Abstract

In March 1977 Portugal applied for full membership in the European Community. The prospect of full membership by 1983 raised the premium on Portugal’s capacity to sustain high rates of growth in an open economy, which the mounting balance of payments crisis was now calling into question. The factors that had contributed to the crisis were not in dispute. They included the higher world price for energy, the loss of privileged markets in Africa, and the abrupt rise in domestic wages. On the appropriate response, however, views differed widely, from those who saw the problem mainly in terms of price distortions that could be corrected to those who traced it to rigidities in resource allocation that had to be accepted.

In March 1977 Portugal applied for full membership in the European Community. The prospect of full membership by 1983 raised the premium on Portugal’s capacity to sustain high rates of growth in an open economy, which the mounting balance of payments crisis was now calling into question. The factors that had contributed to the crisis were not in dispute. They included the higher world price for energy, the loss of privileged markets in Africa, and the abrupt rise in domestic wages. On the appropriate response, however, views differed widely, from those who saw the problem mainly in terms of price distortions that could be corrected to those who traced it to rigidities in resource allocation that had to be accepted.

The Paris Credits

The initial response to the mounting deficits in Portugal’s external payments was to try and finance them. By mid-1977 the European Free Trade Association, the European Investment Bank, and the World Bank had begun to step up their long-term development assistance. In addition, various European central banks, either direct or through the Bank for International Settlements, had helped by lending short-term against gold collateral, and the U.S. Treasury had supplied gold for sale on Portuguese account against short-term repayment in kind. Even so, the Portuguese authorities, their foreign currency reserves fully spent, now found themselves obliged to sell their own gold outright.

It was in these circumstances that a group of 14 countries meeting in Paris agreed in June 1977 to supply US$750 million over 18 months in medium-term balance of payments support (Table 13). While not tied to development projects or secured by gold, most of the credits offered were to be linked to an upper tranche stand-by arrangement with the Fund. Portugal had already drawn on the Fund under the 1974 and 1975 oil facilities and under the compensatory financing facility in 1976, and had entered into a first tranche stand-by arrangement following the February 1977 devaluation of the escudo. To ensure that the need for extraordinary assistance would now be temporary, most contributors thought that upper tranche conditionality would be appropriate.

The provision of special balance of payments assistance was intended to permit a relaxation of restrictions, in particular of the import surcharge. It was soon recognized, however, that the adjustment would still have to be large. The Paris credits would contribute US$500 million within a 12-month period, to which the Fund was prepared to add US$50 million. Based on recent experience, other capital inflows at an annual rate of perhaps US$250 million were thought to be in prospect on reasonable terms. A current account deficit that could be financed would, therefore, total no more than US$800 million, compared with a deficit of US$1,200 million that was then estimated for 1977. The possibility of achieving this target quickly, without disastrous cuts in economic activity and growth, was widely doubted.

Exchange Rates

A policy was nevertheless considered of keeping real domestic expenditures constant in the program year and, by creating price incentives to reduce imports and expand exports, allowing an improvement in the external balance to produce a rate of growth sufficient to keep unemployment in check. Reducing the external deficit on current account to the US$800 million thought manageable in 1978, while keeping domestic demand unchanged, was calculated to produce a growth of GDP in that year not far below 4 per cent. To expect that this would be feasible one had to assume that, whatever originally contributed to the external deficit, an adequate depreciation of the escudo would help to correct it.

Against this view the claim was made that the external deficit was largely structural in character. The effects of the February 1977 devaluation had certainly been disappointing (Chart 3). Further action on exchange rates was, therefore, resisted on the grounds that both exports and imports seemed to be highly insensitive to changes in relative prices. Additional depreciation would only increase the external deficit in local currency and, by causing leakages in purchasing power, would have a purely deflationary effect on economic activity (Krugman and Taylor, 1978). Consequently, only such further exchange rate changes as would compensate for differential inflation rates could at first be agreed upon, and a monthly depreciation to fit was announced in August 1977.

Chart 3.
Chart 3.

Portugal: Relative Unit Labor Costs, 1973–79

(1973 = 100)

Sources: Fund staff calculations and International Financial Statistics.

A more basic objection to exchange rate action was that to be effective it would require cuts in real wages. Raising the domestic price of exports and import substitutes would not help if a parallel increase in money wages was allowed to push up the costs and prices of other goods as well. Similarly, without a shift of income back from wages to profits, saving was unlikely to rise relative to investment to achieve external adjustment. As long as real wages could not be corrected, therefore, the country would have to accept either external deficits or deflation-induced unemployment (Krugman and Macedo, 1979). Thus, perverse cost and price incentives, rather than insensitivity to them, could still account for external deficits.

On this interpretation, the February 1977 devaluation had not gone far enough to restore external balance at full employment. It had been swamped by the demand expansion that was admittedly necessary to absorb a labor force swollen by returning workers and settlers. It was difficult, however, to overcome the great reluctance to risk further depreciation, with its adverse distributional effects, on the mere chance that exports and imports would yet prove responsive. An effort was therefore considered to tackle the current account deficit by a substantially tighter control of imports in the government-controlled sector. The short-run effect of a shift in the composition of public investment, if it could be achieved, would at least buy time until a restructuring of the economy could take effect.

As a practical matter, however, the external deficit would have remained insupportably large without an early contribution from the nongovernment sectors. In the longer run, breaking the external constraint on growth would in any event have required the encouragement of private investment in the external sector, by raising its profitability through currency depreciation (Krugman and Taylor, 1978). If there was to be hope of keeping economic growth positive, even in the short run, exchange rate action would have to be part of any effort to reduce the external deficit to manageable proportions. In either case depreciation would have to go farther than it had yet done in reducing the real wage to a competitive level.

Monetary Policy

A program to keep domestic expenditure constant, and to rely on an improvement in the external balance as the sole source of growth, would also require a firm monetary policy. An extraordinary expansion of domestic credit at low interest rates not only had financed a rapid expansion of domestic demand in the past but also had biased it substantially toward inventory accumulation, particularly of imported goods. It had furthermore encouraged the illegal acquisition of foreign currency balances through over- and underinvoicing of goods, and in transactions with tourists and emigrants. The relative unattractiveness of domestic financial assets had visibly reduced workers’ remittances as well.

On this view, an apparent improvement in the external current account could have been achieved by reversing the capital outflows concealed in it. Domestic interest rates remained well below the expected escudo yield of foreign currency assets, however, even after substantial increases at the time the crawling peg was introduced in August 1977. It was hoped that financial markets might not be sufficiently integrated with those abroad to require parity (Dornbusch and Taylor, 1977). Adverse capital movements were said to have been induced less by opportunities for interest arbitrage than by the prospect of discrete exchange rate changes, which the crawling peg should have eliminated.

A real improvement in the external current account could have been expected from reduced incentives to accumulate inventories as a hedge against inflation. There was hesitation on this score too, however, on grounds that interest rates higher than the inflation rate would have an immediate adverse effect on economic activity and employment, while any effect on commodity speculation would at best be delayed. The public might not, after all, shift from holding goods to holding financial assets. The increased cost of working capital would, all the same, create immediate cash flow problems for all enterprises including those producing for export and, despite its low import content, for the construction sector as well.

The claim that the demand for domestic financial assets should be quite so insensitive to the return on them required vigorous challenge. The critical role of the banking system in providing efficient means for transferring claims over resources from savers to investors could hardly be in doubt (Fry, 1977). After all, the banking system was virtually the only source of domestic finance and bank deposits the only financial instrument available to hold. It was surely no accident that a decline in the yield on these deposits had been followed by a fall in the public’s holding of broad money in relation to GDP (Chart 4). Any improvement in that yield could not fail in turn to increase saving in this form.

Chart 4.
Chart 4.

Portugal: Velocity and Interest, 1970–79

(Per cent)

Sources: Fund staff calculations and International Financial Statistics (IFS).1 M2 represents annual averages of end-of-quarter IFS figures.2 On 6–12 months’ deposits deflated by consumer prices including rents.

If commodity speculation did continue while output declined, as the doubters feared, the external balance would certainly worsen rather than improve. On the other hand, failure to raise the demand for domestic financial assets could have equally serious consequences. An increasing proportion of domestic credit expansion was already being financed by banks borrowing from abroad rather than domestically and by depleting reserves. Now that these external sources were about to dry up, there was the threat that a commensurate reduction in credit expansion would create precisely the squeeze on working capital that low interest rates were meant to forestall.

A lesser squeeze would be required for a given external result if there could be a recovery in the demand for domestic financial assets. To bring this about, some increase in the cost of credit would, of course, be unavoidable. But a fairly prompt dishoarding of speculative inventories and foreign currency balances would surely be a natural response to it. The possible perverse effects of an across-the-board increase in lending rates, in line with deposit rates to safeguard operating margins for banks, also seemed exaggerated. The export sector would not suffer if a real depreciation was allowed to raise its operating surpluses, and activity would not be adversely affected in the construction sector if rent controls were liberalized.

On balance, the risk seemed worth taking and domestic interest rates were raised to near parity with those abroad. Skepticism regarding their capacity to affect the demand for money nevertheless remained strong and led to a supplementary setting of limits on domestic credit expansion that were tighter than might otherwise have been thought necessary to achieve the external target. There was in any case no reason to expect the public sector to reduce its credit requirements solely for interest rate reasons. To protect the productive sector, therefore, and to ensure that its minimum working capital requirements would be met, bank credit to the public sector was limited within the total.

Government Deficits

A policy of keeping real domestic expenditure constant, while allowing an improvement in the external balance to produce continued growth, would require adjustments also in public finance. Along with the deterioration in the external accounts the financial position of the public sector had also worsened markedly. From modest surpluses before the Revolution, the balance of current revenues and expenditures had swung to a deficit of 3 per cent in relation to GDP, and the overall balance to a deficit equivalent to 7 per cent of GDP, in 1976. The social goals of the Revolution required considerable expansion of public sector expenditures on both current and capital account (Chart 5). Revenues were also progressively increased but not by enough to close the gap.

Chart 5.
Chart 5.

Portugal: Public Revenues and Expenditures, 1973–79

(Per cent of GDP)

Source: Bank of Portugal, Annual Report.1 Current plus net capital expenditures.

The emergence of fiscal deficits was welcomed for its effect in maintaining demand by those who believed that the balance of payments had gone into deficit for structural reasons. In the first place, it was argued, leakages of purchasing power abroad through the external deficit required the government deliberately to inject fresh purchasing power into the economy by creating its own deficit to maintain employment. In addition, the drain of liquidity through the exchanges put a squeeze on private credit, which would have introduced another deflationary impulse by reducing investment, had it not been for the offsetting liquidity created by the public sector.

Others stressed that there had been no conscious intent to compensate for the worsening external balance. Apart from the investment effort, the public sector deficit was the result of a determined attempt to redistribute income, mainly through transfers and subsidies, and of the failure of revenues to match them (Cavaco-Silva, 1979). Transfers supported expanded coverage of social security, the creation of unemployment insurance, and improvements in pensions; subsidies were paid mainly to public enterprises, particularly in transport, and also supported lower prices for certain essential products. Both, like higher wages, added costs to the economy that contributed to rather than compensated for external deficits.

On either view the need for a fiscal deficit would have to lessen once the external balance began to improve. There would then no longer be the same absorption of liquidity through the exchanges or further deflationary effects to offset. The liquidity created by continuing public sector recourse to bank credit would now have to be held internally, either by driving prices high enough to keep the liquidity there or by tightening credit to the private sector. To keep the fiscal deficit from being inflationary under these circumstances, the cost of credit to the private sector would have to rise, producing a contraction in output and employment rather than preventing it (McKinnon, 1979).

Whatever the direction of causation, therefore, a successful effort at external adjustment would need to have a fiscal counterpart. To safeguard an adequate supply of credit to private exporters and investors a limit would have to be placed on the overall public sector deficit. If the public sector was to make a contribution to the increased savings on which a reduction in the external current deficit depended, the fiscal balance on current account would also have to be improved. If the standard of social services was to be protected then the main emphasis would have to be placed on increasing revenues. It was recognized that the burden of increased revenues would have to fall mainly on consumption.

The Stand-By Arrangement

When the stabilization program was completed in May 1978, the external current account deficit for 1977 was thought to have reached US$1,500 million. The program objective was therefore raised to a notional target of US$1,000 million for the 12 months to March 1979, despite the risk that its financing might at least initially require further sales of gold. This was regarded as the outside limit, however. Setting inflows of non-monetary capital at a likely minimum of US$200 million left a maximum permissible loss of net foreign assets by the banking system of US$800 million. This figure was made a performance criterion (Table 8), in the sense that Fund drawings would be contingent on compliance with it.

Attainment of this objective was to be ensured through interest and exchange rate policies; both were to be administered flexibly in the light of developments in the net foreign assets of the banking system. Interest rates had already been raised in two steps from 9 to 19 per cent on 6- to 12-month bank deposits, for example. A crawling peg for the escudo was introduced in August 1977 and strengthened in May 1978, which, in combination with a continued limit on nominal wage increases, was to reduce the country’s relative costs below their 1973 level. Pressure on the external position would not lead to an intensification of restrictions, therefore. Indeed, adherence to a precise schedule for reductions in the import surcharge was also made a performance criterion.

In principle, these provisions should have been sufficient to produce the desired results, but in view of the uncertainties concerning the efficacy of the instruments chosen, a fall-back position was deemed desirable. In the context of the traditional limit on domestic credit expansion, it was thought desirable to limit recourse to bank finance by the public sector as an inducement to fiscal discipline, and both limits were again made performance criteria. The measures looked tight, reflecting skepticism on the likely response of financial saving to interest rate increases, and led to caution also on the likely growth of GDP that would be consistent with them. Growth of less than 2 per cent, together with an inflation rate of 25 per cent, was officially forecast.

  • Balassa, B. (1979), “Portugal in Face of the Common Market,” 2.a Conferencia Internacional sobre Economia Portuguesa (Fundacao Calouste Gulbenkian and the German Marshall Fund of the United States, Lisbon, 1980), Vol. II.

    • Search Google Scholar
    • Export Citation
  • Barbosa, M.P., and L.M.P. Beleza (1979), “External Disequilibrium in Portugal: 1975–78,” 2.a Conferencia Internacional sobre Economia Portuguesa (Fundagao Calouste Gulbenkian and the German Marshall Fund of the United States, Lisbon, 1980), Vol. I.

    • Search Google Scholar
    • Export Citation
  • Bruno, M. (1979), “Stabilization and Stagflation in a Semi-Industrialized Economy,” in R. Dornbusch and J.A. Frenkel, eds., International Economic Policy: Theory and Evidence (Johns Hopkins University Press, Baltimore, 1979).

    • Search Google Scholar
    • Export Citation
  • Cardoso, M.T. (1979), “A Politica Monetariae a Balanga de Pagamentos—1976/1978” [Monetary Policy and the Balance of Payments—1976/1978], 2.a Conferencia Internacional sobre Economia Portuguesa (Fundagao Calouste Gulbenkian and the German Marshall Fund of the United States, Lisbon, 1980), Vol. I.

    • Search Google Scholar
    • Export Citation
  • Cavaco-Silva, A.A. (1979), “A Politica Orcamental Portuguesa em 1974/78” [Portugal’s Budget Policy in 1974/78], 2.a Conferencia Internacional sobre Economia Portuguesa (Fundagao Calouste Gulbenkian and the German Marshall Fund of the United States, Lisbon, 1980), Vol. I.

    • Search Google Scholar
    • Export Citation
  • Dornbusch, R. (1979), “Portugal’s Crawling Peg,” prepared for Conference on the Crawling Peg: Past Performance and Future Prospects (Rio de Janeiro, October 1979).

    • Search Google Scholar
    • Export Citation
  • Dornbusch, R. and L. Taylor (1977), Economic Prospects and Policy Options in Portugal: Summer 1977 (Bank of Portugal, Lisbon, September 1977).

    • Search Google Scholar
    • Export Citation
  • Dornbusch, R., R.S. Eckaus, L. Taylor (1976), Analysis and Projection of Macroeconomic Conditions in Portugal, Report from an OECD-Sponsored Mission to Portugal, December 15–20, 1975 (Bank of Portugal, Lisbon, 1976).

    • Search Google Scholar
    • Export Citation
  • Eckaus, R.S. (1977), “Is the IMF Guilty of Malpractice?” The Institutional Investor, September 1977.

  • Eckaus, R.S. and L. Taylor (1979), Macroeconomic Situation and Policies in Portugal (Bank of Portugal, Lisbon, summer 1979).

  • Fry, M.J. (1977), “Financial Instruments and Markets,” Conferencia Internacional sobre Economia Portuguesa (The German Marshall Fund of the United States and Fundagao Calouste Gulbenkian, Lisbon, 1977), Vol. I.

    • Search Google Scholar
    • Export Citation
  • Fry, M.J. (1979), “Money, Interest and Growth,” 2a. Conferencia Internacional sobre Economia Portuguesa (Fundagao Calouste Gulbenkian and the German Marshall Fund of the United States, Lisbon, 1980), Vol. II.

    • Search Google Scholar
    • Export Citation
  • International Bank for Reconstruction and Development (1977), Portugal: An Economy in Transition (Washington, D.C., March 16, 1977).

  • International Bank for Reconstruction and Development (1977), (1978), Portugal: An Updating Report on the Portuguese Economy (Washington, D.C., September 7, 1978).

    • Search Google Scholar
    • Export Citation
  • Krugman, P., and J.B. Macedo (1979), “The Economic Consequences of the April 25 Revolution” (Yale University Economic Growth Center, New Haven, November 1979).

    • Search Google Scholar
    • Export Citation
  • Krugman, P., and L. Taylor (1978), “Contractionary Effects of Devaluation,” Journal of International Economics, Vol. 8 (1978).

  • Macedo, J.B. (1979), “Portugal and Europe: The Channels of Structural Interdependence” (Johns Hopkins University Center for Foreign Policy Research, Washington, D.C., May 2, 1979).

    • Search Google Scholar
    • Export Citation
  • McKinnon, R. (1979), “Comment” (to M. Bruno, cited above), in R. Dornbusch and J.A. Frenkel, eds., International Economic Policy: Theory and Evidence (Johns Hopkins University Press, Balti-more, 1979).

    • Search Google Scholar
    • Export Citation
  • Sadove, R., and S.A. Chaudry (1979), “Portugal: Priorities for Public Sector Investment,” 2,a Conferencia Internacional sobre Economia Portuguesa (Fundagao Calouste Gulbenkian and the German Marshall Fund of the United States, Lisbon, 1980), Vol. I.

    • Search Google Scholar
    • Export Citation
  • Silva Lopes, J. (1980), “Portugal and the EEC: The Application for Membership,” Workshop on Southern Europe and the Enlargement of the EEC (Lisbon, October 1980).

    • Search Google Scholar
    • Export Citation