THE INTERNATIONAL Monetary Fund (IMF) painted a bleak picture of the “unprecedented economic correction” facing Ireland, describing the stress on the State as exceeding that being faced by any other developed nation.

However, in a positive diagnosis of the Government’s response, the global financial watchdog has said that on the two fronts that matter most – fixing the banks and the public finances – the Government has “moved in the right direction”.

The IMF said losses faced by Irish banks could top about €35 billion, or 20 per cent of GDP, to the end of 2010, though it added that the Government “did not formally produce any estimate for aggregate bank losses” during the fund’s recent fact-finding trip to Ireland.

The Department of Finance was quick to point out that “the vast majority” of these losses would be absorbed by the banks’ risk capital and ongoing operating profits.

The IMF endorsed the Government’s plans for the repair of the banking system – from the State bank guarantee to recapitalisation and the plan to buy development and related loans of €80 billion to €90 billion through the State’s “bad bank”, the National Asset Management Agency (Nama).

The IMF said Nama was “potentially the right mechanism to separate the good from the bad assets”.

However, it made several significant suggestions. It highlighted the importance of the “adequate design and timely implementation of Nama” and advised that Government consider “risk-sharing structures to help with the problems with pricing distressed assets”.

This would guard against the risk of the taxpayer bearing a disproportionate burden of the costs.

The IMF and the Government were at loggerheads on whether the temporary nationalisation of the banks would make it easier to price the loans moving to Nama.

The Government disagreed with IMF staff that temporary nationalisation would make the pricing of the loans easier.

“Nationalisation could become necessary but should be seen as complementary to Nama,” said the fund.

“The bad assets would still be carved out, but the thorny issue of purchase price would be less important, and the period of price discovery longer, since the transactions are between two Government-owned entities.”

Nationalisation could also be used to bring about “needed mergers in the absence of more far-reaching resolution techniques”.

The US-based fund said Nama should be “given the legal and operational flexibility” to address all classes of distressed bank loans and not be restricted to buying development loans on which the banks are posting large losses.

This will help the State “deal with further deterioration in bank balance sheets”, said the fund.

“The sharp ongoing rise in troubled loans is a warning that this possibility needs to be seriously considered,” said the fund. “A full scoping-out of the likely distress is needed.”

The IMF suggested the need for “a broader tool kit” to prevent banking crises in future.

The Government was “open to exploring the merits of a special bank resolution regime”, the IMF said. This would allow the State, for example, to transfer loans and deposits quickly to another bank or to set up “a bridge bank” – a new limited-life bank to acquire an old bank to enable its future sale.

This would “facilitate a speedy and less disruptive resolution of distressed banks”, said the IMF.

The fund also recommended “intensified bank-by-bank surveillance” beyond the institutions falling under the State guarantee.

IMF report: the main points

- The economy will contract by about 13.5 per cent from 2008 until the end of next year.

- Further wage reductions will be needed to restore competitiveness and growth.

- Unemployment will reach 15.5 per cent in 2010.

- Bank losses could rise to €35 billion by the end of 2010.

- Nama should be designed to incorporate non-property loans as well as property loans.

- Bank nationalisation could become necessary, but not as an alternative to Nama.

- Budgetary adjustments should focus on spending cuts.

- Social welfare spend should better target the vulnerable.

- Further cuts in the public service wage bill are likely to be inevitable. A review of public service employment is needed.

- Broadening the tax base is a key challenge.