Portugal: 2006 Article IV Consultation—Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Portugal

Important progress can be seen in the economic and policy environment in Portugal, but challenges remain. Firm implementation of strategy is essential to meet these challenges. It will be essential that expenditure measures move to the forefront, realizing the planned shift away from revenue-based adjustment. Fiscal adjustment will be needed to ensure long-term sustainability. A credible deficit reduction strategy is essential to raise potential growth. The financial system is sound and well supervised, but the government should continue to monitor risks closely.


Important progress can be seen in the economic and policy environment in Portugal, but challenges remain. Firm implementation of strategy is essential to meet these challenges. It will be essential that expenditure measures move to the forefront, realizing the planned shift away from revenue-based adjustment. Fiscal adjustment will be needed to ensure long-term sustainability. A credible deficit reduction strategy is essential to raise potential growth. The financial system is sound and well supervised, but the government should continue to monitor risks closely.

I. Overview and Key Issues

1. Reestablishing income convergence and resolving large fiscal and external imbalances remain Portugal’s key challenges. Growth has averaged just over ½ percent since 2000 (Figures 1 and 2), in part due to rapidly rising unit labor costs that have substantially undermined competitiveness (Figure 3). Investment has collapsed, the unemployment rate has doubled, and the current account deficit has swollen to more than 9 percent of GDP (Figure 4). Owing partly to slow growth, but more fundamentally to rising primary spending and the abandonment of one-off measures, the SGP-monitored fiscal deficit reached 6 percent of GDP last year, leading to the launching of the second Excessive Deficit Procedure by the EU in just three years (Figure 5). Portugal confronts a difficult environment, with sizable fiscal and balance of payments deficits; a weak competitive position, especially within an enlarged EU; and high private indebtedness.

Figure 1.
Figure 1.

Portugal: General Economic Background

Citation: IMF Staff Country Reports 2006, 377; 10.5089/9781451832204.002.A001

Source: Bank of Portugal; National Institute of Statistics (INE); and Fund staff calculations.
Figure 2.
Figure 2.

Portugal: Measures of Slack

Citation: IMF Staff Country Reports 2006, 377; 10.5089/9781451832204.002.A001

Source: Bank of Portugal; National Statistics Office (INE); and Eurostat.
Figure 3.
Figure 3.

Portugal: Competitiveness Indicators

Citation: IMF Staff Country Reports 2006, 377; 10.5089/9781451832204.002.A001

Source: AMECO database; National Institute of Statistics (INE); Eurostat; and Fund staff calculations.
Figure 4.
Figure 4.

Portugal: External Current Account and its Financing, 2000–05

(In percent of GDP, unless otherwise indicated)

Citation: IMF Staff Country Reports 2006, 377; 10.5089/9781451832204.002.A001

Source: Bank of Portugal
Figure 5.
Figure 5.

Portugal: Fiscal Developments

(In percent of GDP, unless otherwise indicated)

Citation: IMF Staff Country Reports 2006, 377; 10.5089/9781451832204.002.A001

Source: Bank of Portugal, Fund’s staff calculations, Eurostat.1/ For Ireland, GNP per inhabitant.

2. A sustained period of adjustment will be needed to restore external competitiveness and the sustainability of the public finances. A sharp fall in total factor productivity lies at the root of Portugal’s poor growth performance: over the period 2001–04, TFP grew at an average annual rate of 0.9 percent in the euro area but fell at a rate of 0.7 percent in Portugal, accounting for all of the difference in growth of output per hour worked between the two entities. Over 1996–2004, annual TFP growth averaged 1.0 percent in the euro area but just 0.2 percent in Portugal. Poor TFP growth can be traced to very low levels of human capital, but also to shortcomings in the business environment—including excessive regulation and a slow legal framework—and to insufficient competition in domestic markets, especially in key network sectors where some former-monopolies maintain a dominant share. While the growth impact of measures to address these problems is difficult to quantify, it is potentially very significant: a recent study by McKinsey has estimated that about two-thirds of the gap between Portuguese per capita GDP and that of the top five EU countries could be eliminated over time through improvements to the policy environment. 1 Meanwhile, growth of nominal wages has dramatically exceeded that of productivity, notwithstanding a rise in unemployment, suggesting the presence of significant labor market rigidities. Staff analysis points to a substantial loss of competitiveness that will take years to fully reverse even with strong productivity growth and considerable wage moderation (Box 1). 2 Restoring the sustainability of the fiscal accounts will likewise demand continued consolidation into the next decade.

Measures of Competitiveness

A range of indicators point to a competitiveness gap versus other euro-area members of 10–20 percent. Portugal’s ULC-based real effective exchange rate has appreciated by about 10 percent since the mid 1990s (the benchmark period for Portugal). Over the same period, unit labor costs in manufacturing rose some 20 percentage points faster than for euro-area competitors, and profit margins for Portuguese exporters fell by 15 percent relative to those of exporters from other euro-area countries. Smidkova and Bulir’s (2004) estimates of fundamental exchange rates indicate that by end-2003 the euro was 10–20 percent too strong in real terms for Portugal. Staff estimates suggest that a real depreciation of 12–20 percent would be needed to generate a trade balance consistent with stabilizing net external liabilities at their 2005 level.

The loss in competitiveness is reflected in export data. Constant market share analysis suggests the bulk of export market loss in the 1990s was associated with deteriorating competitiveness (see table). It also points to a moderation in competitiveness losses since 1998, at the expense of a substantial compression of margins.

CMS Analysis of Exports Changes

(Changes in percent; unless otherwise indicated)

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Source: IMF Staff estimates.

Based on the commodity composition of exports as of 1998.

Closing the competitiveness gap will likely require a long adjustment period, even with a dramatic jump in TFP growth and strong wage moderation. Assuming future ULC growth of 1 percent annually for the euro area (as in the April 2006 WEO projections), even if Portuguese ULCs were to fall at a rate of 2 percent annually it would still take three–seven years to close the competitiveness gap with the euro area. Moreover, if capital deepening were to contribute 1 percent annually to labor productivity growth over that period (slightly above the rate experienced in 2001–04), even an increase in annual TFP growth to 1 percent (the euro-area average for those years) would leave no room for nominal wage growth in Portugal under this scenario. While these calculations are simply illustrative, and are—as the authorities pointed out—subject to considerable uncertainty, they demonstrate the scale of the problem Portugal faces and the critical role that reforms to boost productivity and promote wage moderation must play in restoring competitiveness.

Portugal and the Euro Area: Ouput Per Labor Hour

(Average annual growth rate, in percent)

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3. The strategy laid out last year by the government to confront these challenges set appropriate objectives. The main elements of the strategy were threefold:

  • Fiscal consolidation to bring the deficit under 3 percent of GDP by 2008 without oneoff measures;

  • Structural fiscal reforms to contain aging-related spending and raise the efficiency and quality of public spending, to promote the sustainability of the public finances; and

  • Reforms to enhance competition in product markets and improve the business environment, with a view toward spurring productivity growth.

4. Progress with some bedrock structural reforms has been slow, however, and redoubled efforts are needed to safeguard the credibility of the government’s program. Reforms of the civil service pension scheme and health sector have been introduced, and recent initiatives have reduced bureaucratic red tape (Box 2.) However, some critical planned structural fiscal reforms—to the civil service, to the structure of the public sector, and to the social security system for private sector workers—had as of mid-2006 yet to be enacted. Recently, momentum on these reforms has been restored, but even after their approval rigorous implementation will be required. Some progress has been achieved in improving the business environment, but more needs to be done—especially in labor markets—to facilitate investment and innovation, promote wage moderation, and reverse competitiveness losses.

Fund Policy Recommendations and Implementation

The authorities’ fiscal strategy emphasizes medium-term expenditure containment and sets a pace of adjustment in line with Fund policy advice. In recent years, the Fund has called for fiscal consolidation through structural expenditure measures, including civil service reform. In 2002–04, though, the government relied on substantial one-off measures to bring the deficit within SGP limits. In 2005, adjustment depended mostly on revenue measures, pending the implementation of planned spending reforms. Progress with Fund-advocated steps to strengthen budget planning and control and move toward comprehensive multiyear budget targets has been slow, although steps in this direction are under consideration.

The Fund has advocated structural reforms to strengthen the business environment and promote competition in product markets, as well as improved flexibility in labor markets. Steps have been taken to reduce red tape and improve the working of product markets. Measures to enhance labor market flexibility, though, have not been a high priority.

II. Economic Developments and Outlook

5. A gradual recovery is underway after a largely flat 2005, but the authorities and the mission expected growth to remain relatively slow in the short-term. Staff projects growth of 1.2 percent in 2006 and 1½ percent in 2007, in line with official forecasts and recent high frequency indicators (Figure 6).

  • Strong foreign demand is expected to lead to a better external contribution to growth than in previous years.

  • Domestic demand, by contrast, is forecast to remain weak. Consumption growth is projected to slow, reflecting weak employment growth and necessary adjustments to household balance sheets: at end-2005, household debt was close to 120 percent of disposable income, more than double its level of eight years earlier and the second-highest figure in the euro area. While some corporate balance sheet restructuring has occurred, still-high enterprise debt levels will retard investment, as well (Box 3). 3 Fiscal adjustment will likewise weigh on domestic demand growth in the short term.

Figure 6.
Figure 6.

Portugal: High Frequency Indicators

Citation: IMF Staff Country Reports 2006, 377; 10.5089/9781451832204.002.A001

Source : INE, Bank of Portugal, IMF staff calculations, end of period.1/ Seasonally-adjusted data, 6-month moving average on month-to-month growth, end of period.2/ 3-month moving average, end of period.3/ Year-on year growth rate (3-month moving average, seasonally adjusted). The coincident indicator is a composite indicator for economic activity published by the Bank of Portugal. It combines indicators of retail sales, heavy commercial vehicle sales, cement sales, manufacturing production, household’s financial situation, new job vacancies, and a consumer survey of Portugal’s main trade partners.

Understanding Investment Behavior in Portugal

Does the decline in corporate investment in Portugal reflect a more pessimistic private sector view of growth prospects, or high levels of indebtedness following the 1990s investment boom? Estimates using quarterly data from 1987 to 2005 suggest the answer is “both”: investment reacts strongly to expected future output growth and is also negatively correlated with enterprises’ lagged debt levels. Thus, while structural reforms to improve the fiscal environment and raise productivity—thus enhancing potential growth—should have a positive effect on private investment in the future, its recovery will be attenuated by the impact of still-high corporate debt. In this sense, the relatively inefficient corporate investment in the late 1990s could serve as a drag on growth prospects in the future.

The staff sees a further strengthening of growth over the medium term, rising to about 2¼ percent in 2009, still well below the 3 percent rate foreseen for that year in the authorities’ December 2005 Stability Program update.

6. Inflation in 2006–07 is forecast to remain stable. The inflationary effect of last year’s 2 percentage point VAT rate increase is estimated at about ¼ to ½ percentage point. With this effect fully incorporated in price data by the second half of the year, inflation is projected to recede to about 2½ percent by the end of this year and in 2007. Nevertheless, the relatively high rate of price growth despite an output gap estimated by staff at about 1¾ percent of potential output is suggestive of rigidities in product and labor markets that contribute to high costs of doing business and compromise competitiveness.

7. The external deficit is projected to continue widening. Notwithstanding the recent pickup in exports, the oil price-induced terms of trade loss and still-high imports would bring the deficit, excluding capital transfers, to about 10 percent of GDP this year and next. The deficit would continue to be financed by medium- and long-term bank borrowing. Under the staff’s baseline scenario, the current account deficit would narrow to about 7½ percent of GDP by 2010, bringing the net international investment position to a deficit of 88 percent of GDP (versus 66 percent in 2005).4 Portuguese firms have encountered no generalized difficulty in attracting external financing, which with the advent of the common currency now depends almost exclusively on individual firm solvency. Nevertheless, to the extent that the projected sizable external deficit should prove costly to finance, weaker consumption and investment than envisioned under the baseline scenario—and thus a slower recovery of medium term growth—would result.

8. The 2006 budget targets a reduction in the deficit to 4.6 percent of GDP, implying just over 1½ percentage points of structural adjustment this year. Revenue and expenditure forecasts in the budget were not updated to reflect the 2005 outturns and are therefore each understated by about 1 percent of GDP. A little more than half of this year’s deficit reduction is to come from the full-year impact of revenue measures announced last year, in particular the VAT increase, with the balance coming mostly from savings in the public wage bill and intermediate consumption.

Portugal: Fiscal Outlook, 2006

(In percent of GDP)

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Excludes one-off measures: asset sales, the transfer of pension funds, and securitization.

In percent of staff’s estimate of potential GDP.

Staff’s update of 2006 budget in line with 2005 outturn.

III. Report on the Discussions

9. Discussions were marked by broad agreement on the challenges facing Portugal and most policy priorities to address them. It was well understood that Portugal required a fundamental transformation of its economy and its public sector, through reforms that would strengthen domestic competition, improve the business environment, increase government efficiency, and reduce the fiscal deficit through expenditure-based measures. However, proposed fiscal measures had provoked strong opposition from some interest groups, complicating their development and approval. The mission emphasized (especially in outreach efforts) that while even with full implementation of the reform agenda the economic environment was likely to remain difficult—and growth relatively slow—in the near term, slippages to the reform agenda would have a severe effect on the credibility of the adjustment effort, increasing its duration and costs. The mission also pressed the case for a fundamental labor market reform, which has had a low profile in the policy debate.

10. The authorities recognized the complementarity of actions to address Portugal’s challenges. High deficits and indebtedness divert resources from more productive uses, and preclude desirable reductions in marginal tax rates (see ¶14.) They also contribute to uncertainty about future fiscal policy, further discouraging investment. And, of course, faster growth would facilitate more rapid deficit reduction. Beyond this, the mission noted, a history of high tax evasion has introduced distortions that lead to inefficient business decisions; excessive bureaucracy has discouraged investment; and problems with the education and training system have contributed to generally low levels of human capital. Thus, ongoing reforms to create a more dynamic and efficient public sector could boost private sector competitiveness through several channels. The authorities were therefore hopeful that a combination of fiscal adjustment and structural reforms to stimulate innovation and investment could lead to a virtuous cycle of mutually reinforcing output growth and budget consolidation in the medium-term.

A. Fiscal Policy

11. The authorities and staff agreed that achievement of the 2006 deficit target was crucial to maintaining public confidence in the fiscal program, but differed in their view of the risks to the outcome. The authorities noted that revenue performance thus far had been strong, owing in part to enhancements in tax administration such as increased computerization and improved cross-checking among the internal revenue service and the customs and social security authorities. They also observed that spending at the state level through midyear suggested that budget execution was broadly on track. Thus, while the mission pointed to risks—including higher spending on social transfers and health care, and by local governments and autonomous funds—that could together add nearly ½ percent of GDP to this year’s deficit, the authorities were confident that their target of 4.6 percent of GDP would be achieved. Nevertheless, they would take additional spending measures if necessary.

12. The authorities highlighted recent strides in the development of the bedrock structural reforms that are to underpin medium-term consolidation(Box 4). While adjustment in 2005–06 had focused primarily on revenue measures, over the coming years reforms to the civil service, to the structure of the public sector, and to the social security system for privatesector workers would shift the balance of the effort to the spending side and address the root cause of current fiscal weaknesses: the steady rise of spending on pensions and wages over the last decade. Implementation of these measures was therefore fundamental to reducing the budget deficit to 3.7 percent of GDP next year and to below 3 percent of GDP by 2008, in line with EDP commitments. After delays, important progress had been made on some initiatives: Parliament had approved the civil service reform in July, and the government had agreed with the social partners on the outlines of the social security reform that same month. The authorities planned to submit this latter measure to Parliament by September. Steps were also underway to improve the efficiency of spending on health and education, and to modify the system of local government financing to reduce a bias to spend in existing arrangements.

Structural Fiscal Reforms

  • The reform of the social security system for private sector workers follows last year’s reform of the system for civil servants. Benefits will be indexed to the inflation rate (though relatively low pensions will enjoy a small real increase when output growth is above 2 percent and higher pensions will suffer a small real decline when growth is below that threshold), an explicit link between benefits and changes in life expectancy will be introduced, the already-scheduled shift in the reference period for calculating pensions to encompass a worker’s entire career will be accelerated, and disincentives for early retirement will be increased.

  • The reform of the civil service aims to reduce the number of career paths and increase flexibility within public employment. The reform will allow excess workers to be transferred to a pool where they will receive reduced benefits and salaries as an inducement to leave public employment. At the same time, the government intends to continue replacing only half of all retiring civil servants.

  • The reorganization of the public sector(“PRACE”) seeks to reduce the number of administrative structures and streamline procedures. In concert with the reform of the civil service, it should generate an increase in labor mobility within the public sector, a reduction in the wage bill, and, over time, a decline in employment.

  • Reforms of health and education spending and changes to the system of financing local governments are ongoing or planned. Hospitals will continue being converted into public corporate entities, hopefully improving management practices. Steps have been taken to reduce spending on pharmaceuticals and increase copayments for medicines. The government also envisages efficiency gains through changes in the school network and the consolidation of small schools. Municipal governments will be given flexibility to alter tax rates, complementing recent measures that introduced more comprehensive limits on indebtedness and improved reporting requirements.

Portugal: Growth and Composition of Current Primary Spending 1995-2005

(In percent of GDP)

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Stability and Growth Program; 2006 Budget, and Fund staff calculations.

13. The authorities expected the impact of these measures to be incorporated in the 2007 budget but acknowledged that the yield of some was difficult to forecast. Fiscal benefits from the planned social security reform will rise over time, but some savings should be realized even in 2007, primarily through changes in early retirement rules and the indexation of benefits. The yield from the civil service reform and restructuring of the public sector was harder to project, however. There was no doubt that Portugal’s public sector is substantially overstaffed. If implemented effectively, these initiatives therefore had the potential both to increase efficiency—by making it easier to shift public employees across sectors as needed—and to generate significant savings, as some workers would be moved to an excess labor pool where they would receive reduced wages and benefits as an inducement to leave public employment. However, decisions on staffing levels would be made primarily at the unit level, and the authorities understood that inducements for managers to rationalize staffing might be necessary. The mission encouraged the authorities to base the 2007 budget on conservative estimates of the yield of these reforms, supplementing them with additional high-quality spending measures as needed. Continued progress in reducing the deficit in line with the EDP commitments was jointly seen as essential to maintain confidence in the adjustment program and minimize the short-term output costs of fiscal consolidation.

14. Institutional reforms to further strengthen medium-term fiscal performance were also under consideration. The authorities concurred with the fiscal ROSC’s suggestion that a binding multiyear budget framework with explicit expenditure ceilings for outer years would improve budget execution by providing spending units with a clearer indication of the future resources available to them. A pilot program along these lines might be introduced in 2009. Consideration was also being given to revenue-neutral simplification of the tax code, for example eliminating intermediate VAT rates for some goods and lowering the maximum rate, or further phasing out income tax benefits and cutting marginal rates. These measures would decrease the cost of compliance with the system, facilitate administration, and reduce distortions. Given the risk of unanticipated revenue effects, however, a reform would likely await a further strengthening of the fiscal position.

15. It was agreed that additional fiscal adjustment would be needed beyond 2008 to ensure long-term sustainability and to allow fiscal stabilizers to operate. Forecasts of aging-related spending, including recently by the EC, point to large increases in pension and health expenditure in the coming years. Staff simulations show that without additional deficit reduction beyond 2009, the public debt would rise sharply over the medium term. Preliminary calculations based on updated projections for long-term health and pension spending that take account of the pending pension reform, and on realistic forecasts for output growth, suggest that long-run debt sustainability would require a budget surplus of at least ½ percent of GDP by 2013 (Box 5) implying an additional 2 percentage points of GDP of fiscal adjustment after 2009. The authorities’ official medium-term objective calls for a structural deficit of “½ percent of GDP or less,” which they and staff agreed would allow full operation of automatic stabilizers over the cycle without violating the Stability Pact’s 3 percent of GDP deficit ceiling. They agreed that the adequacy of any medium- to long-term target would need to be re-evaluated periodically in light of developments with output and health and pension spending.

Fiscal Sustainability

Staff’s baseline scenario incorporates the adjustment path in the authorities’ Stability Program Update, with the deficit reduced to 1.5 percent of GDP by 2009, and keeps revenue and non-age-related spending ratios to GDP constant thereafter, with no subsequent fiscal adjustment. Under this scenario, the debt ratio would reach some 100 percent of GDP around 2025 and would continue to rise thereafter.

An alternative scenario takes into account the effect on long-term pension spending of the proposed pension reform and assumes a budget surplus of some ½ percent of GDP is achieved by 2013, following which non-age-related spending is kept constant as a percentage of GDP. Under this scenario, the debt ratio would remain broadly stable (and just below the 60 percent of GDP SGP ceiling) over the next four decades.


Portugal: Long-Term Aging-Related Fiscal Projections, 2000-50

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 377; 10.5089/9781451832204.002.A001

Surces: Portuguese authorities; and Fund staff calculations.

B. Revitalizing Growth and Restoring Competitiveness

16. The government’s Technological Plan is central to its program to raise productivity growth. The plan seeks to address Portugal’s very low R&D and IT spending (Figure 7), including by providing fiscal incentives for investment, promoting training, and encouraging contacts between firms and universities. The authorities saw these measures as essential to address market failures, among them the difficulty that small- and medium-sized enterprises face in financing technological investments, and the generally low levels of human capital among workers and managers.

Figure 7.
Figure 7.

Portugal: Structural Indicators

Citation: IMF Staff Country Reports 2006, 377; 10.5089/9781451832204.002.A001

Source: OECD, EUROSTAT; Fund staff calculations.1/ Average of PISA scores in reading, mathematics and science, 2003.2/ Percent of non-residential gross fixed capital formation, total economy, 2001.3/ Index EU15=100, 2006 (1st half).4/ In percentage of GDP, 2002

17. Efforts to reduce bureaucratic impediments to investment are also a key element of the authorities’ program. The authorities observed that different global indices of the business environment—for example, the World Bank’s Doing Business Indicators and the World Economic Forum’s Global Competitiveness Index—tended to give contrasting, and insufficiently nuanced, views of the overall investment climate. As such, they cautioned against relying on any single measure or set of measures when assessing the business environment. Nevertheless, they recognized that there was scope for improvement and noted the important progress already made. Bureaucratic requirements have been streamlined under the SIMPLEX program, eliminating numerous barriers to investment and accelerating the process of opening new firms and registering trademarks. Thus far, the effort to reduce red tape had not been prioritized, in the hope that eliminating a large number of bureaucratic requirements in the first year would raise awareness of, and generate momentum for, the new program. The mission supported the plan to adopt a more targeted approach to SIMPLEX next year, focusing on licensing requirements, which private investors consider to be especially burdensome in Portugal. Steps were also underway to accelerate the legal system, although separation of powers provisions limit the government’s freedom of action. As improvements to the business environment would benefit firms throughout the economy, the mission believed they could have a bigger impact on productivity than would the more targeted initiatives under the Technological Plan. In any case, reforms to the investment climate would leverage the effects of the Technological Plan.

18. The authorities agreed that greater competition and efficiency in domestic markets was also critical to enhancing productivity. Increased competition in key network sectors—including telecommunications, electricity, and natural gas—was in the offing, with potentially important effects on production costs economy-wide. Steps had been taken to enhance competition in electricity generation, although the immediate impact on energy prices would be reduced by the decision to pass on to consumers the costs arising from existing long-term electricity supply contracts with producers (PPAs) and by the policy to increase the share of renewables in generation. Preparations were also underway for a gradual opening of the domestic gas market next year. Action by the Competition Authority had led to the elimination of minimum fees for some professions and had reduced barriers to entry in a number of retail sectors (e.g., pharmacies and gas stations).

19. The privatization process has been reinvigorated, with the objective of reducing the role of the state in the economy and enhancing efficiency. The authorities target sales of equity stakes worth some €3.7 billion through 2009 (€1.6 billion in 2006), with at least 80 percent of proceeds going to reduce debt. 5 Assets in the energy and paper sectors could be sold this year, and the authorities also expected to initiate the privatization processes for the national airline, TAP, and the airports authority. They did not, however, foresee a privatization of Caixa Geral de Depósitos, a fully state-owned financial entity that accounts for some 25 percent of banking system assets. The FSAP mission had suggested that the authorities consider whether, over the longer run, financial market globalization and deregulation implied that full state ownership of the entity might no longer be the most effective means of achieving their policy objectives. The authorities stated, however, that so long as CGD operated as a commercial entity subject to the same regulatory framework as its private competitors, they saw no compelling reason to change its ownership structure. (See below for further details on the FSAP findings and recommendations).

20. As in previous consultations, there was disagreement over the priority due labor market liberalization. The authorities highlighted recent changes to the unemployment compensation system that broaden the definition of “acceptable employment,” promote more active job-seeking by the unemployed, and link the duration of an individual’s benefits to the length of his contribution period. These changes, undertaken jointly with plans to strengthen coordination between the social protection system and the education and training network (in line with OECD recommendations), are expected to speed the reintegration of the jobless into employment. The authorities argued that international indicators that point to high employment protection in Portugal (Figure 8) are misleading, failing to recognize that firms typically use negotiated severance packages to shed labor rather than rely on admittedly cumbersome legal procedures, and discounting the extensive use of short-term contracts and self-employment. The mission noted, however, that recent steps to limit reliance on negotiated dismissals—to reduce their budgetary costs—would effectively make prevailing employment protection legislation more binding, increasing the need for its overhaul. It also argued that firms’ preferences for short-term contracts and self-employment are symptoms of—not cures for—excessive employment protection, and contribute to inequities and to low levels of training while slowing the movement of labor across sectors. Changes are also needed to collective bargaining provisions, the mission argued, to allow greater flexibility at the firm level. More generally, the mission stressed that labor market reforms would contribute to reducing unit labor cost growth from both the wage and productivity sides and should therefore be a critical component of the strategy to strengthen competitiveness.

Figure 8.
Figure 8.

Portugal: Employment Protection Legislation (EPL) Strictness Indicators, 2003

Citation: IMF Staff Country Reports 2006, 377; 10.5089/9781451832204.002.A001

Source: OECD Employment Outlook 2004

C. Financial Sector Issues

21. The FSAP found that Portugal’s financial system is generally sound(see the FSSA and Box 6). The system has weathered the weak macroeconomic environment of recent years relatively well. Banks have diversified income sources, rationalized operating costs, and enhanced risk management procedures. Portugal’s banking sector compares favorably with those of other EU countries in terms of asset quality, efficiency, and profitability, while capital adequacy is about average. The financial soundness of the insurance sector has improved, reflecting a deepening of the market, better alignment of premiums to risk in some categories, positive investment yields, and reduced personnel costs.

Main Findings of the FSAP

  • Portugal’s financial system is sound, well managed, and competitive. Shortterm vulnerabilities appear well contained, as confirmed by stress test results, although banks are sensitive to equity market risk through their employee pension funds. Over the medium term, rising household and corporate sector debt and significant concentration of banks’ exposure across sectors (especially real estate)and borrowers may represent important potential risk factors, especially if economic conditions remain sluggish, and will need to be monitored closely. Potential domestic channels for contagion risk and cross-sectoral spillovers among banks appear quite low.

  • The supervision of banks’ loan classification and provisioning policies—an area which raised some controversy a few years ago—was assessed to be in full compliance with international best practices, following some regulatory changes in 2002–03.

  • In the last few years, the performance and soundness of the insurance sector has strengthened. While relatively sensitive to various types of market and underwriting risks, the insurance sector seems able to withstand a number of severe shocks, though the impact on individual insurers varies widely.

  • The infrastructure for the settlement of payments and securities transactions is highly developed, efficient, technologically well advanced and—from a risk management perspective—robust. Supervision of financial institutions as well as of payments and settlement systems is professional and active, comparing very well with international standards. The financial autonomy of the insurance and securities supervisors should be more formally safeguarded, while the former agency should shed, over time, some nonsupervisory functions.

Figure 9.
Figure 9.

Portugal: Credit and Asset Market Developments, 2000–05

Citation: IMF Staff Country Reports 2006, 377; 10.5089/9781451832204.002.A001

Source: Bank of Portugal; Ministry of Finance, Monthly Economic Indicators; Datastream; and Fund staff calculations.1/ Loans to non-financial corporations of the construction and real estate sectors and to households for housing as a percentage of total loans extended to the non-financial private sector (adjusted for securitization).2/ FTSE Eurotop 100 (in euros).

22. Risks arise mainly from high household and corporate debt. Lending to households—especially mortgages for owner-occupied housing—has expanded rapidly, bringing the private sector credit-to-GDP ratio to about 150 percent, the highest value in the EU. Household mortgages are typically at floating rates. Loan-to-value ratios have risen as a result of greater competition among banks, but there is no evidence of real estate overvaluation. The authorities noted that owing to low interest rates and the lengthening of mortgage maturities, the debt service burden for households has remained moderate. They also emphasized that high indebtedness reflects in large part improved access to mortgage credit by households, as well as inefficient rent control laws that constrain the development of a rental market for housing. Other risks to the financial system include the concentration of bank lending to a limited number of large corporates (albeit within supervisory limits), and the exposure of banks’ employee pension schemes to the stock market.

23. The FSAP considered these risks to be manageable, though worthy of continued close monitoring. Stress tests showed that the capacity of the financial system to absorb even severe disturbances to the macroeconomic environment is strong, given comfortable profitability and solvency buffers. The overall prudential regulatory framework is sound, and the supervision of financial institutions and payments and settlement systems is professional and active, comparing very well with international standards. Nevertheless, a number of specific issues within the financial system merit attention, including the needs to consider additional capital requirements for mortgages under Basel II, and to continue encouraging banks to refine systems to measure and control risks.

24. The authorities broadly agreed with the FSAP analysis and recommendations, which—it was recognized—were primarily technical in nature. In particular, the insurance and stock market supervisors welcomed the call for greater financial autonomy. The Bank of Portugal noted that banks have made considerable strides in assessing credit risks in recent years, and that this process would continue as they adjusted to new requirements under Basel II. More generally, the Bank saw many of the FSAP recommendations as supportive of ongoing initiatives or strands of work, such as the full implementation by the Bank of a comprehensive risk rating system for supervised credit institutions. The authorities welcomed the generally positive assessment of compliance with core principles but felt that in some cases the assessment did not take adequate account of measures already in place or under development (see also paragraph 19 of this staff report regarding the authorities’ views on state ownership in the banking system.)

D. Other Issues

25. The quality of statistical data has improved (Appendix II). Notably, the reporting of fiscal data during the year has become more comprehensive, permitting a better intra-year evaluation of budget execution. The authorities have completed the rebasing of national accounts data to 2000.

IV. Staff Appraisal

26. Recent months have witnessed important progress in the economic and policy environment, but the challenges that Portugal confronts remain considerable. A modest recovery of output is underway, thanks in part to solid export growth in the first half of the year. In addition, some significant structural reforms have been introduced, while others have moved closer to fruition. Nevertheless, reducing large fiscal imbalances and restoring external competitiveness will be a lengthy and difficult process. Fortunately, there are important complementarities between these goals, raising the prospect that successes in each area could generate a virtuous cycle of faster growth and adjustment in the medium term.

27. The authorities’ strategy to meet these challenges is generally sound, but firm implementation is essential to its success. The commitment to bring the fiscal deficit below 3 percent of GDP without one-off measures by 2008 primarily by tackling the public wage bill and pension spending is wholly appropriate. The growth of these spending categories over the last decade is a prime cause of the current high deficit. Moreover, international experience shows that expenditure-based fiscal adjustments tend to be more durable and effective than revenue-based ones. To maximize the credibility of the adjustment effort, planned reforms to the civil service, to the structure of the public sector, and to the social security system for private sector workers must be introduced without delay and implemented rigorously. Likewise, improvements to the business environment and increased domestic competition offer the prospect of enhancing Portugal’s medium-term growth potential, and progress in this area should continue. Slippages in the reform agenda—especially on fiscal measures—would only damage confidence and increase the duration and costs of adjustment.

28. Achieving the 2006 deficit target is fundamental to ensuring the credibility of the adjustment effort, and the authorities’ commitment to reinforce budget measures if necessary is therefore welcome. Risks of spending overruns on social transfers and health care, and by local governments and autonomous funds, call for careful monitoring of budget execution and tight control of spending. Given the predominant role that revenue measures have played in deficit reduction so far—including in 2006, when the full-year effect of last year’s VAT increase will make an important contribution to revenue growth—any additional measures should operate on the expenditure side.

29. For 2007–09, it will be essential that expenditure measures move to the forefront, realizing the planned shift away from revenue-based adjustment. The authorities anticipate that the public sector, civil service, and private sector pension reforms should contribute to this goal starting next year. In light of uncertainties regarding their yield, however, the 2007 budget should be based on conservative estimates of their impact, with additional specific spending measures incorporated as needed to achieve the deficit target. The authorities should ensure that adequate incentives are in place to induce unit managers to maximize staffing efficiency under the civil service and public sector reforms. Steps to increase the effectiveness of spending on health and education should also continue to be implemented, with a view to reducing inputs and improving the quality of outputs from the school and healthcare systems. The pending reform of local government finances will address incentives to spend under current arrangements, and should—along with the more comprehensive limits on indebtedness and reporting requirements already implemented—improve medium-term fiscal discipline.

30. Even with the implementation of recent and planned pension reforms, fiscal adjustment will be needed after 2009 to ensure long-term sustainability. In light of projected future increases in aging-related spending, the authorities should commit to a path of further deficit reduction that would yield a fiscal position consistent with long-run debt sustainability by 2013. Provisional calculations suggest a surplus of ½ percent of GDP will be required, though the adequacy of any target will need to be re-evaluated periodically in light of developments with output and health and pension spending.

31. A credible deficit reduction strategy is essential to raise potential growth but cannot do so alone. Reforms to strengthen the business environment and increase domestic competition are also critical to restarting income convergence. Measures to remove bureaucratic and regulatory impediments are a highly cost-effective means of promoting private investment and growth and will reinforce the effectiveness of the Technological Plan. The intention to focus attention on easing licensing requirements is welcome. Within the constraints imposed by the constitution, the authorities should continue to promote efforts to accelerate legal processes. Increased domestic competition would boost the competitiveness of Portuguese enterprises by reducing prices and promoting innovation and investment, and work by the government and the Competition Authority in this area should proceed apace. Faster growth is a virtue itself, but given the complementarities between output growth and deficit reduction, a failure to make progress with growth-enhancing reforms could complicate the achievement of the medium-term deficit targets, undermining confidence in the authorities’ overall policy package. This is especially a concern given that the medium-term growth projections in the authorities’ Stability Program Update significantly exceed the staff’s.

32. In this respect, fundamental labor market reform should be a high priority. Strong nominal wage growth even in the face of increases in the unemployment rate, high rates of long-term unemployment, and heavy reliance on fixed term-contracts and self-employment all testify to the presence of significant rigidities in labor markets. These rigidities slow the movement of labor to fast-growing sectors, discourage investment in worker training, inhibit the adjustment of wages to market conditions, and raise serious equity concerns by contributing to a dual labor market. Measures to increase labor market flexibility, along with adjustments to collective bargaining provisions to allow greater responsiveness to individual firm conditions, are critical to raise productivity and promote wage moderation, thereby strengthening the competitive position. Recent changes to the unemployment compensation system are welcome but are not a substitute for these reforms.

33. The financial system is sound and well supervised, but the authorities should continue to monitor risks closely. The relatively high levels of household and corporate debt, the concentration of bank lending to the real estate sector and to a limited number of large corporates, and the exposure of banks’ employee pension schemes to the stock market call for continuous vigilance. The FSAP finding that comfortable profitability and solvency buffers are capable of absorbing even severe disturbances to the macroeconomic environment is reassuring. However, as the financial system evolves, the authorities should reassess periodically its capacity to respond to shocks. The authorities are encouraged to implement the FSAP recommendations.

34. Portugal is encouraged to increase its ODA to the 0.7 percent of GNI benchmark.

35. It is proposed that the next Article IV consultation be held on the standard 12-month cycle.

Table 1.

Portugal: Selected Economic Indicators, 2001-07

(Changes in percent, except as otherwise indicated)

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Sources: Bank of Portugal; Ministry of Finance; National Statistics Office (INE); and Fund staff estimates and projections.

GDP ratios use revised GDP series with base year 2000.

Asset sales, including UMTS receipts, the transfer of the postal pension fund and securitization are netted out for purposes of calculating structural balances.

Excludes one-off measures.

End-of-period data.

Excludes the currency in circulation held by non-bank private sector.

Includes securitized loans. 2001 onwards it is also corrected for loan write-offs and reclassifications.

Data refer to new deposits before 2003 and to the stock of outstanding deposits thereafter. Before 2003 deposit rate with 91-180 days maturity.

Average rates on outstanding amounts of loans, denominated in euros to residents in the euro area, for each sector and/or purpose, weighted by the corresponding outstanding amounts at the end of the month in each original maturity. Before 2003 lending rate with 91-180 days maturity.

Table 2.

Portugal: Balance of Payments, 2000-10

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Sources: Bank of Portugal; and Fund staff calculations.

End-of-period data.

Table 3.

Portugal: General Government Accounts, 2000-06

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Sources: Ministry of Finance; and Fund staff estimates.

Budget figures. Staff projects total revenues and expenditures each about 1 percent of GDP higher.

Excludes one-off measures. Ratios based on GDP series with 2000 as base year.

One-off measures consist of the transfer of the postal pension fund in 2003, the state enterprises pension funds in 2004, securitization and asset sales.

Structural balances are calculated using the staff’s estimates of potential output. Asset sales, including UMTS receipts, the transfer of pension funds and securitization are netted out for purposes of calculating structural balances.

Table 4.

Portugal: External Debt Sustainability Framework, 2001-11

(In percent of GDP, unless otherwise indicated)

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Refers to gross external debt and assumes growth at historical (2000-2005) average.

Derived as [r - g - r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in U.S. dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock. r increases with an appreciating domestic currency (e > 0) and rising inflation (based on GDP deflator).

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP. Averages are for the period 1996-2005.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and both noninterest current account and nondebt inflows in percent of GDP) remain at their levels of the last projection year.

Table 5.

Portugal: Public Sector Debt Sustainability Framework, 2001-11

(In percent of GDP, unless otherwise indicated)

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The public sector refers to general government. Uses the Staff’s growth scenario for 2006-01.

Derived as [(r - p(1+g) - g + ae(1+r)]/(1+g+p+gp)) times previous period debt ratio, with r = interest rate; p = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).2/as r - π (1+g) and the real growth contribution as -g.

The real interest rate contribution is derived from the denominator in footnote 2/ as r - π (1+g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 2/ as ae(1+r).

For projections, this line includes exchange rate changes.

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP. Averages are for the period 1996-2005.

Derived as nominal interest expenditure divided by previous period debt stock.

Table 6.

Portugal: Indicators of External and Financial Vulnerability, 2001-06

(In percent of GDP, unless otherwise indicated)

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Sources: Bank of Portugal; Ministry of Finance; IMF, Balance of Payments Yearbook database; and Fund staff estimates.

Reserves and foreign liabilities refer to the Bank of Portugal.

Banks only.

Non-euro area currencies assets vis-à-vis the resident and nonresident nonmonetary sector.

Deposits in non-euro area currencies by the resident non-monetary sector and liabilities in non-euro area currencies by the nonresident nonmonetary sector.

Real estate defined as the sum of total credit by monetary financial institutions to individuals for housing and to nonfinancial corporations for construction; private credit defined as total domestic credit excluding the general government. Stocks adjusted for securitization operations.

NPL concern households and nonfinancial corporations.

Capital over risk-weighted assets. Consolidated data for the banking system.