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From Crisis to Convergence: Charting a Course for Portugal

Author(s):
Dmitry Gershenson, Albert Jaeger, and Subir Lall
Published Date:
March 2016
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3. Maintaining External Balance: Structural Reforms to Boost Competitiveness1

To absorb the still-large internal slack, and to reduce the very high stock of external imbalances at the same time, competitiveness gains achieved in the past few years need to be maintained. An investigation of structural factors with strong empirical linkages to external competitiveness suggests, however, that the sustainability of Portugal’s external gains cannot be taken for granted. The country needs to continue to push forward with structural reforms in a few key areas that were identified during the 2011–14 IMF program, such as further increasing labor market flexibility and enhancing competition.

Portugal’s External Adjustment, 2010–13

Portugal achieved impressive external adjustment in the past few years (Figure 3.1). During the period from 2010 to 2013, Portugal’s gross exports, as a share of GDP, increased from just over 30 percent to above 40 percent. Such an increase in gross exports brought about a big turnaround in the current account balance, from a deficit of 10.1 percent of GDP in 2010, largest among all the EU member states, to a 1.4 percent of GDP surplus in 2013. The 11 percent of GDP improvement in current account balance was the biggest among all the EU economies during this period.

EU Member States: Changes in Gross Exports and Current Account Balances

Source: IMF, World Economic Outlook database.

The improved external performance needs to be maintained on a sustainable basis, which requires continued strengthening of external competitiveness.2 Portugal’s stock external position is still among the weakest in the world, as indicated by both its large negative International Investments Position (IIP) and its high level of gross external debt (Figure 3.2). On the other hand, labor market slack, a broader measure of labor underutilization, is still about 20 percent, compared with less than 10 percent prior to the crisis.3 To absorb the labor slack through job creation, the economy will have to lift its growth trajectory through higher investment, which in turn requires continued improvement in external competitiveness to avoid a resurgence of external flow imbalances.

External Positions

Sources: IMF, International Investment Position Statistics; and IMF, World Economic Outlook database.

1The chart shows net International Investment Positions (IIP) of 117 countries with available data in the IIP database. The only country with a negative IIP over 200 percent of GDP is Iceland (450 percent of GDP, cropped in the chart).

2The chart shows gross external debt of 168 countries with available data in the World Economic Outlook database. There are five countries/regions with gross external debt over 300 percent of GDP (cropped in the chart): Ireland, Malta, Lesotho, Hong Kong, and Cyprus.

Why Is There Concern about Sustainability?

Concerns about the sustainability of Portugal’s improved external performance arise, in part, from the asymmetric adjustment in exports and imports. As shown in Figure 3.1, the 9½ percent of GDP increase in Portugal’s gross exports during 2010–13 ranked only 10th among the EU countries. Its 11 percent of GDP improvement in current account balance was nonetheless the largest. This indicates that part of Portugal’s current account improvement was due to import compression caused by the crisis. Once the economy recovers, imports will likely pick up, raising the risk of pushing the small current account surplus into deficit again.

Adding to the concern are the uncertain competitiveness gains associated with the observed increase in gross exports. The illustrative example in Table 3.1 shows that, with the same observed adjustment in gross exports and imports, different changes in imports of intermediate inputs could give rise to very different real contributions of exports and imports to the overall adjustment.

Table 3.1.Illustrative Example: Why Gross Exports Could Be Misleading
GrossReal contributions to trade balance adjustments
(Percent of GDP)Before crisisAfter crisisIncrease in intermediate input imports
+2+8
Exports3040+8+2
Imports4039−3−9
Trade balance−101+11+11
Source: IMF staff calculations.
Source: IMF staff calculations.

To isolate the real impact of competitiveness gains on external adjustments, we turn our attention to domestic value-added (DVA) exports. DVA exports exclude imported intermediate inputs from gross exports, thereby reflecting the true external demand for domestic products.4 The differentiation between DVA and gross exports is particularly important for the countries where processing trade, such as oil processing and export, plays a big role.5

Structural Factors and DVA Exports

While data on DVA exports often come with a significant time lag, historical information suggests that levels of countries’ DVA exports are closely linked to a few structural factors.6 The latest DVA exports data are for 2011. Figure 3.3 shows that, among the EU member states, DVA exports are strongly correlated with a small set of structural indicators:

  • Degree of employment protection: The restrictiveness of employment protection reflects, to a certain extent, the rigidity of a country’s labor market. The top-left panel of Figure 3.3 suggests that countries with lower degrees of employment protection tend to have higher DVA exports.
  • Gap in unit wage costs between services and manufacturing: Since wages are largely driven by productivity, a bigger gap would indicate that the country’s manufacturing sector is more developed compared with its service sector. Following such an interpretation, the top-right panel of Figure 3.3 seems to suggest that a country with a more developed manufacturing sector (vis-à-vis services) tends to have higher DVA exports.
  • Intensity of local competition: More intense local competition could help boost external competitiveness by forcing domestic producers to raise productivity and cut costs. The bottom-left panel of Figure 3.3 is an indication of such a relationship.
  • Degree of integration with the global value chains:7 This indicator can be interpreted as a composite index that captures the “gravity factors” of international trade, such as distance to market (for instance, countries located closer to major exporters such as Germany tend to be more integrated into the global value chains). It is clear from the bottom-right panel of Figure 3.3 that countries better integrated into the global value chains tend have higher DVA exports.

EU Member States: Domestic Value-Added Exports and Structural Indicators, 20111

Sources: European Commission, LAF database; World Economic Forum, Global Competitiveness Index database; World Input-Output Database; IMF, World Economic Outlook database; and IMF staff estimations.

1Cyprus, Luxembourg, and Malta are excluded from the sample for particularly large financial sectors in these economies. Croatia is not included for the lack of information on domestic value-added exports.

2Simple average of two indicators from the LAF database: (1) regular Employment Protection Legislation (EPL) (overall strictness of protection against dismissals), and (2) temporary EPL (overall strictness of regulation). Several countries such as Bulgaria are not shown due to missing information.

3Supply-chain-related exports as percent share of gross exports.

The linkages noted above are robust:

  • The structural indicators described above capture different forces that affect DVA exports. The results of a panel regression results (Table 3.2) show that not only do these structural indicators have strong bilateral relationships with DVA exports, all their coefficients remain highly significant when included simultaneously in a regression.
  • The strength of the linkages does not seem particularly sensitive to the sample periods. In Table 3.3, the regressions in columns (2) and (4) test the relationships between the structural indicators and DVA exports using precrisis samples, while columns (3) and (5) are based on samples covering 2009–11. All the coefficients stay highly significant.
  • The relationships between DVA exports and the structural indicators stay qualitatively the same, even after adding additional control variables—such as income levels, exchange rates, growth in major trade partners, or time dummies—to the model (Table 3.4).8
Table 3.2.DVA Exports and Structural Indicators1
Dependent variable:(1)(2)(3)(4)(5)
DVA exports (Percent of GDP)
Degree of employment protection−8.858***−4.078***
(0.916)(0.922)
Unit wage cost gap b/w services0.974***0.964***
and manufacturing industries(0.125)(0.183)
Intensity of local competition5.295***4.473***
(1.367)(1.253)
Degree of integration with0.978***0.587***
global value chain(0.083)(0.114)
Observations170214168216134
R-squared0.3580.2240.0830.3940.667
Source: IMF staff statements.Standard errors in parentheses. *** p < 0.01, ** p < 0.05, * p < 0.1.

Cyprus, Malta, and Luxembourg are excluded from the sample. Croatia is not in the regressions because of missing DVA information. The sample covers the period 2003–11. The indicator of local competition intensity became available in 2005. Bulgaria, Latvia, Lithuania, and Romania have no information on employment protection.

Source: IMF staff statements.Standard errors in parentheses. *** p < 0.01, ** p < 0.05, * p < 0.1.

Cyprus, Malta, and Luxembourg are excluded from the sample. Croatia is not in the regressions because of missing DVA information. The sample covers the period 2003–11. The indicator of local competition intensity became available in 2005. Bulgaria, Latvia, Lithuania, and Romania have no information on employment protection.

Table 3.3.Robustness Check: Subsample Periods1
Dependent variable:(1)(2)(3)(4)(5)
DVA exports (Percent of GDP)2005–112005–082009–112003–082009–11
Degree of employment protection−4.078***−3.852***−4.290***−4.628***−5.591***
(0.922)(1.159)(1.501)(0.964)(1.543)
Unit wage cost gap b/w services0.964***0.766***1.583***0.463**1.334***
and manufacturing industries(0.183)(0.237)(0.306)(0.182)(0.316)
Intensity of local competition4.473***4.100**6.048***
(1.253)(1.646)(1.979)
Degree of integration with0.587***0.590***0.520***0.640***0.592***
global value chain(0.114)(0.161)(0.161)(0.126)(0.170)
Observations134746011060
R-squared0.6670.6660.7160.6010.667
Source: IMF staff statements.Standard errors in parentheses. *** p < 0.01, ** p < 0.05, * p < 0.1.

Cyprus, Malta, and Luxembourg are excluded from the sample. Croatia is not in the regressions because of missing DVA information. The sample covers the period 2003–11. The indicator of local competition intensity became available in 2005. Bulgaria, Latvia, Lithuania, and Romania have no information on employment protection.

Source: IMF staff statements.Standard errors in parentheses. *** p < 0.01, ** p < 0.05, * p < 0.1.

Cyprus, Malta, and Luxembourg are excluded from the sample. Croatia is not in the regressions because of missing DVA information. The sample covers the period 2003–11. The indicator of local competition intensity became available in 2005. Bulgaria, Latvia, Lithuania, and Romania have no information on employment protection.

Table 3.4.Robustness Check: Other Factors1
Dependent variable:(1)(2)(3)(4)(5)
DVA exports (Percent of GDP)
Degree of employment protection−4.078***−2.721***−4.319***−4.025***−3.921***
(0.922)(0.984)(0.930)(0.923)(0.942)
Unit wage cost gap b/w services0.964***1.279***0.887***0.983***1.042***
and manufacturing industries(0.183)(0.202)(0.189)(0.184)(0.193)
Intensity of local competition4.473***3.090**4.849***4.546***4.908***
(1.253)(1.282)(1.269)(1.254)(1.310)
Degree of integration with0.587***0.577***0.564***0.586***0.553***
global value chain(0.114)(0.110)(0.115)(0.114)(0.121)
GDP per capita (PPP2-based)0.280***
(0.086)
Real effective exchange rate0.089
(deviation from long-term mean)(0.057)
Growth of major trade partners’−0.239
domestic demand(0.230)
Time dummiesNoNoNoNoYes
Observations134134134134134
R-squared0.6670.6920.6730.6690.673
Source: IMF staff statements.Standard errors in parentheses. *** p < 0.01, ** p < 0.05, * p < 0.1.

The regressions are based on the same sample as the baseline, Table 3.2, column (5).

Purchasing power parity (PPP).

Source: IMF staff statements.Standard errors in parentheses. *** p < 0.01, ** p < 0.05, * p < 0.1.

The regressions are based on the same sample as the baseline, Table 3.2, column (5).

Purchasing power parity (PPP).

These structural factors also have similarly strong relationships with gross exports. Reported in Table 3.5 are regressions for gross exports, based on the same samples as in Table 3.2. The results are similar, suggesting that countries tend to export more if they have (1) a lower degree of employment protection, (2) a larger gap in unit wage costs between services and manufacturing, (3) more intense local competition, and (4) better integration into the global value chain.

Table 3.5.Gross Exports and Structural Indicators1
Dependent variable:

Gross exports (Percent of GDP)
(1)(2)(3)(4)(5)
Degree of employment protection−16.183***−5.473***
(1.979)(1.913)
Unit wage cost between services2.113***2.286***
and manufacturing industries(0.253)(0.380)
Intensity of local competition9.596***6.811***
(2.866)(2.599)
Degree of integration with2.082***1.344***
global value chain(0.168)(0.237)
Observations170214168216134
R-squared0.2850.2470.0630.4190.661
Source: IMF staff statements.Standard errors in parentheses. *** p < 0.01, ** p < 0.05, * p < 0.1.

The regressions are based on the same samples as the corresponding columns in Table 3.2.

Source: IMF staff statements.Standard errors in parentheses. *** p < 0.01, ** p < 0.05, * p < 0.1.

The regressions are based on the same samples as the corresponding columns in Table 3.2.

Where Does Portugal Stand?

The increase in Portugal’s DVA exports during 2010–13 and competitiveness gains achieved in this period are likely to be much smaller than indicated by the growth in gross exports. The empirical relationship established in the previous section suggests an increase of 2 to 3 percent of GDP in Portugal’s DVA exports between 2010 and 2013.9 This implies that the 10 percent of GDP growth in gross exports was to a large extent due to increase in imports of intermediate inputs. As illustrated by the example in Table 3.1, this would also imply that import compression had played a bigger role in the current account adjustments than indicated by the small decline in gross imports.

The latest information on structural factors identified in the previous section also suggests that the sustainability of Portugal’s external adjustment cannot be taken for granted (Figure 3.4). In 2014, Portugal ranked 21st among the EU countries in terms of labor market efficiency.10 Similarly, the intensity of local competition in Portugal ranked only 22nd among the EU countries. The bottom panels of Figure 3.4 indicate that the key bottlenecks constraining the development of manufacturing industries, or of tradables sectors more broadly, are not removed yet—the Portuguese consumers are still paying the highest income-adjusted energy prices, next to only Cyprus, and most of the FDI is still flowing into the nontradables sectors.

Latest Structural Indicators

Sources: Bank of Portugal; Eurostat; World Economic Forum; and IMF staff calculations.

1A lower rank corresponds to a more advantageous competitive position.

2Purchasing power parity (PPP).

3EU28 countries: Austria, Estonia, Italy, Portugal, Belgium, Finland, Latvia, Romania, Bulgaria, France, Lithuania, Slovakia, Croatia, Germany, Luxembourg, Slovenia, Cyprus, Greece, Malta, Spain, Czech Republic, Hungary, Netherlands, Sweden, Denmark, Ireland, Poland, United Kingdom.

Summary

Portugal needs faster growth, and therefore higher investment, to absorb the labor slack through job creation. Considering the very high external stock imbalances, it should avoid reopening the flow imbalances, and doing so requires continued strengthening of external competitiveness. This can be achieved only through structural reforms: Portugal, as a member of the currency union with limited fiscal space, has no other options.

Despite Portugal’s stellar external performance (as measured by the gross exports-to-GDP ratio), we argue that it may not be fully sustainable, because gross exports is a flawed measure of competitiveness gains. DVA exports is a better measure and it has exhibited strong and robust empirical linkages with a small set of structural indicators. Our analysis of DVA exports suggests that competitiveness gains are likely to be much smaller than indicated by the growth of gross exports. In addition, the fact that Portugal continues to lag behind many of its peers and trade competitors in key structural areas suggests that the observed improvement in external performance is likely to be more transitory than desired.

The structural factors identified in this paper should not be interpreted narrowly. For instance, in addition to employment protection, other labor market indicators also exhibit strong empirical relationships with DVA exports. Nonetheless, these indicators indeed point to a few key areas, such as labor market flexibility and development of manufacturing/tradables sectors, which are consistent with the policy recommendations made during the 2011–14 IMF program.

Appendix I. Data
Appendix Table 3.1.1.Data Sources
VariableUnitNumber of observationsMeanStandard DeviationMinimumMaximumSources
DVA exportsPercent of GDP21628.78.89.853.1Koopman, Wang and Wei (2014); and IMF staff calculations
Gross exportsPercent of GDP21645.218.213.396.0Koopman, Wang and Wei (2014); and IMF staff calculations
Employment protectionIndex1702.00.70.83.8LAF database; and European Commission
Unit wage cost gap between services and manufacturing industriesIndex2144.54.3−4.123.9LAF database; and European Commission
Intensity of local competitionIndex1685.40.54.16.4Global Competitiveness Index database; and Global Economic Forum
Integration with global value chainPercent21673.85.759.885.6Global Competitiveness Index database; and Global Economic Forum
PPP1-based GDP per capitaThousand US$21626.29.17.842.7World Economic Outlook database; and IMF
Real exchange rate (deviation from long-term mean)Percent2166.812.0−18.854.5World Economic Outlook database (IMF); and IMF staff calculations
Real growth of major trade partners’ domestic demandPercent2161.92.0−4.24.4DOTS (IMF); World Economic Outlook database (IMF); and IMF staff calculations

Purchasing power parity (PPP).

Purchasing power parity (PPP).

References

    KoopmanRobertZhiWangShang-JinWei. 2014. “Tracing Value-Added and Double Counting in Gross Exports.” American Economic Review.104 (2): 45994.

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    International Monetary Fund (IMF). 2013. IMF Country Report 13/18. “Portugal—2012 Article IV Consultation and Sixth Review Under the Extended Arrangement and Request for Waivers of Applicability of End-December Performance Criteria. Washington.

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    International Monetary Fund (IMF). 2015. IMF Country Report 15/21. Portugal—Staff Report for the 1st Post-Program Monitoring Discussions. Washington.

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1

Prepared by Li Zeng and Dmitry Gershenson.

2

There are different measures of external competitiveness. As explained in more detail later, it is interpreted in this paper as a country being able to export more domestic value added, measured as percent share of GDP.

3

For further discussion of labor market slack in Portugal, see Box 1 in IMF 2015.

4

Please refer to Figure 1 of Koopman, Wang, and Wei 2014 for a more rigorous definition of DVA exports as used in the econometric analysis of this paper, and for more discussions on its applications.

5

Oil processing and export is important to Portugal. According to IMF 2013, between January 2009 and August 2013, fuel exports was the second-largest contributor to the recovery in exports, with an improvement of 1½ percent of GDP that accounted for about a quarter of the cumulative increase in exports.

6

It is DVA exports as share of GDP, instead of as share of gross exports, that is being examined here.

7

It is defined as the percent share of global value chain related exports in gross exports. In the context of Koopman, Wang, and Wei 2014, global value chain related exports is the sum of components of (2) to (9).

8

Income levels and exchange rates are not included in the baseline specification because of endogeneity concerns.

9

This is the difference between the fitted values of Portugal for 2010 and 2013, based on the regression reported in column (5) of Table 3.2. For 2013, the unit wage cost gap between services and manufacturing industries in 2012 (latest available) was used. The range between 2 to 3 percent of GDP reflects different assumptions on the change in degree of integration with the global value chain between 2010 and 2013, from no change to a sharp rise.

10

The labor market efficiency index from the Global Competitiveness Index database is used in the top-left panel because the latest employment protection information from the LAF database is for 2013.

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