The terms of the proposed national pay deal may prove too expensive for some firms, but the impact on the public finances will be a bigger problem, writes Cliff Taylor, Economics Editor.

The economy is in a competitive squeeze, caught between the rock of a rising euro and the hard place of soaring domestic costs. So can business afford the 7 per cent pay rise over the next 18 months negotiated as part of the proposed national deal?

The basic pay terms of the deal should not in themselves undermine competitiveness. However, the impact of meeting the public pay benchmarking terms will put a heavy burden on the public finances and has significant implications for the overall competitiveness of the economy.

Pay costs to private-sector businesses sticking to the deal terms will rise by about 3.5 per cent this year - roughly in line with our trading partners. The addition of a further 3.5 per cent on average in the first half of next year may bring total wage costs over the period a bit ahead of international norms for the 18-month period.

The cost to firms is thus loaded towards the latter part of the term, presumably on the basis that an international upturn is expected. (The length of the wait for the arrival of this upturn is already assuming "Godot" proportions).

If the basic private-sector pay terms are adhered to, it would represent a significant slowing in the pace of wage growth. For business, this is a big "if". In many cases, employers complain that the terms of the last deal were seen as a base from which wages would be negotiated upwards.

Given the competitive pressures on industry, there are some firms that will simply not be able to afford to pay. Any further worsening of competitive conditions - most likely from a further rise in the euro - would leave more companies in this position.

This is the main difficulty of the "one-size-fits-all" approach; the calculation for companies as they go to vote on the deal is whether there is enough leeway for those who cannot afford to pay. And whether the convenience of having an overall deal - and the local negotiations thus avoided - outweighs the difficulties it will cause for some firms.

There is no doubt that the economy has lost competitiveness over the past couple of years. The latest report from the National Competitiveness Council presents data showing that compensation costs per employee here were seventh highest of 16 countries surveyed. (The 16 included the main EU member-states, Poland, Hungary, the US, Japan and South Korea.)

All the indications are that we continue to move up the league. The same survey - based on EU data - showed an 8 per cent increase in compensation per employee last year, the second highest of the 16 countries surveyed. And, allowing for productivity increases, it estimates that the increases in unit labour costs here have also been close to the top of the league both last year and the year before.

Labour costs are only one part of the competitive squeeze. Businesses have also been hit with soaring insurance costs and by a general inflationary environment that has seen the costs of many inputs and services soar.

Meanwhile, the rise in the value of the euro has severely hit many indigenous firms exporting to Britain and the US. The currency has risen from around 90 US cents this time last year to $1.05 now. It is firms directly affected by this trend that are most likely to find the terms of the new deal unaffordable. A danger to the competitive outlook this year is a deflationary squeeze from a further rise in the euro's value,

The negotiators to the agreement are also seeking to address other competitive issues. An initiative on affordable housing is promised, as are measures to try to ease inflationary pressures.

However, another key element of the deal is, indirectly, a major negative for competitiveness. The benchmarking deal for public servants, offering average increases of 8.9 per cent, will give a once-off boost to wage inflation and the cost of running public services.

It remains to be seen how private-sector employees view the deal. The Government - as employer - is trying to secure significant changes in work practices as the price of these payments and the outcome of these discussions will be crucial. Paying more but not receiving better services would place a huge burden on an already slowing economy.

The cost of benchmarking will severely limit the room for other budgetary initiatives over the next couple of years. Already this year, indirect taxes have been hiked to help to pay the cost - thus adding to inflationary pressures.

Meanwhile, any further increase in tax levels or the cost of public services to help pay for higher public pay levels has an inevitable knock-on impact on private-sector wages and competitiveness.

A competitive and efficient public service is a central element in the working of any successful economy.

However, presenting the economy with a €1.1 billion bill heading into a downturn seems an expensive way to achieve this. The rationale for benchmarking was that public servants had been left behind during the boom and deserved high wage levels.

With the competitive winds turning chilly over the next year, the public sector now does not look such a bad place to be.