Policy, Planning, and Research WORKING PAPERS Economic Analysis and Prospects International Economics Department The World Bank August 1989 WPS 262 Ad justment and External Shocks in Ireland Dermot McAleese and F. Desmond McCarthy Long delayed, the Irish adjustment program might well be described as an economic success story - so far. How it comes out depends greatly on the external environment. The Policy, Planning, and Research Complex distributes PPR Working Papers to disseminate the findings of work in progress and to encourage the exchange of ideas among Bank staff and all others interested in development issues. These papers carry the names of the authors, reflect only their views. and should be used and cited accordingly. The findings, inerprations, and conclusions are the authors' own. They should not be attributed to the World Bank, its Board ofDirectors, its maugement, or any of its mant'ercountries. Plc,Plannlng, and Research Economic Analysis and Prospects The Irish economy has faced adjustment prob- Extemal shocks and intemal efforts have lems similar to those of the highly indebted de- wombined to produce a dramatic turnaround in veloping countries. economic perfonnance. It enjoyed buoyant growth through the late Government borrowing declined from 13 1970s, at which time the economy suffered percent of GNP in 1986 to 3 percent in 1988. A external shocks due to adverse tenns of trade chronic balance of payments deficit of 14 and the slowdown in the world economy. percent of GNP was eliminated. And inflation fell from over 20 percent to 3 percent. The initial policy response was to rely on additional extemal borrowing, higher taxes, and Ireland's economy is not yet out of the increased public spending - in short, to post- woods. The political consensus may weaken. pone adjustment. This led to extemal debt Unemployment remains high. Tax levels are problems and unemployment of crisis propor- higher than in other EC countries. And the debt tions in the mid-1980s. overhang leaves Ireland vulnerabl , to exchange rate fluctuations and a rise in interest rates. Since then, the economy has benefited from favorable external shocks. More important, in It remains to be seen whether the new early 1987 a newly elected minority government policies will be sustained long enough to pro- began implementing long-delayed adjustment duce the desired results and rectify the mistakes policies. These efforts were supported by the of the previous decade. main opposition parties and the European Community. This paper is a product of the Economic Analysis and Prospects Division, Interna- tional Economics Department. Copies are available free from the World Bank, 1818 H Street NW, Washington DC 20433. Please contact Milagros Divino, room S7-037, extension 33739 (23 pages with tables). The PPR Working Paper Series disseminates the findings of work under way in the Bank's Policy, Planning, and Research Complex. An objective of the series is to get these findings out quickly, even if presentations are less than fully polished. The findings, interpretations, and conclusions in these papers do not necessarily represent official policy of the Bank. Produced at the PPR Dissemination Center TABLE OF C5NTENTS Page No. SUMMARY INTRODUCTION 1. POLICY BACKGROUND ........................................... 1 2. QUANTIFYING EXTERNAL SHOCKS 1979-85 ......................... 4 Terms of Trade ............................................ 5 Slowdown of the World Economy ............................. 5 Interest Rate Shocks ...................................... 5 3. POLICY RESPONSE ............... ............................. 6 4. EVALUATION AND RECENT DEVELOPMENTS .......................... 8 What Went Wrong? .......................................... 8 Recent Developments ....................................... 10 5. CONCLUSION .................................................. 13 List of Tables 1. The Irish Economy, 1949-86 2. Ireland - Indicators of Economic Performance, 1979-86 3. Indicators of External Shocks and Structural Adjustment 4. Interest Payments and Foreign Debt, 1977-86 5. Relative Wages Costs in Manufacturing Industry 6. Adjustment Process in the Irish Economy, 1986-89 ANNEX - METHODOLOGY BIBLIOGRAPHY Dermot McAleese is Whately Professor of Polittcal Economy at Trinity College, Dublin. F. Desmond McCarthy is Principal Economist at the World Bank. The authors would like to thank Wilfred Chow for research assistance, and Bela Balassa, Patrick Honohan and Dermot Nolan for their comments on an earlier draft. The final draft was prepared by Milagros Divino. INTRODUCTION The Irish economy is one of many semi-industrialized economies which progressed from strongly inward-oriented to outward-looking policies during the 1960s. The change was spread over a number of years but it was consistently adhered to. Unilateral tariff reductions were implemented in 1962 and 1963 and a free trade area agreement was concluded with the UK in 1965. With accession to the European Community in 1973, the commitment to free trade with countries which accounted for over 70% of Irish trade had become irreversible. To date, the authorities have achieved substantial success in export promotion and industrial growth. However, major problems remain such as unemployment rate of 17% (in 1988) and one of the highest external debt/GDP ratios in the world. The purpose of this paper is to study the impact of external shocks on an economy which was well along the path of transition to outward-looking policies. The shocks in question were a deterioration in the terms of trade, slowdown in the world economy during the period 1978-82, and an increase in interest rates. A priori the fact of outward orientation would suggest that the Irish economy should have been able to respond effectively to these shocks. Balassa and McCarthy (1983), for instance, show that open economies generally tended to achieve more successful results in this regard. The analysis in this paper indicates that openness per se was not sufficient and that the Irish authorities' policy response was inappropriate in several respects. By quantifying both the impact of the external shocks and of the policy response, aspects which have been neglected in the literature on Ireland's experience, a more complete understanding of the unsatisfactory performance or the economy during the 1980s can be obtained. The paper is divided into four sections. First, the policy background since 1960 is briefly outlined. Next the effects of external shocks are quantified. The third section contains a discussion of policy response to these shocks. The concluding section discusses the recent policy performance and initiatives. The methodology is given in the Annex. 1. POLICY BACKGROUND Selected summary statistics for the Irish economy are given in Table 1. The period of inward-looking policies lasted from the 1930s to the early 1960s. Import substitution industries were geared to the domestic market and tended to be small and inefficient. Effective rates of protection were high in absolute terms (averaging 79% in 1964-66) and were distributed across industries with little economic rationale (McAleese, 1971). Protected industries received little (often negative) incentive to export as a result of the strong birs implicit in the protectionist regime. The agricultural sector, being the major export sector, suffered from this domestic policy bias. In addition food exports faced severe import restrictions on the European market. Tariff-induced foreign investment played only a limited role in Lreland's early industrial development, mostly because of the small size of the domestic market. The period since 1960 can be divided into three subperiods: 1960-73, 1973-79 and 1979 to the present, corresponding to, before, between, and after the two major oil shocks. Each is now discussed briefly../ Buoyant Economy 1960-73. Outward-looking policies were systematically introduced from the early 1960s onwards. The principal policy instruments were a gradual dismantlement of tariffs and a series of industrial-cum-export promotion measures. The latter included capital grants to new export oriented enterprises and relief on income and corporation profits tax earned from manufactured exports. The exchange rate remained tied on a parity basis with the British pound sterling which, at that time, was the most important currency for Ireland's foreign trade. Industrial exports grew by an average of 13.1% p.a. and agricultural exports by an average 4.6% p.a. during this period so that the composition of Irish exports changed substantially. The share of manufactured goods in total exports rose from 19% in 1960 to 35% in 1973. The authorities reversed the former policies of resistance to foreign investment. They sought to encourage foreign-owned industries to set up For recent historical overviews of the Irish economy, see Kennedy, Giblin and McHugh (1988) and O'Hagan (1987). - 2 - subsidiaries by means of non-repayable cash grants on fixed asset expenditure. Export-oriented manufacturing firms, by far tLe largest number being of overseas origin, accounted for 30% of gross industrial output in 1973 compared to a negligible percentage in 1960. Real. GNP increased at an annual rate of 4.4% during the period, a major improvement relative to the average growth of 1.7% p.a. during the fifties. Ireland's growth performance also improved perceptibly during this period in relation to average OECD growth rates. Emerging Problems 1974-78. By the early 1970s, the general verdict was that outward-looking policies were fulfilling many of their promises. Industrial employment was increasing, agricultural incomes were growing and the problem of emigration--an endemic feature of Ireland since the 19th century--was easing. Population had begun to increase as new jobs in industry appeared in significant numbers. Industrial growth, moreover, had been achieved with little deterioration in income differentials between social classes. After 1973, the slowdown in world economic growth and the 1973-74 oil price increases gave a strong unfavorable negative shock to the Irish economy. At that time about 70 per cent of Ireland's energy requirements were supplied by imported oil. Towards the end of the 1970s, the supply of foreign direct investment was becoming increasingly scarce and more expensive to attract. This, in turn, posed a difficult situation for policymakers. The authorities chose to resort to external borrowing to moderate the effects of the oil shock. This facilitated the maintenance of industrial growth but at the cost of a rise in the external debt/GDP ratio to 20% by 1977. Inflation began to escalate and averaged 14% during the decade. This was the inevitable consequence of maintaining the historical one-to-one parity with sterling in an open economy. The decision of policymakers to adjust to the 1973 shock by increased external borrowing and a modest degree of Government dissaving might have been justified. However, a new Government was elected in 1977 on the basis of an excessively expansionist economic program. This involved the abolition of rates (taxes) on private housing and automobile taxes and the promise of full employment based on government investment. The result was that the country was left vulnerable to the adverse shocks which were to appear after 1979. - 3 - 1979-Present. At the end of the seventies, the general vie,. was that outward-looking policies had provided many of the advantages promised by their advocates. Foreign investment had spread its benefits into many small towns and cities throughout Ireland. A disappointing feature of the new policies, however, was the failure of ir.digenous industry to respond to the new regime. This was because in most instances domestic industry had not succeeded in transforming its sales profile from the domestic market to the export market. Successful indigenous exporters tended to concentrate on the British market, and sold little into continental EEC, where they had little experience and inadequate marketing information for new initiatives. Most of the increase in exports was accounted for by overseas subsidiaries. Moreover, linkages between overseas subsidiaries and domestic industry were limited, reflecting the small size of the economy and the highly specialized nature of their activities. In these circumstances, a key policy imperative would have been to improve domestic cost competitiveness and enhance the incentives for exporters through a more attractive tax regime. The need for such measures was given added urgency by the adverse external shocks detailed in Section 2. Instead of curbing public expenditure, however, it was allowed to continue increasing. A change in the leadership of the government party in 1979 and a succession of weak governments in the early eighties led to less control over public finances. The Exchequer borrowing/GNP ratio increased from an already high 13% in 1979 to 16% by 1981. Because of electoral pressure, efforts to curb the budget deficit took the form of increased taxation rather than reduced expenditure. This approach proved to be ultimately self-defeating. It fueled the domestic inflationary process, led to a serious erosion of work incentives and to a worsening cost position vis-a-vis continental European countries. There was an increase in industrial unrest--led by powerful public sector unions--and widespread dissatisfaction wit- the tax system. Unemployment and debt began to increase very rapidly and GNP growth slowed. By 1987, the economy had reached. a state of crisis. The 1987-88 OECD report on Ireland detailed how within less than a decade, the unemployment rate had risen from 6% to 19%, foreign debt exceeded 70% of GNP and total public debt (foreign and domestic) was 150% of GNP. At the same time, emigration had resumed with population again beginning to fall in spite of a high birth rate. The - 4 - public sector deficit amotunted to 13% of GNP in the 1986 budget. Living standards in 1986 had fallen to 10% below the 1980 levels and investmexic was 14% lower than in 1980 (Table 2). Marginal rates for personal income tax reached 58% for income lavels only slightly above the average industrial wage. Confidence in the conomy had reached a low sbb and capital flight had become an increasingly wtrrisome problem. It was evident that structural imbalances had to be addressed. 2. QUANTIFYING EXTERNAL SHOCKS 1979-85 In seeking to understand what went wrong it is important to analyze some of the external forces (shocks) which affected the economy and the policy response to them. The estimation of external shocks follows the approach which has been applied to analysis of semi-industrial countries by Balassa (1981) and Balassa and McCarthy (1983). The methodology is outlined in the Annex. Following the methodology used in that paper, the magnitude of the principal external shocks are first estimated and the policy response to them evaluated. The shocks considered are: (a) terms of trade; (b) external market effects due to the slowdown of world economic growth; and (c) interest rates. The principal forms of policy response to these shocks considered in this paper are: (a) additional external borrowing; (b) export promotion; (c) import substitution; and (d) changing the level of domestic economic activity-(GNP). The results are summarized in Table 3. For example in 1981 the external shock suffered by the Irish economy when compared with the 1976-78 base period is estimated at US$2460 million. The shock was composed of adverse terms of trade (US$1905), contraction in export markets (1:-$552) and higher interest rates (US$2 million). These effects were offset by a combination of policy measures: additional net external financing US$2183 million; export promotion US$155 million; contraction of economic activity US$480 million; and some deterioration in import substitution efforts US$359 million. Each of the components are now discussed briefly. -5- Terms of Trade The terms of trade shock was largely attributable to the composition and direction of trade. Export prices of agriculture and agricultural products, which accounted for over 35% of total exports, declined, while the import price index, heavily influenced by petroleum, rose over the period. As the composition of exports changed towards industrial goods, the size of the terms of trade shock was moderated a little. Thus while terms of trade deteriorated by about 10% from the base period, 1976-78, to their low point in 1981 they recovered most of those losses by 1986. This resulted from improved prices for manufactures, a recovery in agricultural prices and the large post-1985 fall in oil prices. Slowdown of the World Economy The effect of the slowdown of the world economy is estimated by comparing the growth of world exports in the years 1979-85 to the period 1963-73. By calculating the impact of this .iowdown, one can make appropriate allowance before assessing the effects of export promoting policies on strengthening Ireland's world market share. Thus while export promotion policies were hindered by moderately unfavorible external conditions in 1980 they encountered strong adverse conditions from 1981 to 1984. The economic restructuring of the UK economy added further to adverse shocks during this period due to Ireland's close economic ties with that country.2,/ Interest Rate Shocks The shock due to higher international interest rates in the early eighties was not particularly significant for Ireland. This is primarily because V McAleese (1986) shows that during the period 1979-85, these effects were felt not via direct trade impact but indirectly via the closure of UK manufacturing subsidiaries in Ireland as a result of rationalization in the British parent company and via the increase in Irish unemployment as a result of the rise in UK unemployment - 6 - external debt levels had not yet reached critical levels (see Table 4) and a large proportion of the debt was not dollar-denominated. The revaluation effects are not included in this analysis. FitzGerald (1986) provides details on the national debt at that time. Public sactor external debt amounted to IRL 3217 million by 1980. However, the policy choices during those years, and a fortiori the succeeding years, set the stage for the explosion in debt which reached IRL 12041 million by end-1986. The impact of these shoc' s on Ireland's open economy can be seen in the final row of Table 3. Their combined value was equivalent to 14% of GNP in 1981 and a similar amount in 1982. This finding is important in view of the tendency in Ireland to blame much of the cou':ltry's ills on the inadequacies of industrial policy and more particularly of the lack of control over fiscal. policy. Even with the best policies imaginable, the scale and range of the external shocks during the years 1979-85 would have created major obstacles to growth. The policy response was not appropriate and led to a more difficult economic situation later. 3. POLICY RESPONSE The policy response is summarized in Table 3. For each of the four categories considered there appears to be a noticeable difference between 1979-82 and 1983-85. Up to 1982 the government resorted primarily to external borrowing to offset the impact of adverse external shocks. However, from 1983 onwards, this policy was reversed and the authorities placed greater emphasis on macroeconomic contraction. External Borrowing. In the years 1979-81 external borrowing was the principal policy used to offset the effects of the adverse external shocks. The year 1979 was particularly notable. For that year the external shock was estimated at US$566 million. While there was some success in export promotion that year, the surge in net external financing of US$1779 million was remarkable. This was done to accommodate the tax cuts, public service pay increases and other spending increases. This policy set the stage for the rapid increase in external debt that was to create a severe burden in later years. The L)vernment tried to maintain domestic activity in face of the adverse external environment. Public current spending increased from 39% of GNP in 1978 to 46% in 1981 and 51% in 1982. This share continued to increase until it peaked at 55.8% in 1985. Public investment declined from 15.2% of GNP in 1981 to 11.1% in 1985. From 1982 onwards the pace of borrowing was moderated substantially below trend levels. Below-trend borrowing was still substantial, however, and to this was added the revaluation effects of foreign currency changes on the substantial stock of overseas debt. Taken in conjunction with the declining share of investment during this period, the scale of fiscal retrenchment was inadequate and the economy was not on a sustainable track. Fisc )olicy during this period tended to emphasize increased revenue and not until L87 were there significant expenditure cuts. Export Promotion. Export promotion policies were successful in increasing ireland's market share strongly in the years 1979, 1980, 1981 but at a slower pace thereafter. This may be explained to some extent by the weakening of the strong pro-export bias in the later years as the competitive positi^n for exporters, as measured by labor compensation indices, showed significant erosion (see Table 5). Import Substitution. A decline in import substitution was particularly evident in lS79 and 1980 when a strong increase in public investment-oriented and import-intensive demand contributed to a surge in imports. From 1982 onwards success in developing domestic energy resources together with energy saving policies resulted in substantial import substitution. Domestic Activity. The principal policy response especially since 1982 has been the contraction of domestic economic activity. This has been done by the applicatior f deflationary fiscal and monetary/exchange rate policy. It is desirable that these policies achieve expenditure switching investment in order to achieve a sustainable economic growth. However, in Table 2, it is noted that investment fell to a level of 17% of GNP by 1986. Much of this can be attributed to the winding down of the post 1979 EMS-financed public investment -8- program. Private investment was also depressed during this period. Confidence was weakened by the center-left Coalition government's (1982-1987) inability to deal effectively with the public finances. The stock of debt continued to rise in spice of higher taxes. On numerous occasions, the Government declared its ix. ention of .t!solving these problems but their protestations were heavily discounted. Nominal and real interest rates remained high which further discouraged investment. Thus the authorities faced the unenviable task of trying to convince private investors that the adjustment program would be sustained even though there was a large debt to be serviced and little apparent public support for further public sector cuts. 4. EVALUATION AND RECENT DEVELOPMENTS What Went Wrong? Previous sections have outlined some of the causes of the adjustment problem. The external sources of difficulty were identified as: (a) global economic slowdown especially in Britain; (b) the oil price increase 1979/80 together with the weakening in agriculture prices; and (c) the rise in interest rates. These adverse external shocks were succeeded by favorable shocks in the form of the post-1983 decline in oil prices and recovery in the world economy. Yet the economic situation has remained unsatisfactory. After five years of attempted adjustment, the debt-GNP was higher than ever and interest on debt absorbed over 10% of GNP. Policies during this period had involved a reduction in noninterest government expenditure and heavy cuts in the public capital program. Real disposable incomes had fallen drastically. But, despite all this, deficits remained high. Many of the lessons from the adjustment process in Latin America could be applied also to Ireland (Bianchi 1987). Short-term adjustment achieved by lower private investment impeded long-term structural adjustment. As in many Latin American countries, adjustment was achieved "largely at the expense of growth" (Bianchi, p. 195). Adjustment was not only costly and inefficient but by 1986 was still far from complete. The source of the problem was that 9- adjustment measures, by focussing on increased taxation rather than curbs in expenditure and by cutting capital programs instead of the current government expenditure failed to provide the appropriate climate for growth. Competitiveness indicators show a net 16% disimprovement between 1979 and 1986 (Table 5). Bradley and FitzGerald (1988) have emphasized the importance of these factors in the Irish economy. In many instances attempts to curtail public expenditures have failed because the private sector has responded too slowly in picking up the slack. Political pressures then force their abandonment. In Ireland one also finds the authorities had great difficulty in establishing a credible policy regime to sufficiently stimulate the private sector. Instead of expenditure being switched to tradables from non-tradables, total expenditure fell. The balance of payments improved not because output grew more rapidly but because investment and consumption declined, compressing imports and stunting growth. The issue of adjustment and credibility is discussed at length in a recent paper by Dornbusch (1988). His analysis focuses on Ireland's stabilization policy, meaning by this the commitment to reduce inflation. By joining the European Mcnetary System (EMS) in 1979, the Irish authorities broke the sterling link with the EMS central rate. The policy was a success in terms of its effects on inflation which fell from a peak of 20% in 1981 to 3% in 1987. The elimination of inflation was, in Dornbusch's view, achieved at great cost. Concentrating on the post-1982 period he shows that, because of lack of credibility in the EMS commitment, real interest rates remained high and, because of labor-marlet inflexibility, real wages and costs were uncompetitive. Higher debt-servicing costs and the failure to "crowd-in" export activity through increased competitiveness meant that efforts to control the budget deficit were frustrated. "The triumph of low inflation", he concludes, "has come at the cost. . .of extraordinarily high unemployment, massive emigration and a precarious debt overhang". - 10 - Dornbusch's analysis takes no account of the external shocks which we have identified as important. Ireland's fiscal and unemployment problems are ascribed directly or indirectly to the disinflationary process. This leaves out of the reckoning the delayed effects of the severe shocks 1979-82 and the continuing impact of changes in external demand (Table 3). As a result he tends to overestimate the cost to the economy of the price stabilization policies associated with Ireland's participation in the EMS. Most analysts of the Irish economy--including Dornbusch (1988) emphasize the damage done to the economy by inappropriate fiscal policies and by the loss in competitiveness vis-a-vis its major trading partners. Adjustment policy was sluggish, shortsighted and unsustainable. By end-1986, the economy had run into a major crisis of confidence. A comprehensive 300-page analysis of the economic situation by the National Economic and Social Council (1986) concluded that the economic and social problems facing the country were "extremely grave". Criticism of the economy reached a crescendo prior to the February 1987 election, with the Sunday Times (London) headlining Ireland's plight as a third world country. Around the same time, The Economist pronounced a devastating critique of Ireland's economic management.3/ Recent Developments A new government, elected in early 1987, took steps to deal with the economic crisis. The inappropriate policy choices of the preceding years made the starting position for the adjustment process difficult. However, in confronting this task, the government also had some special advantages: (a) membership of the European Community gave Ireland an umbrella of institutional stability; (b) the main opposition parties promised cooperation with the (minority) government in achieving the objective of economic stabilization; (c) the debt crisis had not degenerated into a liquidity 3/ Sunday Times 8 February 1987; Economist 24 January 1987 "Ireland: flow the Covernment Spent the People into a Slump". The Economist later (1988) provided a more detailed analysis. - 11 - crisis--the Irish government was able to continue foreign borrowing at comparatively iow interest rates; and (d) external "shocks" became favorable due to: (i) the fall in oil prices and strengthening in agricultural prices; (ii) sustained recovery in the UK and continental European economies; (iii) easing of domestic interest rates; and (iv) favorable developments in exchange rate and cost competitiveness trends (Table 6). The four key elements in the recovery strategy were: (a) Restoration of fiscal balance by means of cuts in both current and capital expenditure, the former achieved by strict budgetary controls, tght restraint on publi'. sector pay and reduction in public sector employment. (b) Tax Reform. The main objective was to widen the tax base, to improve collection procedures and to provide incentives for economic development. A specific commitment was made to reduce income tax rates over the period 1987-90. (c) Social Equity. A commitment to greater efficiency in social welfare schemes while ensuring that the least well-off are sheltered as far as possible from the cost of adjustment. There were ambiguities and intrinsic difficulties with this policy, especially in the light of the considerable over-extension of social expenditure in the post-1979 period. In 1986, official figures showed tLat social welfare benefits in Ireland were in some cases higher than in the UK despite the latter's one-third higher income per capita. Emphasis was placed on better targeting of government social expenditure. (d) Development-Oriented Policies. Pay increases in the public sector were limited to a basic 2.5% in each of the years 1988, 1989 and 1990. Costs to industry were curbed indirectly in this way since public and private sector pay are closely intertwined. In addition action was taken to reduce non-labor costs such as the price and - 12 - quality of insurance and of services provided by public sector utilities. Industrial grants were focused increasingly on employment provision and away from capital subsidization. The system of public support for industrial development was reviewed. Gene--ally the intention was to try to boost confidence via restoration of public sector finances, institution of a more finely-tuned system of state support for tradable goods and services in certain sectors such as financial services, marine, semi-state bodies. The initial results of the stabilization policies have been more successful than even the most ardent advocate of fiscal retrenchment would have expected. Government borrowing has been cut from 13% of GNP in 1986 to 5% in 1989. A tax amnesty combined with improved collection procedures brought in a revenue windfall in 1988 worth about 3% of GNP. Moreover the feared deflationary effects of this retrenchment did not materialize. On the contrary, the slack in the public sector's demand was taken up by booming exports, revived investment activity and a rise in personal consumption.!./ Competitiveness vis-a-vis the UK and continental European trading partners improved and the weak dollar eased the debt-servicing burden. In the light of more up-to-date data, suggesting the conclusion that Irish experience was one of a "failed" stabilization program, may be premature. Ireland's stabilization program now seems to be on a track towards success. In explaining this success, reference has already been made to the existence of strong institutional support from Brussels, the constructive approach by opposition parties to the minority government's strategy and favorable external developments. Mention might also be made of the working of virtuous circles which is highly relevant to a heavily-indebted country. One example of many is the way in which success in fiscal policy led to a lower i/ Using data for the period 1961-84, Moore (1987) provides evidence of a strong Ricardian equivalence effect on Irish consumption which may explain why the deflation of the economy was not as severe as the gradualists expected. - 13 - supply of Irish gilts which lowered domestic interest rates and which, in turn, resulted in further progress in reducing current expenditure. The scale of the interest rate decline is clear from Table 6. Irish interest rates have tended to exceed sterling rates yet, by end-1988, Irish 3 month interest rates were over 5 percentage points below LIBOR. The gap between DM and Irish interest rates which averaged over 9 percentage points in 1986 had fallen to below 2 percentage points two years later. 5. CONCLUSION The Irish economy suffered serious external shocks during the period 1979-83. The main policy response to these shocks was to rely on borrowing and postpone adjustment. The result was a huge accumulation of foreign and domestic government debt and high unemployment. The situation reached crisis proportions by end-1986. Since then, the economy has benefited from favorable external shocks which have yielded major benefits. More importantly the long-delayed implementation of proper adjustment policies began with a newly-elected minority government in early 1987. External and internal development reinforced each other with the result that the Irish stabilization program might well be described by future analysts as a success story. However, much will depend on the external environment. These external shocks on the economy for the period 1979-85 played a major role in determining the latitude available to policy planners. In order to assess the credibility or likelihood of sustainability of any stabilization effort it is essential to analyze not only the domestic but also the external environment. The economy, however, is not yet out of the woods; the political consensus may weaken; unemployment remains very high; taxation levels exceed those in other EC countries; and the debt overhang leaves the economy vulnerable to exchange rate fluctuations and a rise in interest rates. - 14 - Table 1: THE IRISH ECONOMY, 1949-86 (selected growth rates) 1949-61 1961-73 1973-86 1981-86 GDP 2.0 4.1 3.6 1.9 Employment -1.3 - 0.9 -1.6 GDP per worker 3.3 4.1 2.6 3.5 Gross National Disposable Income (GNDI) 1.9 4.4 3.4 0.1 Population -0.5 0.7 1.4 0.8 GNDI/person 2.4 3.6 1.9 -0.7 Consumer prices 3.4 6.1 16.0 9.0 Sectoral Growth 1949-61 1961-73 1973-83 Agriculture 0.9 1.7 1.5 Industry 3.6 6.2 3.2 Services 1.6 3.7 2.7 1960 1986 Imports (goods and services) % GDP 37 52 Exports (goods and services) % GDP 32 57 Sources: National Income arnd Expenditure, Central Statistics Office, Dublin, various issues; Ireland Statistical Bulletin, December 1988. - 15 - Tgble 2: IRELAND - INDICATORS OF ECONOMIC PERFORMANCE, 1979-86 ------------------------- Annual Percentage Change --------------- Key Indicators 1979 1980 1981 1982 1983 1984 1985 1986 GDP 3.1 3.1 3.3 2.3 -1.9 4.2 2.0 0.3 GNP 2.7 2.7 2.6 2.0 -3.5 1.8 0.2 -0.5 Personal Consumption 4.4 0.4 1.7 -7.1 -0.1 -0.8 1.1 2.1 Investment 14.5 -3.7 7.3 -3.3 -9.0 -2.4 -4.4 -0.3 Exports: value 17.4 17.3 17.0 19.1 22.0 28.1 9.5 -3.6 voltume 8.2 7.8 0.8 7.2 12.0 18.3 6.6 4.0 Imports: value 30.0 12.3 21.4 3.6 8.1 21.0 5.8 -8.5 volume 14.4 -4.5 2.1 -3.4 3.1 10.4 3.4 3.0 -------------------- in IRL millions ----------------------------- Balance of Payments: trade belance IRL m 365 -1342 -1698 -1120 -522 -197 155 560 Current Account Balance: IRL m -1026 -1038 -1595 -1316 -925 -890 -549 -329 X GDP 13.0 11.0 14.0 9.8 6.3 5.5 3.2 1.8 --------------------- in % of GOP (GNP) ------------------------- Gross Investment/GDP 30.7 29.0 29.5 26.4 23.3 21.7 20.4 18.9 National Savings/GDP 19.6 16.1 13.6 17.2 17.0 17.5 17.6 17.1 Exchequer borrowing/ GNP 13.2 13.5 15.9 15.7 13.8* 12.6 13.2 13.1 Exchequer borrowing (excl. interest)/GNP 7.3 7.0 8.6 6.5 3.8 1.8 1.2 2.1 National Debt/GNP* 85.7 87.7 93.9 103.4 118.1 128.0 133.8 150.6 External Debt/GNP** 20.2 24.5 34.9 42.5 52.0 53.4 55.0 60.1 Interest Payments on debt/GNP 5.9 6.5 7.3 9.2 10.0 10.8 12.0 11.0 --------- Terms of Trade, Prices and Exchange Rates ------------- (1978=100) Terms of trade 95.8 88.4 86.4 89.5 93.0 91.8 92.2 96.2 NominaL Effective Exchange Rates 102.2 100.0 91.3 90.3 86.6 82.0 83.9 87.0 Real Effective Exchange Rates 97.1 100.0 95.0 98.1 100.0 98.5 98.8 104.0 Real Conpensation Per Enployee 4.6 5.6 0.6 -1.1 0.3 5.2 1.3 -0.5 Consumer Prices (X change p.a.) 13.2 18.2 20.4 17.1 10.5 8.6 5.4 3.8 Unemployment X total labour force 7.4 8.2 10.2 12.1 14.7 16.4 17.7 18.2 * Because of doubile counting of local loan fund charges, the figures exaggerate the amount of domestic debt. ** External debt includes only exchequer debt owing to foreigners. External debt of state-owned enterprises is excluded. Source: National Income and Expenditure, 1986; Department of Finance. Review of 1986 and Outlook for 1987, CentraL Bank Quarterly Bulletin, European Economy (Conmmission of the European Cammunities) - 16 - Table 3: INDICATORS OF EXTERNAL SHOCKS AND STRUCTURAL ADJUSTMENT L2 (in USS millions) 1979 1980 1981 1982 1983 1984 1985 Effect of External Shock Terms of Trade 739.6 1583.7 1905.3 1224.2 572.8 391.0 197.5 Export Volume -160.9 131.6 552.4 1128.5 1390.3 1382.3 1639.9 Interest Rate Effect -12.5 6.1 2.3 164.8 95.7 138.7 186.8 Total 566.1 1721.4 2459.9 2517.4 2058.9 1912.2 2024.3 Policy Response Additional Net External Financing 1776.8 1818.1 2183.4 1122.7 68.4 -332.3 -582.9 Export Promotion 1075.6 1474.8 155.5 31.1 -157.0 -407.0 -311.2 Import Substitution -2239.2 -1891.6 -359.0 406.1 562.3 1340.7 1058.1 Macroeconomic Contraction -47.0 220.1 480.0 957.6 1585.2 1310.8 1860.3 Total 566.1 1721.4 2459.9 2517.4 2058.9 1912.2 2024.3 External Shock as X of GNP 3.6 9.3 14.0 14.2 12.2 12.0 12.4 /a The base period used in these calculations is 1976-1978. The trend growth rates were for the period 1963-1973. -17 - Table 4: INTEREST PAYMENTS AND FOREIGN DEBT, 1977-86 (in IRL millions) Gross Other Interest Outflows External (Tncluding Gross Net National Semi-State Inflows Interest External Ext:ernal External Debt and Banks (Interest Catflows Govt. Putblic Official Interest Interest) + Divldend) (l)+(2)-(3) Debt l'ebt Reserves (1) (2) (3) (4) (5) (6) (7) 1977 95 126 235 -14 1039 1449 1201 1978 131 176 279 28 1064 1494 1252 1979 154 257 339 72 1542 2122 975 1980 193 381 465 109 22C,' 3217 1346 1981 266 455 567 154 3794 5100 1473 1982 526 498 585 439 5290 6959 1594 1983 597 489 549 537 7017 9049 2015 1984 720 598 628 690 7926 10091 2101 1985 795 612 722 685 8441 10387 2272 1986 761 588 648 701 9754 12041 2205 Note: Column (1) includes interest paid to non-residents on IRL-denominated debt. column (2) excludes interest payments on loans from overseas companieas to their Irish subsidiaries, while column (3) includes dividend receipts. Column (4) is, therefore, not a fully accurate or comprehensive measure of net interest outflow but it is the closest available approximation. Column (6) equals column (5) plus foreign debt of semi-state bodies. Source: Columns (1), (2) and (3), Balance of Payments, Table El, Central Bankc Quarterly Bulletin. Columns (5) and (6) Department of Finance, and OECD Economic Survey: Ireland 1984-85. - 18 - Table 5: RELATIVE WAGES COSTS IN MANUFACTURING INDUSTRY (% change per annum) 1980-100 Average Hourly Earnings a/ Relative Hourly Earnings k/ Major Trading National Common Ireland Partners Currencies Currency (IRL) 1978 15.5 11.3 92 95 1979 15.3 11.4 94 98 1980 20.5 13.6 100 100 1981 16.0 12.0 104 94 1982 15.5 8.0 110 99 1983 11.2 7.4 115 100 1984 10.1 5.4 119 100 1985 7.9 7.3 121 102 1986 6.8 5.4 122 110 1987 5.3 4.5 123 109 1988 4.5 6.2 121 105 a/ In national currencies. 5/ A rise in the index implies a disimprovement in competitiveness while a fall in the index implies an improvement. Source: Central Bank of Ireland Quarterly Bulletin, Winter 1988 - 19 - Table 6: ADJUSTMENT PROCESS IN THE IRISH ECONOMY, 1986-89 1986 1987 1988 1989 Growth (volume, % growth p.a.) GDP 0 4 3 4 GNP 0 5 2 4 Investment -3.5 -1 -1 8 Private Consumption 2 0 3 4 Public Consumption 3 -3 -4.5 -3 Exports of goods and services 3 13 8.5 7 Imports of goods and services 4 5 5 8 Fiscal Adjustment Current budget deficit (% GNP) 8.4 6.6 1.7 4.1 Exchequer borrowing (% GNP) 13.1 10.0 3.4 5.4 National debt (% GNP) 136.3 136.9 137.0 133.2 Terms of Trade (1985-100) 104 104 105 105 Competitiveness (1980-100) Hourly earnings in common currency 110 109 105 105 Interest Rates 3-Months Dublin Inter-Bank Rate 14.06 8.88 7.60 8.0 Differential against sterling +2.82 -0.06 -2.47 -4.83 Differential against DM rate +9.13 +5.38 +3.68 1.77 UnemDlovment (%) 17.6 17.0 16.4 15.5 Sources: European Economy, November 1988; Central Bank of Ireland - 20 - ANNEX - METHODOLOGY Estimating External Shocks and Short-Term Policy Rtq19onse The methodology used to estimate external shocks on the balance of payments and the response to them follows that given in Balassa (1981) and used in Balassa/McCarthy (1984). The current account deficit,;/ C. and C, in years 0 and 1, respectively, is given by CO - M. - E. + FSP. (1) C, - MP1 - EP1 + FSP1 (2) where MHo Eat FSP0, MP1, EP1, FSP1, are merchandise imports, exports, and net factor service payments for years 0 and 1, respectively in current US$ balance. In order to introduce price effects EP1 and MP1 are written as: EP1 - E1 (1 + PE01) (li) MP, - H1 (1 + PMoH) (2i) where E1 and H1 are value of exports and imports in year 1 and PE01 and PHj are the percentage price changes for exports and imports. The change in current account deficit is thus given ly C1 - C. - MP1 - M, - (EP1 - E%) + FSP1 - FSP. (3) In order to estimate the effects of policy measures on exports the concept of hypothetical exports EH1 is introduced. This is the value of exports if the country maintains its base year share in world markets Equation (3) may then be rewritten as C1 - C. + E1 - EH1 - PMo1HM - PEO0E1 + M1 - M - (EH1 - E,) + FSP+ - FSP, (4) This differs from the usual definition. FSP includes interest payments on external debt less interest receipts on reserves. - 21 - In order to estimate the effects of changes in global demand the trend value of exports ET1 is introduced. This is exports that would result if the country maintained its share of exports in year 0 and the trend of export demand remained the same as in the base period. Equation (4) may then be written as C1 - C. + El - EH1 PM0lMl - PEOE1 + M1 - MO + (ET, - EH1) - (ET, - E.) + FSP1 - FSPO (5) Hypothetical imports MH1 are then estimated with actual country GNP and on the assumption that the income elasticity of import demand remained unchanged from the base period. This then gives C, - C. + El - EH1 + MH1 - Ml = PMOQM1 - PEOEl + MH1 - MO + ET1 - EH1 - (ET1 - EO) + FSP1 - FSPO (6) Next we introduce the trend value of imports, MT1, using both the base period elasticity and GNP growth rate. This then gives Ci - CO + E1 - El1 + MH1 - M1 + MT1 - MH1 = PMoiMl - PEOEl + MT, - Mo + ET1 - EH1 - (ET1 - EO) + FSP1 - FSPO (7) The trend current account deficit, CT, can then be defined as CT - MT1 - ET1 + FSPT1 (8) Substituting Equation (8) into (7) and using equation (1), one obtains C1 - CT + E1 - EH1 + MH, - Ml + MT1 - MH1= PM01M - PE01E, (9) + ET, - EH, + FSP1 - FSPT, (10) The left hand side of equation (9) may be interpreted as the various components of the policy response while the right hand side gives the various components of the external stocks as follows. - 22 - Policy Response Component C1 - CT Additional external financing used above the trend value for exports, imports and factor service payments El- EH1 Effect of domestic policy on exports Hl1i - M1 Effect of import substitution policy on imports MT1 - Mu1 : Effect of changes in growth rate of GNP on imports - that will also include the spillover effects of changes in exports on the demand for imported inputs. Components of External Shocks PMM1 - PEoIE: Terms of trade shock due to changes in import and export prices. ET1 EH1 . Export volume effect shock due to changes in external demands for a country's exports. ISP, - ESPT1 Additional factor service payments above the trend value - if it is assumed that this is all attributable to interest rate changes then this is termed the interest rate external shock. - 23 - BIBLIOGRAPHY Balassa, Bela, The Newly Industrializing Developinp Countries after the Oil Crisis, Washington, D.C., World Bank, 1981. Reprint Series 190. Balassa, Bela, and F. Desmond McCarthy, Adjustment Policies in Developinp. Countries. 1979-73, An Update, Washington, D.C., World Bank, 1984. Workinig Paper No. 675. Bianchi, Andres, "Adjustment in Latin America" in V. Corbo el al, Growth-Oriented Adjustment Programs. Washington, D.C. 1987. Bradley, John and John FitzGerald, "Industrial Output and Factor lnput Determination in an Econometric Model of a Small Open Economy", European Economic Review, July 1988. Dornbusch, Rudiger, Credibility. Debt and Unemployment: Ireland's Failed Stabilization, mimeo, Cambridge, Massachusetts, 1988. Massaclhusetts Institute of Technology, National Bureau of Economic Research 1988. Economist, Ireland Survey, January 16, 1988. FitzGerald, J.D. , The National Debt and Economic Policy in the Mediun Term, Thie Economic and Social Research Institute, Dublin, Ireland, 1986. K.A. Kennedy, T. Giblin and D. McHugh, The Economic Development of Ireland in the Twentieth Century, Routledge, London, 1988. McAleese, D. Effective Tariffs and the Structure of Industrial Protection in Ireland, General Research Series No. 62, Economic and Social Reseai h Institute, Dublin 1971. McAleese, D. "Anglo-Irish Economic Interdependence: Effects of Post-1979 Changes in the British Economy in Ireland", Irish Banking- Review, Spring 1986. McAleese, D. "Member State Report: Ireland; Europe, Magazin.. of the European Communities, Washington, D.C., January/February 1989. Moore, Michael, "The Irish Consur.)tion Function and Richardian Equivalence", Economic and Social Review, October 1987. National Economic and Social Council, A Strategy for Development. 1986-1990, Dublin, November 1986. Nolan, Sean, "Economic Growth: Theory and Analysis" in J. O'Hagan (ed) The Economy of Ireland: Policy and Performance (fifth edition), Irish Management Institute, Dublin 1987. OECD Economic Surveys. Paris, France, 1987/88. OECD Economic Surveys, Ireland. Review of 1987 and Outlook for 1988. Dublin, Department of Finance, Central Statistics Office. PPR Working Paper Series Contact Author DA fo WPS237 The Curricular Content of Primary Aaron Benavot June 1989 C. Cristobal Education in Developing Countrie- David Kamens 33640 WPS238 The Distributional Consequences of Ehtisham Ahmad August 1989 A. Bhalla a Tax Reform On a VAT for Pakistan Stephen Ludlow 60359 WPS239 The Choice Between Unilateral and Julio Nogues July 1989 S. Torrijos Mulilateral Trade Liberalization 33709 Strategies WPS240 The Public Role in Private Ake Blomqvist August 1989 A. Bhalla Post-Secondary Education: Emmanuel Jimenez 61059 A Review of Issues and Options WPS241 The Effect of Job Training on Ana-Maria Arriagada July 1989 C. Cristobal Peruvian Women's Employment and 33640 Wages WPS242 A Multi-Level Model of School Marlaine E. Lockheed July 1989 C. Cristobal Effectiveness in a Developing Nicholas T. Longford 33640 Country WPS243 Averting Financial Crisis - Kuwait Fawzi H. Al-Sultan July 1989 R. Simaan 72167 WPS244 Do Caribbean Exporters Pay Higher Alexander J. Yeats July 1989 J. Epps Freight Costs? 33710 WPS245 Developing a Partnership of Peter Poole August 1989 S. Davis Indigenous Peoples, Conservationists, 38622 and Land Use Planners in Latin America WPS246 Causes of Adult Deaths in Richard Hayes July 1989 S. Ainsworth Developing Countries: A Review of Thierry Mertens 31091 Data and Methods Geraldine Lockett Laura Rodrigues WPS247 Macroeconomic Policies for Carlos AKf redo Rudriguez August 1989 R.Luz Structural Adjustment 61588 WPS248 Private Investment, Government Mansoor Dailami August 1989 M. Raggambi Policy, and Foreign Capital in Michael Walton 61696 Zimbabwe WPS249 The Determinants of Hospital Costs: Ricardo Bitran-Dicowsky August 1989 V. Israel An Analysis of Ethiopia David W. Dunlop 48121 WPS250 The Baker Plan: Progress, William R. Cline August 1989 S. King-Watson Shortcomings, and Future 33730 PPR Working Paper Series Contact Title Author for paper WPS251 Patents, Appropriate Technology, lshac Diwan August 1989 S. King-Watson and North-South Trade Dani Rodrik 33730 WPS252 Do the Secondary Markets Believe V. A. Hajivassiliou August 1989 S. King-Watson in Life After Debt 33730 WPS253 Public Debt, North and South Helmut Reisen August 1989 S. King-Watson 33730 WPS254 Future Financing Needs of the Ishrat Husain August 1989 S. King-Watson Highly Indebted Countries Saumya Mitra 33730 WPS255 The External Debt Difficulties of Charles Humphreys August 1989 S. King-Watson Low Income Africa John Underwood 33730 WPS256 Cash Debt Buybacks and the Sweder van Wijnbergen Insurance Value of Reserves WPS257 Growth, External Debt, and the Real Sweder van Wijnbergen August 1989 M. Bailey Exchange Rate in Mexico 31854 WPS258 Understanding Voluntary L. David Brown Z. Kranzer Organizations: Guidelines for David C. Korten 69485 Donors WPS259 Dealing with Debt: The 1930s and Barry Eichengreen August 1989 S. King-Watson the 1980s Richard Portes 33730 WPS260 Growth, Debt, and Sovereign Jagdeep S. Bhandari August 1989 R. Luz Risk in a Small, Open Economy Nadeem Ul Haque 61588 Stephen J. Turnovsky WPS261 Inflation, External Debt and Sweder van Wijnbergen Financial Sector Reform: A Roberto Rocha Quantitative Approach to Consistent Ritu Anand Fiscal Policy WPS262 Adjustment and External Shocks in Dermot McAleese August 1989 M. Divino Ireland F. Desmond McCarthy 33739 WPS263 How Has Instability in World Markets Peter Hazell August 1989 C. Spooner Affected Agricultural Export Mauricio Jaramillo 30464 Producers in Developing Countries Amy Williamson WPS264 Two Irrigation Systems in Herve Plusquellec H. Plusquellec Colombia: Their Performance 30348 and Transfer of Management to Users' Associations