1 - Overview
We welcome the IMF Staff Report on the combined eighth and ninth reviews, namely in what regards the recognition of the progress over the last two and a half years. All end-June performance criteria were met as well as all structural benchmarks, given that also the Public Administration Labor Law was approved and sent to Parliament in October.
On October 15th, the Government submitted the State Budget for 2014 to Parliament – which constitutes a prior action for the conclusion of these combined reviews – as well as a Supplementary Budget for 2013. The Supplementary Budget was approved on November 1st. The State Budget for 2014 has been approved in general terms and is currently under discussion. Its final approval is set to occur on November 26th.
In terms of economic activity, the updated macroeconomic scenario confirms the steady improvement in high frequency indicators over the past year and the gradual recovery in quarterly GDP growth. For 2013-2014, GDP growth was revised upwards and unemployment was revised downwards.
Strong compliance with the program has allowed for further progress in all of its dimensions. Fiscal consolidation proceeds, with annual targets proving to be within reach and structural adjustment continuing at a good pace. External adjustment is also on track – following the net lending position achieved in 2012, the current account balance is expected to become positive this year, which represents a major breakthrough for the Portuguese economy. In the financial sector, Portuguese banks are adequately capitalized and in a better position to withstand liquidity shocks. Finally, while important structural reforms have entered into full force, the structural transformation agenda continues to be implemented.
Following the political events in July, as well as the impact of perceived changes in US Fed’s monetary policy stance, Treasury Bond yields in the secondary markets increased in all maturities. However, they remain at significantly lower levels than those registered in January 2012 and fall close to values of late 2010. Treasury Bill auctions continue to take place as planned, and they were never interrupted. Overall, recent developments since the end of the review suggest that the Program remains on track. This will pave the way for a gradual build-up of confidence that, with the continued European support, will allow the exit from the Program in June 2014, as initially foreseen.
The present state of play is definitely more favorable than at the start of the Program. The Portuguese authorities are aware of the potential risks ahead, but remain confident that these can be overcome. At the external level, although recent indicators suggest that euro area economies are gradually recovering, uncertainty prevails. While exports to non-EU countries keep growing, unfavorable developments in Portugal’s main trading partners could influence economic recovery. In addition, financing conditions continue to prove tight, but the Portuguese authorities remain determined to look for ways to improve access to finance, in particular for SMEs. At the internal level, while the possibility of different views by Constitutional Court concerning some measures could constitute further hindrance, the fact is that the Government has overcome similar setbacks in the past and remains determined to comply with the objectives and commitments set in the Program. At the same time, one should bear in mind that these decisions are part of the democratic process.
2 - Economic Activity
Following ten quarters of consecutive decline, GDP grew by 1.1% in 2013Q2 (-2.1% y-o-y). With this result, Portugal registered the best quarter-on-quarter performance in the European Union. Moreover, recent data continue to be positive, hence suggesting that economic activity may be bottoming out. In fact, there are indications that the economy is likely to have grown in the third quarter, as high frequency indicators continue to improve overall and Banco de Portugal’s coincident indicator registered the first positive year-on-year growth since the beginning of the Program (0.1% this September).
In addition, while unemployment rate remains high, recent data from Eurostat suggest a stabilization trend. In monthly terms, unemployment rate fell this September, when compared to August and also to September 2012. In quarterly terms, 2013Q3 marked the second consecutive quarter-on-quarter decline in unemployment rate.
While uncertainty prevails internally and in the euro area, the Portuguese authorities are confident that economic activity may in fact have turned the corner. Measures to boost the recovery, including the CIT reform, will be submitted by Government, carefully taking into account budgetary implications in order not to undermine confidence.
3 - Fiscal Policy
Budget execution in the first three quarters of the year remained in line with the budgetary target of 5.5% of GDP for 2013, as confirmed by recently published data. The General Government budget deficit on a cash basis, according to the Program’s definition, was € 4,335.7 million, hence falling below the 2013Q3 target. In addition, the monthly increase of tax revenue in September was the highest since the beginning of 2013. This result benefits from the recovery of both direct and indirect taxes, hence reflecting an improvement in the economy, as well as further progress in fighting tax evasion. At the same time, the Supplementary Budget submitted to Parliament in mid-October confirms the Portuguese authorities’ commitment to meet both Program targets and Fiscal Compact rules, as well the rapid response to challenges that may arise in terms of budget execution.
In 2014, General Government deficit will decrease to 4.0% of GDP, as defined in the seventh review of the economic adjustment program. While the State Budget is still under discussion in Parliament, the Government has proposed consolidation measures amounting to 2.3% GDP, which will allow for important milestones in 2014: (i) first positive primary balance since 1997 (0.3% GDP); (ii) structural adjustment of 1 p.p. GDP; (iii) 86% of permanent measures are on the expenditure side, allowing for the rebalancing of the adjustment effort over the Program period. In addition, as stated in the Staff Report, the net yield from the Public Expenditure Review (PER) package was maintained, despite some changes in composition. The outcome will clearly depend also on economic performance and its adherence to the current macro scenario.
4 - Financial Sector Policies
Over the last three years, a comprehensive strategy has been put in place aimed at strengthening banks’ solvency, improving the banking system liquidity, enhancing the effectiveness of supervision, and improving the regulatory framework. In fact, the banking system is now better capitalized and more able to withstand significant and prolonged liquidity shocks, with the core tier 1 ratio of the banking system reaching 11.9 percent at the end of June 2013, 3.2 percentage points higher than in June 2011. In addition, the transparency on asset quality, the pro-activeness of supervision and the regulatory framework and architecture have been stepped up. These developments occurred against the background of a very demanding domestic and external environment, characterized by an encompassing adjustment process in the Portuguese economy, the persistence of financial fragmentation and economic weakness in the euro area.
The improvement of the ratio is not only a result of the capitalizations operations, but also due to Banco de Portugal’s recommendations to banks’ sales of non-core assets and prudent policy results distribution. Already starting in 2010, most banks voluntarily abstained from distributing dividends and started selling part of the international loan book and participations. Portuguese banks stand now more prepared to go through economic conditions that are showing signs of recovery, which may still bring about additional credit losses, and to undergo a smooth transition to the new European prudential regulatory requirements.
The deleveraging process of Portuguese banks has also started already in 2010 and, accordingly, the loan to deposits ratio, which hovered 160 percent in 2010 (one of the largest among European countries by that time), came down to 123 percent by end-June 2013. This evolution reflected the behaviour of household deposits – which, after growing sharply in 2011, remained relatively stable from 2012 onwards – and a fall in credit granted by banks. In what concerns credit, it should be highlighted that situation is heterogeneous. In fact, the most affected sectors have been those more dependent on domestic demand (trade, construction and real estate development) and credit to exporting firms has been growing steadily. In turn, the resilience of bank deposits contrasts with the developments in other Programme countries and is a sign of the public’s confidence in the soundness of the Portuguese banking system.
Significant challenges remain in restoring the profitability of the domestic activity – which continued to remain under pressure, on account of elevated loan impairments and compressed net interest margin, also due to structural factors such as the low yielding mortgage portfolio – and in reshuffling commercial networks to the medium term features of financial services demand, characterised by lower activity in the credit market.
Bank lending to the non-financial private sector continues to decline reflecting the need of many firms to converge to a more sustainable financing structure. At the same time, it is crucial that funding continues to reach the most productive and competitive sectors, including exporting companies. This issue deserves ongoing analytical efforts by Banco de Portugal, involving intense use of micro-level information. Similarly, and in view of improving financial access, namely to SMEs, it was signed a protocol with the German KfW on October 28th, through which KfW is instated as an official advisor in the development of a specialized financial institution.
The architecture of supervision was strengthened and Banco de Portugal has been entrusted with an explicit mandate for macro-prudential policy and has been designated as the resolution authority. That implied deep organizational changes within Banco de Portugal with the creation of a Financial Stability Department.
Prudential supervision was reinforced manifold, with more resources involved both on and off-site being supervisory activities now more intrusive with the maintenance of permanent teams in banks’ offices. At the same time, Banco de Portugal became more pro-active in ensuring that banks’ assets are accurately valued and, after the two previous exercises, in the first half of 2013, the total loan book was revisited in a new asset quality review that concluded that 1.1 billion of impairment reinforcement was needed. At the end of June 2013, that amount was completely recognized in the banks’ accounts. A special inspection programme dedicated to the review of banks’ recovery process of problem loans is ongoing, including the scrutiny of strategies, policies, and procedures in place, as well as an assessment of the adequacy of the resources dedicated to this function and governance and internal control issues.
5 - Structural Reforms
The Government remains committed to its reform agenda to boost growth and create jobs, which is very ambitious and encompassing.
Significant steps have been taken in liberalizing the exercise and activity of regulated professions, in transposing the Services Directive and in improving the regulatory authorities’ architecture.
The by-laws of 18 public professional associations and related regimes are being adapted to the horizontal legal framework on public professional associations, being an important step in liberalizing the exercise and activity of regulated professions.
The full transposition of the Services Directive is near completion (only 9 out of nearly 70 diplomas still need to be adjusted). This is an important step in removing outstanding barriers to free trade in services in the EU, a key driver of competiveness.
The Government also continues committed to removing excessive licensing procedures, regulations and other administrative burdens in order to remove bottlenecks in our economy. It should also be noted that the Zero Licensing regime, which introduces a simplified scheme for the installation and operation of various activities, is now fully implemented.
In the energy sector, with the liberalization of both the electricity and gas market already in place, the Government keeps focused on ensuring the sustainability of the National Electricity System (NES). Adding to the already approved and implemented measures announced in May 2012, the Government has presented additional measures to address the pressures in the NES (namely the drop in demand that has resulted from lower than expected economic activity), including the introduction of a levy on the energy operators that will be used for fiscal consolidation purposes and for the sustainability of the NES.
Also in what concerns the communications sector the commitment to continue with the structural reforms was kept. Three tenders for the telecommunications universal service providers were issued. Two of these were successfully completed and the third having remained deserted was attributed by direct award for a period of one year whereupon a new tender process will be evaluated. In the postal sector the decree-law laying down the framework of the postal concession contract was amended.
Portuguese authorities reaffirm the commitment towards the privatization program which has already surpassed the initial overall financial objectives. The Government continues to see the program as an important tool for opening up the Portuguese economy and attracting new investment that will increase Portugal's competitiveness in the medium-term. As such, work is ongoing in order to ensure that binding offers for CTT (postal company) are received by the end of 2013 and for EGF (waste management) in early 2014. Furthermore, the restructuring of Águas de Portugal is underway.
In the health sector, operational improvements geared at cost control and efficiency such as the publishing of clinical and prescription guidelines continue to be implemented. To this end a decree law was published opening the MCDT market to new players thereby fostering competition. Difficult negotiations with the pharmaceutical industry were concluded resulting in the state’s drug expenditure being reduced to 1% of GDP in 2013. The reorganization plans for the hospital network were presented and the Government remains committed to this reform as well as to further improve expenditure control mechanisms so as to better control and eliminate arrears.
In what concerns judicial reforms, the main commitments agreed under the program have been completed and efforts went even beyond as detailed and recognized in Box 3 of the Staff Report.
Labor Market reforms
In the Labor Market, significant progress has been made since the beginning of the program. A distinctive mark of these reforms has been the tripartite agreement, which served as a basis for the revised labor code, and was signed by the Government, all the employers’ associations and the confederation of labor unions UGT, thus minimizing social unrest. An example of a recent move in this area is a new reduction in the severance payments, which entered into force on October 1st, that brought the value from 30-36 days/year in the beginning of the program to a value aligned with the EU average (12 days/year). The recent Constitutional Court ruling, while keeping most of the changes introduced in the Labor Code revision of 2012, rejected some of the provisions regarding the individual dismissal. The Government will work with the Social Partners in designing alternative measures with similar effects, while respecting the Court ruling.
Overall, the Government’s view of the labor market is more prudent than the one expressed in the staff report. There is the belief that there is not enough data, nor has sufficient time passed after the recent reform, to reach confident conclusions on this topic. In recent exchanges the Government has argued that the deep change in the economy and the severe economic crisis makes it next to impossible to assess what is cyclical and what is structural in recent developments in the labor market1. This recommends restraint in privileging a dominant explanatory variable from the usual ones: wage rigidity, structural change, reallocation of resources, or credit constraints. This last factor, for example, should be assessed more carefully in coming discussions in light of a recent working paper published by the Bank of Portugal2. More specifically, views of “persistent nominal rigidities” or “modest improvement in the overall price competitiveness3” are, in the view of the Government, not supported by the data. Nor are the views that the unskilled are bearing most of the costs of the crisis, as the Government has shown, in particular if the period of the adjustment program (2011-13) is taken into account. In sum, the Government recognizes the centrality of this issue, the need to monitor developments closely and fine tune reforms as needed. But the Government also believes that the assessment and resulting policy implications, should at this time be more cautious and tentative.
For example, the recent paper by the European Commission “Labour Market Developments in EU 2013” suggests that “the NAWRU in the current situation is likely to overstate the magnitude of unemployment linked to structural factors, notably in countries most severely hit by the crisis”, pointing out “that in some cases it could be of poor guidance for structural policy because of the possible large discrepancies between the NAWRU and the value of unemployment explained by institutions and structural factors only.”
See Carneiro, Portugal, Varejão, “Catastrophic Job Destruction”, Banco de Portugal Working Papers 14, October 2013 in which “[authors] uncover what we believe is convincing evidence that the severity of credit constraints played a significant role in the current job destruction process.”
Especially in light of the strong performance of exports and gains in market share.