Impact Effects

Although the size of the adjustment may have caused surprise, its main features are not difficult to identify. Real domestic demand was severely restrained over the two stabilization years, leaving the recovery in the external balance on goods and nonfactor services to contribute 6 out of 8 percentage points to the real growth of GDP (Table 3). Even so, these components of the external balance contributed, in current dollars, less than one third to the swing in the current account as a whole (Table 9). More than two thirds was contributed by factor services despite a substantial rise in interest payments abroad, mainly because of the rebound in workers’ remittances.

The external recovery can, in the first instance, be traced to exchange rate changes, which helped to improve the country’s competitive position as measured by relative unit labor costs by 20 per cent beyond its 1973 level. Nominal wage increases remained below their legal limits in both stabilization years, reflecting downward pressure from the accumulated overhang of unemployed workers and returnees from the former colonies. Accordingly, real wages dropped 17 per cent below the plateau they had reached in 1976 (Table 1). In response, exports of goods and nonfactor services rebounded, rising by 15 per cent in volume in 1978, and by as much as 28 per cent in 1979. Imports paused before resuming a more normal growth (Chart 7).

Portugal: Index of Industrial Production and Imports, 1973–79

(1973 = 100)

Source: Bank of Portugal, Annual Report.

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Portugal: Index of Industrial Production and Imports, 1973–79

(1973 = 100)

Source: Bank of Portugal, Annual Report.

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• Download figure as PowerPoint slide

Portugal: Index of Industrial Production and Imports, 1973–79

(1973 = 100)

Source: Bank of Portugal, Annual Report.

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• Download figure as PowerPoint slide

The effect on the external balance of interest rate increases was equally striking. Although real interest rates remained negative, the margin below the rate of increase in the cost of living shrank from nearly 9 per cent in 1977 to less than 3 per cent in 1978, arresting and then reversing the decline in the public’s willingness to hold domestic financial assets (Table 6). The consequent drop in stockbuilding was the major factor in holding real domestic demand, and imports, virtually constant in 1978 (Table 3). Predominantly financial motives also prompted the overwhelming response of workers’ remittances, and may have been a factor in the recovery of tourist receipts per night spent in Portugal (Cardoso, 1979).

A final element in the external adjustment was the limit on domestic credit expansion. This limit had been set on the basis of a lower increase in the stock of domestic financial assets than in fact took place and was, therefore, tighter than it was meant to be even with the degree of flexibility found in the omission of bad debt (Table 8). However, the demand for credit was also being reduced by an exchange rate policy designed to increase the profits of enterprises producing exports and import substitutes. In addition, the response of foreign credit to domestic tightness turned out to be far more substantial than had been expected, sustaining output while adding to the improvement in the external balance.

The public sector deficit unfortunately remained higher than had been planned. To be sure, the Government was also able to mobilize substantially larger amounts of financing abroad than had been anticipated. In the logic of credit ceilings, greater recourse to foreign financing by the public sector should have left more of a margin of domestic credit expansion for the private sector. As it happened, however, there was also greater recourse by the public sector to the banking system than had been intended (Table 8). Within the domestic credit constraint, therefore, a greater burden of adjustment was placed on the private sector than should have been necessary (Cavaco-Silva, 1979).

Structural Change

The much greater-than-expected recovery in the external balance was achieved at rates of growth for the Portuguese economy that remained above the weighted average for its trading partners. Industrial production alone continued to rise at 6–7 per cent through both stabilization years compared with 3–4 per cent elsewhere. The balance of payments constraint on growth was thus largely removed. In consequence it was possible to begin reversing the drift to trade and payments restrictions that had characterized the period of disequilibrium. Together with the stabilization program, the authorities had announced in May 1978 a schedule for phasing out the import surcharge and kept to this schedule for all steps but the last.

To achieve this result the stabilization program was designed to begin dealing with some of the more intractable structural problems of the Portuguese economy. The first step was to restore the competitiveness of the economy to the point where it could sustain external balance at full employment. Apart from its effects on costs, the wage explosion had also contributed to a decline in national saving that reinforced rather than offset the effect on the external balance of the decline in the terms of trade, at a time when employing an increased labor force required a higher level of economic activity than before. By 1979 real wage rates had been corrected, and the share of wages in the national income was reduced to 55 per cent, close to the ratio it had been in 1973 (Table 4).

A second structural improvement set in motion by the stabilization program concerned the mobilization of domestic saving through the financial system. The role of the financial system had declined in the crisis years as inflation increased while interest rates were kept low. Compared with 1973, the public’s holding of broad money claims had declined in real terms to below 80 per cent in 1977; the increase in real interest rates restored it to over 90 per cent in 1979. In relation to GDP, broad money claims had declined to 91 per cent but now returned to their initial 100 per cent. As the capacity of the monetary system to mobilize domestic saving continued to improve, domestic credit could also expand without placing undue stress on the external balance.

A strengthening of the financial position of the public sector was the third fundamental change the stabilization program was meant to initiate. Tax revenues had in the past failed to keep up with rising social expenditures. The current account of the public sector had thus moved sharply into deficit and the capacity of the economy to grow was thereby reduced. The 1978 budget planned to eliminate that deficit which had amounted to 2 per cent of GDP the year before (Table 5). Instead the ratio of the deficit to GDP rose to 3.4 per cent in 1978, due equally to revenue shortfalls and expenditure overruns, and to 3.9 per cent in 1979. A substantial part of the increase in private saving was thus dissipated by an increase in net public consumption.

The stabilization program was also intended to foster a substantial redirection of domestic investment. Leaving stockbuilding aside, the investment boom, which had raised real gross fixed capital formation by 12 per cent in 1977, was thought to have been seriously misdirected toward capital-intensive production for the domestic market (Table 3). A careful reappraisal of the public sector investment program was in any case overdue. It was also recognized that any general reorientation in the sectoral allocation of investment would entail at least a temporary reduction in its total. After slowing down to 4 per cent in 1978, gross fixed domestic investment did in fact drop slightly in 1979, but has begun to recover since then.

A last structural change that the stabilization program was meant to encourage concerned labor markets. There had been no recovery at all since 1975 of the flow of migrant workers abroad (Table 1). Nor had the rapid expansion in economic activity prior to stabilization increased employment opportunities sufficiently to prevent a persistent rise in unemployment. The change in the direction of economic growth after 1978 was expected to foster labor-intensive export-oriented enterprises. These enterprises have since begun to draw on the pool of openly unemployed, bringing the unemployment rate down for the first time since the Revolution. To maintain their momentum they will soon need to draw labor from declining enterprises.

A large part of the improvement in the external position of the economy appeared on capital account. The Government, which borrowed some US$90 million net in 1976–77, raised over US$850 million in 1978–79, while the private nonbank public turned from small repayments to net borrowing of well above US$1,000 million. In the stabilization program no limits were set on the accumulation of nonbank foreign debt. As access to international capital markets eased, however, the authorities began to monitor external borrowing more closely, to conserve the country’s borrowing capacity for the time when a more firmly managed development effort could be launched.

Current Prospects

The large surplus in the overall balance of payments in 1979 was not necessary and is unlikely to be sustained. Renewed increases in the international price of petroleum are expected to double the energy import bill for Portugal in 1980. At the same time the very high rates of expansion for exports and for workers’ remittances are also likely to moderate as these complete their recovery from the very low levels to which they had declined. The external balance on current account will, therefore, probably swing back into deficit. Nevertheless, if care is taken to maintain a steady policy stance, an adequate capital inflow should be forthcoming to permit continued growth with external equilibrium.

The recent growth of the Portuguese economy has been led by a rapid expansion of exports. Although the rates achieved have been exceptionally high in the recovery phase, export prospects should nevertheless remain substantial as long as investors are assured that the present degree of competitiveness will be maintained. As the growth in world markets slows down in response to new energy shortages, the main concern will shift to ensuring adequate market access abroad. After a period of hesitation, exports to the European Community rose again from 52 per cent in 1977 to 57 per cent of the total in 1979 (Table 10). Full membership in the Community is now being sought to safeguard this trend against protectionist pressures (Silva Lopes, 1980).

After buoyant exports, it has again been workers’ remittances that have contributed most to the recovery of the external balance on current account. However, without any upsurge in the flow of emigrant workers abroad, remittances have contained a large capital repatriation element and are, therefore, unlikely to continue expanding at the same rates for very much longer. Even with entry into the Community the flow of workers to the rest of Europe should not recover very soon. While this prospect will force less reliance on emigrants’ remittances in the future, it should also prevent renewed upward pressure on real wages unrelated to the growth of productivity at home.

The massive capital inflow following stabilization has been a novel feature in the Portuguese balance of payments. It is no doubt appropriate that instead of labor moving abroad in search of capital, capital should now be brought in to employ labor at home. In the process, capital inflows should assume the same role in easing the balance of payments constraint on growth that workers’ remittances have played in the past. Most of the inflow to date has been of portfolio capital and of debt, including short-term debt, and should continue as long as interest rates are kept at realistic levels. As yet there has been no major response of direct investment, although legislation is now in force to encourage it.

The deficit in the public sector budget on current account continues at some 4 per cent of GDP and, for a given investment effort, places an unnecessary burden on the external balance on current account. Financing this deficit by borrowing abroad adds to the country’s debt service burden without contributing to the growth of its debt servicing capacity. As long as total debt service, including that of the private sector, rises no faster than foreign exchange earnings increase, there need perhaps not be much cause for concern. When it begins to rise more rapidly, however, a case can be made for seeking to reduce the external deficit by compressing the public sector deficit that lies behind it.