We thank staff for the report of the fifth Post-Program Monitoring (PPM) discussions. The exchange of views that took place during the visit is very welcome, but it is our authorities’ assessment that the progresses achieved in the economic, fiscal, financial and structural fronts are not fully recognized in the report.
The Portuguese Government reiterates its firm commitment to design and implement economic and fiscal policies that promote sustained and inclusive growth, in a context of fiscal consolidation. Those policies are focused on the recovery of households’ and firms’ incomes, by reducing the fiscal burden and improving labor market conditions; on the capitalization of firms, allowing them to invest, generate jobs and grow; and on addressing the remaining challenges of the financial system, critical also for the recovery of investment.
Developments and concrete results in all these areas were visible in 2016 and efforts in this direction will be further pursued in 2017.
For the Portuguese Government, strengthening the financial sector has been a priority. The staff report could have better recognized and evaluated actions undertaken in this area.
Legislative updates allowed for the strengthening of banks, which reinforced capital levels and stabilized shareholders’ structures (discussed in section III).
Moreover, it is also our authorities’ view that their strong commitment to promote a growth-friendly fiscal consolidation strategy is downplayed, at a time when its accomplishments are evident, most notably in the simultaneous breakthroughs on the fiscal and the employment fronts. The Government strategy is paying-off as evidenced by steady employment growth, unemployment close to single digits, stabilization of the financial system, and the lowest budget deficit in 40 years. The 2017 State Budget, approved in November, will continue on this path, ensuring a sustainable fiscal consolidation.
Finally, the structural bottlenecks of the Portuguese economy are being steadily addressed. It is also the Government’s view that these efforts are not duly recognized in the staff’s assessment. The ambitious reform agenda set out in the 2016 National Reforms Program, which was praised by the European Commission (EC), is being swiftly implemented, strengthening the reform momentum.
The combination of policy actions is allowing the economy to move to a higher and sustained growth path, with improved labor market developments and steady competitiveness gains. In 2016, GDP increased by 1.4 percent according to INE and the public deficit is expected to be clearly below 2.3 percent of GDP, under the EC target of 2.5 percent and the revised national target of 2.4 percent. The fiscal outturn did not depend on any extraordinary measure; it is rather the result of judicious policies put forward during the entire year. Moreover, the primary surplus is expected to be above 2 percent. These results are significantly better than those forecasted by the Fund staff, which, in its September report, envisaged a GDP growth of 1 percent, a 3 percent budget deficit and a 1.6 percent primary surplus. Going forward, in 2017 the Government expects GDP growth to accelerate to 1.5 percent, with a 3.1 percent increase in investment, further consolidating the recovery. This is a conservative scenario as can be seen from the recent EC Winter Forecast for Portugal, which revised upwards Portugal’s growth projection to 1.6 percent, from 1.2 percent in the Autumn Forecast.
II. Recent developments and outlook
The Portuguese economy is now on a sustained higher growth path. In the 3rd and 4th quarters of 2016, Portugal registered one of the highest GDP growth rates of the euro area, with a strengthened contribution from net external demand in the third quarter and investment in the fourth quarter. According to the balance of payments statistics from Banco de Portugal, the balance of goods and services continued to firmly improve and recorded an increase of €938 million up to November, with respect to the same period in 2015, due to improvements in both the balance of goods and the balance of services. The unemployment rate stood at 10.5 percent in the 4th quarter of 2016, 1.7 percentage points below the figure for the same period in 2015. Investment is also showing positive signs: private entrepreneurial investment rose 7.7 percent in the 3rd quarter of 2016, imports of equipment goods increased 8.5 percent in the 3th quarter of 2016 and heavy and light commercial vehicles sales expanded 12 percent in the second semester of 2016. Consumer confidence indicators are at a 17 year high.
This strategy will continue in 2017, with policies to reduce indebtedness of households and firms, promote investment and foster social cohesion. The Portuguese Government expects labor productivity to improve by 0.5 percent and unemployment is expected to improve over the 10.3% target envisaged in the 2017 State Budget. The Government is committed to continue to deliver strong reform impetus through the implementation of the National Reform Program (discussed in section V). The competitiveness of the Portuguese economy will continue to be at the top of the Government’s agenda.
III. Financial sector
The Portuguese banking system went through a deep adjustment process that started in 2010, in anticipation of the Economic and Financial Assistance Program (EFAP), impacting size and composition of balance sheets, solvency and cost structures. Despite the progress achieved, the banking system still faces several significant challenges, also vis-à-vis the European regulatory and institutional background. In particular, profitability remains subdued on the back of significant challenges concerning non-performing loans (NPLs) and cost cutting amidst low interest rates, weak economic growth and uncertainty on the contribution of Portuguese banks’ international activity.
Positive developments should also be highlighted. The large reduction in the loan-to-deposit ratio (from a peak of 165 percent to 102 percent in June 2016) decreased banks’ vulnerability to shocks in market sentiment. This trend has been persistent and is a sign of confidence in the banking system. Reliance on Eurosystem financing also continued to decline in 2016.
Returning to adequate levels of profitability remains a key challenge. In the first half of 2016, profitability remained subdued and reverted from non-recurring levels observed at the end of 2015. Net interest income continued to recover, on account of lower deposit interest rates, while income from financial operations, by nature less recurring, declined. The flow of impairments continued to weigh significantly on profitability. The reduction in administrative costs in 2015 due to restructuring efforts continued in 2016. Notwithstanding, the cost-to-income ratio increased year-on-year on account of a decline in operating profits.
Despite a clear medium term improvement, capital ratios fell marginally in the first half of 2016, as a result of the aforementioned weak profitability and the gradual elimination of transitional provisions for eligibility of own funds, as foreseen in CRDIV/CRR. The Portuguese banking sector still presented a lower CET 1 ratio than its European peers at the end of the first quarter of 2016, but continues to compare very well in what concerns the leverage ratio.
Against this background, further adjustment efforts are warranted, as banks need to proceed reshaping operating structures, outlets and distribution networks, also taking into account the challenges and opportunities of digital banking. Still subdued economic growth, very low nominal interest rates and low inflation rates challenge banks’ business models in Portugal and other EU countries.
Finding adequate solutions to the high stock of non-productive assets, most notably NPLs of non-financial corporations, remains of paramount importance. Non-productive assets have been hampering banks’ profitability and negatively affecting markets’ perception of banks resilience. The systemic nature of the persistently high levels of NPLs, the need for a comprehensive approach and the European dimension of the problem (also related with potential spillover effects) recommend a European approach. This is a priority followed so far. Notwithstanding, at national level, the comprehensive and coordinated approach must be continued, involving all relevant stakeholders, in the various fronts: intrusive banking supervision; structural reforms in the legal/judicial/tax framework; and the promotion of a portfolio oriented NPL management, which may include a more systemic approach also dependent on the EU regulatory context (notably State Aid and BRRD).
The financing of companies with better risk profiles remains a key feature of the adjustment of the non-financial corporations’ sector. In addition, the reduction of the share of the construction sector, particularly impacted by the economic crisis, and the increase of manufacturing and trade in banks’ loan book continued. The profitability ratios in the latter two sectors exceed the average of the non-financial corporation sector. Although loans by the resident financial sector to non-financial corporations continued to decline, total corporate debt has slightly increased. This was associated to loans granted by non-residents to Portuguese companies, both by companies of the same economic group and by nonresident banks. Finally, credit granted to exporting companies has been growing at more favorable rates than the average. Households’ stock of credit for house purchase continued the deleveraging path initiated in 2011, while credit for consumption and other purposes has been accelerating and showing positive growth rates since the second half of 2015. These latest developments are being closely followed by Banco de Portugal, as national macro- prudential authority, despite not being considered a source of significant risk in the short run.
It should be highlighted that strengthening the financial sector has been the priority of the Portuguese Government. The policy and legislative decisions aimed at strengthening banks’ capital and promoting mechanisms that facilitate the recovery process of NPLs are bearing fruit. This strategy will continue to be pursued in 2017.
A number of key measures has already been implemented in 2016 thanks to the approval of legislation and political action. This allowed for a reduction of uncertainty in the banking system, particularly relevant to stakeholders. As such, the main private banks were able to stabilize their shareholders’ structure and raise capital; the selling process of Novo Banco was re-launched, in a context of reinforced capital ratios, attracting several bidders; the stock of DTAs was stabilized and the remaining procedural aspects clarified; the maturity of the loan granted by the State to the Resolution Fund was extended and the interest payments reduced, eliminating uncertainty for the banking sector, and the ongoing capitalization of Portugal’s biggest bank, Caixa Geral de Depósitos (CGD), thanks to the approval of the business plan by the EC, in a landmark decision recognizing the non-state aid nature of the investment.
IV. Fiscal policy
The strong commitment by the Portuguese Government to promote a growth-friendly fiscal consolidation is reflected in the fiscal results of 2016: budget execution data indicates that the deficit will be clearly below 2.3 percent of GDP and the primary surplus above 2.0 percent of GDP. This result was achieved due to a rigorous implementation of the budget and favorable developments on both the revenue and the expenditure side, which include inter alia cost savings and better Social Security revenues. According to the EC Winter Forecast the Portuguese primary government surplus is foreseen to have been, in 2016, the third largest in the euro area.
The 2016 budgetary outturns shall allow Portugal to exit the Excessive Deficit Procedure with a secure margin of safety. The Government is committed to continue these efforts in 2017, having in mind the Medium Term Objective set forth by the EC.
The State Budget for 2017, approved on November 29, promotes a sustained fiscal consolidation, fostering private investment and reinforcing the recovery of households’ income, fully in line with the Government program and with international commitments. To achieve these goals, the envisaged strategy focuses on five main pillars, namely (i) strict control of public expenditure, with the continuation of the spending review started in 2016 (focusing, initially, on health, education and public procurement, including SOEs); (ii) promotion of investment by creating incentives for firm capitalization and job creation; (iii) fiscal stability and fight against fraud and tax evasion; (iv) public administration reform; (v) support for the measures envisaged in the National Reforms Program (discussed in the next section).
In this context, the Portuguese Government expects the public deficit to maintain its downward trajectory in 2017, decreasing to 1.6 percent of GDP, and the primary surplus to increase further, reaching 2.8 percent. The weight of public expenditure on GDP is expected to be reduced in 2017, as is the fiscal burden. Public investment is forecasted to improve, reaching 2.2 percent of GDP in 2017.
In 2016, the general government debt-to-GDP ratio stood close to 130 percent, mainly due to the prefunding of the financing needs for CGD recapitalization that will occur in 2017 (€2.7 billion). However, the public debt excluding central administration deposits (net debt) has already declined in 2016 as a percentage of GDP, with the cash-buffer amounting to €10.2 billion at the end of the year (€6.6 billion in 2015). After a period of stabilization, the debt- to-GDP ratio will decrease in 2017, on the back of the primary surplus and of accelerating economic growth.
V. Structural Reforms
The Portuguese Government reiterates its commitment to address the remaining structural bottlenecks of the Portuguese economy. The National Reforms Program (NRP), published in end-March 2016, sets an ambitious reform agenda, with a well-defined calendar and goals, and was also based on the Country Specific Recommendations presented by the EC to Portugal. The NRP was welcomed by the EC, which considered that it showed sufficient ambition to tackle the excessive imbalances faced by the Portuguese economy.
The strategy outlined in the NRP, allows for an overarching, broad-based approach aimed at addressing (a) the historical skill’s deficit of the population; (b) the medium-low innovative character of the economy; (c) the modernization of the public sector, including simplification of administrative and licensing procedures for enterprises and the reduction of red tape costs; (d) the high levels of public and private debt, which constrain the investment perspectives for the Government, firms and households; and (e) the need to ensure social cohesion and equality as key features for a sustainable economic growth. Amongst these priorities a special mention is needed to the first objective, which will be object of a National Skills Strategy supported by the OECD. This is key to enhance the medium- to long-term potential growth.
The implementation of the envisaged measures is being closely followed by the Government, with states of play being published every six-months (the first assessment was released in September 2016). From the total of 139 measures proposed, 2/3 were concluded or put in place in 2016 and, for the remaining 1/3, 78% were already launched or are ongoing.
The elimination of structural bottlenecks in the Portuguese economy has been advancing steadily. While the full materialization of the benefits stemming from reforms is only possible in the longer run, the ambition of the Portuguese reform agenda is already showing positive signs, with improvements in many of the structural indexes reported by institutions such as the World Bank, the World Economic Forum or the OECD. A very good example is the recently released OECD’s Program for International Student Assessment results, where Portugal registered one of the largest improvements and is now above the OECD average in all indicators.
Overall, confidence indicators have been boosted, export capacity has been robustly strengthened, investment is expected to recover and unemployment, in particular youth unemployment, should continue on a downward path.
The Portuguese authorities are fully confident that their obligations towards the Fund will continue to be timely met, and reiterate their strong commitment to uphold such obligations. The Government is also committed to a strategy that promotes sustained and inclusive growth, in a context of growth-friendly fiscal consolidation. The positive fiscal and economic results of 2016 support the maintenance of these efforts in 2017. Both the strategy envisaged in the 2017 State Budget and the ambitious National Reforms Program will decisively contribute to further consolidate the recovery.
The Portuguese authorities look forward to the sixth PPM mission, which will again constitute a good opportunity to closely work with the Fund, deepening our dialogue and promoting a broader mutual understanding.