Central Bank upfront about the challenges that lie ahead

ANALYSIS: Bank stability, a healthier fiscal position and gains in competitiveness are prerequisites to recovery

A PERIOD in which forecasts were repeatedly slashed has given way to one where predictions are being edged upwards gradually.

This is particularly obvious at the global level, where each successive IMF and OECD publication is a bit more optimistic than the previous one.

The same is broadly true on the domestic scene, albeit on a more moderate scale. The forecasts in the latest Central Bank Quarterly Bulletin see the economy contracting by 2 per cent this year, an improvement on the 3.1 per cent forseen in its previous bulletin.

Though this may look like a big move, the reality is that the bank has simply touched up its projections here and there. Moreover, it leaves the Central Bank very much in line with the Government and the ESRI.

Roughly half of the upward adjustment comes from better exports. This cautious approach reflects the fact that recent upgrades to global growth exclude Britain and the euro zone, two of our more important trading partners.

The other half comes from consumer spending where the bank has improved its estimate despite listing a variety of factors that will keep the consumer on the back foot for the foreseeable future. The bank says the economy appears to be close to the trough of the downturn, although it adds that “some weakness will persist into the first half of this year, and there are likely to be further employment losses”. As one would expect, it is pretty upfront as regards the challenges that lie ahead.

There is no talk of the worst being over or of turning the corner. Instead, it emphasises that recovery, when it emerges, is likely to be both gradual and modest. To realise our medium-term potential, restoration of banking stability, significant further improvement in the fiscal position and recovery of lost competitiveness is required.

The bank did not produce detailed 2011 forecasts but guided growth of 2.5-3 per cent, ie somewhat more cautious than the 3-3.3 per cent forecast in December’s budget and even further below that proffered by the ESRI’s Prof John FitzGerald in a paper last year. The bank is in broad agreement with the budget scenario that another €6.5 billion in “cuts” must be found. It emphasises that this requires a more stable and reliable tax base, ie property tax and user charges, as well as the abolition of tax reliefs. However, it also means bringing “expenditure back into line” and “much of the burden” will fall on this side.

The focus on spending cuts in the recent budget is fully endorsed and reform of the public service via greater flexibility and cost containment is recommended.

The banks will require further injections of capital to cover Nama and likely non-Nama losses. Though not explicitly stated, it appears increasingly likely that these will have to come from the taxpayer, hence the reference to policy challenge. However, the result should be a reduction in market uncertainty and funding costs.

The bank notes that it is important to avoid a “negative feedback loop” between the banks and the real economy; in other words, the banks must be strengthened sufficiently to facilitate an adequate supply of credit. This is a more realistic approach than the “force the banks to lend” argument one frequently hears.

Restoring lost competitiveness is the third challenge. Here the recent recommendations of the National Competitiveness Council are echoed. Forecast reductions in wage rates are less than 3 per cent in both 2009 and 2010. However, when allowance is made for productivity and exchange-rate movements, competitiveness is expected to improve by up to 12 per cent over the two years. This seems like a lot but the loss has been even greater, hence the relative caution regarding the prospects for exports.