We would like to start by thanking staff, on behalf of the authorities, for their comprehensive analysis and constructive attitude during these consultations. The well-balanced report stands broadly in line with the authorities’ own views and priorities, while the Selected Issues paper is always welcome as a thought-provoking exercise.
The Portuguese economy has been going through a period of slower growth and higher unemployment for the last few years, as it adjusts to the aftermath of a boom induced by first-wave EMU accession and to enhanced external competition.
Recovering the growth momentum and thus advancing the long-term goal of real convergence towards the EU average will critically hinge on two major challenges: sustained fiscal consolidation and increased competitiveness.
The new government, backed in Parliament by a strong single-party majority, stated its commitment to address those issues, through an appropriate medium-term fiscal strategy and a vast array of structural measures, already taken or under preparation.
Fiscal policy, put forward in the Stability and Growth Program recently endorsed by the EU Council, aims for a deficit below 3 percent of GDP in 2008 and further less beyond, focusing on expenditure restraint and refraining from one-off measures.
Structural action on several fronts – from the business environment to education and IT use – will seek to improve the country’s competitive position, building on pillars such as the robust banking system, further strengthened in recent years.
After a recession in 2003, the Portuguese economy recovered somewhat in 2004, although with declining impetus from mid-year onwards. Accordingly, unemployment rose further, while inflation abated and macroeconomic imbalances intensified. Indeed, the contribution of net external demand to growth was negative, reversing the favorable trend of previous years and leading to an increase of external indebtedness. The recovery was therefore based on domestic demand, particularly private consumption, fueled by an increase of disposable income and a rise in private indebtedness, as real interest rates remained very low.
Developments in 2005 confirm a pattern of slow expansion, with subdued export growth, in a context of enhanced competition from inside the enlarged EU and other emerging countries. Such a pattern tends to be reinforced by the rise and increased volatility of world oil prices, as well as by the need for fiscal consolidation. This latter, together with wage moderation, is critical to lay the foundations for future sustained growth, which hinges also on structural reforms to enhance productivity and potential output – thus further allowing for the correction of imbalances.
Turning to staff’s assessment of the current slowdown as “the slump that followed the bursting of the euro-adoption bubble”, it does not seem to be appropriate. In fact, the idea of “bubble bursting” applies to very steep corrections, typically in asset prices, which occur in a short period of time and lead also to sharp adjustments to the real side of the economy. No such events have occurred in Portugal. Moreover, given the current economic regime shaped by monetary union, the correction of past excesses is likely to be rather prolonged.
Going for sound public finances
Rapid expansion over an extended period pushed current primary expenditures from 28.1 percent of GDP in 1990 to 39.4 percent in 20041. As the EMU-induced effect of falling interest payments tended to wear-off, while that expansionary trend kept going, a sizeable deficit became apparent in 2001 (4.2 percent of GDP). In subsequent years, weakening economic activity weighed on revenues, prompting the authorities to use one-off measures of significant magnitude in order to keep the deficit below 3 percent of GDP, as required by the Stability and Growth Pact.
After taking office, last March, the new single-party majority government appointed an independent commission, headed by the Governor of the Bank of Portugal, to estimate the likely fiscal outcome for 2005. This commission concluded that, without policy changes, the deficit would reach 6.5 percent of GDP. That assessment reflected several corrections to the original budget, including more realistic assumptions and the rejection of one-off measures. These latter are perceived by the authorities as a palliative that masks the true dimension of problems, promoting a misguided sense that the worst has been overcome.
The authorities are determined to address the root causes of fiscal imbalances and have accordingly committed to refrain from one-off measures and to address the unsustainable level of current primary expenditures. However, in view of their high rigidity – about 87 percent of such expenditures could not be tackled without cumbersome changes to the legal framework – action on the revenue side became inevitable to get immediate results, as deemed imperative. Several measures were thus introduced – including a rise of the top VAT rate and a freezing of automatic civil service promotions – in order to bring the deficit down to 6 percent of GDP. According to available figures, this goal is within reach, benefiting among other factors from the significantly increased efficiency of tax administration.
Looking ahead, the authorities have pledged to reduce the deficit below 3 percent of GDP in three years, taking it further to 1.5 percent by 2009, as stated in the revised Stability and Growth Program endorsed by the EU Council on September 20. Fiscal targets for 2006 will benefit from the full effect of the VAT rate rise – together with a new income tax top rate and increases in fuel and tobacco taxes. Efforts will nevertheless focus on expenditures, particularly as regards social transfers and the wage bill, which accounted for most of past expenditure increases.
Measures in this context include, among others, an alignment of the social security regime for public servants with the general regime, a review of this latter, an audit-based reform of public administration, several efficiency-enhancing measures directed to the National Health System, a reform of local finances, preparation of a multi-year budget framework and heightened efficiency criteria for public investment, which is to be preserved. Finally, the authorities stand ready to take additional measures as necessary to abide by the deficit targets in case macroeconomic assumptions embedded in the Program do not materialize – as regards for instance GDP projections over the medium term.
Tackling structural risks and weaknesses
Developments in the Portuguese economy since EMU was launched in 1999 illustrate the importance, for countries participating in a monetary union, of ensuring that fiscal policy is consistently able to play a counter-cyclical role. Such developments further demonstrate the cost, in terms of lost competitiveness and thus eventually output loss and unemployment, if wage increases are too much out-of-line with developments in other monetary union members. Indeed, that can only be sustained if productivity grows at a sufficiently strong pace to compensate for the wage differential, which is why the agenda for structural reforms currently envisaged by the authorities turns out to be so critical.
Although quite diverse in nature, as they encompass a vast array of relevant subjects, those reforms share a common focus on fostering productivity and potential output, by removing undue barriers to business, fostering capabilities and providing appropriate incentives to private agents. They touch upon education, the legal system, the energy sector, R&D, ICT use and the broad business environment, among other areas. Several specific measures have already been implemented, including the possibility of creating a firm in one hour, an increase in classroom time for teachers, enhanced competition to promote broadband internet use and simplified legal proceedings for low-value debt claims.
Staff rightfully points to inefficiencies in the business environment identified by the World Bank’s Doing Business Indicators and its recent review of governance. That analysis is valued by the authorities but it should be seen together with other appraisals, such as for instance the Global Competitiveness Index recently published by the World Economic Forum for 2005. This ranked Portugal 22nd among 117 countries, up two places from last year and well positioned within the EU context.
Current levels of indebtedness in the Portuguese economy are a concern taken very seriously by the authorities, either in their capacity as policymakers or as financial regulators. Nevertheless, the issue must be put into perspective, on several grounds. Public debt rose from 51.2 percent of GDP in 2000 to 59.4 percent in 2004 and is only expected to start declining by 2008. However, it is just now breaching the Maastricht criterion, stands below the euro area average and its spreads to relevant benchmarks remain at historically low levels. Household debt tripled as a percentage of disposable income in the last ten years, reaching one of the highest levels for OECD countries. And yet, household wealth stands at about 500 percent of the same disposable income and there is no evidence of significant asset price overvaluation. Credit growth slowed down markedly since 2001 and is overwhelmingly long-term and housing-related. Moreover, reflecting historically low rates, the interest burden is now about as heavy as it was a decade ago (see chart). External debt also rose steadily in the last few years, standing above 150 percent of GDP since 2004, in gross terms. Still, it is overwhelmingly expressed in euros, the Portuguese currency, and does not go beyond 40 percent of GDP in net terms.
Household debt and interest payments
(In percent of disposable income*)
Citation: 2005, 375; 10.5089/9781451832198.002.A003
* Old NA series
Indeed, it should be stressed that participation in the euro area represented a fundamental regime change for the Portuguese economy regarding its external constraint and financing channels. The external imbalance is now financed in the common currency and therefore not constrained by the possibility of an exchange rate crisis. However, the solvency conditions arising from intertemporal budget constraints faced by individual agents remain as valid as before euro adoption. Thus, a persistent gap between the growth of domestic expenditure and that of income, financed by ever rising external indebtedness, is obviously unsustainable. This said, the unwinding of existing imbalances may take quite some time under the current regime. If the appropriate structural reforms are implemented and succeed in increasing the economy’s growth potential, external imbalances may essentially be corrected through rising exports. Otherwise, the domestic savings rate will inevitably have to rise and domestic expenditure will need to be curbed, so as to serve a growing stock of external debt.
The above considerations suggest two additional remarks regarding the staff report. First, we believe that the exercises on external and public debt sustainability (Tables 4 and 5 of the report) are complementary and so should share the same baseline assumptions – which is not the case for GDP growth. Second, we further believe that several conventional indicators of external and financial vulnerability, adequate for small open economies with monetary sovereignty, become irrelevant or misleading for EMU members like Portugal. This is notably the case for such indicators as official reserves and external liabilities of the central bank, presented in Table 6 – one which would be better excluded from the report.
The Bank of Portugal remains alert, in the context of its responsibilities as supervisor of the banking system, to issues such as the concentration of credit risk in the housing sector. Yet, it should be stressed, as staff acknowledges, that broad developments in the banking sector continued to be rather positive. Indicators of solvability, liquidity and credit quality improved again in 2004, while profitability remained comfortable, amid an environment of strong competition. A similarly favorable pattern could be observed as regards the insurance sector, where cost-cutting, an improved balance of premiums to risk and the recovery of capital markets allowed for enhanced profitability. As the overall financial system stands solid, and preparations for regulatory changes such as the new IFRS and Basle II are on-track, the authorities look forward to receiving the first FSAP mission by year-end.
Portugal has endured sizeable shocks over the last decades, and yet managed to develop at a pace matched by few other countries in the world. There certainly seems to be no reason to think it will be different this time.
As part of regular methodological reviews at the European level, the Portuguese Statistics Office recently issued a new series for the country’s National Accounts. Ratios presented in this statement are based on the higher GDP figures resulting` from that review.