Ireland s Competitiveness Performance

Transcription

1 Ireland s Competitiveness Performance By Mark Cassidy and Derry O Brien 1 ABSTRACT This paper assesses Ireland s current competitiveness position in light of recent trends in prices, costs and productivity as well as a range of relevant technological and structural indicators. It shows that, having been in an extremely favourable position at the beginning of the current decade, which was probably unsustainable, the Irish economy has subsequently lost competitiveness due to a range of factors including rising prices and production costs relative to our trading partners, an appreciation of the effective exchange rate and weaker productivity growth. Ireland s labourcost competitiveness position is now broadly on a par with the average for the EU-15 but some important non-labour costs are now high relative to the rest of the EU and our other main trading partners. There is also some evidence that Ireland s price level is now excessive relative to our economic fundamentals. In terms of other determinants of competitiveness, the economy fares quite well by international standards in the hightechnology intensity of output and exports, the percentage of the young workforce with third level qualifications, the relatively light regulatory burden facing business and a taxation environment that is supportive of enterprise, investment and labour. However, the economy fares less well in terms of business expenditure on R&D, ICT and innovation expenditures, standards of competition in a small number of sheltered sectors of the economy, the state of development of our pre-primary education system, the share of the population that has completed second-level education and the physical infrastructure. From a policy perspective, measures to improve the infrastructure, skills and innovation capacity of the economy as well as increasing standards of competition in some key sectors of the economy will be essential in order to improve productivity potential while competition and fiscal policy can also have an important role in improving price and cost competitiveness. Section 1. Introduction Recent developments in inflation, costs and productivity, as well as some high profile job losses in the multinational sector of the economy, have understandably focussed attention on Ireland s competitiveness position. International competitiveness relates to an economy s ability to compete in international markets. This depends in part on being able to produce goods or services at a lower cost or sell them at a lower price than competitor countries. The concept of competitiveness needs to be understood in broad terms, however, and depends on a wide range of factors in addition to price and cost developments including productivity, product or service quality, innovative capacity, the economic infrastructure and marketing and sales expertise. Indeed, for many developed economies with relatively high levels of production costs, these non-price elements of competitiveness are particularly important. While these factors are more difficult to measure than standard price and cost 1 The authors are Senior Economist and Economist, respectively, in the Economic Analysis, Research and Publications Department. The authors would like to thank Tom O Connell and Maurice McGuire for helpful comments. The views expressed are the personal responsibility of the authors and are not necessarily those held by the CBFSAI. 93

2 competitiveness trends, they should not be overlooked in any assessment of economic competitiveness. This paper provides an update of recent trends in inflation, costs and productivity with a view to assessing Ireland s current competitiveness position. There is a particular emphasis on the recent re-emergence of inflationary pressures and the implications for price competitiveness, which are discussed in Section 2. In this regard the paper complements a detailed assessment of Ireland s export performance published in a recent Quarterly Bulletin, which focussed more on cost competitiveness. 2 An update of subsequent cost competitiveness trends is provided in Section 3. In light of the need to adopt a broad approach when examining competitiveness, some other relevant factors including non-labour costs and non-price elements of competitiveness such as technological competitiveness, physical and human capital and the general business environment are discussed in Section 4 although readers are recommended to refer to the wide range of publications of the National Competitiveness Council, in particular the Annual Competitiveness Reports, for a much more detailed assessment of these issues. A summary and assessment are provided in Section 5. Some of the main findings of the paper are: At the start of EMU, the Irish economy was in an extremely healthy competitive position due to a combination of strong productivity growth, relatively low production costs and a relatively weak exchange rate. Some subsequent loss of competitiveness from this position was inevitable and this has, indeed, occurred. The weaker competitiveness position of the economy has been associated with a loss of export market share and a declining balance of payments position. The Irish share of world exports of goods and services fell from 1.45 per cent in 2003 to an estimated 1.23 per cent in Over the period , Irish consumer prices (HICP) increased by around 28 per cent, compared to just over 15 per cent for the EU-15. As a result, the Irish price level for consumer goods and services is now the second highest in the EU and the highest in the euro area. Services prices are over 20 per cent above the EU-15 average, with particularly high prices for utilities, hotels and restaurants and some locally-traded business services including industrial and commercial rents, energy costs, some legal and professional fees and waste disposal charges. Electricity prices for industrial users, for example, are now the third highest in the EU-25. Labour costs have also been increasing at a faster rate than in our trading partners over the past eight years. Over the period , Irish economy-wide wages increased at 2 Export Performance and Competitiveness of the Irish Economy, Cassidy, M. and D. O Brien, CBFSAI Quarterly Bulletin No , p.p

3 an average rate of 5.9 per cent. The corresponding increase in the EU-15 over the same period was 3 per cent. EU projections also point to higher wage increases in Ireland than in the rest of the EU over the next two years. Productivity growth has slowed in recent years, due to a combination of the shift of economic activity to more labour-intensive sectors (construction and services) and weaker productivity growth in the industrial sector. Economy-wide productivity growth on a GNP basis declined from 5.6 per cent in 2000 to 0.7 per cent in The corresponding decline in productivity in the manufacturing sector was from 11.5 per cent to 4.6 per cent. Some recovery in productivity was recorded in 2006, however, and, generally, the productivity potential of the economy remains quite favourable. Labour cost competitiveness has deteriorated since the end of the last decade, albeit from a very healthy starting position. Ireland s unit labour costs on a GNP-basis were significantly lower than in the EU-15 in 1999 but, due to relatively higher pay increases and a moderation in productivity growth, unit labour costs in Ireland are now slightly above the EU-15 average. Unfavourable exchange rate developments in the recent past have also contributed to competitiveness difficulties. The average value of the nominal effective exchange rate in 2006 was almost 13 per cent above the corresponding value in 2001 although it needs to be recognized that the exchange rate was very low by historical standards in the earlier year. Moving beyond the rather narrow concepts of price and cost competitiveness, the paper also examines how the economy performs in terms of some of the other determinants of competitiveness. Some issues for concern in this regard include the relatively low level of business sector R&D carried out in Ireland, the transport and energy infrastructure of the economy and a lack of competition in some key sectors of the economy. Section 2. Consumer Prices and Competitiveness 2.1 Determinants of Irish Inflation A number of studies of the underlying determinants of inflation in Ireland have been carried out in the Bank. 3 These studies have 3 E.g. Non-Traded, Traded and Aggregate Inflation in Ireland: Further Evidence, Kenny, G. and McGettigan, D. CBFSAI Technical Paper 5/RT/96. Bayesian Var Models for Forecasting Irish Inflation, Kenny, G, Meyler, A and Quinn, T. CBFSAI Technical Paper 4/RT/98. Forecasting Irish Inflation Using ARIMA Models, Kenny, G, Meyler, A and Quinn, T., 3/RT/98, Structural Model of Irish Inflation, Slevin, G. CBFSAI Technical Paper 1/RT/03. 95

4 traditionally considered separate price determination processes for the traded and non-traded sectors of the economy, while allowing for interactions between the two. The results indicate that prices in the traded sector are primarily determined by changes in world prices and the nominal exchange rate in accordance with long run purchasing power parity (PPP) and international arbitrage, while prices in the non-traded sector are also affected by domestic demand conditions and wages as well as productivity effects. In addition to the underlying determinants of inflation, a number of other external, structural or temporary factors can impact on consumer price inflation. Changes in world oil prices, for example, can have a significant impact on the headline HICP figure in Ireland, as was the case during 2005 and Structural changes in the economy, including deregulation in specific sectors or markets or other measures to enhance standards of competition, can also have an impact on prices. For example, the opening up of the telecommunications market during the 1990s, along with technological advances, led to a substantial drop in the price of telecommunications services which had a dampening effect on overall consumer price inflation. On the other hand, regulatory measures such as the ban on below-cost selling of groceries, abolished during 2006, and restrictions on opening public houses have been cited as structural factors which have put upward pressure on inflation in recent years. 4 Finally, government measures, including changes to administered prices and indirect taxes, can also have a significant impact on year-on-year inflation rates. Figure 1: Irish and Euro Area Inflation January 1999-January Jan-01 Apr-01 Jul-01 Oct-01 Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Jan-99 Apr-99 Jul-99 Oct-99 Jan-00 Apr-00 Jul-00 Oct-00 Ireland: HICP Eurozone: HICP Ireland CPI 4 E.g. Report of the Consumer Strategy Group (May 2005). 96

5 2.2 Recent Trends in Irish Inflation This section reviews Ireland s inflation performance since the start of EMU in the context of these fundamental and temporary determinants of inflation. Figure 1 shows Irish HICP and CPI inflation as well as the euro area average rate of HICP inflation over this period. A number of different sub-periods can be identified. Inflationary pressures began to build in Ireland towards the end of the 1990s. Having fallen as low as 0.6 per cent in September 1997, HICP inflation increased steadily, peaking at 6 per cent in November Over the following two years, inflation was sustained at a quite high rate, mainly fluctuating between 4 and 5 per cent between December 2000 and February There were a number of reasons for the acceleration in the inflation rate during the late 1990s and the relatively high rate of the early years of the current decade. These included (1) a sharp depreciation of the nominal exchange rate, which led to higher import prices and contributed to overheating pressures in the domestic economy, (2) the tightening of the domestic labour market and the achievement of near full employment conditions which meant that pay increases began to accelerate across most sectors and (3) strong domestic demand growth which enabled many firms in the non-traded sectors to increase the wage/price mark-up. HICP inflation declined during 2003, leading to an elimination of the adverse differential vis-à-vis the euro area. This coincided with a significant appreciation of the nominal exchange rate and some weakening of domestic demand and wage pressures. During 2004 and 2005, Irish inflation fluctuated mainly in the per cent range and close to the average for the euro area. The CPI was higher than the HICP during 2005 due to the impact of rising house prices on the mortgage interest component of the CPI. 5 It was from the beginning of 2006 that inflationary pressures in Ireland began to escalate and a differential between Irish and euro area HICP inflation re-emerged. During the first eight months of last year both the CPI and the HICP increased significantly. The rate of increase in the HICP picked up from 1.9 per cent in December 2005 to 3.2 per cent in August 2006, the highest rate since November The CPI increased from 2.4 per cent to 4.5 per cent over the same period. The higher rate of increase in the CPI was due to the impact of rising mortgage interest rates and, to a lesser extent, rising house prices over this period. While some increase in the euro area HICP was also recorded during 2006, this was modest relative to the increase in Ireland. Accordingly, the differential between Irish and euro area HICP widened from -0.3 per cent in December 2005 to +0.9 per cent in August 2006, which was the largest gap since 5 Average mortgage interest repayments are included in the CPI but not the HICP. 97

6 December Between August and November 2006, headline inflation fell in both Ireland and the euro area due to the effect of lower oil prices. The rate of increase in the Irish HICP fell from 3.2 per cent in August 2006 to 2.4 per cent in November. The corresponding outturn for the euro area HICP fell from 2.3 per cent to 1.9 per cent. However, Irish HICP inflation increased quite significantly in December 2006, from 2.4 per cent to 3 per cent, largely due to higher tobacco prices, and the differential with the euro area widened to 1.1 per cent. Recent inflation trends have been affected significantly by developments in energy prices. In order to assess more fundamental inflationary pressures, it is important to examine also movements in the HICP excluding energy (Figure 2). This measure of core inflation increased significantly in Ireland during 2006, from 1.2 per cent in December 2005 to 2.9 per cent in December Similarly, while overall euro area HICP inflation remained reasonably stable during the first eight months of last year, before falling in September and October, the core inflation measure increased steadily during the year, rising from 1.4 per cent in December 2005 to 1.8 per cent in December Notwithstanding this rise in core inflation in the euro area, the differential between Irish and euro area core inflation widened quite significantly during 2006 reaching 1.1 per cent in December. Figure 2: Underlyling Inflation: HICP Excluding Energy Jul-02 Sep-02 Nov-02 Jan-03 Mar-03 May-03 Jul-03 Sep-03 Nov-03 Jan-04 Mar-04 May-04 Jul-04 Sep-04 Nov-04 Jan-05 Mar-05 May-05 Jul-05 Sep-05 Nov-05 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-01 Mar-01 May-01 Jul-01 Sep-01 Nov-01 Jan-02 Mar-02 May-02 Ireland Euro Area 2.3 More Detailed Analysis of Factors Contributing to Recent Rise in Inflation This section looks in more detail at the main factors behind the rise in inflation during 2006 with some analysis also of the outlook for some important sub-components of the price level 98

7 index. Table 1 shows the contribution of some broadly defined components to the annual increase in the CPI during The contribution of a component depends on two things, its annual increase over the period in question and its weight in the CPI. As can be seen from Table 1, despite its small overall weight of around 5 per cent in the CPI, mortgage interest repayments accounted for almost half of the overall 4.9 per cent increase (2.3 percentage points), due to an annual increase of around 45 per cent. Items included in the HICP contributed 2.7 percentage points to the CPI, comprising a contribution of 0.8 percentage points from goods and 1.9 percentage points from services. The main contribution to higher goods price inflation came from alcohol and tobacco, due mainly to the increase in excise duty on tobacco prices introduced in Budget Prices for energy products increased by 3.8 per cent, year-on-year, and contributed 0.3 percentage points to the overall increase in the CPI despite a weighting of just under 8 per cent. Finally, prices for non-energy industrial goods, including clothing and footwear and household goods continued to decline last year. Table 1: Contribution of Components to Annual Change in CPI in December 2006 Annual % Change Weight in CPI (%) Contribution to 4.9% increase in CPI (percentage points) CPI +4.9% Mortgage Interest +45.0% Other excluded items 1.0% HICP +3.0% Services +4.4% Goods Energy +3.8% Food +1.8% Alcohol and tobacco +5.1% Other non-energy goods 0.6% Source: CSO and CBFSAI calculations (i) Mortgage Repayments Changes in average mortgage interest repayments account for a significant part of the difference between HICP and CPI inflation. Average mortgage interest repayments can increase either because of rising house prices or increases in interest rates. Notwithstanding the fact that house prices have been increasing steadily in recent years, average CPI inflation over the period has only slightly above average HICP inflation (3.6 per cent against 3.5 per cent) (Figure 1). This reflects the fact that interest rates declined quite significantly over the period , a decline that has been only partly reversed by more recent rate increases. As can be seen from Table 1 above, mortgage interest repayments contributed significantly to higher CPI inflation 99

8 during 2006, increasing by around 45 per cent, year-on-year, between December 2005 and December About one quarter of this increase was due to the impact of higher house prices while the remaining three quarters reflected higher interest rates following decisions by the ECB to raise official interest rates in December 2005 and March, June, August and October Each of these quarter point increases in interest rates added about 0.3 per cent to CPI inflation such that by December 2006, while the increase in the HICP was 3 per cent, the increase in the CPI was 4.9 per cent. The outlook for interest rates and, consequently, the mortgage interest component of the CPI, will depend on the macroeconomic outlook for the euro area as a whole, in line with the ECB mandate for price stability. Interest rates were increased again in December 2006 and March 2007, widening further the gap between the CPI and HICP. These rate increases mean that average CPI inflation will exceed HICP inflation again this year and also, because of base effects, in However, it is generally accepted that interest rates are currently closer to normal levels, having been extremely low by historical standards between 2003 and 2005, and with house price increases expected to moderate, the longer term outlook is for CPI and HICP inflation to remain broadly in line with each other although annual variations between the two will always be possible due to short-term interest rate movements. (ii) Energy Prices Energy sector inflation has contributed significantly to overall HICP inflation in recent years, as indicated by the gap between the aggregate HICP and the HICP excluding energy (Table 2). The HICP excluding energy is one measure of core or underlying inflation and, as can be seen, this was quite modest over the period , albeit with quite a sharp rise during 2006, reaching 2.9 per cent in December High energy sector inflation in recent years mainly reflects the rise in global oil prices. The average price of a barrel of Brent Crude in 2006, at around $65, was around two and a half times the price in 2002, which was around $25 although the depreciation of the dollar against the euro over this period has mitigated to an extent the impact on Irish energy prices. Table 2: Energy Sector and Overall HICP Inflation Energy HICP HICP excluding energy Source: CSO and CBFSAI calculations. 6 Interest rates were increased again in December However, the impact of this did not show up until the January 2007 inflation figures when the CPI increased to 5.2 per cent. 100

9 Table 3 shows the cumulative percentage change in energy prices for consumers over the past five years. It can be seen that electricity and gas prices in Ireland have both increased by much more than the euro area average. Electricity prices for industrial users also rose by more than in the rest of Europe over the same period. This reflects a number of factors including the fact that the generation of electricity is much more oil intensive here than elsewhere over 90 per cent of Ireland s fuel for electricity generation comes from fossil fuels as well as some factors related to the energy infrastructure in this country, including the small size and relatively high concentration of the market, with the market incumbent retaining a large share compared to most other European countries. By contrast to prices in the administered part of the sector, prices for liquid fuels, including petrol and diesel, have increased at a slower pace than the euro area average over the past five years. Table 3: Cumulative Percentage Change in Price (HICP components) Euro area Ireland Global Brent Crude (Euro price) Total Energy Liquid Fuels Electricity Gas Source: Eurostat In terms of the most recent trends, energy price inflation was high and volatile during 2005 and the first eight months of 2006 due to rising oil prices. However, international oil prices have declined significantly since August 2006 and this, along with some base effects, has meant a much lower contribution to headline inflation from the energy sector. While energy inflation is projected to be low in 2007 and 2008, with higher prices for electricity and gas offset by lower average retail petrol prices, the high price level in the Irish energy sector remains an issue of concern, particularly in the context of economic competitiveness. This issue is discussed in more detail below in the section on Ireland s relative price level. (iii) Services Inflation Inflation in the services sector, much of which is non-traded, i.e. insulated from external competition, has generally been much higher than in the, predominantly traded, goods sector in recent years. Since the start of EMU in 1999, HICP services sector inflation has averaged around 5 per cent per annum. In its analysis of inflation, the Central Bank distinguishes four subcomponents of the overall services index, namely core services, administered services, alcohol related services and 101

10 telecommunications, because they are subject to different factors and influences. Table 4 shows trends in each of these subcomponents over the period Table 4: Components of Services Sector Inflation , per cent Total services Core services Administered services Alcohol-related services Telecommunications Source: CSO and CBFSAI calculations The easing of regulations governing entry to the telecommunications market led to downward pressure on prices of telecommunications services between 1995 and 2001, which was followed by modest price increases averaging close to 2 per cent per annum in 2003 and 2004 and modest declines during 2005 and Alcohol-related services are treated as a separate sub-component to reflect the high tax content in the price of alcohol and the licensing system for public houses. During the late 1990s and the early years of the current decade, a combination of restrictions on supply and strong demand pressures resulted in relatively high increases in prices for alcohol-related services. There has been evidence in more recent years, however, of some moderation in the rate of increase in alcohol-related services which, anecdotal evidence would suggest, might reflect weaker demand as a result of high price levels in bars and pubs and perhaps some effect of the smoking ban. Administered services include local authority rents and charges, public transportation and toll charges, examination fees, hospital charges and health insurance, library and postage charges, television and postage licences, driving test, passport and birth certificate fees. These charges increased very significantly during 2002 and 2003, with more modest increases over the period Nevertheless, the rate of increase in administered services remained high last year, at around per cent. Core services refer to other domestically contested services, where price trends tend to reflect domestic demand conditions and wage pressures. 7 As a result, price trends tend to reflect domestically generated inflationary pressures more accurately than the overall services index. For example, the tightening of labour market conditions during the late 1990s resulted in higher wage inflation and an increase in unit wage costs in the services 7 Core services account for just over 60 per cent of all services in the HICP. 102

11 sector which in turn led to rising core services inflation (Figure 3). The labour market stabilised somewhat after 2001, which was reflected in a decline in core services inflation between 2003 and However, some pick-up in core services inflation was recorded during 2006, in line with strong domestic demand growth and the continued tightness of the labour market, which contributed to the rise in the overall inflation rate. Figure 3: Irish Services and Core Services Inflation % 9% 8% 7% 6% 5% 4% 3% 2% 1% Jan-99 Apr-99 Jul-99 Oct-99 Jan-00 Apr-00 0% Jul-00 Oct-00 Jan-01 Apr-01 Jul-01 Oct-01 Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Total HICP Services HICP Core Services The outlook is for services sector inflation to remain close to current high levels over the next year, with some decline from the second half of 2007 in line with the forecast for a gradual deceleration of consumption growth and economy-wide wage increases. However, as will be discussed, following several years of high services sector inflation, Irish services prices are now very high by international standards. (iv) Non-Energy Goods Over the past seven years, goods price inflation has been substantially lower than services sector inflation, particularly when the volatile energy component is excluded. Since most goods in the economy are tradable, it is not surprising that changes in goods price inflation have been strongly influenced by exchange rate developments and changes in world prices. Changes to indirect taxes are another important factor in terms of explaining changes in goods price inflation particularly in the case of alcohol and tobacco prices. Table 5 sets out annual changes in food, alcohol and tobacco and other non-energy goods (including clothing and footwear and household goods) over the period

12 Table 5: Components of Goods Sector Inflation, excluding energy, Food Alcohol and tobacco Other non-energy Source: CSO and CBFSAI calculations Figure 4: Index of Prices Formerly Covered by Groceries Order, January 2002= Jan-02 Mar-02 May-02 Jul-02 Sep-02 Nov-02 Jan-03 Mar-03 May-03 Jul-03 Sep-03 Nov-03 Jan-04 Mar-04 May-04 Jul-04 Sep-04 Nov-04 Jan-05 Mar-05 May-05 Jul-05 Sep-05 Nov-05 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Food prices can be quite volatile, influenced by a number of factors including agricultural conditions, production costs and the exchange rate. Table 5 shows relatively strong increases over the period , in line with the weak euro exchange rate, with low, often negative, increases over the period Some increase in food prices was recorded during the first half of last year for both processed and unprocessed foods. This was followed by a decline during the second half, which has led some commentators to suggest that the abolition of controls on the price of groceries has begun to feed through. CSO data provide some tentative evidence in support of this. Figure 4 shows the trend in prices of all goods covered by the Groceries Order. It shows that prices for these goods were broadly stable between mid-2003 and early There was some reduction in prices over the period May-December However, this followed a quite sharp increase in prices during the first five months of last year. Overall, the current price level for these goods is now slightly below the average level over the past three and a half years. The recent monthly declines in prices, combined with announcements by some large retailers that they have cut prices, suggest that it is likely that the abolition of the Order will indeed have some effect on food prices. Against this, however, there 104

13 have been indications from the food industry that rising business costs are likely to lead to price increases on a wide range of food items during 2007, which could offset any further effect from the ending of the Groceries Order. As can be seen from Table 5, alcohol and tobacco prices have increased quite significantly in recent years, albeit more moderately during 2005 and Part of this reflects changes in excise duty, particularly for tobacco and, given that these increases are deliberately imposed in order to discourage people from smoking, there are strong arguments for excluding tobacco from the analysis when examining underlying inflationary trends. The increase in tobacco prices of roughly 7 per cent in Budget 2007 will add around 0.35 per cent to consumer price inflation this year. Other non-energy goods include clothing and footwear and household goods. CSO data show that clothing and footwear prices have been declining very sharply over the past decade. This partly reflects globalisation pressures arising from more international competition in these sectors from emerging, lowercost, economies as well as more competition at retail level in Ireland. Prices of other goods have been relatively contained in recent years, also reflecting international competitive pressures as well as some effect from the stronger euro exchange rate. Figure 5: Comparative Consumer Price Level, EU-15= Denmark Ireland Finland Sweden Luxembourg France UK Italy Germany Belgium Netherlands Austria Spain Portugal Greece The Relative Price Level High inflation in recent years has made Ireland an expensive country for consumers. At the start of EMU, in 1999, the Irish price level was roughly equal to the EU average, above that of many Southern European countries like Italy, Spain, Greece and 105

14 Portugal but lower than that of many Northern European countries like Denmark, Sweden, Finland, Germany, the UK and Belgium. However, by 2005 the Irish price level was the highest in the euro area and second highest in the EU, behind only Denmark, and about 17 per cent above the EU-15 average (Figure 5). 8 As already noted, price increases for services have been above those for goods over the past seven years. As a result, the price level for consumer services, relative to the EU average, is higher than for consumer goods. Services prices in 2005 were around 23 per cent above the EU-15 average with goods prices about 13 per cent above the average (Figure 6). Figure 6: Consumer Goods and Services Price Levels, 2005, EU-15= Denmark Finland Ireland Sweden France Luxembourg Netherlands Belgium Germany UK Italy Spain Greece Portugal Greece services goods Figure 7 shows the price level for a selection of broadly defined consumer goods and services relative to the EU average in It shows that the relative price level is highest for housing and household utilities (water, electricity, gas etc). Prices are also high for restaurants and hotels, food, health, education and communications services. There is already evidence that price levels in Ireland are problematic. While it can be difficult to be precise about the appropriate price level, academic research commissioned by the National Competitiveness Council suggested that by the end of 2003, Ireland s real exchange rate (i.e. relative price level expressed in a common currency) was eight per cent above its 8 Eurostat produce several different measures of consumer price levels. For example, some include government consumption and others only private or household consumption. This explains why different sources can give slightly different measures of Ireland s relative price level. However, the different sources generally point to the same conclusion, i.e. that Ireland now has the second highest price level in the EU, behind only Denmark. 106

15 sustainable level. 9 An excessive price level (i.e. when prices are higher than would be justified by economic fundamentals) affects competitiveness and as a result can lead to lower output and employment. If prices in Ireland are out of line with those in our trading partners, it creates an incentive for domestic retailers to import products rather than sell domestically produced goods. Similarly, it implies that Irish producers of traded consumer goods will be at a competitive disadvantage in foreign markets. These effects combined mean that an excessive price level can give rise to a current account deficit, which is associated with pressure on output and employment. While such a deficit would be expected to correct itself through the process of international price arbitrage, this process can be difficult. In addition even a temporary increase in relative prices can lead to a permanent loss in international market share if hysteresis effects are important (i.e. when short-term disturbances result in long-term consequences such as the closing down of a business). Figure 7: Price Level for Irish Consumer Goods and Services, EU-15= Housing, water, electricity and gas Restaurants and hotels Health Communication Food Miscellaneous goods and services Education Household goods Recreation and culture Transport Clothing and footwear An excessive price level can affect competitiveness in other ways. For example, high prices for many consumer services such as electricity, water, refuse collection, professional fees and insurance can be indicative of high charges for businesses for the same services, which are important inputs in the production process. High prices can also deter inward migration of skilled workers, which can restrict potential output growth, while consumer prices, in particular prices for hotels and restaurants, are also an important element in terms of the attractiveness of an economy as a tourist destination. Negative competitiveness 9 Assessing Ireland s Price and Wage Competitiveness, P. Lane; Institute of International Integration Studies (IIIS) and Economics Department, Trinity College, Dublin and CEPR, July

16 effects can also be expected if higher domestic prices contribute to a wage-price spiral with further detrimental affects on activity. In this case any increase in wages above gains in labour productivity implies an increase in unit labour costs which damages export competitiveness. The extent to which rising consumer prices can be indicative of rising business costs is an important issue at the current juncture, given that the high level of non-labour costs seems to have become an important element in Ireland s current competitiveness difficulties. As already noted, electricity and gas prices have been increasing at a much faster rate than in our trading partners during the current decade and price levels are now high by international standards. Eurostat data show that Irish electricity prices in early 2006 were the third highest in the EU for industrial users, 17 per cent above the average, and sixth highest for household users, 5 per cent above the average (Figure 8). Moreover, these figures do not include the further increase of over 12 per cent from January 2007, which will add further to competitive pressures in Irish manufacturing. While industrial gas prices were slightly below the EU-25 average in January 2006, the increase of over 20 per cent from late 2006/early 2007 puts further pressure on industrial users of gas. Figure 8: Industrial and Household Electricity Prices January 2006 (EU25=100) Italy Cyprus Ireland Germany Belgium Netherlands Luxembourg EU-25 Austria UK Portugal Denmark Slovakia Hungary Spain Czech Republic Malta Greece Slovenia Poland Sweden France Finland Estonia Lithuania Latvia industry index EU-25=100 household index EU25=100 In its Annual Competitiveness Report 2006, the National Competitiveness Council publishes a range of other comparative business costs. They show that in addition to utilities such as electricity and waste disposal, costs here are high for industrial and commercial rents as well as some locally traded services including IT services, accountancy and legal fees Summary and Outlook Short-term inflation projections are presented in the Domestic 108

17 Prices, Costs and Competitiveness chapter of this Bulletin. The objective of this paper is to look at the wider picture, particularly the competitiveness implications of recent trends in inflation. It has been shown that, having come back in line with the euro area average in 2004 and 2005, Irish inflation began to pick-up again during This was primarily due to rising prices for energy and services, with some contribution too from the food sector during the first half of last year. In the services sector, price increases have been particularly strong for health, education, hotels and restaurants. As a result, consumer services prices in Ireland are now over 20 per cent above the average for the EU- 15 with prices also high for a range of locally-traded business services. Energy prices in particular have been rising much faster in Ireland than in the rest of Europe. Between 2001 and 2006, for example, electricity and gas prices for Irish consumers increased by around 52 per cent and 57 per cent, respectively. The corresponding increases in the euro area were 14 per cent and 28 per cent, respectively. Industrial users of electricity have also been subject to rapidly rising electricity prices, with the level of electricity prices now the third highest in the EU. The outlook is for some moderation in headline HICP inflation from the relatively high outturn of However, this will be due to the impact of lower average oil prices in 2007 and 2008, assuming that oil prices move in line with market expectations as reflected in futures markets. Underlying inflationary pressures will remain quite strong, particularly in non-traded sectors of the economy, in line with strong domestic demand growth and the continued tightness of the labour market. Rising production costs, including labour and utilities, will also put upward pressure on some traded goods prices, including food, although there is less scope for producers in traded sectors to pass on cost increases to consumers. The ending of the Groceries Order is expected to have some downward effect on food prices, which can hopefully offset any upward impact from higher production costs. In other traded sectors, price pressures are expected to remain reasonably contained, in line with the strength of the euro exchange rate and globalisation pressures related to increased competition from emerging economies in international markets. CPI inflation will remain above HICP inflation in 2007 and 2008 due to the effects of higher interest rates on average mortgage interest repayments. This assumes that interest rates move in line with market expectations, which implies that rates remain close to current levels over the next two years. High prices for utilities and other domestic services have a negative impact on the competitiveness of Irish firms, putting them at a cost disadvantage in international markets. Moreover, recent trends in labour costs have added to these competitive pressures, particularly in certain sectors which have had limited productivity growth. These trends are discussed in more detail in the following section. 109

18 Section 3. Cost Competitiveness 3.1 Overview Labour cost based competitiveness measures give an additional perspective on developments in an economy s competitiveness. Labour costs, an important component in the total cost of producing exports, are typically defined as total pay or compensation whereas unit labour costs indicate the labour cost of producing a unit of output. Unit labour costs are calculated by dividing an index of per employee labour costs by an index of productivity. This section discusses recent trends, and our current position, with regard to both absolute and relative unit labour costs. Relative unit labour costs measured in common currency provide an assessment of cost competitiveness vis-à-vis our main trading partners and are important given Ireland s dependence on international trade and foreign direct investment. These are particularly relevant for the manufacturing sector, while relative cost competitiveness for the whole economy should also be considered since (1) services are growing in importance in the overall tradable sector with the expansion of financial and IT related services as well as tourism and (2) many non-traded services are inputs in the production process of the traded sectors. The overall picture emerging from labour cost competitiveness indicators is that Ireland s competitiveness position has weakened substantially since the late 1990s, due to a more muted productivity performance, relatively high labour cost increases and adverse exchange rate movements. The actual performance of the economy in terms of exports and foreign investment inflows confirms that the economy was, indeed, highly competitive in the late 1990s, but that there has subsequently been quite a significant deterioration. One could argue that Ireland s elevated competitiveness position in the late 1990s was unsustainable and choosing that period as the baseline may put Ireland s recent competitiveness performance in an exaggeratedly poor light. However, further significant losses in cost competitiveness would be of concern, particularly, given that a large current account deficit has already emerged and declines in export market shares have been experienced in recent years. Table 6: Whole Economy Nominal Compensation per Employee Levels and Changes, Average rate of Average annual 2006 (euros) change, change, (euros) Ireland 28, ,400 EU-15 31, ,600 Source: European Commission AMECO 110

19 3.2 Labour Costs The Irish economy has performed relatively strongly over much of the past decade, significantly surpassing average EU-15 growth. As a result, tightened labour markets arose in certain sectors during the late 1990s, exerting upward pressure on pay increases, albeit relieved partially by strong inward migration from new EU Member States in recent years. At the end of the last decade, compensation per employee levels in Ireland were lower than the EU-15 average but pay increases in Ireland have been significantly higher than the EU-15 average in the interim such that, at present, compensation per employee levels in Ireland exceed those in the EU Table 7: Labour Cost per hour, in euro, EU15 Labour Cost Labour Cost Total Total labour per hour for per hour for Economy compensation manufacturing total Productivity as in 2005 economy in (output per percentage 2005 hour) of GDP 11 (1) (2) Denmark Luxemburg Germany Denmark Finland France Netherlands Sweden Belgium Belgium Austria UK Sweden Netherlands Luxemburg Ireland (GNP) UK Austria France Germany Ireland Finland Italy Italy Spain Spain Portugal 5.89 Portugal EU EU Czech Rep Czech Rep Hungary 4.88 Hungary Poland 3.65 Poland US US Japan Japan Canada Canada Australia Australia Korea Korea Sources: (1) US Bureau of Labor Statistics and (2) European Commission AMECO, Groningen Growth and Development Centre and CBFSAI calculations. Note: Greece data not available. The per hour compensation level in the Irish economy is the 8th highest in EU-15 and slightly lower than in the US and the UK see Table 7 above. The picture for manufacturing is somewhat more favourable. In both manufacturing and the whole economy, the compensation per hour level is substantially higher in Ireland than in new EU Member States such as Poland, Hungary and Czech Republic. It is also worth noting that total labour compensation as a proportion of output (using a GNP- 10 Compensation includes employers social security contributions along with pay. See also Box on Irish Labour Cost Levels in an International Perspective in Central Bank and Financial Services Authority of Ireland, Quarterly Bulletin, In the case of Ireland, GNP is used rather than GDP. 111

20 based measure in Ireland s case) is not particularly high by international standards 12. However, total economy productivity in Ireland compares favourably with those new Member States and is also higher than in the UK and US. While comparisons of compensation levels may seem somewhat reassuring, the picture in terms of increases in pay is less so. The gap between pay increases in Ireland and in the EU-15 is significant and is projected to persist in the short-term. Indeed, projections for pay per employee increases in Ireland this year are the third highest in the EU-15 behind Greece and the UK. Thus, unless there are strong increases in productivity domestically in the coming years, a further deterioration in Ireland s cost competitiveness relative to many EU-15 trading partners looks set to materialise. Table 8: Whole Economy Nominal Pay Increases for Ireland and the EU-15, per cent per annum (e) 2007 (f) 2008 (f) Ireland EU Source: CBFSAI and European Commission, (e)=estimate and (f)=forecast 3.3 Productivity The GNP-based productivity level for Ireland at the end of the 1990s was similar to the EU-15 average but higher average productivity growth in the meantime means that the productivity level in Ireland now exceeds the average, as can be observed from Table 9. On a GDP basis, Ireland s productivity level is particularly high by international standards the second highest in the EU, behind only Luxembourg. However, it is generally accepted that GNP measures of productivity are more representative of underlying productivity and Irish living standards because they exclude the substantial profit outflows of foreign-owned firms. 13 Table 9: Whole Economy Productivity Per Person Employed Levels and Changes, , Average Average 2006, euros Percentage Percentage euros Change, Change, Ireland (GDP) 58, ,500 Ireland (GNP) 51, ,200 EU-15 51, , The samples for some countries include only full-time workers, perhaps producing an upward bias on compensation levels in those countries. However, according to the US Bureau of Labor Statistics, using data from Austria, Spain and the UK, for which data are available for both full-time and part-time workers separately, the effect of excluding parttime workers increases earnings by about only 0.8 per cent to 1.2 per cent. 13 The remainder of this section focuses on GNP measures of productivity. For a comparison of Irish GNP and GDP productivity measures see Productivity in Ireland: Trends & Issues, Mark Cassidy, CBFSAI Quarterly Bulletin, Spring

21 Productivity increases in Ireland have been quite erratic in recent years, with the global downturn affecting the trend at the beginning of the decade. Also, more recent developments in productivity have, to an extent, reflected shifts in the relative shares of the manufacturing, construction and services sectors in overall economic output. The relatively high-productivity manufacturing sector experienced a slowdown due in part to a weakening competitiveness position as well as some sectorspecific factors. Meanwhile, the construction and services sectors, typically characterised as labour intensive and of relatively low productivity, have continued to expand strongly such that aggregate productivity increases were quite modest during 2004 and 2005, before picking up again in Table 10: Productivity per hour by Sectors in Levels and Average Changes for Ireland and EU Sectors Ireland EU-15 Ireland EU-15 Ireland EU-15 euros average % change euros Public services Wholesale, retail Other services Agriculture Construction Hotels, catering Transport services Materials, minerals Food, drink and tobacco Electrical and optical equipment Finance Communications Transport/misc manufacturing Chemicals Printing, Publishing Textiles, Clothing Utilities Wood, paper Computer services* Whole economy Source: Groningen Growth and Development Centre, 60-Industry Database, October 2005 and authors calculations. Per-hour productivity. *Annual figure for computer services for Ireland is for 2000 rather than 1999 and average is for Ireland s output on a GDP basis per person employed exceeded the EU-15 average in 1999 and, to an even greater extent, in 2006, with a similar picture emerging when viewed in per hour productivity terms. Table 10 presents a breakdown of per hour productivity developments since 1999 by sector and indicates that the chemicals, electrical equipment and food sectors in Ireland had substantially higher productivity levels in 1999 compared to their respective EU-15 sectors and that, subsequently, the gap in productivity widened further. Again, 113