The IMF staff presents an accurate report of the current state of the Portuguese program. The program provides an adequate framework to address the imbalances accumulated in the Portuguese economy. It is a very demanding and persistent effort. The Portuguese authorities are strongly committed to the implementation of the program. All end-June performance criteria and structural benchmarks for the review were met. However, the end-September performance criterion on the government deficit was missed (end-September is the test date for the 6th Review, but the Board discussion took place after end-September). Therefore, there was a need to adjust the fiscal consolidation path to avoid excessive economic and social costs that could be detrimental to the program’s success.
The IMF staff report provides ample evidence that much progress has been achieved. The external imbalance has been corrected faster than anticipated, mainly due to strong export growth. Portuguese firms have shown greater flexibility than expected. They have been able to diversify the destination of their exports, reducing the reliance on traditional European markets, and increasing exports to non-EU countries, such as Angola, US, China, and Brazil. The Portuguese authorities expect a current and capital account surplus in 2013, a more favorable projection than the IMF. If confirmed, it would be the first time for the last 20 years. This shows that the Portuguese economy is successfully making a transition from a growth model excessively based on domestic demand to a model based on exports. The staff’s recommendations for more decisive actions to raise competitiveness, employment and potential growth are well taken, but the recent evolution of exports and the decline in unit labor costs in 2012 suggest that Portugal is already improving competitiveness, thus showing that being part of a monetary union is not an impediment for external rebalancing. The authorities are strongly committed to pressing ahead with our ambitious structural reform agenda to continue improving flexibility in labor and product markets that would lead to further benefits in the longer-term.
There has also been significant progress in reducing the debt levels of households and corporations. Portuguese banks are in a stronger financial position, as detailed below. Progress in the adjustment has resulted in enhanced credibility that, in turn, has led to a substantial improvement in the sovereign debt market. Better financing conditions seem to be spilling over to the private sector. An important development has been the issuance of debt by some large Portuguese firms in international bond markets at reasonable interest rates. However, nonperforming loans have continued to increase and bank lending rates remain at excessively high levels. The authorities are seeking ways to reduce the high borrowing costs (through dedicated credit lines to SMEs with state guarantees, the use of structural funds, and the use of equity funds created in the context of bank recapitalization) and are studying further initiatives to improve overall financing such as the creation of a specialized institution to finance innovative projects.
2. Fiscal Policy
An important decision taken during this review, (already approved by the Eurogroup and the Ecofin), was the decision to revise upward the limits to the budget deficit (5.0 percent in 2012, 4.5 percent in 2013 and 2.5 percent in 2014). As explained in the staff report, the new path strikes a better balance between the need to contain debt accumulation and imposing an excessive burden on the economy. The new limits will help the economy to achieve a virtuous cycle of increased credibility, access to finance, and the recovery of economic activity and employment. The targets will also help to avoid excessive social costs from the adjustment. In this regard, the government is stepping up its social dialogue to preserve the broad consensus and support for the program.
The State Budget for 2013 has been submitted to Parliament on October 15th (prior action) and is an important milestone on this path towards the recovery of credibility.
According to the staff report, in 2013 the primary balance will be close to equilibrium, but in structural terms the primary balance will show a surplus of around 2 percent of GDP. In the period 2011-2013, the fiscal adjustment in Portugal will be around 7 percentage points of GDP in structural terms. This development is unprecedented in the Portuguese economy. To comply with the agreed limit for the deficit in 2013, the authorities are taking consolidation measures of around 3.2 percent of GDP.
On the revenue side, the 2013 budget includes the increase in personal income taxes, property taxes, and taxes on investment income. We are implementing a reform of the personal income tax, which will include a reduction of brackets and tax deductions. A surcharge will also be applied.
On the expenditure side—and in order to take into account a Constitutional Court ruling—only up to one salary of public workers and up to 90 percent of a monthly payment of pensions will remain suspended. This suspension will not apply to monthly wages below EUR 600, and it will progressively apply to monthly wages between EUR 600 and EUR 1100. These are important features to protect the most vulnerable groups of the population.
At the level of public administration, compensation of employees will be curbed by cutting the number of permanent employees by 2 percent, through the non-renewal of a substantial amount of fixed-term contracts and the reduction in compensation for overtime. There will be rationalization of General Government expenditure. Building on the results of a study by an international auditor concerning PPPs, the authorities concluded the negotiation of PPP sub-concessions, which resulted in capital cost reductions. The renegotiation process of the remaining PPP contracts will ensue, based on the established strategy, and taking advantage of the PPP Technical Unit that is being established in the Ministry of Finance. There will be cuts in the transfers to foundations. The restructuring of the SOE sector will continue. The authorities are also making changes to social benefits, with the aim of ensuring that the increasingly scarce resources of the state are directed to those who need it most effectively, extending means testing. There will also be substantial savings in Health and Education.
The progress done so far has resulted in the gradual build-up of trust and credibility in international markets, improving the prospects for a return to full bond market financing. Portugal has been able to issue T-bills at declining interest rates. In the latest auction in October, the rates paid at 12 and 18 month maturities were around 2 and 3 percent respectively. Importantly, a bond swap done in early October allowed to significantly reduce refinancing risk by swapping 39 percent of the bonds maturing in September 2013 for a bond maturing in October 2015, thus representing an important step in the path toward full bond market access.
3. Financial Sector Policies
The resilience of the banking sector has been considerably reinforced throughout the year. Progress has been noteworthy on several fronts.
First, the liquidity position of the banking sector has been strengthened, on the backdrop of decisive non-conventional measures taken by the ECB and of continued trust displayed by the depositor base. Banks have further strengthened their collateral buffers, despite adverse external conditions. To facilitate redistribution of liquidity among domestic banks, Banco de Portugal developed a new platform for interbank unsecured lending which started operating on September 3rd. The secured segment of the domestic interbank money market is expected to be operational by early 2013.
Second, the solvency of the banking system has been significantly reinforced. This was achieved through a decrease of risk-weighted assets—given the nature of the ongoing deleveraging process—through an increase in core own funds and, in the case of two banks, by resorting to the Bank Solvency Support Facility (BSSF) established under the program, in an amount close to EUR 5 billion (of the EUR 12 billion available in the Facility). This allowed banks to fulfill their regulatory capital requirements, including the European Banking Authority’s capital exercise. The most recent stress test exercise, conducted by Banco de Portugal in tandem with the quarterly Funding and Capital Plans, confirmed the resilience of all participating banks. This exercise revealed the importance of the capital increases carried out in June 2012, as banks were able to absorb the severe adverse scenario and still keep a core tier 1 ratio clearly above 6 percent.
Third, the supervision of the banking system and the regulatory framework continued to be strengthened. Several initiatives are worth highlighting in this respect. First, with a view to discouraging evergreening of problematic loans, Banco de Portugal published an Instruction aimed at ensuring the identification in the banks’ information systems of restructured credits due to financial difficulties of the borrower. Early insights from this work are expected in the forthcoming weeks. Second, as part of Banco de Portugal’s regular supervisory activities, a new on-site inspections program has been launched and the field work has already started in all the eight largest banking groups, with first conclusions expected by November. Finally, draft proposals concerning (i) Bridge Banks, (ii) Recovery Plans; (iii) the Resolution Fund Regulation and (iv) Contributions to the Resolution Fund by the participating institutions have already been completed.
The continuation of a balanced deleveraging process continues to be a central goal for banks over the medium term. This process aims at ensuring a sustainable funding structure over the medium term, which is instrumental to ultimately regain access to international financial markets. This deleveraging process should be consistent with the adjustment of economic agents’ balance sheets. In particular, it should ensure that the most dynamic and productive segments of the economy maintain access to the domestic credit market.
In the context of an unprecedented economic contraction, total credit granted to private non-financial corporations (including loans, debt, and trade credit) has decelerated gradually from mid-2011 onwards, but still records year-on-year rates of growth around zero. Non-domestic sources of financing have contributed decisively to this dynamics. There is however high heterogeneity in the flow of credit to the economy, as credit is only increasing for large firms. Some of this heterogeneity is inescapable, given the required sectoral restructuring of the Portuguese economy. However, the fact that domestic loans are contracting at a strong pace, in particular to SMEs, suggests that stronger action is needed to reduce financing constraints. In particular, the diversification of sources of financing remains of the essence for the sustainable recovery of the Portuguese economy. Authorities have been working on several proposals in this regard. First, the setting-up—in a European context—of a vehicle to reduce the weight of legacy mortgage credit in banks’ balance sheets. This would allow banks to immediately deleverage through a stock adjustment—without impacting on the financing of the economy—instead of relying on a gradual restraint on new loans, in particular as regards non-financial corporations. This would also reduce funding pressures which are currently impacting on deposit rates and being transmitted to the cost of new lending. Further, it would allow banks to restructure the asset side of the balance sheet, by potentially promoting new lending flows to the most productive and dynamic firms in the economy. Overall, it would contribute to a smoother functioning of the monetary transmission mechanism in the euro area. Another proposal being explored is the development of a dedicated public financial institution in the context of the forthcoming EU financial package. This proposal aims at enhancing the mix between grant-based financing and the use of financial instruments, in order to maximize the financing of viable non-financial corporations and to promote EU regional development goals.
Progress on all these fronts is essential to preserve financial stability in the Portuguese economy. This should also contribute to an efficient adjustment of the Portuguese economy going forward. Notwithstanding, the Portuguese banking system still faces important challenges, stemming in particular from the exacerbated uncertainty on a supranational level and from the downside risks still facing the Portuguese economy.
4. Structural Reforms
The new labor law approved by Parliament will promote a competitive economy with an increasingly flexible and dynamic labor market. Furthermore, the Portuguese authorities recognize the need to decentralize wage bargaining and decrease market segmentation. The decline in unit labor costs in the Portuguese economy is a reflection of the significant steps already taken to this end. Of particular importance to the whole economy is the ambitious law presented to Parliament concerning port work which aims at the significant reduction of barriers in this crucial and historically inflexible sector.
As for the product market, the Portuguese authorities have continued the substantial work already undertaken in addressing excessive rents in network industries. After eliminating the power guarantee scheme, the authorities concluded the agreements with the wind energy sector and revised the calculation of cogeneration, establishing more efficient mechanisms and reducing the cost to end users. Further steps to reduce excessive rents were taken on the telecommunications and pharmaceutical sectors.
Following the approval of a new competition law and the establishment of the new Competition Court, a new regulatory architecture is nearing completion with the regulatory framework law currently under discussion. The authorities have reaffirmed their commitment to enlarge the scope of the privatization program to develop a more open and competitive Portuguese economy.
Reforming the judicial system is critical to improve business environment. The new Insolvency Code came into effect and the law governing the new Extrajudicial System for Recovery of Viable Companies (SIREVE) was published. A new Arbitration Law created a task-force of judges for high value pending tax cases and proposed a number of measures to eliminate the backlog of enforcement cases. Additionally, the new judicial map and the Code of Civil Procedure were subject to extensive public scrutiny and resulted in draft laws that are being concluded.
Moreover, a new ambitious initiative on licensing reform was presented with the objective of simplifying and reducing procedures, and removing excessive regulations and other administrative burdens to the economy. These barriers represent a major obstacle for economic growth in Portugal. This initiative covers all families of licenses and will have a substantial impact in the business environment.
The first signs of an opening up of international financial markets to longer-term financing of the Portuguese government and of large companies and financial markets this autumn provides some optimism for a gradual improvement of financial conditions in the economy. The malfunctioning transmission mechanism of monetary policy and the fragmentation of the European financial system continue to pose important challenges for Portuguese firms. The resolution of these problems, which have a European dimension, would reduce obstacles to the competitiveness of Portuguese companies and facilitate the adjustment under the program.