The Government has been warned by the International Monetary Fund that the economy is in danger of overheating and that next year's Budget should aim to eliminate borrowing entirely. This year's Budget had been too generous, the IMF said, and it was now essential that the Government moved to control public sector pay and limit the overall growth in spending.

In a blunt warning in its annual review of the economy, the IMF - the influential Washington based international institution said its directors " were of the view that continued growth at the pace of the last few years carried risks of overheating." It added that the authorities must be " vigilant for signs of emerging strains, with particular attention to the tightening labour and housing markets. "

Market expectations that Irish interest rates would move down to the levels prevailing in other EU states were complicating the implementation of Irish policy, the IMF said. Because the economy was growing so strongly, the Central Bank should try to stop Irish rates from falling to EU levels for as long as possible, the review indicated. The recent increase in interest rates had been " appropriate".

The IMF directors commended Ireland's record of low borrowing. However they" expressed concern about the pro-cyclical stance of fiscal policy in the current year, owing partly to the front-loaded tax cuts in the Budget." It would be desirable to tighten Budget policy, they recommended, " focussing on expenditure restraint - particularly restraint on public sector pay."

It a strongly worded message to the Government, the IMF added that "renewed slippages from announced intentions to limit the growth of current spending would reduce the scope for tax reform and weaken the credibility of fiscal policy."

The IMF then went on to criticise the medium-term financial targets set down in the 1997 Budget, arguing that " more ambitious targets should have been set, given the strong growth of the economy. The expected run-down of EU funds after 1999 and the need to prepare for EMU were seen as other reasons for a tighter Budget policy.

In his 1997 Budget, the Minister, Mr Quinn, said that borrowing would be 1.6 per cent of national output this year and the same in 1998. However this year the Budget is running well ahead of target and the Department of Finance now estimates that borrowing will be 0.7 per cent of GNP this year and it could be eliminated completely.

Against this background, the Department of Finance officials warned in their outlook published this week that the 1998 Budget should aim for no borrowing, a view echoed by the IMF.

The IMF says that GNP should grow by 6.5 per cent this year, in line with the Department forecast. They forecast that the rate of inflation this will year average 1.7 per cent, compared to the Department's 2 per cent prediction.