Portugal
2007 Article IV Consultation: Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by Executive Director for Portugal
Author: International Monetary Fund
Publication Date:
11 Oct 2007
eISBN:
9781451832280
ISBN:
9781451832280
Language:
English
Keywords:
ISCR; CR; bank equity price; market tension; deficit; current account; equity; debt ratio; market share; GDP deflator; Banco de Portugal; Competition; Wages; Exports; Global
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This 2007 Article IV Consultation highlights that a modest recovery is finally under way in Portugal. Growth rose to 1.3 percent in 2006, led by strong external demand, which is driving a notable rebound in export growth. In response, corporate investment shows signs of strengthening, but overall domestic demand remains relatively weak. Real GDP growth is projected to strengthen to about 1.8 percent in 2007 and 2008. Portugal’s financial system remains sound and well supervised, and appears to have weathered the recent tensions in financial markets relatively well, though risks remain.

Abstract

This 2007 Article IV Consultation highlights that a modest recovery is finally under way in Portugal. Growth rose to 1.3 percent in 2006, led by strong external demand, which is driving a notable rebound in export growth. In response, corporate investment shows signs of strengthening, but overall domestic demand remains relatively weak. Real GDP growth is projected to strengthen to about 1.8 percent in 2007 and 2008. Portugal’s financial system remains sound and well supervised, and appears to have weathered the recent tensions in financial markets relatively well, though risks remain.

I. Overview: Boom to Bust

“The Portuguese economy is in serious trouble. Productivity growth is anemic. Growth is very low. The budget deficit is large. The current account deficit is very large.”

Olivier Blanchard, 2006

1. Portugal boomed at the end of the 1990s. The prospect of adopting the euro turbocharged the convergence process as real interest rates plummeted, investment and consumption (fuelled by borrowing) boomed, and the underlying fiscal stance loosened. The result was rapid growth of GDP, employment, wages, debt, and the current account deficit.

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Falling Behind

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

2. Boom turned to bust in 2000. Balance sheets became stretched and, as the expected productivity gains failed to materialize, corporates cut investment and employment, and growth slumped. Reflecting the erosion of competitiveness and negative external developments, exports flagged, and the convergence process went into reverse.

3. Real wage increases have waned, but with anemic productivity growth, unit labor costs have remained high. Wage growth moderated to the euro area average as the economy slowed after 2000. However, real wage increases continued to outpace labor productivity growth, further raising unit labor costs. Poor productivity growth can be traced to low levels of human capital, investment in R&D and ICT penetration, but also to shortcomings in the business environment, insufficient competition in domestic markets, and labor market rigidities.

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Wage Growth Slows 1/

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

1/ Calculated as compensation of employees divided by employees (national account data).
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Labor Productivity Growth Has Fallen

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

4. The sustained large current account deficit (and the corresponding external indebtedness) is symptomatic of the imbalances of the economy. In particular, it reflects weak competitiveness, sustained high private sector borrowing1 and declining household savings, and the large fiscal deficit. As a member of the euro area with a robust financial sector, external financing is, however, readily available.

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Current Account and Private and Public Savings

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

5. Recent policies have been impressive, especially on the fiscal front. The government that came to power in March 2005 (with, for the first time, a single-party majority) has started expenditure-based fiscal consolidation, reformed the pension system (both private and public) and improved the business environment.

II. Outlook: A Modest and Fragile Recovery

6. A modest recovery is finally underway. Growth rose to 1.3 percent in 2006 (still the lowest in the euro area), led by strong external demand, which is driving a notable rebound in export growth (Box 1). In response, corporate investment shows signs of strengthening, but overall domestic demand remains weak as the anticipated retrenchment of households in response to their debt burden unfolds, and construction activity continues to decline. And while employment and participation rates have risen, so too has unemployment. Inflation has remained consistently higher than the euro average despite a still-significant output gap and sluggish domestic demand, suggesting rigidities in product and labor markets.

7. Staff’s central scenario is one of continuing but modest structural adjustment and gradually strengthening growth. With fiscal consolidation broadly as envisaged by the government’s SGP commitments, modest further structural reforms are projected to prompt a gradual recovery in competitiveness and productivity. Strong external demand is expected to lead to a positive contribution from the external sector (though exports are projected to lose slightly more market share), while domestic demand will likely remain subdued. Consumption should be constrained by weak employment growth and high indebtedness, though credit growth has picked up.2 While some corporate balance sheet restructuring has occurred, still-high enterprise debt levels may restrain any rebound in investment. Staff projects growth of around 2 percent in 2007 and 2008, in line with official and Commission estimates. Over the medium-term, staff foresees growth increasing to around 2¼ percent leading to a closing of the output gap by 2012—before settling down to potential rates of about 2 percent.

Portugal’s Exports: Blip or Recovery?

After several years of dismal performance, exports of goods and services picked up strongly in 2006, growing at almost 9 percent in real terms compared to an average of 2½ percent in the previous five years. What explains this surge, and are there signs it might be a blip or a more permanent recovery?

  • Exports were led by strong demand in Portugal’s main trading partners (especially Spain, Germany, and the U.S), though smaller partners (such as Angola and Singapore) contributed.

  • The 2006 pick up was mainly due to faster growth in exports of machinery and transport equipment, manufactured material, as well as tourism and transport services; clothing and footwear sectors remained stagnant.

  • The loss of market share in recent years appears to have stopped (though this also happened in 2002–03 before falling again).

  • On the other hand, a wide range of indicators still suggests Portugal has a significant competitiveness gap.

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Portugal’s Export Grow th and Export Share

(Percent)

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

Since the beginning of this decade, two trends stand out:

  • Portugal continues to move away from low-tech exports (clothing and footwear), although the process is slower than in the 1990s.

  • Portugal’s export share continues to slip in the EU market, its largest export destination, but has been growing outside the EU (though these markets are still comparatively small).

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Technological Specialization of Portuguese Exports 1/

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

1/ As measured by share in Portuguese exports divided by share in w orld exports.

As external demand is forecast to remain robust, the strong response of Portugal’s exports to world demand since 2006 bodes well for a gradual recovery. However, given the competitiveness loss of recent years, it seems premature to expect any gains in market share.

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The Economy Has Slumped…

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

Sources: Bank of Portugal; National Institute of Statistics (INE); and IMF staff calculations.
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…But Shows Signs of a Moderate Pick-Up

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

Sources: INE, Bank of Portugal; and IMF staff calculations, end of period.1/ Three-month moving average of year-on year growth rate.2/ Year-on year growth rate (three-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.
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Portugal Has Lost Competitiveness…

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

Sources: OECD Economic Outlook; AMECO; National Institute of Statistics (INE); Eurostat; and IMF staff calculations.
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…And the External Accounts Remain Weak

(Percent of GDP, unless otherwise indicated)

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

Source: Bank of Portugal.
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Private Debt Is High and Growing

(But No Housing Boom)

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

Sources: Bank of Portugal; Ministry of Finance, Monthly Economic Indicators; Datastream; and IMF staff calculations.1/ Data refers to 2004.2/ Data refers to 2006.3/ Loans to nonfinancial corporations of the construction and real estate sectors and to households for housing as a percentage of total loans extended to the nonfinancial private sector (adjusted for securitization).4/ FTSE Eurotop 100 (in euros).

8. Risks to near-term growth outlook appear balanced, but are skewed to the downside further forward. In the short term, private investment may not pick up as strongly as projected, but exports could grow more strongly, benefiting from more favorable global demand. In the longer term, the main risk is that the pace of reform will slacken and balance sheet problems may depress household consumption and investment.

9. The authorities were more optimistic, especially about the prospects for private investment, and saw stronger growth over the medium term. The authorities emphasized that business investment excluding construction grew by 3 percent in 2006, after a long slump and that substantial foreign investment plans were in the pipeline. Overall, the authorities saw upside risks to domestic demand in the near-term and growth accelerating to 3 percent by 2010.

III. Policy Challenges

10. Staff and officials agreed that raising the economy’s long-term growth potential requires maintaining the reform momentum, building on the gains already made. The current favorable economic setting should be used, in particular, to further streamline the public sector and to boost productivity and competitiveness. Further streamlining the public sector would help regain competitiveness by moderating wage growth (as in the Netherlands during the 1980s and 1990s) and improving the efficiency of public services. And greater competitiveness would spur growth and employment, easing fiscal adjustment. In contrast, letting the reform effort slip would increase the duration and costs of adjustment.

11. There was broad agreement that Portugal continues to face a competitiveness problem. Staff estimates, based on a range of indicators, indicate a real exchange rate overvaluation of some 10–20 percent.3 While these estimates should be assessed with caution, the presence of such a gap is consistent with developments in relative unit labor costs, the current account and export market share. Going forward, fiscal consolidation, balance sheet adjustment by households, and a series of product market reforms should help narrow this gap, but at the current juncture, staff considered that, on balance, the real exchange rate was overvalued.

12. While agreeing with the challenges facing Portugal, the authorities downplayed quantitative assessments of competitiveness based on standard indicators. In the authorities’ view, standard indicators of competitiveness (such as equilibrium real exchange rates) suffered from significant methodological shortcomings and masked the fundamental restructuring underway in some sectors of the economy.

A. Streamlining the Public Sector

“Good results only mean that we are…able to reach the end of the path faster. But there is still road ahead of us.”

Prime Minister Sócrates, Budget address, 2007

13. Much-needed, expenditure-based fiscal consolidation is now firmly underway. The overall balance improved sharply from a deficit of 6 percent of GDP in 2005 to 3.9 percent of GDP in 2006 (without one-off measures), compared to a budget target of 4.6 percent of GDP. The improvement was mostly due to lower spending.

Fiscal Overperformance, 2006

(Percent of GDP)

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Consistent with 2006 Budget.

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Change in Fiscal Deficit 2005–06

(Percent of GDP)

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

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Contribution: Revenue and Expenditure

(Percent of GDP)

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

  • After a decade of almost one Spending is Falling From a High Base percentage point of GDP increases a year, primary current spending fell in 2006. Most of the reduction was due to a lower wage bill (which remains the highest in the euro area), reflecting the government’s civil service reforms and wage restraint. Capital spending also came in well under budget, as local governments scaled investment back from election-related higher levels of 2005 and in response to the firm application of the local and regional government financing framework.

  • Most of the deficit overperformance relative to the budget was driven by revenue strength towards the end of the year. While such revenue strength is being seen elsewhere in the euro area, in Portugal’s case, the marked improvement in tax administration is clearly a contributing factor.

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Spending is Falling From a High Base

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

14. Reflecting stronger-than-expected fiscal outturns, the authorities have updated their deficit targets for 2007 and 2008. In April 2007, the authorities revised the deficit targets set at the time of the SGP in December 2006. The revision implied somewhat less adjustment in structural terms, but continued to reduce the structural deficit by at least ½ percent of GDP a year until meeting the government’s Medium-term Objective (MTO) of half a percentage point of GDP in 2010.

Fiscal Targets

(Percent of GDP)

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Source: Ministry of Finance.

15. Staff welcomed the authorities’ intention to accelerate the pace of consolidation, but saw a greater opportunity to further front-load the adjustment. Data through June suggest that revenues are coming in stronger than envisaged at the time of the revision, driven primarily by buoyant corporation tax receipts. In staff’s view, somewhat more ambitious deficit targets for 2007 and 2008 were warranted given the substantial uncertainties about the budgetary implications of the current fiscal reforms, the growing pressure to cut taxes, and to make the remaining adjustment in 2009 (an election year) and 2010 to achieve the MTO more credible. Specifically, staff saw a case for maintaining the envisaged pace of structural deficit reduction, which implies additional tightening by about ¼ percentage point of GDP in both 2007 and 2008. Staff also supported the new mechanism in place to better monitor budget execution of local government, but noted that any further large shortfalls of capital spending compared to budget should be carefully monitored.

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Weak Fiscal Accounts Are Starting to Improve

(Percent of GDP, unless otherwise indicated)

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

Sources: Bank of Portugal; IMF staff calculations; and Eurostat.1/ euro area=100.
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Fiscal Adjustment Running Ahead of SGP

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

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Expenditure-based Consolidation Planned

(Percent of GDP)

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

16. While agreeing in principle, the authorities pointed to the need for caution in setting targets. The authorities expressed their concerns about whether the current revenue buoyancy would last, partly due to high volatility in corporate tax. Nevertheless, they stated their intention to lower the deficit further to the extent that the revenue overperformance persists. On spending, officials concurred with staff’s assessment that there may be overrun risks, in particular, in social transfers, health, and transfers to the public roads company, but stressed their close monitoring of monthly spending patterns and that a contingency reduction had been implemented to ensure the targets are met.

17. Staff recognized that recent reforms had substantially improved long-term sustainability. The recent fundamental changes to the social security system imply that if the underlying (i.e., non age-related primary balance) MTO position is achieved and maintained, public debt would remain below 60 percent of GDP through 2040. However, the debt ratio would exceed 90 percent of GDP by 2050 (compared to nearly 200 percent of GDP before the reform), and the SGP reference level for the deficit of 3 percent of GDP would also be breached in the 2030s. Assumptions in the long-term projections could also prove optimistic, especially, for example, health-care inflation.

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The Pension Reform - Before and After

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

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Fiscal Sustainability Risks

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

18. The restructuring of the central administration is making good progress and is entering a critical phase. The number of central administration structures has been cut by a quarter, the new public employment framework has been submitted to parliament, and recruitment has been kept to less than half of departures. Staff and officials recognized that the process is now entering a critical phase of identifying significant numbers of weaker-performing civil servants and moving them into the special mobility pool (where they will receive increasingly lower pay as an encouragement to leave).

19. With fiscal consolidation performing better than expected, the government has faced pressure to reduce the tax burden; staff and officials agreed it should be resisted (Box 2). Given Portugal’s fiscal situation and the relatively low revenue ratio, no room exists for a discretionary reduction in the tax burden in the near term. Nevertheless, some tax laws should be further simplified and procedures, which could have a significant impact on competitiveness, especially for small and medium-sized firms, streamlined.

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Corporate Tax Rates—Pressures to Cut

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

20. Fundamental reforms to substantially enhance the budgetary process are envisaged. The interim report of the program budgeting committee envisages moving to performance-based, medium-term budgeting with expenditure ceilings. Staff agreed that such a reform would greatly enhance the efficiency and quality of public spending and would make government fiscal programs more transparent and credible, but suggested that the target of a full roll-out by 2010 may prove unduly demanding.

B. Boosting Productivity and Competitiveness

“The problems have been diagnosed…what the Portuguese expect…is action and more action…we need to increase our productivity and to be more competitive.”

President Silva, Inaugural Address, 2006

Wage restraint and labor market flexibility

21. Given the membership in EMU, staff noted that competitiveness needed to be restored by a combination of factors that includes sustained wage moderation. Experiences from other economies point to the importance of wage moderation in regaining competitiveness and that this process may take considerable time, even with a highly flexible labor market (Box 3). For Portugal, however, indicators suggest significant labor market rigidities. Despite high unemployment in recent years and widespread use of temporary contracts, real wages have not fallen. This in turn may reflect substantial employment protection of permanent workers and limited movement within employment.

Making the Tax System More Pro-Growth

The current tax system has its roots in the late-1980s tax reform, when the VAT and the income tax were introduced in preparation for EU accession in 1992. Since then, the tax burden has increased, but remains low compared to other industrialized countries and below the EU average. The system relies more on consumption taxes than the European average, which is typically positive for long-term growth, a result of good (although declining) VAT productivity, but also the low revenue response of income tax (mainly due to generous base reductions and noncompliance).

Tax administration has recently improved (updated registers; better use of electronic filing; improved audit results; more reliable databases; and better use of cross-checking), helping bring the administration more in line with international best practice. But there is considerable scope for the tax administration to further encourage growth by promoting a fair and less burdensome business environment.

Given the current need for fiscal consolidation, measures to make the tax system more pro-growth require a balanced approach between policy and administration, such as: strengthening the economic efficiency of the tax system (through broadening the tax base which, in turn, could create some margin for revenue-neutral rate reductions); increasing the system’s simplicity and predictability; reducing administrative and compliance costs; and enhancing tax administration (through greater focus on taxpayer services and a reduction in noncompliance).

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Tax Burden

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

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Tax Burden Composition

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

22. Against this background, staff saw the recent decision to increase the minimum wage by 5.3 percent a year annually on average between 2007–11 as potentially problematic. While the minimum wage is only binding for 5 percent of the total employment, it is substantially higher in sectors facing intensive competitive pressures, including textiles (15 percent). In staff’s view, the existing high employment protection combined with a higher floor on wages could make the much-needed restructuring more challenging. The authorities, however, emphasized that the minimum wage had eroded significantly in recent years and that poverty remained a pressing issue.

23. Staff urged the authorities to take the opportunity of the current labor code review to take steps to make the labor market more flexible. In this context, staff stressed that it will be important to ease employment protection legislation (especially for individuals), end the automatic extension of collectively agreed contracts to firms not part of the agreement, and make procedures less cumbersome.

24. Officials broadly agreed with the need to make the labor market more flexible, but some differences emerged. In the authorities’ view, while there is scope for increasing labor market flexibility, and action will be taken, staff overstated both the problems and the benefits. The authorities saw the labor market as more flexible than the standard indicators suggest, especially in practice. They also explained the difficult political economy aspects of labor market reform, especially in the Portuguese historical context of “solidarity.” In their view, the focus of reform efforts should be on enhancing labor productivity and human capital rather than restraining wage growth, which they pointed out has been slightly below inflation recently.

25. Progress is being made to support labor market participation and skill upgrading. Recent changes to the unemployment benefit system to broaden the definition of “acceptable” employment and to promote more active job-seeking should encourage more rapid reintegration by the jobless into employment. The authorities indicated that the “New Opportunities” program has been successful in boosting training and skill level of the labor force. Staff welcomed the extent of the initial take-up and the outcome of the “New Opportunities” program, but cautioned that care should be taken to ensure that the quality of the training does not deteriorate as numbers increase.

The Importance of Labor Market Flexibility in Regaining Competitiveness

The experiences of Hong Kong SAR and Germany, both with fixed exchange rates, suggest labor market flexibility is key to regaining competitiveness, but the adjustment process can still take many years.

Hong Kong SAR faced a large competitive shock stemming from the 1997 Asian crisis and integration with the mainland. Similarly, Germany experienced significant cost pressures in the early 1990s with unification. In both cases, the key to adjustment was wage moderation and labor shedding from manufacturing and low-end services towards higher value-added services, which lowered unit labor costs. In Hong Kong SAR, this process took about six years, involving a sharp contraction in output upfront followed by sustained deflation. Its highly flexible labor market allowed nominal wage growth to turn negative, especially in manufacturing. As a result, the REER depreciated by about 5 percent a year. The economy rebounded strongly and the trend growth rate increased. In contrast, the adjustment process took about 12 years in Germany. With less flexible labor and product markets, the REER depreciated gradually at about 2 percent a year based on a sustained reduction in real wages.

Portugal has broadly followed Germany’s path, but its unit labor cost of manufacturing continues to rise and the REER has barely moved. A 10–20 percent competitive gap implies the adjustment could still take about 5–8 years, assuming equal labor productivity growth but lower nominal wage growth in Portugal relative to the euro area by 2 percent annually.

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Unit Labor Cost of Manufacturing

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

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Real Effective Exchange Rate (ULC)

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

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Real GDP (level)

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

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Employment Is Highly Protected

(Data refers to 2003)

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

Source: OECD Employment Outlook 2006.

Boosting productivity

26. Staff and the authorities concurred that increasing domestic competition in the nontradable sector was key to improving productivity. Increased competition in the nontradable sector was critical to ensuring that real wage moderation in the tradable sector results in lower prices rather than higher mark-ups. Lower prices could also foster support for labor market reform. Key areas to be addressed include the business environment, network sectors, and energy.

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Structural Indicators Lag the Euro Area

(Larger is Better)

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

27. Staff welcomed the emphasis and progress made on improving the business environment. All the mission’s interlocutors welcomed the substantial improvement generated by the government’s “SIMPLEX” program which, for example, greatly eased procedures to create companies. Initiatives to simplify the permit system, especially at the local level, should further enhance the business environment.

28. There was agreement that the Competition Authority should continue to advocate and enforce competition, as done recently in the pharmaceutical and telecommunication sectors. In this context, the planned spin-off of the cable network operator from Portugal Telecom in September was welcome, though staff suggested that its effectiveness for enhancing competition may be determined by whether the two network operators share the same ownership structure going forward.

29. Progress continues to be made on increasing competition in the energy sector and integration with Spain is accelerating. Electricity consumers have been able to choose their suppliers since September and the electrical and gas grid company is about to be privatized. But their immediate impact on electricity prices will be muted by the decision to pass on to consumers the costs arising from existing electricity supply contracts and the policy to increase the share of renewables in generation. Promoting competition is thus critical and staff argued that actions such as the recent capping of regulated price increases should be avoided. In the gas sector, it was agreed that meeting the target of end-2008 for full liberalization will be important.

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Structural Indicators Are Poor

Citation: IMF Staff Country Reports 2007, 341; 10.5089/9781451832280.002.A001

Sources: OECD; EUROSTAT; and IMF staff calculations.1/ Average of PISA scores in reading, mathematics, and science, 2003.2/ Percent of nonresidential gross fixed capital formation, total economy, 2001.3/ Index EU15=100, 2006 (first half).4/ In percentage of GDP, 2005. Italy, Netherlands, and the U.K. data are for 2004.

Safeguarding financial system soundness

30. Staff and the authorities agreed that Portugal’s financial system remained sound. While intensified competition has resulted in banks granting somewhat more favorable lending terms, and in a slight deterioration in banks’ liquidity ratios, average loan-to-value ratios are in line with other EU countries, nonperforming loans remain low, and the banking sector compares favorably with those of other EU countries in terms of asset quality, efficiency, and profitability (capital adequacy is about average). Recently, profitability has been helped by the economic pick-up, and banks have further rationalized operating costs and enhanced risk management procedures in adopting Basel II. While interest rates have risen and unemployment inched higher, the increases are modest and the FSAP exercise last year found that the financial system could withstand even severe macroeconomic disturbances.4

31. The authorities have made progress in implementing FSAP recommendations (Table 8), and the Bank of Portugal is monitoring key risk areas closely. The FSAP last year found that the financial system was well supervised. Since then, the Bank of Portugal has further strengthened its supervisory capacity with the adoption of a new risk rating system, completion of the Household Wealth Survey, and enhanced housing price statistics. High household and corporate debt remains the main source of risk to the financial system. In addition, bank lending concentrates on the real estate sector and on a limited number of large corporates, and banks’ employee pension schemes are exposed to stock market fluctuations. While the FSAP found risks were well managed, staff stressed the need to update the results regularly. Therefore staff welcomed the Bank of Portugal’s plan to conduct bottom-up stress tests every other year, with the next round due early 2008. The forthcoming results of the wealth survey will also help risk management by identifying key vulnerable subgroups of households.

IV. Staff Appraisal

32. Decisive action is being taken to correct the fiscal imbalances accumulated during the 1990s, and the results are beginning to be seen. In particular, substantial, expenditure-based fiscal consolidation is now firmly underway, the pension system has been reformed, and the business environment has been enhanced.

33. But the economic situation remains challenging and a significant external competitiveness gap persists. The income convergence process with the EU has reversed, and labor market rigidities, coupled with anemic productivity growth, cast doubt about the ability to substantially lower unit labor costs. To regain competitiveness and increase the economy’s long-term growth potential, further reforms are needed. This means making the most of the current favorable economic setting and building on gains already made to further streamline the public sector and to boost productivity and competitiveness.

34. The ambitious fiscal deficit reduction target for 2006 was surpassed. This improvement was mainly driven by expenditure reduction, especially of the wage bill, and to a lesser extent by unexpected revenue strength in the latter part of the year. This strong performance reflects the authorities’ determination to stick to tight expenditure targets and to strictly enforce the new local and regional government financing framework, as well as recent improvements in tax administration.

35. The revenue overperformance is continuing and should be saved. The government’s intention to do so is welcome, but somewhat more ambitious deficit targets for 2007 and 2008 (by about ¼ percent of GDP), front-loading the adjustment, seem warranted given the continuing revenue boom, the uncertainties about the budgetary implications of the current fiscal reforms, and the need to make the remaining adjustment in 2009 and 2010 to achieve the MTO more credible.

36. Following through on central administration restructuring will be important for achieving fiscal consolidation goals and improving productivity. Encouraging progress has been made, and it will be important to follow through in the forthcoming critical phase of moving significant numbers of civil servants to the special mobility pool.

37. Pressure to reduce the tax burden in the near term should be resisted. Given Portugal’s fiscal situation, there is no room for a discretionary reduction in the tax burden in the near term. But there is scope for further simplifying some tax laws and procedures and the recent improvement in the efficiency of the tax administration should be built upon.

38. The plan to move to performance-based budgeting is welcome. Such a move could greatly improve the efficiency and quality of public spending, though care should be taken to ensure the timetable is not unduly demanding.

39. A comprehensive strategy is needed to substantially enhance the economy’s potential growth. Fiscal adjustment, while necessary, is not sufficient to regain competitiveness and boost productivity and a comprehensive strategy is needed to avoid prolonging the recent slump. Strengthening productivity, including by enhancing contestability in the nontradable sector, is a key element in this strategy, but the effect of policies on productivity is uncertain in both impact and timing. It is thus also essential to address the cost side of competitiveness through policies that might foster wage moderation.

40. In this regard, the government’s reform strategy would be strengthened by addressing labor market rigidities more fully. The government’s intention to consider reforming the labor market in setting up a commission to study the issue is thus encouraging, and should be quickly followed by concrete measures. In particular, it will be important to ease employment protection legislation (especially for individual dismissals), end the automatic extension of collectively agreed contracts to firms not part of the agreement, and make procedures less cumbersome. In this context, the impact on labor market functioning of the recent decision to sharply increase the minimum wage in coming years should be carefully monitored.

41. Strengthening ongoing product and service market reform could also appreciably boost competitiveness and consumer welfare, lending support for reform in general. Important progress has been made with the SIMPLEX program, and initiatives to simplify the permit system, especially at the local level, should further enhance the business environment. Continued progress on increasing competition in domestic markets, especially in network industries and some service sectors, will also be important. Among other areas, improving the working of the judicial system should be a priority.

42. Progress continues to be made on increasing competition in the energy sector. However, the immediate impact on consumers is likely to be limited and actions, such as the recent capping of regulated price increases, should be avoided.

43. The financial system remains sound and well supervised. Some risks have increased slightly, though the system’s capacity to absorb even severe macroeconomic disturbances is strong. Close monitoring of key risk areas, as being exercised by the Bank of Portugal, should help ensure the financial system’s continued health, and in this context, the progress made on following up on last year’s FSAP is welcome.

44. Portugal is encouraged to increase its ODA to 0.7 percent of GNI. Statistical data provision is adequate for surveillance. Nevertheless, improvements in timeliness and quality of employment and wage compensation data and sectoral balance sheet data should be a priority (Appendix II).

45. It is recommended that the next consultation occur on the standard 12-month cycle.

Table 1.

Portugal: Selected Economic Indicators, 2002–08

(Changes in percent, except as otherwise indicated)

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

End-of-period data.

Excludes currency in circulation held by nonbank private sector.

Includes securitized loans. Also corrected for loan write-offs and reclassifications.

Table 2.

Portugal: Balance of Payments, 2001–12

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Sources: Bank of Portugal; and IMF staff calculations.

End-of-period data.

Table 3.

Portugal: General Government Accounts, 2001–50 1/

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Sources: Ministry of Finance; and IMF staff estimates.

Staff projections based on the latest available EDP figures and the authorities’ updated SGP figures.

Structural balance calculated using staff’s estimate of the output gap.

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.

Calculated using the staff’s estimates of potential output. Asset sales, including UMTS receipts, the transfer of pension funds and securitization are netted.

Table 4.

Portugal: Medium-Term Scenario

(Changes in percent, unless otherwise indicated)

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Sources: National Statistics Office (INE); and IMF staff estimates and projections.

As projected in the World Economic Outlook, April 2007.