There is a significant risk that house prices are overvalued, leaving the property market vulnerable if unemployment rises sharply, the International Monetary Fund (IMF) has warned.
The boom in credit could have helped to push house prices to unsustainable levels, it says, leaving purchasers exposed and posing risks for banks and building societies which have lent them money.
In its latest assessment of the Irish economy, the IMF forecasts a pick-up in growth next year, but warns that declining competitiveness could hinder the economy.
It calls for a moderation in wage growth, and says that basic pay increases below inflation may be needed in the second phase of the current national agreement, particularly for the public sector.
In a detailed study of the housing market, the IMF says that it is impossible to say for sure whether there is a price " bubble " as fundamental factors, such as a housing shortage and strong demand, are behind much of the price rises.
However, there is a risk that market "psychology" could have pushed prices to unsustainable levels. This led the IMF directors, in their assessment accompanying the study, to warn that "a sharp rise in unemployment could . . . pose risks to the housing market and the financial sector".
The IMF warning on house prices is the latest in a line of pessimistic predictions for the sector, although the Central Bank has said it expects the market to stabilise rather than experience sharp price falls.
The IMF also warns of risks to the financial sector from exposure to investor-owned housing and the commercial property market. Overall it feels these risks are "manageable", but warns that the Irish Finance Services Regulatory Authority (IFRSA), the new regulator, will need to be vigilant.
The Central Bank, which is linked with IFSRA, also warned in its recent annual report about the financial sector's exposure to the housing market. IFRSA is currently undertaking a review of lending policies in the mortgage market, with recent figures showing an annual rise of 24 per cent in credit growth clearly concerning the authorities.
The IMF, the international economic institution based in Washington, undertakes an annual visit and report on member economies each year, which is then considered by its executive board.
The board commended Ireland's "exemplary track record of sound economic policies" in recent years. It predicted that Gross National Product growth would be 1.5 per cent this year and 3 per cent next year as the Republic benefited from an expected international recovery.
However, it warned that there were risks to this outlook as the "global recovery could be more anaemic than expected", while a further rise in the euro's value could hit competitiveness. This emphasised the need to control costs and bring down inflation.
It says negotiations due next year on pay increases for the second half of the new national agreement must reflect economic conditions, and this may mean rises below inflation "especially in the public sector and publicly-owned enterprises". Meanwhile verifiable evidence of improved productivity was essential in return for benchmarking increases in the public sector.
In a short statement, the Minister for Finance, Mr McCreevy, welcomed the IMF's findings, and said he agreed "that the likelihood of slower growth in the period ahead requires us to get our prices and cost increases more in line with our EU partners in order to improve our competitive position".
Fine Gael's Mr Richard Bruton said the report was a "timely warning" to the Government of the dangers that lie ahead and the need to bring down inflation and improve public sector productivity. However, Mr Brendan Howlin, of the Labour Party, said the IMF report was "predictably conservative", and did not adequately consider the case for borrowing to fund investment.
The IMF report calls for tight control on current spending to free resources for capital investment. It said that the 2004 budget should be "neutral", implying tight spending control and no major tax changes. The report supported the tax reductions of recent years and said that if there was a need to raise more revenue, this should be done through broadening the tax base and introducing new user charges, rather than by increasing tax rates.