Journal Issue

From Crisis to Convergence: Charting a Course for Portugal

Dmitry Gershenson, Albert Jaeger, and Subir Lall
Published Date:
March 2016
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1. Preface1

Portugal is recovering from a sudden stop and the severe recession that followed it. While the external flow imbalance has been corrected and full access to financing restored, stock vulnerabilities remain large, labor slack high, and economic growth modest. This paper reviews Portugal’s experience of postcrisis recovery and points to ways to reduce stock vulnerabilities, absorb labor slack, and generate sustainable growth.

The recent economic history of Portugal can be viewed through the prism of a Swan diagram, a simple macroeconomic model of a small open economy. An economy attains internal balance (IB) when it has full employment and stable prices. External balance (EB) requires equilibrium in the balance of payments.2

Portugal: Current Account Balance and NIIP1

(Percent of GDP)

Source: Haver.

1Net International Investment Position (NIIP).

Since the mid-1990s, Portugal ran very large external deficits accompanied by low competitiveness and, since 2000, near-zero growth (a point below and to the right of the EB line). At the same time, internal balance was largely maintained, with low inflation and low unemployment (a point on the IB line).3

Once the crisis erupted in early 2011, the adjustment program helped to restore external balance. This, however, came at the cost of a large internal imbalance, which had been driven by a decline in domestic demand (the move to a point on the EB line). Internal imbalance arose because restoring the credibility of the country’s policies required a gradual closing of the external imbalance and—at a minimum—stabilizing excessive leverage and public debt levels. That in turn required bringing the unsustainable level of domestic demand in line with the country’s national disposable income.

Portugal: Swan Diagrams

Source: IMF staff.

The emergence of a large internal imbalance could have been mitigated by increasing external competitiveness through structural reforms or a fiscal devaluation. This would have led to improved external price-cost competitiveness of existing firms or to the emergence of new exporting firms. Such an improvement was, however, difficult to achieve in the short run.4

Looking forward, the key macroeconomic challenge for Portugal is to maintain external balance while returning to internal balance by raising competitiveness (and, correspondingly, potential growth) through structural reforms (a movement along the EB line). Conversely, internal balance can be achieved by a reduction in the potential growth without improvements in competitiveness (a shift of the IB line to the left). The former scenario would allow for a reduction in the large labor market slack, while the latter—clearly undesirable—scenario would condemn Portugal to years of low growth, high labor market slack, and high unemployment.

Portugal: Restoring Internal Balance

Source: IMF staff.

Meeting this macroeconomic challenge implies restoring internal balance, maintaining external balance, reducing public and corporate debt overhangs, and generating sustainable growth. The subsequent chapters address these issues.

Chapter 2 reviews the challenge of restoring internal balance, stressing the need to create jobs for the lower skilled. The brunt of employment losses during the recession fell on the lower skilled, and the lower skilled have seen few job gains during the recovery so far. Simulations based on a production function that allows for both skilled and lower-skilled labor and different types of capital suggest that given present growth projections and policies, it is unlikely that job creation will be sufficient to absorb existing labor slack over the medium term. To support job creation for the lower skilled, badly needed structural reforms in the public and financial sectors (see Chapter 7) should be complemented by a prudent minimum wage policy, measures that increase the limited pool of managerial skills, and a more inclusive and transparent social partner dialogue that takes into account the interests of labor market outsiders.

Chapter 3 looks at external balance and competitiveness through the lens of value-added content in exports. Portugal achieved impressive external adjustment in the past few years, but—absent continued competitiveness gains—the economic recovery may lead to reopening of external imbalances, as domestic consumption and investment rebound. The analysis suggests that Portugal continues to lag behind many of its peers in structural areas closely linked to higher value added in exports, with rigid labor markets, high (relative to income) energy prices, a low degree of domestic competition, and bias of foreign direct investment (FDI) toward the nontradables sectors.

Turning to the public debt overhang issue, Chapter 4 reviews the status of fiscal adjustment. Because weak expenditure controls played a key role in the buildup of fiscal imbalances prior to the crisis and because the adjustment under the program was more revenue-based than had been initially planned, the authorities should now focus on increasing public expenditure efficiency with particular emphasis on public wages and pensions. Expenditure rationalization will help create room for pro-growth fiscal measures, such as reduction in the tax debt bias. While there is little fiscal space for scaling up public investment to support growth, education reform can have a positive impact on the skills composition of the labor force.

Chapter 5 discusses corporate debt restructuring. The level of corporate debt increased markedly in the precrisis years and remains high today, constraining investment and growth. Corporations and banks do not have incentives to speed up debt restructuring, due to weak corporate governance and banks’ reliance on lending backed by assets for which there is no obvious valuation. The current benign environment affords an opportunity to implement a systemic approach to debt restructuring. It would require a standardized bank-led, time-bound framework that calls on banks to raise more capital, increase provisioning, and accelerate the pace of write-offs to deal with debt restructuring. This would pave the way for restoring the flow of private credit to viable firms to support economic growth and for improving the overall asset quality of the banking system.

The remaining two chapters focus on structural reforms needed to generate sustainable growth.

Chapter 6 focuses on the need for institutional change. With Portugal’s working-age population and capital stock contracting, and productivity growth stifled by inefficient allocation of resources due to rent-seeking, institutional change becomes a key element of reform going forward. Such change should aim to empower the country’s tradables sector, allowing it to compete successfully in the global economy.

And Chapter 7 uses a firm survey conducted by staff to take stock of the effectiveness of structural reforms under the program, and to identify the areas where additional reform efforts are most urgent. On staff’s count, specific structural reforms were initiated in 35 different reform areas, with 494 reform actions taken. Looking backward, firms perceived that many of the reforms had some positive effects, but few reforms were perceived as having had a significant impact so far on firms’ competitiveness or growth prospects. Looking ahead, firms singled out the need for urgent additional reform efforts in the public sector (low efficiency of public administration and courts, payment of bills on time) and in the financial sector (insolvency and debt restructuring procedures and credit allocation by banks).

This paper provides a guide to key areas of reform and identifies benchmarks for measuring success based on outcomes. It falls on the authorities to identify specific needs in each sector of the economy and ensure that reforms induce the needed reallocation of resources from less productive to more productive activities. If successful, the reforms will improve the economy’s competitiveness and allow Portugal to enjoy balanced growth for years to come.

Portugal’s Path of Successful Reforms

Source: IMF staff.

An earlier version of this collection of papers was issued as a Selected Issues paper (IMF Country Report No. 15/127) and served as background material for the 2015 Article IV Consultation for Portugal. The analysis and recommendations are based on the data available at the time of the completion of the 2015 Article IV Consultation. Nevertheless, some higher-frequency series have been updated for this publication.


    International Monetary Fund (IMF). 2013. “Portugal: 2012 Article IV Consultation.” IMF Country Report 13/18. Washington.

    ReinertK. editor. 2009. The Princeton Encyclopedia of the World Economy 1049–1052. Princeton University Press. Princeton.


Prepared by Dmitry Gershenson, Albert Jaeger, and Subir Lall.


For a discussion of the Swan diagram, see Reinert 2009.


For a more detailed narrative of the buildup to the crisis, see IMF 2013.


A fiscal devaluation in particular proved impossible to implement.

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