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Article

Portugal: Selected Issues

Author(s):
International Monetary Fund
Published Date:
March 2004
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I. Introduction

1. The 2003 Article IV discussions with Portugal focused on policies to overcome structural and cyclical impediments to growth as well as on steps to secure fiscal consolidation, and the following three chapters provide background analysis on these issues. The recession in Portugal has been accompanied by a large fall in real investment (by almost 15 percent during 2002–03), and a sustained economic recovery depends importantly on an investment rebound. There are some doubts, however, if company balance sheets are sufficiently strong to support a rebound at this juncture, and the links between corporate balance sheet strength and investment are analyzed in a cross-country context in Chapter II. The main medium-term challenge of the Portuguese economy—securing real income convergence with the leading advanced economies—has to take place within an increasingly competitive environment. The latter may be affected by European Union (EU) accession of 10 countries in May 2004, and the potential external trade implications are reviewed in Chapter III. Sizable fiscal deficits and a public debt ratio around 60 percent of GDP underscore the need to move ahead with fiscal consolidation, but securing fiscal solvency will also depend on redressing aging–related spending trends. Accordingly, Chapter IV reviews pension prospects and the implications of various policy reform scenarios.

2. Portugal ranks high among European countries in terms of corporate indebtedness. Interest rate convergence after EU accession as well as expectations of large benefits from monetary union have played a key role in fueling domestic demand growth and thus indebtedness. Furthermore, corporate leverage ratios were also affected negatively by the collapse in equity prices after 2000. Chapter II explores to what extent the rise in corporate indebtedness or developments in other balance sheet indicators may undermine investment in Portugal—a critical issue as the economy emerges from the recession. Dynamic panel data techniques are used to investigate the empirical relationship between corporate indebtedness—and other corporate balance sheet indicators—and investment. Covering a group of seven EU countries, the econometric results suggest that there is, in general, only weak evidence of links between corporate investment and leverage or other corporate balance sheet indicators. However, investment is significantly affected by these indicators above certain threshold levels of leverage and over the downturn phases of the real business cycle. The estimates suggest that balance sheet factors contributed to some extent to the weakness of investment during the current recession in Portugal, and also add a note of caution concerning a near-term prospects for investment.

3. Enlargement of the European Union from 15 to 25 members on May 1, 2004, is expected to bring important economic benefits for old and new members, largely through an expansion of trade. Chapter III explores the potential trade implications of EU accession for Portugal. With currently very little trade between Portugal and the accession countries, model-based estimates suggest a potentially large trade expansion—perhaps by some two-thirds or more above current levels. However, the experience of earlier EU accession countries and of monetary union in Europe also indicates that the trade benefits do not accrue automatically and evenly across countries: further structural reforms (in labor and product markets) as well as steps to strengthen competitiveness may be critical if Portugal is to secure the fruits of trade integration.

4. Chapter IV examines the Portuguese public pension system and its future financial sustainability. As in most other EU countries, Portugal will face adverse demographic trends in the coming decades, which will, absent further reforms, result in significant aging-related spending pressures. While the pension system has undergone a number of reforms, and current pension expenditures are slightly below the EU average, projections suggest that the system remains fundamentally unsustainable in its present form. The authorities’ official projections predict that pension expenditures, equivalent to 9.8 percent of GDP in 2000, will increase by 2.3 percentage points of GDP by 2050. Moreover, these projections may be, for macroeconomic and demographic reasons, overly optimistic, with expenditures likely to rise to an even greater extent. With the general government debt burden already approaching 60 percent of GDP, and with social insurance contributions rates above the high EU average, there is little scope to finance the coming spending pressures. Thus, addressing these pressures most likely will have to involve some steps to reduce the scope and scale of pension benefits themselves. The chapter considers the quantitative effects of reforming several basic parameters determining pension benefits—including the retirement age, the accrual rate, the degree of indexation to inflation or real wage growth, and pension income taxation—and determines that each reform by itself would most likely not be sufficient to address fully spending pressures. This suggests that consideration be given to combining a number of different reform options.

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