The Central Bank Governor has urged the Finance Minister to focus on three issues in next month's Budget as the economy continues to grapple with the effects of Covid-19.

In his annual letter to the Minister for Finance, Gabriel Makhlouf said the budget policies must support the productive capacity of the economy to avoid scarring effects such as long-term unemployment.

Mr Makhlouf also pointed out in his letter that the rise in the country's deficit and debt ratios has been both warranted and necessary.

But he added that a path to lower and more sustainable levels will eventually have to be taken.

He also stressed the need for a continued focus on building resilience to future shocks, such as the ongoing impact of Brexit, the challenges of international tax reform, climate change and, in the longer-term, demographic change.

The Central Bank boss said the actions taken to contain Covid-19 has caused a sudden and severe contraction in economic activity across the world.

The coronavirus has posed an "unparalleled challenge" to governments and policymakers everywhere," he added. 

He noted that data for the economy here pointed to a trough in activity being reached in April, with current activity now above this low point as the economy started to re-open.

"Reflecting this, there has been a strong rebound in some elements of spending but with continuing weakness still evident in other areas," he wrote. 

The Governor said the shock to household incomes from Covid-19 has been mitigated by the provision of large-scale income supports, while "precautionary" behaviour has intensified, which is evidenced by the sharp rise in household savings. 

How these savings are used will be important in shaping the recovery from the current downturn, he added.

Mr Makhlouf also said that although there have been some signs of improvement - following the phased reopening of the economy - the overall level of activity still remains well below pre-Covid-19 levels.

"The challenge ahead will be to move from tentative re-opening to sustainable recovery," he stated.

On SMEs, the Governor highlighted the important role they play within the local economy, the challenges they face and some of the key issues around supports they will likely need going forward.

The Central Bank Governor also warned Mr Donohoe in today's letter that the outlook for the country is highly uncertain. 

He said the path ahead for the economy will depend on the future path of the virus, the immediate and longer-lasting effects on behaviour and economic activity and the extent to which there is lasting damage to the productive capacity of the economy. 

He also said recent Central Bank's projections assume that a Free Trade Agreement between the EU and the UK, with no tariffs and quotas on goods, takes effect in January 2021. 

"If such an agreement is not reached - and on the evidence so far it would appear wise to plan on the basis that it will not be achieved - we estimate that could subtract between 1-2 percentage points off the growth rate of the Irish economy in 2021," he added.