 1999

\ million % \ million %

Agriculture and forestry 223 8·0 15 0·5 Fishing 49 51·2 12 9·1 Mining and quarrying 8 4·2 −28 −11·8 Manufacturing 842 21·6 −147 −3·0 Electricity, gas and water supply 108 48·9 11 3·5 Construction 609 38·2 174 8·6 Wholesale/retail trade and repairs 433 15·8 −59 −1·8 Hotels and restaurants 850 36·2 213 7·1 Transport, storage and communications 345 30·8 90 6·5 Financial intermediation 8,606 49·4 575 2·3 Real estate and business activities 1,441 29·3 608 10·6 Education 20 23·3 26 31·7 Health and social work −30 −15·5 −48 −22·9 Other community, social and personal services 79 10·3 96 12·8 Personal: 6,543 26·2 2,026 6·9 — House mortgage finance 4,357 23·1 1,191 5·4 — Other housing finance 44 9·9 37 8·2 — Other 2,142 37·8 798 11·4 Local authorities/regional governments −2 −1·4 −2 −1·3

Total 20,096 31·7 3,532 4·4 a See Note a, Table 9.

CHART 5 due to membership of monetary union, have also played an important Nominal Private-Sector Credit and GDP part. (annual % changes) 30 Residential mortgage lending contributed \1,454 million to the increase in private-sector credit in the third quarter, more than a third 25 of the total increase. The annual rate of growth in mortgage lending rose to 25·3 per cent. in September, compared with 22·4 per cent. in 20 June. This apparent sharp acceleration reflected a base effect caused by the securitisation of \254 million worth of mortgages by one 15 institution in September 1998. The fall in the annual rate of mortgage growth to 23·9 per cent. in October was largely due to another 10 securitisation in that month, amounting to \300 million. The underlying

5 rate of increase has tended to rise since the spring, probably reflecting, in part, reductions in mortgage rates in that period. This rise occurred

0 despite the slowdown in the rate of increase in average residential 1991 1992 1993 1994 1995 1996 1997 1998 property prices, possibly reflecting an increased volume of activity in Credit GDP the market or an increase in the average size of mortgage.

CHART 6 The most recent sectoral breakdown of credit data is for August 1999. Real Private-Sector Credit and GDP In the three months to end-August, lending to the personal sector (annual % changes) 25 accounted for more than 70 per cent. of the increase in private-sector credit. Most of this was due to mortgage lending, but there was also a strong increase in other personal sector lending, which includes 20 consumer credit. There were strong increases as well in lending to real estate activities, financial intermediation, hotels and restaurants and 15 construction.

10 In the year to August, lending under the heading ‘Financial intermediation’ (which includes lending to financial institutions other than banks and building societies), accounted for the largest proportion 5 of the overall increase. However, excluding IFSC lending and adjusting for the merger between Irish Life and Irish Permanent, personal sector 0 1991 1992 1993 1994 1995 1996 1997 1998 lending predominated. Again, non-mortgage personal borrowing

Note: accounted for a significant share of the increase. Lending to the Credit Credit growth not adjusted for valuation category ‘Financial intermediation’ and to the personal sector GDP and IFSC effects. Real growth rates for credit calculated by substracting the accounted for 75 per cent. of the increase in credit in the year to GDP deflator from the nominal rates. August. The remainder was largely due to real estate activities (7·8 per

34 cent.), hotels and restaurants and manufacturing (both 4·2 per cent.) and construction (3 per cent.).

Financial Markets Euro-area money-market interest rates firmed in the fourth quarter of the year, reflecting strengthening economic activity and the prospects CHART 7 Selected Interest Rates of higher inflation. As interest rates are the same across the monetary % union, the increase was the same in Ireland as in other euro-area 8 countries. Following this increase in early November in the cost of central bank money in the euro area, domestic retail credit institutions increased lending and deposit rates. This included increases in 6 mortgage rates, although these remained lower than at mid-year. The latter reflected the increase in competition in the residential mortgage 4 market caused by the entry of a UK institution in late August offering more competitive variable rate mortgages. Domestic mortgage lenders responded by reducing their standard variable mortgage rate by 2 amounts which were generally of the order of 1·25 percentage points in September and early October. In November, a number of mortgage lenders increased their standard variable rate by around 0·4 of a 0 NOV DEC JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV percentage point, following the increase in ECB interest rates. Demand "98 "99 deposit rates also rose following the ECB action but generally remained 1 Month Interbank Rate very low. However, competition in this area also increased with a UK Clearing Banks' Prime Rate institution entering the market in November. Clearing Banks' Deposit Rate £25,000-£100.000

Central Bank Short Term Facility Rate The cost of loans to many commercial borrowers is based on the Marginal Lending Facility Rate clearing banks’ prime rate, which in turn is directly linked to changes in wholesale money-market interest rates. Following the increase in market rates, both in anticipation of and following the increase in official rates by the ECB, there was an increase in prime rates. By end- November, prime rates averaged almost 3·6 per cent., compared with closer to 3 per cent. from April to October. Notwithstanding this increase, the level of interest rates generally remains relatively low by CHART 8 historical Irish standards. Rates are also very low in real terms, taking Irish Yield Curve % account of the relatively high level of inflation in Ireland. The one- 6 month money-market rate averaged around 2·8 per cent. in the first eleven months of this year, compared with an average consumer price 5 inflation rate from January to October of 1·4 per cent., or 2·2 per cent. using the Harmonised Index of Consumer Prices (HICP) measure. In 4 addition to the relatively low interest rate environment, the exchange rate has weakened since the start of the year. The effective exchange 3 rate index for the euro fell by close to 9 per cent., in both real and 2 nominal terms, in the first ten months of the year. Of particular importance for Ireland was a fall of around 9 per cent. in the euro 1 against sterling. The notional Irish pound value against sterling fell from around stg£0·90 at the start of the year to just below stg£0·80 at end- 0

November. O/N 1-Wk 1-Mth 3-Mth 6-Mth 12-Mth 2 Year 5 Year 10 Year

04-Jan-99 Irish bond yields have generally firmed this year, especially since the 30-Jun-99 spring, reflecting international trends. Rates peaked in late October as 30 Nov-99

35 Euro-Area Retail Bank Interest Rates (Provisional) Table 11

Deposit interest rates Lending interest rates

Overnight To enterprise To households

Up to 1 Over 1 Consumer For house year year lending purchase

1998 September 1·05 6·60 5·65 10·00 5·66 October 1·04 6·50 5·52 9·79 5·49 November 0·94 6·38 5·43 9·68 5·43 December 0·87 6·22 5·11 9·61 5·29

1999 January 0·79 6·07 5·04 9·61 5·10 February 0·74 5·98 5·00 9·54 5·02 March 0·73 5·85 4·99 9·50 5·05 April 0·70 5·68 4·82 9·37 4·91 May 0·65 5·57 4·73 9·31 4·84 June 0·62 5·49 4·78 9·29 4·96 July 0·62 5·41 4·96 9·21 5·18 August 0·61 5·42 5·17 9·31 5·47 September 0·62 5·40 5·20 9·31 5·53

Source: ECB. Rates are calculated as the weighted average of national rates. These rates should be used with caution as they are not harmonised across euro-area countries.

the markets anticipated a rise in official interest rates, which duly occurred in November. The Irish five-year yield peaked at 5·28 per cent., compared with 3·15 per cent. at the start of the year. The ten- year yield rose from 3·86 per cent. to 5·72 per cent. over the same period. The differential between Irish and German yields fluctuated within a narrow range from late May to late November. The five-year differential averaged a little below 0·4 of a percentage point and the ten-year differential averaged around 0·26 of a percentage point. By end-November, the ten-year differential was one of the highest of the euro-area countries, probably due in part to the relatively high level of Irish growth and inflation.

Irish Government Bond Yields and Differentials Table 12

End-month 5-year Differentials against: 10-year Differentials against: bond bond yield Germany UK US yield Germany UK US

1998December 3·21 0·06 −1·38 −1·47 3·99 0·18 −0·44 −0·70

1999January 3·25 0·04 −0·93 −1·33 3·84 0·21 −0·32 −0·84 February 3·47 −0·03 −1·13 −1·72 4·18 0·19 −0·43 −1·09 March 3·33 −0·01 −1·22 −1·73 4·10 0·12 −0·47 −1·09 April 3·07 −0·09 −2·08 −1·74 3·89 0·04 −1·39 −0·84 May 3·72 0·35 −1·88 −1·33 4·34 0·23 −1·36 −0·65 June 4·21 0·36 −1·67 −1·23 4·78 0·25 −0·32 −1·21 July 4·53 0·34 −1·20 −1·30 5·06 0·26 −0·26 −0·88 August 4·62 0·32 −1·16 −1·22 5·17 0·28 — −0·78 September 4·84 0·42 −1·37 −0·97 5·37 0·28 −0·25 −0·56 October 5·02 0·36 −1·16 −0·94 5·44 0·28 −0·01 −0·62 November 5·02 0·35 −1·18 −1·16 5·46 0·27 0·18 −0·75

Note: (−) denotes Irish yields are lower than foreign yields.

On the whole, the level of short-term money-market interest rates was broadly similar at end-November to the start of the year, whereas bond yields were significantly higher. Therefore, there has been a marked

36 steepening of the Irish yield curve this year, more so than in other euro- area countries influenced by market concerns about possible overheating. CHART 9 Ten-Year Yield Differentials vis-à-vis Germany Financial Institutions End-November 1999 percentage In recent months, a significant institutional development in the Irish points financial sector has been the effect of the entry into the market of two 0.35 British institutions, Bank of Scotland and Northern Rock. Both availed of the EU law aimed at creating a single banking market; Northern 0.30 Rock are operating on a branch basis and Bank of Scotland on a cross- 0.25 border basis. Bank of Scotland, which has increased competition in the 0.20 Irish residential mortgage market, has no physical presence in Ireland, offering services by telephone from their offices in the UK. Northern 0.15

Rock have increased competition for demand deposits, operating a 0.10 direct banking service (e.g., by post or telephone). 0.05

TSB Bank established a subsidiary, Tusa Financial Services Limited, which 0.00 from 20 October offered in-store banking services in co-operation with BEL SPA FRA IRE ITA NL AUS POR FIN a supermarket chain. This is the first such arrangement in Ireland. On 6 December, the Minister for Finance announced that he had decided to withdraw the State-owned ICC Bank plc from sale for the present.

Monetary Policy Implementation In Ireland, any institution regulated by the Central Bank — of which there are currently 79 — may, in principle, act as a counterparty for monetary policy operations. At present, 38 (including banks in the IFSC) have met the general eligibility requirements to do so. This is a substantial increase on the number of institutions the Bank dealt with before monetary union. Up to the start of November, the Bank had dealt with a total of 17 counterparty institutions in main refinancing operations and 11 counterparty institutions participated in longer-term refinancing operations. At end-October, outstanding advances through sale and repurchase agreements amounted to \4,777 million. The equivalent figure was \1,356 million at end-January and it has steadily trended upwards since then. Since the start of this year, both of the Eurosystem’s standing facilities have been regularly availed of at the Central Bank.

In the maintenance period from 24 October to 23 November, institutions held balances in their minimum reserve accounts which were, on average, \10 million more than required.

Up to late November, twelve of the Bank’s counterparties had used the Correspondent Central Banking Model (CCBM). Collateral with a market value in excess of \4·4 billion was held in custody accounts in other NCBs on behalf of the Bank. The securities involved were mainly located in Germany, Italy, the Netherlands and Spain.

In terms of technical performance, TARGET has experienced few disruptions in Ireland, achieving 100 per cent. availability in September (i.e., no disruptions) in common with just six other EU members. In the third quarter, the Central Bank’s RTGS system averaged 1,050 domestic payments per day, with an average daily value of just under \9·5 billion. There were 579 cross-border payments per day, on average, with an average daily value of close to \4 billion.

37 Box 2: The Central Bank of Ireland and Monetary Policy Implementation The procedure for the formulation and implementation of monetary policy in the euro area is described in detail in another article in this bulletin1, which highlights the continued active role of the Central Bank in monetary policy operations since the start of monetary union. The implementation of monetary policy is effected through the use of various instruments, by which the Eurosystem (and thus, in Ireland, the Central Bank) adds liquidity to, or withdraws it from, the financial system. In performing this function, the Central Bank conducts transactions with specific banks and credit institutions, acting as counterparties.

For monetary policy purposes, the Bank conducts open-market operations with institutions located in Ireland; it also provides access to the standing facilities of the Eurosystem and oversees the compliance of domestic monetary financial institutions (MFIs) with the minimum reserves system of the Eurosystem. The Bank is not permitted to publish details of liquidity supplied or absorbed in its monetary policy operations. However data for the entire euro area are published by the ECB in its monthly bulletins. Transactions with the Central Bank relating to the use of the Eurosystem’s standing facilities or participation in open-market operations are settled on the counterparty’s account with the Bank (or on the account of a settlement bank acting on the counterparty’s behalf) through the settlement system operated by the Bank.

The bulk of liquidity support to the financial sector is provided by means of main refinancing operations, with tenders held on a weekly basis with a maturity of two weeks. Longer-term refinancing operations are conducted monthly with a three- month maturity. Both the main and longer-term refinancing operations are carried out under Master Repurchase Agreements entered into by the Bank and its counterparties, whereby the movement of liquidity and the supporting collateral is reversed on maturity of the operation.

In addition to the above, the Bank also operates the two standing facilities of the Eurosystem, by means of which liquidity may be added to or absorbed from the system on an overnight basis. Institutions may borrow from the Bank through the Marginal Lending Facility, or they may lodge surplus funds through the Deposit Facility. Access to these facilities is at the initiative of counterparty MFIs with no limits on the amounts which can be borrowed (subject to provision of adequate collateral) or deposited. The terms and conditions for access to and use of the facilities are the same throughout the euro area.

All credit operations undertaken by the Bank on behalf of the Eurosystem (including Marginal Lending Facility drawings) must be secured by adequate collateral and only assets deemed eligible by the ECB can be used. The list of eligible assets is published by the ECB. When a counterparty seeks funds from the Central Bank it must give details of the collateral which will be provided. The Bank checks this information to ensure that the collateral nominated is on the list of eligible assets and that the asset does not have a maturity date during the term of the transaction.

The third instrument of monetary policy in the euro area is the requirement for credit institutions to hold minimum reserves on account with the local NCB. The Central Bank assesses for minimum reserve requirements all the credit institutions which report to it, currently 79 in total. The current minimum reserve requirement is 2 per cent. of specified liabilities in the deposits, debt securities and money- market paper categories. Compliance with the reserve requirement is determined on the basis of the institution’s average daily reserve holdings over a one-month ‘maintenance period’. Holdings of required reserves are remunerated at the average rate of the main refinancing operation over the maintenance period. Failure by an institution in Ireland to adhere to its reserve requirement in any maintenance period results in a sanctions procedure initiated by the Central Bank.

The number and type of assets eligible to be used in monetary policy operations have increased substantially under monetary union. Previously, the Central Bank only accepted Irish Government securities. Now, the range of eligible assets includes paper issued or guaranteed by central, regional and local government of all monetary union members, as well as marketable instruments issued by credit institutions and corporate entities and some non-marketable instruments. The Bank co-operated with Irish credit institutions in the development of mortgage-backed promissory notes which have been deemed eligible for use in monetary-policy

1 Monetary Policy in the Euro Area: The Role of National Central Banks by R. Mottiar.

38 operations. These securities are not themselves rated by rating agencies but the Bank monitors the rating of the issuing institution. The Bank is required to monitor the assets it holds as collateral, including daily calculation of value. If a fall in the value of an asset results in the available collateral no longer being adequate for the transaction, the counterparty involved will be required to supply additional assets to the Bank.

Eligible assets may be used on a cross-border basis within the euro area. To facilitate this, the participating central banks developed the Correspondent Central Banking Model (CCBM). Under this system, the NCBs, including the Central Bank, act as custodians for each other in respect of securities accepted in their local depository or settlement system. Thus, a bank or other counterparty in Ireland can use eligible assets deposited in another monetary union member country to obtain liquidity from the Central Bank of Ireland. In doing so it will lodge the asset in a Central Bank of Ireland account with the central bank of the euro-area member country in which the asset is located. Funds are not advanced until it is confirmed that the counterparty’s securities have been received by the correspondent central bank.

The Eurosystem applies risk control measures to the assets underlying monetary- policy operations to guard against the risk of financial loss if the assets have to be realised owing to the default of a counterparty. Some assets are acceptable as collateral because they are of particular importance for national financial markets and banking systems. In Ireland, the Central Bank has established eligibility criteria for such assets and it is also responsible for compiling the risk control measures to be applied.

In each of the monetary union members, large value payments between banks are made through a real-time gross settlement (RTGS) system. This means that transactions are settled immediately by transferring balances between settlement accounts at the central bank. Each RTGS system in the euro area is linked through a system which allows area-wide settlement in central bank money. This system is called Trans-European Automated Real-Time Gross Settlement Express Transfer, or TARGET. It enables large value payments to be settled with the same certainty and timing throughout the euro area, facilitating the integration of the money market in euro and contributing to the smooth implementation of a single monetary policy. Payments related to the monetary policy operations of the Eurosystem are required to be processed through TARGET.

TARGET is a decentralised system, with credit institutions maintaining their settlement accounts with their home central bank. Thus, domestic payments in Ireland are processed through the RTGS system operated by the Bank. Cross-border TARGET payments are processed through the Bank and exchanged on a bilateral basis with other NCBs.

39

Domestic Prices, Costs and Competitiveness

Overview The underlying inflation performance of the Irish economy has deteriorated significantly during 1999, both in absolute terms and relative to that of our main trading partners. The inflation rate, as measured by the Harmonised Index of Consumer Prices (HICP), which as recently as 1997 was the lowest in the European Union (EU) is now, at 2·8 per cent. in October 1999, the highest in the EU. This deteriorating performance has not been evident in the trend in the headline rate of consumer price inflation which has remained broadly 1 stable at about 1 ⁄2 per cent. There has, however, been a gradual deterioration in the underlying position which has been masked in the Consumer Price Index (CPI) by the temporary effect of lower mortgage interest rates. The upward drift in underlying inflation reflects a combination of domestic and external factors. Against a background of very strong domestic demand and increasing labour market pressures, underlying inflation in the sheltered non-traded sector has increased to over 6 per cent., year-on-year. The build up of domestic inflationary pressures is also evident in the continued rapid increase in residential and commercial property prices. In addition to these factors, the rise in oil prices has pushed up energy prices sharply and exchange rate weakness has put upward pressure on traded goods prices. In the final two months of 1999 and in the first quarter of 2000, the headline rate of CPI inflation is likely to rise sharply. This increase is expected because of the removal of the effect of the decline in mortgage rates at the end of 1998 and a continued deterioration in the underlying trend. This expected rise in the CPI inflation rate will not materially affect the average rate for 1999 as a whole, which is 1 now expected to average about 1 ⁄2 per cent. This slight downward revision in the forecast for average inflation in 1999, compared with 3 the figure of 1 ⁄4 per cent. published in the Autumn Bulletin, reflects the impact of more recent mortgage rate changes rather than a revision of expectations about the immediate inflation outlook. In 2000, the upward pressure on traded prices is likely to continue until about mid-year, before easing somewhat in the second half of the year, as the effect of recent exchange rate weakness fades. With little likelihood of a significant slowdown in domestic demand, however, and the prospect of an acceleration of wage increases, the upward drift in the rate of inflation in the non-traded sector is likely to continue throughout 2000. The forecast is predicated on broadly unchanged oil prices, exchange rates and interest rates. In addition, it is assumed that the Budget is broadly neutral in terms of its impact on domestic demand and no account is taken of changes in indirect taxes. Overall, 3 CPI inflation is forecast to average 2 ⁄4 per cent. for the year as a whole.

41 The weakness of the euro is likely to offset the faster rate of wage inflation in Ireland relative to our main trading partners outside the euro area in 1999. Accordingly, a marginal improvement in wage competitiveness is likely this year. The carryover effect of the recent decline in the euro, if sustained, will likewise offset some of the effect of higher wage inflation in 2000 thereby limiting any prospective loss of competitiveness. For Irish firms trading primarily within the euro zone, however, this offsetting factor will not operate.

Consumer Prices According to the latest available data, the year-on-year rate of inflation, as measured by the CPI, was 1·5 per cent. in October. This outturn was unchanged from the rate in September and close to the average rate of 1·4 per cent in the previous three quarters. The stability of the headline rate of inflation contrasts with the marked acceleration in both the CPI (excluding mortgage interest rates) and the HICP since late Summer. The year-on-year increase in the CPI excluding mortgage interest payments was relatively stable at about 2·4 per cent in the first seven months of the year but has accelerated since then to a rate of 3·2 per cent in October. The Harmonised Index of Consumer Prices (HICP), which also excludes mortgage interest rates, increased at an annual rate of 2·8 per cent. in October, compared with an average of 2·2 per cent in the first three quarters of 1999 and a low of 1·9 per cent in July last.

Chart 1: Consumer Prices 3.5

3.0

2.5

2.0

1.5

% Change, Year-on-Year Year-on-Year % Change, 1.0

0.5

0.0 Jul 99 Jul 98 Jan 99 Jan 98 Jun 99 Jun 98 Apr 99 Apr 98 Feb 99 Feb 98 Sep 99 Sep 98 Oct 99 Oct 98 Aug 99 Aug Aug 98 Aug Mar 99 Mar 98 Dec 98 Nov 98 Nov May 99 May May 98 May

Ireland: Consumer Price Index Ireland: EU Harmonised Index of Consumer Prices (HICP) EU: Monetary Union Index of Consumer Prices (MUICP)

The acceleration in underlying consumer price inflation reflects a combination of upward pressure on traded goods prices due to the persistent weakness in the value of the euro during 1999, increased energy prices due to the rise in oil prices and a marked acceleration in services sector inflation due to strong domestic demand conditions and a very tight labour market. The lagged effects of the decline in the euro to date are likely to persist for several months ahead putting upward pressure on traded prices until about mid-year 2000. Thereafter, a

42 fading of the exchange rate effect should lead to a deceleration in traded price increases in the second half of the year. The likelihood of a further acceleration in wage inflation during 2000, however, will maintain the upward pressure on services inflation throughout the year. Headline CPI inflation, therefore, is likely to continue to rise until about mid-2000 before declining slightly during the second half of the year.

Producer prices Industrial and agricultural producer price indices which reflect price trends at the factory and farm gate level are potential leading indicators of future price developments at the retail level. During 1999 there have been contrasting trends in agricultural and manufacturing output price indices. Agricultural prices have remained very weak while manufacturing output prices have risen sharply reflecting the impact of exchange rate weakness on export prices and the emergence since the second quarter of an upward trend in the price of goods sold on the home market.

Following a decline of 1 per cent. in the second quarter of this year, the seasonally adjusted index of agricultural output prices rebounded by 1·5 per cent. during the third quarter but was down by 5·5 per cent., year-on-year. Almost all sectors have recorded price falls, year-on- year, with sheep and cattle prices recording the largest annual declines. Potato prices dropped sharply by 40·6 per cent. in the third quarter and were down by 31·7 per cent., year-on-year, reflecting the return to more normal weather conditions this year in contrast to the unusually wet conditions in previous years which contributed to a sharp increase in unprocessed food prices.

The Manufacturing Output Price Index (OPI) rebounded sharply in the first three quarters of this year following a protracted period of decline during most of 1998. In the third quarter of this year, the OPI increased at a quarterly rate of 0·8 per cent. following increases of 1·3 per cent. and 0·6 per cent. in the previous two quarters. The year-on-year change in the OPI moved from -1·6 per cent. in the first quarter of the year to 1·4 per cent in the third quarter. The initial rebound in the overall OPI index in the first quarter reflected the impact of exchange rate changes on export sales. In the second and third quarters, however, about half of the overall increase was accounted for by a significant rise in the price of manufactured goods sold on the home market.

The Services Sector Services sector inflation, as measured by the services and related expenditure sub-index of the CPI, averaged 5·1 per cent. in the three months to October 1999 up from 4·3 per cent., year-on-year, in the previous three months, and 3·5 per cent., year-on-year, in the same period last year. While services sector inflation has been increasing during 1999, headline CPI inflation has remained relatively stable at close to 1·5 per cent. It is usually the case that services sector inflation is higher than average inflation due to the relatively labour intensive nature and lower productivity growth of many services and their limited exposure to international competition. The trend in this gap, however, can provide useful information regarding the contribution of domestic factors to the overall trend in inflation. The gap between services inflation and headline inflation has increased significantly to 3·6 per

43 Chart 2: Manufacturing Output Price Inflation

6 5 4 3 2 1 0 -1 -2 Year-on-Year Change % Change Year-on-Year -3 -4 -5 Jul 99 Jul 98 Jan 99 Jan 98 Jun 99 Jun 98 Apr 99 Apr 98 Feb 99 Feb 98 Sep 99 Sep 98 Oct 99 Oct 98 Aug 99 Aug Aug 98 Aug Mar 99 Mar 98 Dec 98 Nov 98 Nov May 99 May May 98 May Home Sales Export Sales Total Manufacturing

cent. in the three months to October 1999 from 0·5 per cent. in the same period last year. While much of this increase is accounted for by the effect of lower mortgage rates on the headline rate, the gap between CPI inflation, excluding mortgage interest has also risen, albeit to a lesser extent. Furthermore, the overall rate of services inflation is being restrained by falling telecommunications prices; excluding this factor, the underlying rate of inflation has accelerated to over 6 per cent. in recent months.

Chart 3: Services Sector Inflation*

5.5

5.0

4.5

4.0

3.5 Year-on-Year Change %

3.0

2.5 Jul 98 Jul 99 Jan 98 Jan 99 Jun 98 Jun 99 Apr 98 Apr 99 Feb 98 Feb 99 Sep 98 Sep 99 Oct 98 Oct 99 Aug 98 Aug 99 Mar 98 Mar 99 Dec 98 Nov 98 May 98 May 99

*services and related expenditure sub/index of the CPI.

Asset Prices With the exception of equities, asset price inflation has continued to exceed the rate of CPI inflation by a wide margin in 1999 but in some cases, notably agricultural land and house prices, the rate of increase

44 has slowed somewhat compared to the previous year. According to official Department of Environment and Local Government (DoE) data, average new house prices nationally increased by 1 per cent. during the second quarter of 1999 compared to 4·9 per cent. in the previous quarter. The year-on-year increase decelerated from 20·9 per cent. to 16·7 per cent. over the same period. The annual increase in average second-hand house prices nationally decelerated from 30·3 per cent. in the first quarter to 22·3 per cent in the second quarter of 1999. On a quarterly basis, the rate of price increase accelerated from 3·6 per cent. to 3·9 per cent. over the same period. While the rate of increase is slowing somewhat, the fact remains that absolute increases in house prices continue to be substantial.

Agricultural land prices increased by 6·7 per cent. during the second quarter of 1999 and were 9·7 per cent. higher, year-on-year, according to CSO data. This rate of increase represents a deceleration when compared with the first quarter of 1999 and the second quarter of last year when the year-on-year rates of increase were 15 per cent. and 22·6 per cent., respectively.

Chart 4: Fixed Asset Values

45

40

35

30

25

20

15 % Change Year-on-Year 10

5

0

Q4 1997 Q1 1998 Q2 1998 Q3 1998 Q4 1998 Q1 1999 Q2 1999 Q3 1999

Agricultural Land Commercial: Jones Lang Lasalle Index of Capital Values New Houses

The latest available data on price trends in the commercial property market provide little evidence of a slowdown. The highest rates of increase were in the office sector where an acute shortage of available space is reflected in an historically low vacancy rate of under 2 per cent. The Jones Lang LaSalle (JLL) index of capital values in the office sector increased by 31·5 per cent, year-on-year, in September 1999, down slightly from an annual rate of 32·6 per cent., in the previous June. In the retail sector, the annual rate of increase in capital values slowed to 18 per cent. in September from 25·5 per cent. in June. Over the same period industrial sector capital values accelerated from a 16·6 per cent. year-on-year increase to 17 per cent. The JLL rental value indices for commercial property point to an acceleration in office rents from 21·3 per cent., year-on-year, in June to 22·6 per cent., year-on- year, in September. Over the same period the annual rate of increase

45 in retail rental values slowed to 9·6 per cent. from 10·6 per cent. while rent inflation in the industrial sector slowed from 6·4 per cent. to 6·2 per cent. Turning to financial assets, the Irish Stock Exchange Index (ISEQ) has under-performed relative to international trends since the beginning of this year. The average value of the ISEQ in October last was 10 per cent lower than its average in January 1999 but was 14·5 per cent. higher, year-on-year. The Dow Jones index was up by over 27·3 per cent., year-on-year, in October and the FTSE and GDAX indices increased by 19·9 per cent. and 22·5 per cent., respectively over the same period. In general, Irish bond yields moved in line with those in Germany in the year to October 1999 with ten year differentials with respect to Germany averaging about 0·21 percentage points. A more detailed analysis of the bond market is contained in the previous chapter.

Chart 5: Irish and International Share Price Indices

120

115

110

105

100

95

90 Base: Jan. 1999=100

85

80

75 Jul 99 Jan 99 Jun 99 Apr 99 Feb 99 Sep 99 Oct 98 Oct 99 Aug 99 Mar 99 Dec 98 Nov 98 May 99

FTSE-100 Dow Jones Industrial Frankfurt DAX ISEQ

Pay 1 Earnings per capita in the non-agricultural sector rose by 5 ⁄2 per cent. in 1998. The further tightening of labour market conditions which occurred this year is likely to have put additional upward pressure on wages. Available data, although quite limited, are consistent with this analysis. In the financial sector, for example, weekly earnings in the first half of the year were 5·5 per cent. higher than in the same period of 1998. This compares to an increase of 3·7 per cent. for 1998 as a whole. In the manufacturing sector, hourly earnings in the first quarter of 1999 were 5·5 per cent. higher, year-on-year. The public sector pay bill is estimated to have risen by about 6·1 per cent. in 1999 reflecting a somewhat lower increase in per capita earnings and a small rise in numbers employed. In overall terms, earnings per capita in the non- agricultural sector are estimated to have risen by about 6 per cent. this 1 year. With non-agricultural employment rising by around 5 ⁄2 per cent., 3 the non-agricultural pay bill is estimated to have risen by around 11 ⁄4 per cent. this year.

46 Chart 6: Hourly Earnings in Manufacturing

7

6

5

4

3

% Change Year-on-Year % Change 2

1

0

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999f 2000f

Ireland Major Trading Partners

As mentioned above, conditions in the labour market have tightened considerably in recent years, with shortages of labour evident in almost all sectors. With another year of strong employment growth in prospect for 2000, the imbalance between the supply of, and the demand for, labour is set to intensify next year. In these circumstances, it is likely that there will be further upward pressure on private sector wages. In regard to public sector pay, the Abridged Estimates provide for an increase in the Exchequer pay and pensions bill of 9 per cent. next year. In this general environment, growth in earnings per capita in the 1 non-agricultural sector is forecast to accelerate to about 6 ⁄2 per cent. next year. With employment in the non-agricultural sector forecast to rise by around 4 per cent., the non-agricultural pay bill is expected to rise by about 11 per cent. next year.

Competitiveness Hourly earnings in manufacturing in Ireland have risen at a higher rate than in our major trading partners this year. The weakness of the effective exchange rate, however, is expected to have offset these adverse pay developments, vis-a`-vis our trading partners outside the euro area, so that in common currency terms, some marginal improvement in cost competitiveness is estimated to have taken place at least in the short term. In addition, productivity growth in the Irish manufacturing sector once again exceeded that of our major trading partners, resulting in a decline in relative unit wage costs and a consequent improvement in competitiveness. As has been the case in recent years, however, these productivity increases were largely attributable to the mainly foreign-owned high-technology sectors. Elsewhere in the manufacturing sector, productivity gains have been much lower.

47 Chart 7: Irish Hourly Earnings and Unit Wage Costs relative to Main Trading Partners (in Common Currency)

105

100

95

90

85

80

75

Base: 1990=100 Base: 70

65

60

55

50

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999f 2000f

Relative Hourly Earnings Relative Unit Wage Costs

Looking towards next year, the growth of manufacturing earnings in Ireland is once again expected to exceed that of our major trading partners. The current value of the euro relative to sterling, if sustained, will act as a short-term buffer for those indigenous firms trading with the UK. For those sectors of industry trading mainly in the euro area, adverse cost developments and accelerating wage inflation will, unless offset by superior productivity performance, impinge on the competitiveness of Irish industry, with implications for the rate of employment creation.

Summary In summary, the underlying inflation outturn since the publication of the Autumn Bulletin was in line with expectations although the headline rate was lower due to the recent decline in mortgage rates. The forecast for average inflation in 1999 has, accordingly, been 1 revised down slightly to 1 ⁄2 per cent. In the coming months the headline rate of inflation will converge on the underlying trend as the effect of mortgage rate reductions fall out of the index. In the first half of 2000, CPI inflation is likely to rise markedly reflecting the combination of base effects from previous mortgage rate reductions, the pass-through to retail prices of exchange rate weakness in 1999, higher energy prices and the continued upward drift in non-traded inflation. Some easing of traded goods inflation is likely in the second half of the year as the exchange rate effect fades, but non-traded inflation is likely to continue its upward drift. Accordingly, overall inflation may ease back slightly in the second half of the year but will remain above the rate prevailing for most of 1999. For 2000 as a 3 whole, CPI inflation is forecast to average at least 2 ⁄4 per cent.

48 An Timpeallacht Gheilleagrach

Le blianta beaga anuas, ta´ an fa´s geilleagrach la´idir eisceachtu´il tar e´is leanu´int ar aghaidh. Tha´inig ra´ta fa´is, measu´naithe ag 7 faoin gce´ad, i 1999 tar e´is tre´imhse me´aduithe fa´is ar an mea´n de thimpeall 8 faoin gce´ad in aghaidh na bliana sna cu´ig bliana roimhe sin.

Se´ an du´shla´n ata´ roimh an polasaı´ geilleagrach anois na´ ´ısliu´ beaga´n ar bheaga´n san fha´s geilleagrach a bhainistiu´ agus a e´ascu´ chuig ra´ta ata´ i gcomhre´ir le fe´idearthacht mhea´n-te´armach sa ra´ta fa´is i ngeilleagar na tı´re chun bonn a chur faoi sprioc chobhsaı´ocht praghasanna. Ta´ ana-chuid samplaı´ro´-the´ite sa gheilleagar — ma´ fha´gtar gan smacht iad — a bhainfeadh o´n ndo´chas do fha´s seasmhach leanu´nach.

O´ tharla go bhfuil inne´acs praghasanna do thomhalto´irı´ (CPI) ag le´iriu´ fa´is bliantu´il de thimpeall 1.5 faoin gce´ad le tamaillı´n, ionchorpraı´onn se´ seo toradh sealadach na nı´slithe mo´ra i ra´ta u´is mhorga´istı´ a tharla le linn teacht isteach an airgeadra aonair ag deireadh na bliana seo caite.

Samplaı´ eile de bhru´nna sa gheilleagar na´ praghasanna tithı´ochta agus fadhbanna bru´ite a d’eascair o´ne´ileamh ar bhonneagair de chuile so´rt. Tugann tuilleadh ra´ta fa´is sciobtha san e´ileamh intı´re chun cumas an gheilleagair earraı´ agus seirbhı´sı´ a chur ar fa´il le´argas ar an athru´ o´ bharrachas i gcomhardu´ na nı´ocaı´ochtaı´ chuig easnamh don che´ad uair le blianta fada.

Le´irı´onn an staid sa gheilleagar na´isiu´nta an ga´ ata´ le srianadh sa treo ina bhfuil polasaı´ maicreacnamaı´ochta ag dul, go ha´irithe lena chinntiu´ nach gcuirfidh se´ chun cinn timpeallacht ina mbeidh arduithe pa´ ro´- iomarcach.

Cuireann na cu´insı´ seo an-bhe´im ar an nga´ ata´ ann le srianadh fioscach sa timpeallacht reatha in toscaı´ buacach geilleagrach. Ardaı´onn fairsingiu´ polasaı´ fioscach do´chu´lacht ro´-the´ite a chuirfeadh tu´slehı´sliu´ san fha´s.

Le´irı´onn re´amh-mheasu´nu´ an Bhuise´id deireannach agus Phlean Forbartha Na´isiu´nta go bhfuil spreagadh mo´r fairsingithe tugtha ag am mı´-oiriu´nach. Ardaı´onn se´ seo riosca farasbairr i leith forbairtı´ pa´, boilscu´, praghasanna tithı´ochta agus comhardu´ na nı´ocaı´ochtaı´.

Ta´ an claonadh ann go niompo´idh cinneadh i leith caiteachais phoiblı´ agus ca´nach ina gceangaltais bhuan nach fe´idir a chealu´ go he´asca. Maolaı´onn se´ seo an sco´ip do pholasaithe fioscacha roghnacha amach anseo chun maothu´ a dhe´anamh ar thoradh aon suaitheadh dochrach geilleagraigh.

49 Ta´thar ag su´il go mbeithfear i nda´n seasamh fairsingithe an polasaı´ fioscaigh a mhaolu´ le he´abhlo´id fheiliu´nach i bpa´ agus tuarastail, ag glacadh, san am ce´anna, leis na hı´slithe mo´ra ca´nacha ata´thar tar e´is a fho´gairt. Bainfidh e´ileamh iomarcach, cioca poiblı´ no´ prı´obha´ideach, faoi fha´s seasmhach agus le´anu´nach a ghno´thu´.

50 Statement by Governor, Central Bank of Ireland, to Oireachtas Committee on Finance and the Public Service 13 October 1999

Chairman,

In July 1998 your Committee completed a report on the Regulation and Supervision of Financial Institutions. This was laid before the Houses of the Oireachtas. Subsequently, the Government decided in principle to establish a Single Regulatory Authority for all financial services.

In the context of the preparation of your report last year you visited a number of countries in Europe to study arrangements at first hand. Across the European Union there is a great diversity of arrangements. It is the exception to the rule to combine within one organisation the functions of prudential supervision and consumer affairs. The UK have set up a single regulatory authority, outside the Bank of England; it is much too early to pass judgement on this but there have been very serious transition problems. The UK may not be a good precedent for our situation because of the huge difference of scale. In eight out of eleven of the euro member States the Central Bank is the prudential regulator for credit institutions. There is a broad expectation that the European Central Bank may have some co-ordinating role in this area in due course. I would only be engaging in speculation if I went further than this.

Worldwide, there are likely to be considerable changes ahead. There is a general realisation that the current rules may be inadequate because of the rapid expansion of the financial markets and the need for greater attention to risk factors. The big issues being addressed include capital adequacy, cross border mergers, internet banking, electronic money and money laundering.

The debate on the Single Regulatory Authority has up to now been driven essentially by concern for the consumer. This is entirely understandable but it must not blind us to the fact that prudential supervision is also most important. It may be forgotten that prudential supervision is the first line of defence for the consumer. Its first duty is to the depositor, who is also a consumer. The Central Bank has been berated for failing to pursue other consumer issues. The reality is that up to now we have no authority to do this. We are criticised over bank charges, retail interest rates, disputes with customers. This is not our area. I am not being defensive. I am just stating the facts as they are.

51 There is a gap in the system. In a submission to the McDowell Group the Central Bank outlined how a consumer protection activity might be structured and operated. To my knowledge, the Bank is the only organisation that has addressed this subject in detail.

Consumer regulation is high profile. This high profile sometimes leads to unreasonable expectations. The essence of consumer regulation centres round access to information, standards of transparency and the right of appeal. It does not extend to taxation. The key factor is the right of the consumer to be properly informed at all times. Thereafter, the consumer should be responsible for his or her own commercial decisions. The old principle of caveat emptor applies. This is not just a responsibility; it is a right and it would be an insult to the intelligence of the consumer to seek to change this. The consumer has the right of choice and the right to make mistakes. There is a balance here and we need to get it right.

It is difficult to explain in layman’s terms what precisely prudential regulation is all about. In short, it aims to protect depositors and secure the stability of the financial system. It focuses on risk in particular. It must achieve a balance between intervention and interference. When it succeeds there is no visible and measurable result. No system can guarantee 100 per cent success because it is so difficult to detect an individual or institution determined to break the law. Ultimately supervision requires co-operation from the institution being supervised.

The Central Bank has no role in relation to the tax affairs of clients of financial institutions. We have no means whatever of establishing the tax status of a client. We have no communication with the Office of the Revenue Commissioners. This is the law, as it now stands, and I hope I am right in believing that this is no longer an issue of dispute.

Our track record on prudential supervision is very good. The last bank failures in this country were some twenty years ago and were relatively small. This contrasts with the picture in so many European countries, in the US and in Japan where rescue operations have had to be undertaken at great cost to the taxpayer. The AIB/ICI crisis in 1985 was an insurance failure, not a bank failure.

Over the years, our banking system has gone from strength to strength and has extended overseas more and more. This development is of benefit to all of us. Our banking industry, and indeed our financial industry in general, is facing a period of unprecedented change and challenge. The latest manifestation of this has been the arrival of the Bank of Scotland into the Irish mortgage market. Of more significance perhaps in the longer term is the reality that, if our industry is to expand further, it must do so for the most part overseas. You and I have an interest in asking what will the position of the industry be in 5-10 years from now. I want to see a strong, vibrant and indigenous Irish banking industry in the longer term. I want to see Irish banks survive and retain an Irish identity. I would be most disappointed if the Irish names had disappeared. Part of the strategy for survival and expansion must be a good regulatory system that carries credibility at home and abroad.

52 In recent years, the Central Bank has been assigned additional supervisory responsibilities, including the Stock Exchange and investment intermediaries. We have never hesitated to take on extra work. We have set up controls and inspections where none existed before. This embraces most activities, with the exception of insurance, in the International Financial Services Centre. There is total agreement that good regulation is vital to the continuing success of the Centre. Ask the leading practitioners who are there, if there is any doubt about this. Ask them why they have such confidence in the Central Bank and why it means so much to them that the Bank should continue as regulator. It is common knowledge that they are quite disturbed at the prospect that the Bank might not be the regulator in future. I admit that this kind of regulation may be far removed from the standard problems of consumer protection. It is essentially about measurement of risk. Many of the activities in the Centre are at the forefront of financial technology. The regulator must be an expert; he or she must be on top of the job.

If we wanted new structures to deal with regulation of the IFSC, we had better be very sure of our ground, before we throw away a system that, by common consent, is working very well.

The Central Bank is bound by strict rules of confidentiality that are not of our making. We may not reveal information about individual companies or individuals in the normal work. These rules are international, they are enshrined in European law and in Irish law. If we breach them, we are liable to severe penalties. The reasoning behind this confidentiality is that regulators worldwide share information and suspicions. This sharing would simply break down if information were available to third parties. It is vital to good regulation because the financial industry is so mobile internationally. I can assure you that more than once I have wished that there could be a public profile on the work that we do so as to demonstrate the importance of prudential regulation.

The Central Bank has a duty to be satisfied that management of financial institutions are people of integrity and observe proper ethical standards at all times. I am disappointed at the failing in standards unearthed by the revelations in regard to DIRT tax abuses. There are lessons here for the Central Bank as well as others and I readily acknowledge this. In fairness, it should be acknowledged that in recent years the culture has changed. I believe that, across the financial sector generally, there is now a genuine intention to be compliant.

The debate on regulation has continued on for more than a year. I trust that it can be concluded reasonably soon so that we can begin to put in place whatever changes are decreed. Uncertainty is in nobody’s interest. Because of the extended delay, there is now a problem of uncertainty in the Central Bank. We find it increasingly difficult to recruit experienced personnel because we can give no assurances about the future. This situation should not be allowed to continue. If it does, damage will be done to the fabric of regulation.

A decision in principle has been made to establish a Single Regulatory Authority that embraces all financial activities. If this decision is to be

53 implemented, I contend that this authority is best located within the Central Bank framework. We have already set out in submissions to the McDowell Group how this might be organised, giving due weighting to the prudential and consumer responsibilities. We would of course be open to other variations provided they fitted into a workable organisation. We have already demonstrated our readiness to assume extra responsibilities. We are ready now to go further.

54 Section 2

The articles in this Section are in the series of signed articles on monetary and general economic topics introduced in the Autumn 1969 issue of the Bank’s Bulletin. The views expressed in these articles are not necessarily those held by the Bank and are the personal responsibility of the authors.

Monetary Policy in the Euro Area: The Role of National Central Banks by Rafique Mottiar1

1. Introduction On 1 January 1999 the Eurosystem2 — comprising the European Central Bank (ECB) and national central banks (NCBs) of the EU Member States which adopted the euro — assumed the task of formulating and implementing the single monetary policy for the euro area. The new system redefined the roles of NCBs. NCBs no longer have exclusive responsibility for the conduct of monetary policy; rather, through a complex institutional arrangement, NCBs, as integral parts of the Eurosystem, share this role with the ECB for the euro area. Part 1 of this paper describes the institutional structure of the Eurosystem. Part 2 focuses on how the NCBs are involved in the decision-making process on the formulation of monetary policy. Part 3 discusses the implementation of monetary policy in the euro area (conducted primarily through the NCBs). Some conclusions are offered in Part 4.

Part 1: Institutional Structure of the Eurosystem Institutional Framework The institutional framework of the ECB and the European System of Central Banks (ESCB) is defined by the Treaty establishing the European Community (the ‘‘Treaty’’) and the Statute of the ESCB and the ECB (‘‘Statute’’). The ESCB is composed of the ECB and the NCBs of all 15 EU Member States. Since not all members joined monetary union from the outset, the term Eurosystem was adopted to describe the ECB and the NCBs of the 11 Member States which have adopted the euro. If and when all EU Member States participate in the euro area, the term ‘‘Eurosystem’’ will become a synonym for the ESCB. It should be noted that, unlike the ECB and the NCBs, neither the ESCB nor the Eurosystem has a legal personality or is a decision-making body. Within the Eurosystem, the ECB ensures that the tasks conferred by the Treaty on the Eurosystem are implemented, either by its own activities or through the NCBs. All decisions relating to the Eurosystem are taken

1 The author is Senior Economist in Monetary Policy & Statistics Department. This is an edited version of a paper delivered at the Annual Economic Conference in Kenmare (October 1999) organised by the Dublin Economics Workshop. I wish to thank my colleagues, Pa´draig McGowan, Joe Doherty, Gabriel Fagan, Paul McBride and Nick Vidalis, for helpful comments and suggestions. The views contained in this paper are not intended to represent those of the Central Bank of Ireland or the Eurosystem. 2 The Treaty establishing the European Community and the Statute of the European System of Central Banks and of the European Central Bank confer several tasks upon the European System of Central Banks (ESCB) which have to be carried out by the ECB and NCBs. To enhance transparency and enable the public to understand the complex structure of central banking in the euro area, the Governing Council of the ECB decided to adopt the term Eurosystem.

57 by the decision-making bodies of the ECB, i.e., the Governing Council and the Executive Board of the ECB.3

The Governing Council comprises the members of the Executive Board and the Governors of the NCBs participating in the euro area. It is the primary decision-making body of the ECB. Competent authorities of their respective Member States appoint the Governors of NCBs. In their capacity as members of the Governing Council of the ECB, the Governors act in a personal capacity and not as national representatives. In Ireland under Section 4 of the Central Bank Act, 1998 ‘‘sole authority and responsibility for the performance of any function or duty of the exercise of power conferred or imposed upon the Bank by or under the Treaty or the Statute shall be vested in the Governor’’.

According to Article 12(1) of the Statute, the Governing Council: • adopts the guidelines4 and takes the decisions necessary to ensure the performance of the tasks of the Eurosystem; and • formulates the monetary policy of the euro area, . . . and shall establish the necessary guidelines for their implementation.5

The Executive Board comprises the President and the Vice-President of the ECB and four other members.6 It implements monetary policy in accordance with the guidelines and decisions laid down by the Governing Council. In doing so, the Executive Board gives the necessary instructions to national central banks. In addition, it executes certain powers delegated to it by the Governing Council, including those of a regulatory nature. It is also responsible for the current business of the ECB. An important function of the Executive Board is the preparation of the meetings of the Governing Council.

The NCBs form an integral part of the Eurosystem and act in accordance with the guidelines and instructions of the ECB. The Treaty and the Statute weave a complex institutional structure to combine the creation of a central authority, the ECB, with a prominent role for the NCBs. The Governing Council is the premier decision-making body and as already noted, formulates monetary policy. The Executive Board

3 It should be noted that the third decision-making body of the ESCB is the General Council which comprises the President and the Vice-President of the ECB and the Governors of the NCBs of all EU Member States. It is a transitory body, which exists as long as not all EU Member States participate in the euro area. Among others, it has taken over those tasks of the former European Monetary Institute (EMI) which, because of the derogations of some Member States, still have to be performed. It has no role in the formulation and implementation of monetary policy in the euro area. 4 The Treaty assigns to the ECB powers to adopt any legal acts that are necessary to fulfil the tasks assigned to the Eurosystem. There are two kinds of ECB legislation: the first relates to third parties and the second relates to the internal arrangements of the ESCB. Given the unique structure of the Eurosystem in which each of the constituent bodies retains its own legal personality, the internal legal instruments (ECB Guidelines and Instructions) have been designed for the efficient functioning of the Eurosystem (see ECB Monthly Bulletin, November 1999). 5 In addition, the Governing Council is responsible for the following: deciding on the use of other operational methods of monetary control; adopting the regulation concerning the calculation and determination of the required minimum reserves; adopting regulations to ensure efficient and sound clearing and payments systems; issuing guidelines for operations of NCBs and the Member States with remaining foreign reserve assets; fulfilling the necessary steps to ensure compliance with ECB Guidelines; authorising the issuance of euro banknotes and the volume of issue of euro coins; and collecting statistical information necessary for the fulfilment of tasks assigned to the Eurosystem. For a full list of tasks of the Governing Council see ECB Monthly Bulletin, July 1999. 6 Currently these members have been appointed from Finland, Germany, Italy, Spain, France and the Netherlands. There is no formal procedure determining the rotation of nationalities.

58 ensures that monetary policy is implemented according to the decisions of the Governing Council. In doing so it gives instructions to the NCBs. This hierarchical structure is, however, attenuated by the fact that the Governing Council includes the Governors of the NCBs. This welds together rather neatly the new ECB with the NCBs. In addition, Article 12·1 of the Statute provides operational meaning to the principle of subsidiarity by stating that: ‘‘to the extent deemed possible and appropriate and without prejudice to the provision of this Article, the ECB shall have recourse to national central banks to carry out operations which form part of the tasks of the ESCB’’.

In taking its decisions on whether tasks are to be carried out on a centralised or decentralised basis, the ECB adheres to the principle of decentralisation in line with Article 12·1 of the Statute. If the Governing Council feels that a particular task can be carried out more effectively through centralised procedures, it has the power to arrange that this be done. It is generally accepted that the NCBs act as the operative arms of the Eurosystem, carrying out the tasks conferred upon the Eurosystem in accordance with the guidelines established by the ECB (see Part 3).

The Committee Structures — Links between the ECB and the NCBs The Treaty and the Statute provide for the legal framework of the Eurosystem. The Governing Council, to further meld the components of the Eurosystem established 13 ESCB committees to assist in the performance of the Eurosystem’s tasks. These committees are composed of experts from NCBs and the ECB and they play an important role in the performance of the ESCB’s tasks and in intra- ESCB cooperation. As a rule each of the committees is chaired by a representative of the ECB. The committee structure was found extremely useful under the Committee of Governors and the EMI. These committees did much of the preparation for EMU in Stage Two of EMU which preceded monetary union. The Governing Council lays down the mandates of the ESCB committees which, apart from the Budget Committee, report to the Governing Council via the Executive Board. There are 13 committees with a significant number of additional Task Forces and Workshops.

Through these committees, NCBs’ representatives assist in the work of the ESCB. These representatives provide expertise in their fields of competence and facilitate the decision-making process of the ESCB/ECB. They also play an important consultative role on issues arising before the Governing Council. In some cases, the mandates of the committees require them to provide regular reports to the Council. In addition, the Governing Council may request the opinions of committees on issues facing the Eurosystem (see section on Role of the Governing Council in Part 2). The workload for NCBs has increased substantially as a result of the mandated tasks of these committees. Most of them meet regularly, some on a monthly basis. The Monetary Policy and the Markets Operations Committees7 are directly involved in assisting the Eurosystem in the conduct of monetary policy.

7 The other Committees are the following: International Relations; Accounting and Monetary Income; Banking Supervision; Banknote; Budget; External Communications; Information Technology; Internal Auditors; Legal; Payments and Settlements Systems; and Statistics.

59 Chart 1 provides a graphic description of the institutional links of the Eurosystem. It can be seen that there is a significant amount of communication between the various strands of the system. While the institutional arrangements may appear complicated, it is a highly professional and effective undertaking.

Chart 1

ECB Governing Council

NCB Governors ECB Executive Board

Committees

NCB Staff ECB Staff

Operational Working Task Ad Hoc Working Framework Groups Forces Groups

Credit Institutions

Part 2: Formulation of Monetary Policy Objective The primary objective of the ESCB is to maintain price stability.8 Without prejudice to this objective, the ESCB ‘‘shall support the general economic policies in the community and act in accordance with the principle of an open-market economy’’ (Article 105 of the Treaty on European Union and Article 2 of the Statute of the ESCB and ECB).

Monetary Policy Strategy The Eurosystem is solely responsible for the euro area’s single monetary policy and pursues the goal of price stability on the basis of independence from political pressure from EU institutions, interest groups or individuals (Article 107 of Treaty). In October 1998 the ECB announced the Eurosystem’s stability-oriented monetary-policy strategy9 and endorsed it on 2 December 1999 to guide its policy

8 See ECB Monthly Bulletin, January 1999. 9 See ECB Press Release, 13 October 1998.

60 decisions, which consists of three main elements: a quantitative definition of price stability and ‘‘two pillars’’ used to achieve this objective.

The first pillar is a prominent role for money, as signalled by the announcement of a quantitative reference value for the growth rate of a broad monetary aggregate (M3). When devising its strategy, the Eurosystem took into account the fact that the relationship between money and prices might be affected, in the short term, by the structural changes and behavioural and statistical uncertainties associated with the regime shift to Economic and Monetary Union. The reference value for M3 growth (which is currently 4·5 per cent. per annum) is not a monetary target in that deviations do not automatically lead to a policy response.

The second is a broadly-based assessment of the outlook for price developments and the risks to price stability in the euro area as a whole. This assessment is made using a wide range of indicators including developments in wages, the exchange rate, bond prices and the yield curve. This information is combined to form an overall view of the outlook for prices as input into the formulation of the appropriate monetary-policy stance. The economic and financial situation is continuously updated as new information becomes available. The information given to the Governing Council is regularly reviewed in the ECB Monthly Bulletin. It should be noted that while the exchange rate plays an important role since it can have an impact on consumer prices, the strategy eschews mechanistic reactions to exchange-rate movements. The monitoring and analysis of a wide range of economic indicators helps to identify the forces which determine the overall price climate and distinguish between temporary and underlying factors.

Price stability is defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2 per cent. Price stability thus defined ‘‘is to be maintained over the medium term’’ thereby imparting a forward-looking orientation to the strategy. The phrase ‘‘below 2 per cent.’’ delineates the upper bound for the rate of measured inflation in the HICP, which is consistent with price stability. It should be noted that the word ‘‘increase’’ in the definition signals that deflation, i.e., prolonged declines in the level of the HICP would not be deemed consistent with price stability. This quantitative definition of price stability is not an inflation target. The strategy does not rely on a single monetary policy indicator or intermediate target.

Role of the Governing Council According to the Treaty and Statute, the Governing Council formulates monetary policy in the euro area. As members of the Governing Council, meeting on a fortnightly basis, Governors of NCBs play a crucial role in decisions relating to monetary policy for the euro area. Governors participate as individuals, and not as representatives of their NCBs, in the Governing Council. Governors may not be subject to any instructions (Article 107). All members of the Governing Council are required to act on the basis of the best interests of the euro area as a whole. This supranational responsibility is underlined by voting rules of

61 the Council whereby each member has one vote.10 The Statute provides that the Council acts with a simple majority of votes on major policy issues.11 In practice a vote may not be taken. For example, at the Press Conference on 7 October 1999, President Duisenburg indicated that the Governing Council did not take a vote in deciding not to change interest rates on that occasion.

Although Governors are appointed in their personal capacities to the Governing Council, they are all still the chairpersons of the NCBs. In the performance of their duties on the Governing Council, Governors use the expertise residing in their NCBs in the formulation of monetary policy. They take advice, but not instructions, with the result that the NCBs perform an important advisory role within the Eurosystem. NCBs have a substantial legacy of experience in the formulation and implementation of monetary policy. Involvement of NCBs means that this shared knowledge is not lost. In the Central Bank of Ireland the Governor is advised and provided with a full brief on all the issues arising at Governing Council meetings and is accompanied by the Director General of the Bank at the Governing Council meetings.

NCBs’ involvement in the formulation of monetary policy spans a number of areas. The first, as noted above, is the provision of advice and briefing material to Governors by the staff of NCBs along the lines of the regional Federal Reserve Banks in the US. Given that monetary policy discussions at Governing Council meetings focus on the euro area, NCBs brief their Governors with information and analysis regarding developments in the euro area, including individual Member States, against the backdrop of the world economic outlook. This can only be achieved through detailed ongoing analysis of economic developments and policy issues in euro area countries which supplements the analysis prepared by the ECB. The provision of policy analysis by NCBs strengthens the Eurosystem.12 NCBs have a deep understanding of their own economies and how they are affected by developments both in other euro area countries and internationally. While the formation of the euro area may give rise to changes in economic behaviour, the properties of which may not yet be fully understood, and given the difficulties with euro-area data, it is essential that NCBs’ knowledge and experience is brought into the decision- making process.13 On occasion there may be different views but this diversity can stimulate deeper analysis of the issues facing the Eurosystem as a whole.

A second aspect of the role of NCBs relates to the focus of policy- making within NCBs, which has had to change with the onset of monetary union. In the past these functions related primarily to their own countries. Policy issues were addressed to the Boards of Directors of the NCBs for consideration and decision on both the strategy and implementation of monetary policy. Other issues included macroeconomic and inflation forecasts, assessment of the public

10 See Tietmeyer, (1999). 11 The fact that Governors of the NCBs could theoretically outvote the Executive Board has been discussed by a number of authors. See Buiter, Von Hagen, Begg, et al. and Honohan. Much of this discussion is based on the experience of the US Federal Reserve Bank where the role of regional Feds is limited. This analysis does not appear to take account of the fact that the euro area is not a single or united political entity. 12 See Marvin Goodfriend, (1999). 13 See Ignazio Angeloni, (1999).

62 finances, labour market issues and developments in banking. None of these issues can be ignored. Rather, they now arise in the euro-area- wide context. These are now discussed, usually in the first instance, at the various ESCB Committees, with a view to achieving an agreed position. For example, many of the issues noted above are part of the mandate of the Monetary Policy Committee. NCBs are involved in constructing national macroeconomic models for the purpose of assisting in the formulation of monetary policy, macroeconomic and inflation forecasts, examining fiscal policy issues including the Stability and Growth Pact, and labour market issues including wage-price interactions, structural and cyclical developments. These are coordinated by working groups of the Eurosystem and reported to the Monetary Policy Committee. The working groups and the Monetary Policy Committee also provide an input into euro-wide analysis prepared by the ECB. Other issues that require ongoing investigation include conceptual and theoretical issues of a longer-term nature. For example, the issue of the regional transmission mechanism of monetary policy across the Union14 is important and requires detailed analysis including econometric work. In addition, analysis on the demand for money and the integration of the euro-area market are important subjects which need to be kept under review.

A third area relates to the issue of generating support among the general public for the objectives and policies of the Eurosystem. Given the diversity of the legal, linguistic and cultural systems of the 11 Member States, the NCBs have a comparative advantage in explaining the Eurosystem’s monetary-policy stance to the public of the Member States of the euro area.

Over time NCBs may choose to specialise in certain specific fields. This could relate either to specific research areas or to operational issues.15 In the US Federal System, the research programme of regional Feds tends to specialise in areas relating to their regions. For example, the New York Fed follows financial market developments while the Chicago Fed monitors commodity markets.

Part 3: Monetary Policy Implementation NCBs carry out the operational tasks of the Eurosystem. In this regard, NCBs have a long experience in dealing with counterparties (banks and other credit institutions) and knowledge of their financial systems and legal frameworks. As a result of this, decentralisation of operations allows the Eurosystem to take full advantage of this knowledge. It is also an advantage to credit institutions: they can continue to deal with the NCB with which they have been associated. In addition, a huge administrative structure would have been necessary at the centre to manage the reserve requirement system of about 8,000 credit institutions in the euro area. While refinancing operations would apply to a smaller number of credit institutions, it would still have led to a significant administrative structure at the centre.

14 See Cechetti, (1999). 15 For example, the Governor of the Belgian Central Bank has stated that the Belgians could have a comparative advantage in providing a service in big value payments. See Quaden, (1999).

63 Chart 2

European Central Bank •Formulation of Monetary Policy •Choice of Instruments •Operational Decisions

Central Bank of Ireland Other NCBs •Implementation of •Implementation of monetary policy Cross Border monetary policy •Liduidity forecasts •Liduidity forecasts •Calculation of minimum •Calculation of minimum reserves Collateral reserves •Banks' reserve balances •Banks' reserve balances Sanctions regime Sanctions regime

a RTGSa TARGET b RTGS

a. Real Time Gross Settlement System. b. Trans-European Automated Real-Time Gross Settlement Express Transfer.

NCBs play an important role in all these issues and the main tasks are shown in broad terms in Chart 2. These monetary-policy operations are carried out on uniform terms and conditions in all Member States.

The Eurosystem has at its disposal a set of monetary-policy instruments to achieve its objectives. It conducts open-market operations, offers standing facilities and requires banks and other credit institutions to hold minimum reserves on accounts with the Eurosystem16 (see Chart 3). The design of monetary instruments and procedures reflects the requirement that the implementation of monetary policy be decentralised. The Markets Operations Committee assists in fulfilling the tasks related to the implementation of a single monetary policy.

Open-Market Operations The main refinancing operations (MRO) play a pivotal role in pursuing the aims of steering interest rates, managing financial system liquidity, and signalling the stance of monetary policy. These liquidity-providing operations provide the bulk of refinancing to the financial sector and are executed weekly through standard tenders, with a maturity of two weeks, according to a predetermined, published calendar. The current interest rate, (announced on 4 November 1999) on the main refinancing operations of the Eurosystem is 3 per cent. All credit institutions fulfilling the general eligibility criteria may submit bids.

16 See Central Bank of Ireland Documentation on Monetary Policy Instruments and Procedures (1998), and the ECB Document Single Monetary Policy in Stage Three, (September 1998).

64 Chart 3: Monetary Policy Operations

Monetary Policy Operations Liquidity Impact Maturity Frequency

Provision Absorption of liquidity of liquidity

Open-Market Operations Main refinancing operations X Two Weeks Weekly

Longer term refinancing operations X Three Months Monthly Fine-tuning operations: • Reverse operations X Not standardised Non-regular • Foreign-exchange swaps X X Not standardised Non-regular • Outright transactions X X Not standardised Non-regular • Collection of deposits X Not standardised Non-regular

Structural Operations: • Reverse operations X Not standardised Non-regular • Outright transactions XX iStandardised/ Regular/ • Issuance of debt y non-standardised Non-regular certificates X t

Standing Facilities 1. Marginal lending facility X Overnight Access at 2. Deposit facility X Overnight discretion of counterparties and automatic

Reserve Requirements Maintenance period One month Reserve base End of calendar month balance sheet data on liabilities Lag One month or less Averaging Yes Carryover Not permitted Remuneration At average of main refinancing operation Eligible assets Banks’ and credit institutions’ balances with NCBs Penalty for non-compliance Yes

Longer-term refinancing operations are executed monthly, with a maturity of three months. These provide additional longer-term liquidity to the financial sector; they encompass only a limited portion of the liquidity provided by the Eurosystem, thus emphasising the role of weekly tenders as the main instrument in liquidity management. The intention is that developments in these longer-term refinancing operations should not send a signal to the market about the policy stance, so the Eurosystem normally acts as a price-taker in these monthly refinancing tenders (i.e., these operations are usually executed as variable interest-rate tenders). Eligibility criteria for the counterparties are the same as for the main refinancing operations.

Transactions relating to weekly tenders are conducted by NCBs in the form of standard (fixed-rate or variable-rate) tenders. NCBs are responsible for collecting the tender offers and transmitting them to the ECB. Moreover, NCBs are responsible for informing credit institutions of the results of the tenders and arranging the settlement aspects, i.e., receiving the collateral and providing the liquidity. Monthly longer-term refinancing operations with three-month maturity are also carried out by NCBs. In addition, NCBs may carry out structural open-market operations. The Governing Council can authorise fine-tuning, outright transactions of securities, foreign- exchange swaps and the collection of deposits to be conducted, in exceptional circumstances, by the ECB itself.

65 Standing Facilities As noted above, two standing facilities are at the disposal of the Eurosystem: a marginal lending facility and a deposit facility. Effective from 5 November 1999, the interest rate on the marginal lending facility is 4 per cent., while that on the deposit facility is 2 per cent. These facilities are of overnight maturity and are available to counterparties at their own initiative. They are administered on a decentralised basis with their features harmonised across the Eurosystem. Overnight liquidity is provided at a pre-specified interest rate against eligible collateral. In normal circumstances, the interest rate on the marginal lending facility is above market interest rates, and thereby defines the ceiling for overnight interest rates — Euro overnight index average (EONIA) — in the market. Similarly, the deposit facility is normally below market rates and thereby defines the floor for overnight market rates (see Chart 4). All financial institutions fulfilling the general eligibility criteria may access this facility. Access is granted through the NCB in the country in which the financial institution is established on all days when the national payment and securities settlement systems are operational.

% Chart 4: ECB rates and EONIA, 1999 %

4.75 4.75 4.50 4.50 4.25 4.25 4.00 4.00 3.75 3.75 3.50 3.50 3.25 3.25 3.00 3.00 2.75 2.75 2.50 2.50 2.25 2.25 2.00 2.00 1.75 1.75 1.50 1.50 1.25 1.25 3 Jul 4 Jan 9 Jun 9 Feb 1 Sep 15 Jul 27 Jul 7 Oct 8 Aug 5 Mar 4 May 16 Jan 28 Jan 21 Jun 10 Apr 22 Apr 21 Feb 13 Sep 25 Sep 19 Oct 31 Oct 20 Aug 17 Mar 29 Mar 12 Nov 16 May 28 May

Marginal lending rate Deposit rate EONIA MRO rate

Except for the requirement that all Eurosystem lending is fully collateralised, there is no limit to the amount of overnight credit provided to eligible counterparties through this facility.

Minimum Reserves The Eurosystem’s minimum reserves system applies to all credit institutions in the euro area and primarily pursues the aims of stabilising money-market interest rates and creating (or enlarging) a structural liquidity shortage. The reserve requirement of each institution is determined in relation to its reserve base, i.e., mainly short-term liability elements of its balance sheet. The reserve requirement of each individual institution is calculated by applying a ratio of 2 per cent. to

66 the reserve base. In order to pursue the aim of stabilising interest rates, the Eurosystem’s minimum reserves system enables institutions to make use of averaging provisions. This allows credit institutions to vary their reserve balances over a maintenance period. Unexpected liquidity shortages on a given day may be funded by drawing down the reserve balance, provided that it is subsequently offset by holding a sufficiently large balance to meet the required balance over the reserve maintenance period. The use of averaging provisions exercises a steadying influence on markets and reduces the need for the Eurosystem to intervene in the money market every day. Compliance with the reserve requirement is determined on the basis of the institutions’ average daily reserve holdings over a one-month maintenance period. Institutions’ holdings of required reserves are remunerated at the rate of the ESCB’s main refinancing operations (currently 3 per cent.). Credit institutions in the euro area are required to hold minimum reserves at the NCB of the Member States in which they are located. Operations relating to credit institutions’ reserve accounts are conducted by the NCBs.

Counterparties All operations between counterparties (i.e., certain credit institutions which have a relationship with NCBs) arising from the implementation of monetary policy and of the Eurosystem are routed through NCBs. The general eligibility criteria for counterparties include operational requirements specified by the NCBs. Based on these criteria, NCBs are responsible for establishing and maintaining a list of credit institutions with which to conduct monetary-policy operations.

Liquidity Forecasts In order to assess the liquidity situation in the euro area, with a view to making decisions on the day-to-day implementation of monetary policy, the ECB must prepare a forecast of the changes in liquidity requirements. The ECB’s daily liquidity analysis is based on the NCB’s balance sheet data for the previous day, the NCB’s forecast of the development of autonomous factors which influences levels of liquidity (including net Government deposits, net foreign assets and banknotes) and other relevant information. This information has to be transmitted to the ECB before 7.35 a.m. NCBs are also required to submit a daily money-market sentiment report to the ECB. The NCBs are then required to monitor the intra-day development, and the end-of-day positions, of factors in their respective Member States relevant to the liquidity situation in the euro area. In addition, NCBs exchange information with the ECB on the movement in the liquidity situation of credit institutions throughout the day.

Sanctions Regime In order to ensure that counterparties comply with their obligations, a sanctions regime is now in place and is implemented through NCBs. The sanctions relate, in general, to infringements of credit institutions’ obligations arising under tender operations, collateralisation and the requirements of the minimum reserve system.

67 Payments System Settling money-market operations in the euro area requires a reliable payments system capable of providing rapid settlement throughout the euro area. In each of the monetary union members, large-value payments between banks are made through a real-time gross settlement (RTGS) system. Transactions are settled immediately by transferring amounts between settlement accounts of credit institutions at the NCBs. Each national RTGS system in the euro area is linked through the Trans-European Automated Real-Time Gross Settlement Express Transfer (TARGET) system, which allows area-wide settlement in central bank money. This enables large-value payments to be settled with the same certainty and timing throughout the euro area, facilitating the integration of the euro-area money market and also contributing to the smooth implementation of a single monetary policy.17 Both the provision of liquidity to and its absorption from the market under the monetary-policy operations of the Eurosystem are processed through TARGET. TARGET requires a constant availability of liquidity during the day to allow the system to operate smoothly. In this connection reserve balances of credit institutions can be used for payments purposes because these balances only need to be complied with on a monthly rather than a daily basis.

Underlying Assets All ESCB credit operations (i.e., liquidity-providing operations) have to be based on adequate collateral. The Eurosystem accepts a wide range of assets as collateral to secure its financial operations. A distinction is made between two categories of eligible assets: ‘‘Tier One’’ and ‘‘Tier Two’’. Tier One assets consists of marketable debt instruments fulfilling uniform euro area-wide eligible criteria specified by the ECB. Tier Two consists of additional assets, marketable and non-marketable, which are of particular importance for national financial markets and banking systems and for which eligible criteria are established by the national central banks, subject to ECB approval. NCBs bear the solvency and legal risks arising from Tier Two assets while such risks associated with Tier One are borne by the Eurosystem. The assets eligible for Eurosystem monetary-policy operations can also be used as underlying assets to secure intra-day credit for payments and settlements purposes in TARGET. Furthermore, Eurosystem counterparties may use eligible assets on a cross-border basis, i.e., they may borrow from the central bank of the Member State in which they are established by making use of assets located in another Member State. All operations relating to the use of collateral are carried out by NCBs.

Conclusion Since the start of monetary union, the Eurosystem has successfully assumed responsibility for the single monetary policy for the euro area. As integral components of the Eurosystem, the national central banks of participating countries, including the Central Bank of Ireland, contribute substantially, both to the formulation and to the implementation of this policy. In the first year of operation, the operational framework for the implementation of monetary policy has generally worked smoothly and the monetary-policy strategy of the Eurosystem, has been successful with respect to the price stability objective.

17 See Hartmann, (1999).

68 References Angeloni, Ignazio, (1999): The Role of a Regional Bank in a System of Central Banks Forthcoming: Carnegie-Rochester Conference Series in Public Policy.

Buiter, Willem H., (1999): Alice in Euroland, CEPR Policy Paper No. 1, April 1999.

Begg, David, and Paul de Grauwe, (1998): The ECB: Safe at any Speed? Monitoring the European Central Bank, Economic Policy Research Paper 1998.

Central Bank of Ireland, (1998): Documentation on Monetary Policy Instruments and Procedures, December 1998.

Cechetti, Stephen G., (July 1999): Legal Structure, Financial Structure, and the Monetary Policy Transmission Mechanism.

European Central Bank Monthly Bulletin, July 1999: The Institutional Framework of the European System of Central Banks.

European Central Bank Monthly Bulletin, January 1999: The Stability- Oriented Monetary Policy Strategy of the Eurosystem.

European Central Bank (September 1998): The Single Monetary Policy in Stage Three, General Documentation on ESCB Monetary Policy Instruments and Procedures.

European Central Bank (November 1999): Legal Instruments of the European Central Bank.

Goodfriend, Marvin, (1999): The Role of a Regional Bank in a System of Central Banks, Federal Reserve Bank of Richmond, Working Paper 94, 4 July 1999.

Hartmann, Wendelin, (1999): Monetary Policy and Payment Systems in EMU in Framing Macroeconomic Policy in EMU and the International Financial Architecture edited by Nicholas C. Carganas.

Honohan, Patrick, (1992): Regional Autonomy in Central Banking, Irish Banking Review 1992.

Tietmeyer, Hans, (20 January 1999): Der Euro: Vera¨nderte Aufgaben fu¨r die Deutsche Bundesbank (The Euro: Changed Tasks for the Deutsche Bundesbank), Quelle: Bankinformation und Genossenschaftsforum.

Treaty on European Union, (1992). Von Hagen, Jurgen, (August 1998): EZB 1st Keine ‘‘Superbundesbank’’ (ECB is no ‘‘Super Bundesbank’’), Quelle VWD-Finanz-und Wirtschaftsspiegel, 10 August 1998.

Quaden, Guy, (1999): Euro Central Banks in Competition, Handelsblatt, 23 September 1999.

69

Structural Differences between the US and the Euro Area by John Flynn1

1. Introduction The aim of this study is to assess the extent to which structural differences between the US and the euro area help explain the observed differences in economic performance and to consider what possible guidance the US experience may provide for the euro area. Section 2 briefly outlines the main features of the US and the euro area economies and examines relative economic performances over both the longer term and in more recent years, noting the main similarities and differences. In section 3, an attempt is made to identify the factors that account for the continued strong non-inflationary growth of the US economy at a relatively late stage in the present economic cycle. In particular, the extent to which the current economic performance may be due to favourable cyclical developments or structural changes is examined. The results of this examination suggest that structural factors may be playing some role. Section 4 looks at structural differences between the US and the euro area, focusing on a number of specific areas. Finally, in section 5, the main conclusions are summarised.

Carrying out this type of study necessarily involves examining the euro area in aggregate. It is recognised that this approach ignores diversity both between and within countries. Economic performances across euro area economies display a variation over time, with some economies more successful than others. In general, however, in terms of their functioning and notwithstanding some of their diversity, euro area economies are probably more similar to each other than to the US and it is reasonable to compare them as a group to the US, which itself is not an entirely homogenous economic area.

This is not to deny that differences between the US experience and that of some countries or regions within the euro area may be much less than is the case for the euro area economy as a whole.

2. The US and the euro area in perspective 2.1 Key Characteristics Table 1 summarises the key characteristics of the US and the euro area. As the table indicates, there are a number of similarities between both economies. The population of both areas is broadly similar in size, and though the US share of world output is greater than that of the euro

1 The author is Deputy Head of the European Monetary Affairs and International Relations Department. He would like to gratefully acknowledge the contribution of Andrew Mawdsley who wrote section 4·2 ‘Government involvement and intervention in the economy’ and also the helpful comments and suggestions of Padraig McGowan, George Reynolds and Anne Marie McKiernan. The views expressed in this paper are not necessarily those held by the Bank and are the personal responsibility of the author.

71 area, the two economies are considerably larger than any of the other major economies. Patterns of production are relatively similar in both the US and Europe, and the degree of openness of both economies is relatively low.

Table 1: US and Euro area — key characteristics

Euro Area US

Similarities Population (m) 292 270 Share of World GDP (%) 15·5 20·8 Sectors of production (% of GDP) • Agric 2·4 1·7 • Industry 30·9 26·0 • Services 66·7 72·3 Openness (% of GDP) • Exports 13·6 8·5 • Imports 12·0 11·1

Differences Gen govt. (% of GDP) Receipts 46·7 35·9 • Social security contribution 17·0 9·4 Expenditure 49·1 34·5 • Current transfers to households 20·2 13·7 Bank deposits (% of GDP) 84 54 Domestic credit (% of GDP) 130 81 Domestic securities (% of GDP) 91 155 Stock mkt. capitalisation (EUR bn) 3,655 13,025 • % of GDP 63 172

Source: ECB Monthly Reports, January 1999 and August 1999. Reporting periods vary.

There are also some important differences, however. Reflecting differences in the perceived importance of social objectives, the size and structure of the government sector differs significantly as between the two economies. There are also some notable differences in the monetary and financial area. In the euro area, traditional bank lending and deposit taking is much more important than in the US, where capital markets are dominant.

2.2 Relative Economic Performances The performance of the US and the euro area economies in terms of economic growth, employment, unemployment and inflation, along with data on fiscal positions and interest rates is set out in Table 2. This suggests the following: • GDP growth — Since the early 1980s, US economic growth has averaged 2·8 per cent., as compared to 2·3 per cent. in the euro area. The difference in growth performance is almost entirely accounted for by the stronger growth of the US over the last 7 years, during which time US economic growth has been almost twice that of the euro area. The current US economic expansion (which began in April 1991) is the longest peacetime expansion in US history and is set to become the longest US expansion ever if it continues until February next. The most unusual feature of the present expansion is that the growth rate has accelerated as the cycle has matured. Prior to this decade, there had been little noticeable difference in growth performance between the US and the euro area. Indeed, the average economic growth rate of both economies in the period 1971-91 was almost identical.

72 Table 2: Key macroeconomic data, fiscal positions and interest rates

1982-91 1992-98

US Euro area US Euro area

GDP growth (% p.a.) 2·5 2·8 3·1 1·7 Employment growth (% p.a.) 1·6 0·6 1·6 −0·3 Unemployment rate 7·0 9·6 5·8 11·6 Inflation rate 4·1 5·5 2·6 2·8 Gen. Govt. financial balance (% GDP) −3·0 −4·5 −1·6 −4·1 Gen. Govt. debt (% GDP) 50·8 55·4 61·0 73·8 Short-term interest rates 7·6 10·1 4·4 6·5 Long-term interest rates 9·7 10·7 6·4 7·5

Source: OECD Economic Outlook, June 1999.

• Labour markets — While the economic growth performances of the US and the euro area may have been broadly similar until fairly recently, there have been considerable differences in terms of labour market performance. US employment growth has outstripped that of the euro area by a wide margin. This trend goes back to the 1970s and, since the beginning of that decade, total employment has grown by 70 per cent. in the US as compared to only 10 per cent. in the euro area. The differences in employment performance have become even more pronounced in the present decade. Since the early 1990s, employment has contracted slightly across the euro area, while it has continued to grow at a relatively healthy 1·6 per cent. annual rate in the US, generating an increase of 11 per cent. in net job growth since the beginning of the present economic expansion.

Not surprisingly, against this background, the euro area unemployment rate has risen sharply and is now roughly twice the level of the US rate, having been around one-half of the US rate in the early 1970s. A noticeable difference between the two areas is the fact that the US unemployment rate has been a cyclical variable with little or no trend since the early 1970s, while the euro area unemployment rate has been an upwardly trended variable. The relative strength of the US unemployment rate performance can be gauged from the fact that the unemployment rate has remained extremely low against the background of strong growth in the labour force and a rise in the participation ratio, both of which are developments which contrast sharply with the euro area experience.2

Different employment growth rates and similar GDP growth rates up to the early 1990s imply significant differences in productivity growth in favour of Europe (Table 3). This appears to reflect a movement towards more capital intensive production in Europe in response to the sharp rise in real labour costs from the early 1970s onwards. In recent years, however, labour productivity growth has risen sharply in the US, to move above the euro area rate. The implications of this development are discussed in section 3.

2 US labour force participation has been on a steady upward trend since 1970, rising from 65 per cent. to over 77 per cent. Labour force participation in the euro area has been relatively steady at 65 per cent. over the same period.

73 Table 3: Productivity in the business sector (percentage change at annual rates)

US EU

Labour productivity 1973-79 0·3 2·5 1979-97 0·9 2·2

Source: OECD, Economic Outlook, June 1999. Separate data for the euro area are not available.

• Inflation — Consumer price inflation in the US and euro area has been broadly similar since the early 1990s. However, the average data mask the pattern whereby euro area inflation, which had tended to be a little higher than US inflation in the early part of the decade, is now somewhat lower. The most striking feature of the recent US experience, however, is the fact that inflation has fallen in recent years, and remains remarkably low, despite the acceleration in economic growth and the late stage of the economic cycle. • Fiscal positions — In terms of fiscal deficits and debt, the US performance has been better than that of the euro area. Not surprisingly, the US fiscal position has improved since the early 1990s, with the general government financial balance moving from deficit into surplus in recent years. The euro area has also seen an improvement, with the Maastricht deadlines encouraging deficit reduction. Debt ratios have risen in both the US and the euro area, though the increase has been less in the former case. As regards structural deficits, the pattern is broadly the same, though the removal of cyclical factors reduces the size of both the US surplus and euro area deficit. • Interest rates — Short and long-term interest rate differentials between the US and the euro area have been relatively significant over time, with the US, on average, having lower rates, particularly in the case of short-term rates. However, the picture has changed markedly in recent years, with euro area short-term and long-term interest rates moving well below corresponding US rates. Until recently, euro area short-term interest rates were at their lowest level in several decades, while long-term interest rates also approached historic lows at the beginning of this year.

3. What explains the recent rapid non-inflationary growth in the US? The most striking feature of the recent US economic performance has been the acceleration in the growth rate which has occurred at a relatively late stage of the current economic cycle and has been accompanied by low and stable inflation. This runs counter to normal experience, where, late in the economic cycle, productivity tends to decline and inflation accelerate, thus giving rise to forces which, ultimately, bring an end to the cyclical expansion. In the US, however, wage growth remains relatively subdued despite a long and powerful expansion in activity and the rate of productivity growth has risen markedly in recent years. While the conduct of economic policy has obviously facilitated the growth of the US economy over the present

74 cycle, its main contribution in recent years has probably been to prolong the cycle, ensuring its longevity. Sustained low inflation has meant that the conditions which would normally bring about the end of a cyclical expansion have been absent. The steadier hand on the wheel has undoubtedly helped; however, it is difficult to identify developments induced by economic policy as being mainly responsible for the unusual cyclical performance.

What then can account for the rapid non-inflationary growth of the US in recent years? To what extent do cyclical factors play a role or are more fundamental structural forces at work? The current economic expansion is now in its ninth year, during which time real GDP has increased by almost 30 per cent. Growth has been entirely domestically generated, with the strength of domestic demand outweighing a significant negative external effect. In particular, the expansion of the US economy has been driven by the remarkable growth in business investment and, in more recent years, by the strength of consumer spending. The buoyancy of consumer demand reflects not only strong employment growth and rising real income, but also a decline in the household savings rate which has occurred against the background of strong growth in asset prices. Much the same is true of the corporate sector, where an increasing amount of funding for investment in recent years has been provided through increased borrowing. The net result has been the creation of a significant private sector deficit which has only been partly offset by the movement from deficit to surplus in the public finances. Consequently, a large share of the rapid growth of US domestic demand and the private sector financing gap has been met by an increasing external deficit and a corresponding inflow of capital from abroad.

The rise in the external deficit and the associated increase in capital inflows, which were sufficiently strong to generate a sizeable appreciation of the dollar over the second half of the 1990s, is evidently part of the reason why strong US growth has not generated an increase in inflation. In addition, one can identify a number of other cyclical/temporary influences which also help explain recent developments. First, there is the role of external factors. As in the rest of the global economy, US inflation has, until recently, been constrained by the disinflationary influence of oil and international commodity price developments and the increase in global spare capacity as a result of the crisis in emerging market economies, though clearly this influence is now reversing. Second, changes to benefit and welfare programmes (largely as a result of efforts to cut healthcare costs) have led to sharp reductions in non-wage costs in recent years and have encouraged many former welfare recipients to return to employment.3 Third, partly related to these developments, there appears to have been a downward shift in the level of unemployment at which inflation begins to emerge — the so-called NAIRU (Non-Accelerating Inflation Rate of Unemployment). Until the last few years, the general perception was that the level of unemployment 1 below which inflation would begin to accelerate was around 5 ⁄2 per

3 The labour force expanded by around 2 per cent. in 1997, which is about double the population growth rate. Much of the strong rise in labour force growth is attributed to the impact of the Personal Responsibility and Work Opportunity Reconciliation Act 1996 which radically altered welfare arrangements in the US.

75 cent. In recent years, however, the US economy has operated at unemployment rates well below this level (currently the unemployment rate is 4·1 percent) without generating an acceleration in wage inflation, suggesting that the NAIRU has fallen. Obviously, such a development would raise the level of output and would have a transitory effect on the economic growth rate, which would return to normal once the adjustment to the higher level of output was complete.

3.1 The new paradigm view While the above explanations can help account for some of the recent developments in the US economy, they do not explain why labour productivity has risen so sharply in the last few years and it is this development which is at the core of the view that structural factors play a key role in accounting for the recent period of strong non- inflationary growth. While US labour productivity growth for the whole of the current expansion is not much better than average, the rate of labour productivity growth has picked up sharply since the mid-1990s. Having averaged less than a 1 per cent. annual rate of increase in the early 1990s, labour productivity growth rose to 2 per cent. in the mid- 1990s before climbing to almost 3 per cent. in the year ended in the third quarter of 1999. In the past, as cyclical expansions have lengthened, the rate of productivity growth has typically declined.

Initially, the rise in productivity growth was seen as representing a catch-up from slow productivity growth in the early part of the decade. Thus, the rise was seen as part of the normal tendency for productivity growth to pick-up when growth in output accelerates. This would be consistent with the view that employers would initially attempt to coax more output out of the existing workforce, while it could also be rationalised on the grounds that labour market tightness reduced the availability of new workers. However, the continued rise in the rate of growth of labour productivity has not only weakened this interpretation but has strengthened the view that there has been a structural change in the economy. This has led some to conclude that, not only has there been an acceleration in labour productivity growth which has helped push up the actual rate of economic growth, but there has also been a rise in the trend rate of productivity growth which, even if of a smaller scale, has increased the potential rate of growth of output. An increase in the underlying growth rate of productivity would be a relatively significant development. Unlike a fall in the NAIRU, which would raise the level of output, a rise in the trend productivity growth rate would generate a sustained increase in the rate of growth of output.

This view is controversial and there is not a consensus on what lies behind the rise in productivity growth. However, it is accepted that increased labour productivity growth has lowered the growth of unit labour costs which, in combination with declining import prices, has engendered lower price inflation and inflation expectations. An advocate of the view that the recent acceleration in labour productivity

76 growth represents a fundamental change is Federal Reserve Chairman Greenspan.4

The main elements of this view (the so called ‘new paradigm’) are as follows: • The current US economic expansion has seen a rise in business investment which goes well beyond the normal cyclical experience. Between 1995 and 1998, US business fixed investment increased by 35 per cent. as compared to 7-9 per cent. in the bigger euro area countries over the same period.5 • Rapid advances in technology related largely to the use and management of information, and an acceleration in the process of shifting capital from older technologies to newer ones has generated a technology-driven rise in the rate of return on new capital. The newer technologies have facilitated a shortening of lead times, improvements in inventory management and a quickening of product cycles. This has made capital investment more profitable, enabling firms to substitute capital for labour more productively than they could have done previously. As a result, significant capital deepening (i.e. increasing capital intensity of employment) has occurred since the mid-1990s. • Nonetheless, the strength of domestic demand has meant that, despite the substitution of capital for labour, further employment growth has been necessary to generate sufficient output to meet demand. • The surge in investment has increased capacity faster than the rise in output. The resulting slack in product markets has put greater competitive pressure on business to hold down prices. Moreover, despite the tightening of labour markets in recent years, the pace of change has heightened workers’ fear of job skill obsolescence, which has been an important moderating influence on wage behaviour.

The recent rise in productivity means that it is no longer the case that ‘you can see the computer age everywhere but in the productivity statistics’ (Solow). The evidence for a technology-driven rise in the rate of return on new capital, and an associated acceleration in labour productivity, is now more compelling, though not conclusive. However, many economists remain sceptical of the ‘new paradigm’ story and maintain that it is still too early to conclude that a 25 year trend of relatively slow productivity growth has been reversed. Doubts

4 In testimony to the Joint Economic Committee on 17 June 1999, Mr. Greenspan said the following: ‘An impressive proliferation of new technologies is inducing major shifts in the underlying structure of the American economy.... As a consequence, many of the empirical regularities depicting the complex of economic relationships on which policymakers rely have been markedly altered..... The failure of economic models based on history to anticipate the acceleration in productivity contributed to the recent persistent underprediction of economic growth and overprediction of inflation’. In his Humphrey-Hawkins testimony to the House Banking Committee on 22 July he added: ‘It is this acceleration of productivity over recent years that has explained much of the surprising combination of a slowing in inflation and sustained rapid real growth.’ Mr. Greenspan also pointed to the synergy of the newer technologies and the existing capital 1 stock, noting that the motor vehicle industry has experienced a 4 ⁄2 per cent. annual rise in 1 productivity over the past two years as compared to an average annual increase of 1 ⁄4 per cent. earlier in the decade. He added that much the same was true of many other mature industries such as steel and textiles. 5 BIS Annual Report, June 1999.

77 that advances in information technology are changing the nature of the economy revolve around the fact that computers represent only 2 per cent. of the aggregate capital stock, which is considered too small a proportion to make much difference for the economy as a whole, even if, to date, they have generated supernormal returns. What is undisputed, however, is that US productivity growth has accelerated in recent years.

As yet, there is no significant evidence that a similar process is occurring in Europe. This could be related to the existing rigidities in European product and labour markets or simply reflect a slower application of technological innovation, suggesting that Europe has yet to feel the positive effects of this type of development. The fear, however, is that it is the former and, thus, as a result, the power of competitive forces arising from the application of technological innovation and, ultimately, the stimulus to output in Europe will be weaker.

3.2 Equity market developments and potential risks In an economic expansion resulting from a rise in the rate of return on capital and an underlying increase in productivity, a much stronger rally in the equity market is likely to develop than in a traditional expansion caused by rising demand. This is all the more likely given that, in an expansion driven by a positive supply shock, inflation and, hence, interest rates will remain low. The result is likely to be strong growth in profits.

This broadly reflects the pattern of recent developments in the US. Over the 1990s, real corporate earnings have increased at an average annual rate close to 10 per cent.,6 which has helped fuel a significant stock market rally. Given the size of personal sector equity holdings, this has generated sizeable wealth effects. Against the background of the rapid expansion in their financial asset positions, the household sector has reduced its savings rate and, as conventionally measured, the household savings rate is now negative. With the corporate sector also engaged in increased borrowing to fund the strong growth of investment spending in recent years, there has been a significant increase in net private sector borrowing.

While the growing federal government surplus has helped offset part of the increase in the private sector deficit, as noted earlier, the development which has largely facilitated the deterioration in the private sector net savings position has been a rising current account deficit and a corresponding inflow of capital from abroad. Such a development is consistent with an increase in the rate of return on capital in the US relative to the rest of the world. However, there is a limit to how long and how far deficits can be sustained, and with the US current account deficit expected to rise to around 3·5 per cent. of GDP this year, some consider that this limit is rapidly approaching. The arithmetic of foreign debt accumulation and compounding interest costs suggests that at some point in the future, unless reversed, the growing US external imbalance may create significant problems for the economy.

6 OECD, Economic Outlook, June 1999.

78 Domestically, the main source of downside risk for the US economy going forward, however, concerns the possibility of a fall in equity prices. Of itself, the increase in productivity growth does not ensure that the rise in the equity market which has occurred in recent years is entirely warranted. With price-earnings ratios extremely high in historical terms, investors appear to be anticipating even stronger corporate earnings growth than has been the case over the present cycle. In such circumstances, the stock market is vulnerable to a sharp correction. Such a correction, should it occur, would be likely to have significant macroeconomic effects. Both the household and corporate sectors would be forced to re-balance their financial positions leading to a likely retrenchment in spending in both cases. This would depress US demand and alter the balance of trade, with spillover effects to other economies. Capital flows could also be expected to reverse, as investors would seek to liquidate their holdings of US assets, with consequent implications for the bond and foreign exchange markets. The three interest rate increases which have occurred since June indicate that the Federal Reserve is conscious of the cyclical risks facing the US economy. Moreover, Mr. Greenspan has also adverted to the difficulty of attempting to gauge when an economy is overheating at a time when productivity is accelerating. However, the Federal Reserve’s continued emphasis on the fundamental changes which have occurred in the US economy suggest that it is of the view that the underlying productivity performance and growth potential have improved and that, despite the savings imbalance which has emerged, the current expansion can be maintained for some time yet, if the growth rate of the economy can be slowed to the underlying potential rate. 3.3 Summary assessment On balance, there would appear to be sufficient evidence to suggest that recent strong non-inflationary growth in the US reflects a mix of cyclical and structural factors. The longer run evidence with respect to the labour market indicates strong US out-performance vis-a`-vis the euro area in this field. The general conclusion that could be drawn from sections 2 and 3 is that the US is a more dynamic economy, is better at generating jobs, may be experiencing an increase in the potential growth rate and, thus, may be capable of generating higher growth than the euro area in the long run. Against this background, it is useful to examine some structural factors which may be operating in favour of the US. 4. Structural differences between the US and the euro area Before focusing on specific structural differences between the US and the euro area, some general observations can be made. The US and euro area have fundamentally different economic philosophies with respect to economic organisation and management. By and large, the European approach has been to establish welfare state arrangements as reflected in government regulation of product markets and social partnership arrangements in labour markets. The US, on the other hand has adopted a much less interventionist approach. Both sets of arrangements imply differences with respect to the economic role of government, the operation of labour markets, competition policies and incentive systems generally. Second, cultural differences between the US and the euro area are relatively significant. A common language and culture in the US contrasts with diversity in Europe. This has

79 important implications in a host of areas and affects things such as attitudes to labour mobility, risk-taking, entrepreneurship etc. In considering what lessons could be learned from the US, it must be borne in mind that the broad parameters of the existing arrangements can probably only be changed slowly. In looking at key structural differences between the US and the euro area, three areas are worth examining: • Labour markets; • Government involvement and intervention in the economy; • Differences in the structure of financial systems. 4.1 Labour Markets As highlighted in section 2, US and European labour market performances have differed markedly over recent decades. Rising unemployment and a poor employment creation record have been the main problems facing Europe. In contrast, the US has experienced rapid employment growth, rising labour force participation and a relatively low unemployment rate. Studies suggest that the responsiveness of real wages to fluctuations in activity is relatively high in the US. Nominal wages do not seem to display much downward rigidity, implying that a low inflation environment does not hinder changes in relative wages that are required to reallocate resources. However, the US has seen a widening of wage inequality and the emergence of the ‘working poor’ has been a downside of the US experience. An examination of labour market performance suggests that the US has experienced a relative demand shift between skilled and unskilled workers, while Europe has experienced a stronger relative demand shift between labour, as a whole, and capital. The key role of labour costs in explaining the diverging developments in US and European employment is highlighted in the IMF World Economic Outlook of May 1999. Since 1970, real labour costs in the euro area have increased by 65 per cent. and total employment by 10 per cent., compared to a 25 per cent. increase in real labour costs and an almost 70 per cent. increase in total employment in the US. Rising labour costs in Europe encouraged moves towards more capital intensive production in those areas where activity remained profitable. As a consequence, Europe has had a higher average rate of labour productivity growth than the US, where economic growth has been fed to a much greater extent by additional labour input. However, higher productivity growth is not a root cause of the European employment problem but, rather, is a by- product of labour cost developments. Another measure of poor European labour market performance is provided by the fact that the unemployment rate associated with normal rates of capacity utilisation has moved up over time in Europe, pointing to a rise in structural unemployment.7 In the US, on the other hand, the unemployment rate has tended to be inversely related to the rate of capacity utilisation. High euro area unemployment implies a significant loss of output, has implications for fiscal positions and taxation and transfer systems while also imposing wider social costs. As a tentative indication of the scale of the loss, the IMF has estimated that reducing the euro area

7 Source: IMF, World Economic Outlook, April 1999.

80 unemployment rate from its current level to around 5 per cent. would increase GDP by around 4 per cent.8 The general consensus is that the differing labour market performances largely reflect structural factors. In particular, the low level of unemployment in the US is perceived to reflect the flexibility inherent in labour and product markets in that country as well as the structure of taxes and transfers. In contrast, Europe is considered to be adversely affected by inflexible labour market arrangements, as reflected in the combination of unemployment compensation regimes, minimum wage arrangements, employment protection legislation and institutionalised wage bargaining procedures, as well as the prevailing high degree of social protection.9 It is this combination of factors which is perceived to distort the functioning of labour markets in Europe and weaken the relationship between employment/unemployment developments and wage behaviour. As against this, with respect to the system of education and human capital development, which is an important long- run influence on the labour market, the US performance is somewhat uneven. In particular, OECD studies suggest that there is a wide gulf in standards between the primary and secondary stages of education, which are relatively weak, and the college and university system, which performs much better. With earnings differentials largely a function of relative skill levels and educational attainment, this dichotomy in educational performance is also an important factor accounting for the wider income inequality observed in the US. Some measures of the extent of labour market rigidities in Europe relative to the US are set out in Nickell (1997) and reproduced in Table 4 below. These summary statistics are derived from indices set out in the OECD Jobs Study (1994) and give a relative measure of the scale of direct rigidities and the treatment of the unemployed. As can be seen, the measures suggest that the average scale of rigidities is much greater in Europe and, although benefit replacement rates are broadly similar, the average benefit duration period in Europe is a multiple of that of the US.

Table 4: Features of US and euro area labour markets

Direct rigidities Treatment of unemployed

Employment Labour Benefit Benefit Spending Protection Standards Replacement Duration on Active (0 = lax) (0 = lax) Rate (%) (years) Market (20 = strict) (10 = strict) Policies*

US 1 0 50 0·5 3·0 Euro area 15 5·3 56 2·6 12·4

Source: Derived from Table 4, Nickell (1997). Euro area figures are a simple average of the measures for individual euro area countries (excluding Luxembourg) presented by Nickell. *Spending on active labour market policies per unemployed person as a percentage of GDP per member of the labour force.

8 Source: IMF, World Economic Outlook, April 1999. 9 There is much evidence for this proposition from sources such as the OECD (various), IMF (1999), Nickell (1997), Artis (1998), Blanchard (1997), Mortensen and Pissarides (1999) and many more. However, care must be exercised in talking about a European model as there is a good deal of diversity across countries. In general terms, the European experience suggests that employment protection legislation and the payment of unemployment compensation have to some degree been used as substitutes in different countries (e.g. in Italy, unemployment compensation would be relatively unimportant compared to the strength of employment protection legislation, while in countries like the Netherlands and especially Denmark, the opposite would be the case). Moreover, there are also significant differences in the share of GDP spent and transferred by national governments.

81 Moves by the EU aimed at reforming European labour markets have been underway for some time now. While there is an acceptance that structural reform is required, progress has been slow and the pace of reform across countries has been uneven. The main obstacle to labour market reform is clearly the concern that the necessary changes will have adverse effects on income distribution and social cohesion in Europe. In addition, it must be remembered that US flexible labour markets work in an environment where there is considerable regional labour mobility, which is not the case in the euro area. However, without reform of a wide range of labour market arrangements, European labour market performance is likely to continue to lag well behind the US. In this respect, it is encouraging to note that those euro area countries which have made greater progress in implementing wide-ranging reform policies have been relatively successful in reducing structural unemployment.

The move to EMU has made the need to increase labour market flexibility all the more important. In the absence of such flexibility, macroeconomic policy will come under greater pressure to be more accommodative in the face of difficulties arising as a result of what may be, primarily, structural problems. This gives policymakers a strong interest in ensuring that labour market flexibility increases and that this happens evenly across countries. Reform at different speeds in individual countries could result in asymmetric national labour market responses to a symmetric euro area shock. To increase the benefits and reduce the threats to the success of EMU it would seem essential to improve the flexibility of labour markets.

4.2 Government involvement and intervention in the economy The euro area can be characterised as having ‘‘big’’ government in the sense that general government accounts for a considerable proportion of GDP. In comparative terms, the share of government spending as a proportion of GDP in the euro area economy is roughly one-half, compared to a share of one-third for the US (Table 5). Financing this expenditure places an equally large tax burden on the economy which, due to the distortionary effects of taxation, hinders the operation of the euro-area economy by comparison with that in the US. Empirical evidence suggest that, while growth effects attributable to government spending and tax policy are difficult to quantify, there is some evidence that the levels of taxation and expenditure are negatively related to the level of activity.

Table 5: Key General Government Data

%ofGDP 1982-1991 1992-1998

US Euro Area US Euro Area

Total Outlays 32·8 48·4 34·7 50·3 Current Receipts 29·9 43·9 33·1 46·2 Financial Balance −3·0 −4·5 −1·6 −4·1 Gross Debt 50·8 55·4 61·0 73·8 Net Debt 34·3 35·2 45·2 55·1

Source: OECD Economic Outlook, June 1999.

82 The composition of expenditure and revenue has further distortionary effects in the euro area compared to the US. Subsidies and transfers are 27 per cent. of GDP in the euro area as compared to 14 per cent. of GDP in the US (Table 6). While there is some evidence that such expenditures may be positively related to growth, there is also contrary evidence that subsidies and transfers adversely affect incentives, in the labour market for example, and the allocation of resources. Regarding taxation, the starting assumption must be that taxes are distortionary in terms of the excess burden of taxation. While the respective shares of direct taxes and social security contributions as a percentage of GDP do not appear markedly different (24 per cent. in the US versus 30 per cent. in the euro area), both of these together account for a much higher proportion of current revenue in the US than in Europe (75 per cent. versus 60 per cent.). By implication, therefore, the US concentrates the distortionary effects of taxation in particular markets. The euro area, however, needing to raise proportionately more revenue to fund higher expenditure, levies taxes across a broad range of categories, thereby distorting the labour-leisure choice, the consumption-savings choice and investment decisions. This broader distribution of distortions has a depressing effect on economic dynamism and growth, particularly in relation to the accumulation of capital, both human and physical. Given the much higher revenue requirement, following the US approach of relying more heavily on direct taxation would not be optimal. However, the euro area experience demonstrates the need to reduce the distortionary effects of taxation across a broad range of categories. This is particularly relevant in the area of income taxation, with some euro area tax systems combining high marginal tax rates with various exemptions, which can give rise to a misallocation of resources and generate inefficiencies.

Table 6: Breakdown of Revenue and Expenditure in 1996

%ofGDP US Euro Area

Current Revenue 31·6 48·8 of which Direct Taxes 14·6} 12·1} 23·7 30·4 Social Security 9·1} 18·3} Indirect Taxes 7·9 13·4

Expenditure 32·7 53·4 of which Consumption 15·5 17·3 Subsidies 0·3 2·3 Transfers 13·9 23·2 Interest 3·0 5·5 Investment 2·9 2·4

Sources: OECD Survey of the United States, 1997 and ECB Monthly Report, Table 7.

Historically, the euro area can also be characterised as a heavier borrower than the US. This has led to a greater build-up in the stock of debt relative to GDP for the euro area and a necessity to undertake more vigorous fiscal consolidation to stabilise the public finances. As a result, while both the US and the euro area have undergone fiscal consolidations, the euro area has had to make a greater adjustment as countries sought to meet the Maastricht criteria for entry into EMU.

83 This is reflected in the stance of fiscal policy in recent years, with the euro area adopting a more contractionary stance, especially in the years just prior to the start of EMU.

The euro area can also be characterised in terms of greater state regulation and ownership of economic activity. While such state involvement can be rationalised in terms of market failure, there are costs to regulation. These take the form of market rigidities and inefficiencies related to the overuse of factors of production. In the 1970s, it was concluded in the US that these costs were too great and a process of deregulation commenced. This took the form of the removal of regulations, regulatory reform and the privatisation of state owned enterprises. Empirical evidence suggests that such deregulation is associated with improved economic growth. Although the euro area has started to deregulate, it lags behind the US and so has yet to reap the full benefits of such reform.

4.3 Differences in the structure of financial systems There are many differences between banking systems and capital markets in the US and Europe and what follows is a summary of the main differences, not an evaluation of the relative merits of the different systems. As indicated in section 2, in the euro area, traditional bank lending and deposit taking is much more important than in the US, where capital markets provide the principal means of financing and saving (Table 7). The differences as between the relative importance of banking and capital markets tend to reflect the different corporate and banking traditions in the two blocs. Before the beginning of EMU, the euro area capital market consisted of eleven national markets of various sizes separated by different currencies. The provision of state supported pensions and other social security supports removed the need for private savings plans and the market infrastructure needed to support them. As a result, universal banks dominate the euro area financial system.

In the US, on the other hand, the approach to regulation has provided greater encouragement for the development of capital markets. Moreover, given the costs of traditional financial intermediation and the economies of scale arising in large, well functioning debt markets, the US corporate sector has primarily relied on the bond market and equity issuance as the preferred means of obtaining finance. The personal sector in the US has also come to rely on capital markets for savings purposes. The lower degree of social protection in the US, the greater onus on individuals to plan for retirement, the rising proportion of prime savers (i.e. these aged 40-60) and low transactions costs have all contributed to increasing capital market participation on the part of the personal sector. As a result, the US personal sector holds a relatively small portion of its wealth in cash/deposits (roughly one-third of the proportion held in euro area countries) and a much greater portion in debt securities and investment funds. The difference in behaviour is illustrated most sharply in the case of personal sector equity holdings which, in the case of the US, are roughly 8-10 times higher than in the main euro area countries.

84 Table 7: Banking and financial markets

Euro area US

Bank deposits — \bn 4,849 4,128 % of GDP 84 54

Domestic credit — \bn 7,477 6,132 % of GDP 130 81

Domestic debt securities — \bn 5,240 11,787 % of GDP 91 155 issued by private sector — \bn 1,997 5,096 issued by public sector — \bn 3,243 6,691

Stock market capitalisation — \bn 3,655 13,025

Source: ECB, Monthly Report, August 1999. All data relate to end-1997, except stock market capitalisation data, which relate to end-1998.

Private equity and venture capital markets are also relatively well developed in the US, which gives US small and medium enterprises far better access to risk capital than their European counterparts. The US has a well developed private equity market which channels third-party finance to enterprises not quoted on a stock exchange. In addition, there is easy access to exit mechanisms, such as initial public offerings (IPOs) on securities markets such as NASDAQ. The success of this process is evidenced by the fact that equity raised by US IPOs grew from US$1·4bn in 1980 to US$30bn in 1997. Since 1993, the total of US IPOs was around 7,000, compared to just over 700 in Europe. In addition, institutional arrangements in the US tend to be more business- friendly and impose fewer administrative burdens than in Europe. For example, US arrangements provide for low cost entry and exit from a business, flexible labour market practices and relatively low levels of profits taxation.

Two important conclusions can be drawn from the above. First, the greater reliance on traditional bank intermediation by the euro area corporate sector makes the cost of funding more expensive than would be the case if funding was carried out through securities markets. Second, higher financial asset to income ratios in the US generate much stronger wealth effects arising from price movements in equity and bond markets. This has obviously been an important factor accounting for the strength of US consumer spending growth in recent years. On a related point, the difference in financial asset to income ratios are also likely to result in significant differences in the interest rate transmission process via financial asset prices. The relatively high ratio of personal sector financial asset holdings is likely to generate stronger pro-cyclical effects in the US. In an economic expansion, when financial markets are rallying, private demand is amplified by capital gains, whereas a downturn is likely to be aggravated as contractionary wealth effects weaken consumer demand. In contrast, European style bank-based financial intermediation would tend to operate in a more stabilising counter-cyclical fashion.

EMU is certain to have a significant impact on the banking sector and capital markets in Europe. However, EMU is occurring at a time when there are already many other powerful forces — such as technological developments, heightened global competition and demographic

85 factors — which are also likely to have a significant impact in this area (White, 1998).

The introduction of the euro and the elimination of exchange rate risk between the participating countries brings the prospect of an integrated European capital market considerably closer. However, though the various national capital markets are no longer separated by different currencies, national differences in tax regimes, debt and equity issuing practices and legal and regulatory frameworks remain obstacles to full euro area capital market integration. Nevertheless, the introduction of the single currency significantly increases the number of issuers and investors operating in the same currency. This, in turn, increases liquidity in the market, makes larger issue sizes possible and should reduce the cost of funds. As a consequence, the incentive for euro area borrowers to shift from bank loans to debt security and equity issuance should increase. Thus, private capital market activity can be expected to grow at the expense of bank borrowing and there is some evidence, particularly from the corporate bond market, that this has happened since the beginning of the year.

For the banking sector, the growth in capital market activity and increasing disintermediation is likely to lead to a structural change from on-balance-sheet lending to investment banking type activities. One would expect the move to EMU and the broad harmonisation of banking legislation to accelerate the trend towards consolidation already evident in the banking sector and stimulate cross-border integration. However, to date, this has not been the case. While the degree of concentration in banking is much higher in individual euro area countries than it is in the US, this is not the position for the euro area as a whole. It is estimated that the five largest banks in the euro area hold just over 10 per cent. of the sector’s total assets as compared to 20 per cent. in the case of the five largest US banks.10 Thus, consolidation has remained primarily confined within national boundaries and it would appear that legal, fiscal and cultural barriers will ensure the segmentation of national markets for retail banking services for some time yet.

As indicated above, there are already many other powerful forces at work which are also likely to have a significant influence on banking and capital markets. For example, technological change has led to the development of a host of new financial products and a significant expansion in the means to deliver them. These developments represent a significant long-term challenge to the continued dominance of the relationship banking model in Europe. Another force for change is likely to come from demographic factors. Given the ageing population and the extent of unfunded state pension liabilities across the euro area, continued reliance on unfunded pension schemes seems unsustainable. Against this background and while likely to prove controversial and, consequently, slow to bring about, a restructuring of European pension system arrangements seems inevitable. In the long run, this is likely to be a very important catalyst for change in European capital markets.

10 J. Thomsen and J. Ulriksen Thuesen, The euro and the new perspectives, Danmarks Nationalbank Bulletin, January 1999.

86 In summary, the US would seem to have arrangements which allow borrowers to benefit from the economies of scale arising in large, liquid capital markets and are more likely to facilitate risk-taking. Greater disintermediation comes at a price, however, and is likely to give rise to stronger pro-cyclical effects. On balance, the euro area financial system is likely to move in the direction of the US system but only slowly and probably also only partially. For example, one would not expect to see the development of a significant risk capital market in Europe for some time yet. However, while it would be unrealistic to expect the euro area financial system to come to exactly resemble that of the US, movement towards a more efficiently functioning capital market in Europe seems likely.

5. Conclusions and issues arising A comparison of the US and the euro area suggests that while both economies share a number of characteristics in common (size, openness, structure of production), the US has outperformed the euro area across a range of key economic variables. This has been most noticeable in the labour market area but, more recently, the gap in economic growth performances has also been widening. Significantly, over the course of the 1990s, the US has been able to generate this superior growth performance while still enjoying an inflation rate which is only marginally higher than that prevailing in the euro area. While cyclical influences can account for part of the current impressive performance of the US economy, structural factors also seem to be playing an important role. The flexible nature and functioning of the US economy has facilitated rapid adjustment to changing economic circumstances, giving the economy vibrancy and dynamism.

Given the existence of rigidities across a broad range of areas, structural reform in Europe could play an important part in improving the efficiency and functioning of markets. More generally, there is a complementarity between structural reform and macroeconomic policies. If structural reform is implemented successfully, the burden on macroeconomic policy to overcome inefficiencies arising at the microeconomic level should be much reduced. Thus, there is a clear interest in encouraging moves towards structural reform.

References Artis, M.J. (1998): ‘The Unemployment Problem’, Oxford Review of Economic Policy, Autumn 1998.

Blanchard, O.J. (1997): ‘The Medium-Run’, Brookings Papers on Economic Activity, 2: 1997.

ECB, Monthly Bulletin (various).

IMF, (1999): ‘Chronic Unemployment in the Euro Area: Causes and Cures’, World Economic Outlook, April 1999.

Koedijk, K. and J. Kremers (1996): ‘Market Opening, Regulation and Growth in Europe’, Economic Policy, October.

Mortensen, D. and C.A. Pissarides (1999): ‘Unemployment responses to skill-biased technology shocks: the role of labour market policy’, Economic Journal, April.

87 Nickell, S. (1997): ‘Unemployment and Labour Market Rigidities: Europe versus North America’, Journal of Economic Perspectives, Summer

OECD, Economic Survey of the US (various).

Tanzi, V. And H. Zee (1997): ‘Fiscal Policy and Long-Run Growth’, IMF Staff Papers, June.

Thomsen, J. and J. Ulriksen Thuesen (1999): ‘The euro and the new perspectives’, Danmarks Nationalbank Bulletin, January.

White, W.R. (1998): ‘The Coming Transformation of Continental European Banking?’, BIS Working Papers No. 54.

88