This Selected Issues paper analyzes Portugal’s export performance in 2006 and assesses whether it might augur a sustained recovery. The paper examines the factors underlying the recent export rebound, and searches for signs of fundamental changes in structures of the export industries during the last decade. It highlights the importance of labor market flexibility. Using a four-country version of the IMF Global Economic Model, the paper attempts to illustrate the benefits of labor market reform to help close the competitiveness gap.

Abstract

This Selected Issues paper analyzes Portugal’s export performance in 2006 and assesses whether it might augur a sustained recovery. The paper examines the factors underlying the recent export rebound, and searches for signs of fundamental changes in structures of the export industries during the last decade. It highlights the importance of labor market flexibility. Using a four-country version of the IMF Global Economic Model, the paper attempts to illustrate the benefits of labor market reform to help close the competitiveness gap.

III. The Importance of Labor Market Flexibility in Regaining Competitiveness27

Objective: To assess whether labor market reforms could help Portugal regain competitiveness.

Results: Theory and experience from other countries suggest that a flexible labor market is key in regaining competitiveness. Portugal’s relatively rigid labor market may thus significantly prolong the adjustment process.

Policy implications: Labor market reform can significantly increase Portugal’s output in the long-run. Employment protection is a key area to tackle. The government’s ongoing reforms in the product market would complement efforts to increase labor market flexibility and speed improvements in Portugal’s competitiveness.

A. Introduction

1. Portugal is emerging from a slump that followed the boom in the run-up to adoption of the euro. In the second half of the 1990s, a significant decline in interest rates and the prospects of faster income convergence to the level of other European countries associated with euro entry boosted domestic demand and growth. Output growth exceeded that of the euro area, allowing for a catch-up to the euro area average. The boom, however, produced some substantial macroeconomic imbalances. Household and corporate balance sheets became stretched, and pro-cyclical fiscal policy undermined public finances. Rapid wage growth persistently outpacing that of labor productivity resulted in a sustained increase in unit labor costs. Strong import growth combined with the erosion of competitiveness prompted a substantial widening in the current account deficit and a persistent loss of export market share. As a result, growth has dropped below average euro-area levels since 2001, and income convergence with the EU has reversed.

uA03fig01
Source: Eurostat1/ Compensation of employees divided by total employees (full-time adjusted if available) from national account data.

2. Various indicators suggest Portugal continues to face a significant competitiveness gap.28 While the standard methods of assessing competitiveness are subject to various shortcomings including uncertainty surrounding econometric estimates and the inability to fully incorporate all relevant country-specific factors, on balance they suggest a competitiveness gap of about 10–20 percent. The presence of such a gap is also consistent with the performance of exports. Until recently, export growth persistently trailed demand growth in Portugal’s major trading partners, implying significant export market share losses.29

Summary Competitiveness Gap Assessment

(in percent)

article image
Sources: Eurostat, OECD; and IMF staff estimates.

From IMF Country Report No. 06/386.

Staff estimates based on CGER methodology.

3. The objective of this chapter is to consider how this competitive gap may be closed given that Portugal is in a currency union. The chapter draws insights from the experiences of Hong Kong SAR and Germany in adjusting to a competitiveness shock and highlights the importance of labor market flexibility. In addition, using a four-country version of the IMF Global Economic Model (GEM), the chapter attempts to illustrate the benefits of labor market reform to help close the competitiveness gap.

B. The Importance of Labor Market Flexibility

4. The importance of labor market flexibility is well founded in economic theory.30 A flexible labor market is key to making the economy more productive by effectively and smoothly allocating labor. It enhances competitiveness by better linking productivity and wages and increases the speed of adjustment to economic shocks. Especially in the context of a fixed exchange rate (or a country in a monetary union), in the absence of nominal exchange rate adjustments and independent monetary policies, the labor market bears the brunt of any required adjustment in response to idiosyncratic economic shocks. Any adjustment must come from relative price and wage deflation vis-à-vis trading partners.

5. Experience from Hong Kong SAR and Germany illustrate how a flexible labor market is key to regaining competitiveness. Hong Kong SAR faced a large competitive shock in the wake of the 1997 Asian crisis with China emerging as a major manufacturing center and an exporting power. Similarly, Germany experienced significant cost pressures in the early 1990s as a consequence of 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. The figure below illustrates the different adjustment paths in Hong Kong SAR and Germany following their competitiveness shocks in 1997 and 1991, respectively (referred to as T in the figure below), and compares them with adjustment in Portugal since 1999 (the date of euro adoption).

uA03fig03

Comparison of Adjustment Path

Citation: IMF Staff Country Reports 2007, 342; 10.5089/9781451832297.002.A003

Sources: IFS, WEO, CEIC database, and staff calculations.

6. In Hong Kong SAR, it took about six years to achieve a real depreciation to sufficiently reduce its competitiveness gap. This involved a sharp contraction in output and employment upfront followed by sustained deflation. Hong Kong SAR’s highly flexible labor market allowed nominal wage growth to turn negative, especially in manufacturing. As a result, the real effective exchange rate depreciated by about 5 percent a year. In contrast, the adjustment was considerably slower in Germany, taking about 12 years. With less flexible labor and product markets, the real effective exchange rate depreciated only gradually at about 2 percent a year based on a sustained reduction in real wages. The comparison of two economies needs to be interpreted with some caution given that adjustment in Hong Kong SAR was eased somewhat by buoyant growth in those sectors of the economy that benefited from the growth in China.

7. The experience from Hong Kong SAR also suggests that the adjustment process can take many years even with a highly flexible labor market. Portugal has broadly followed Germany’s path but its unit labor costs of manufacturing continue to rise. With sustained increases in real wages outpacing labor productivity growth, the real effective exchange rate has barely moved. The sluggish adjustment suggests significant rigidity in Portugal’s labor market. A 10–20 percent competitive gap in this context implies the economy may be subject to a protracted adjustment phase.

C. The Flexibility of Portugal’s Labor Market

8. Recent analysis has focused on the interaction between shocks and labor market institutions to explain different adjustment processes and outcomes.31 These studies show that institutions affect not only labor market performance but also the impact of shocks and the speed of the adjustment process. Institutions that contribute to slower adjustment in response to shocks can make the impact of shocks more persistent. Research has identified a number of channels through which different institutions influence the adjustment mechanism. For example, some institutional arrangements like replacement rates and duration for unemployment benefits have a direct impact on wages and hence affect how wages respond to disequilibrium in the labor market. Other factors like employment protection legislation or active labor market policies directly affect the flows in and out of unemployment.

9. Drawing on the results of Blanchard and Wolfers (2000), a summary indicator of labor market flexibility can be calculated based on the institutional arrangements. Following U.K. Treasury (2003) and using the same eight measures of labor market institutions and their estimated coefficients from Blanchard and Wolfers (2000), the indicator is constructed as a simple linear sum of the impact from each measure:

Fi=ΣjbjXij

where i indicates a country and Xij is a measure of labor market institutions in country i, where the measures are: the replacement rate, unemployment benefit duration, spending on active labor market policies (ALMPs), employment protection legislation (EPL), the tax wedge, union coverage, union density, and union coordination.32 The measures of institutions are defined so that an increase in the measure would amplify the impact of an adverse shock to the labor market by bj. In addition, they are constructed as deviations from the cross-country average of 20 countries (EU15, the U.S., Japan, Canada, Australia, and New Zealand), thus by definition, a country with average degree of flexibility scores 0. Countries that are more (less) flexible than the average score negative (positive) value. The figure (below) sorts countries by the score and shows the decomposition by the contribution from different measure of institutions.

10. A comparison of the flexibility indicators suggests Portugal’s labor market is significantly less flexible than the average. Key measures pushing up the score are employment protection and the generosity of the unemployment benefits. Recent reform of unemployment benefit (not reflected in the indicator) that tightened eligibility criteria and introduced better link between the duration of benefit and the period of contributions may contribute to lowering the flexibility indicator to some extent. More flexible countries are the United Kingdom and Ireland with most of the variables consistently pointing to more flexibility than the average. The contribution from different measure of institutions is less uniform in most of the countries close to average, with some factors offsetting others. For example, in Denmark highly generous unemployment benefits increase the indicator but this is offset by higher spending on ALMPs which allow the unemployed to be more effectively and smoothly matched to job vacancies.

uA03fig04

Flexibility Indicator

Citation: IMF Staff Country Reports 2007, 342; 10.5089/9781451832297.002.A003

11. The results seem to be consistent with other indicators that point to higher rigidity in Portugal’s labor market institutions and regulations. The OECD ranks Portugal’s labor market as more rigid than other euro area countries, particularly reflecting stricter employment protection and difficulty in getting back to work. Similarly, the rigidity of employment index constructed by the World Bank following the methodology by Botero et al. (2004)33 ranks Portugal 51st, compared to the euro area average of 41st. While the specific ranking of countries differs depending on the indicators, on balance, they all suggest there is a significant scope for increasing labor market flexibility in Portugal.

D. Quantifying the Benefits of Labor Market Reform

12. The potential benefits of labor market reform can be illustrated using the IMF’s Global Economic Model (GEM).34 The model incorporates monopolistic competition in labor and goods markets, which means wages can contain a markup over the marginal rate of substitution between consumption and leisure, and prices can contain a markup over the marginal cost of production.35 By varying the markups in labor and product markets, the model can illustrate the macroeconomic implications of structural reform aimed at promoting competition. The paper uses a four-country version of GEM, calibrated to represent Portugal, the euro area excluding Portugal, the new EU member states (NMS), and the rest of the world (RoW).36

13. The model simulations show that large gains in terms of GDP, employment, and consumption can result from reforming Portugal’s labor market (Figure 2 and 3). Reforms are introduced by reducing markups gradually to their level in the RoW block (U.S. and U.K. equivalent level) and their impact is assessed relative to a baseline without reform. In the long-run, output would be about 7 percent higher than the baseline owing to higher employment (hours worked) and a larger capital stock. However, labor market reforms on their own result in a fall in real wages because prices do not decline in proportion with wages, as monopolistic firms extract higher rents and limit the expansion of output. This suggests that product market reforms (goods and services) are also important.

Figure 2.
Figure 2.

The Impact of Reform in Labor, Goods and Services Markets in Portugal

(Percent or percentage point deviation from Baseline; time period = years)

Citation: IMF Staff Country Reports 2007, 342; 10.5089/9781451832297.002.A003

Source: IMF GEM simulations.
Figure 3.
Figure 3.

The Impact of Labor and Product Market Reforms in Portugal

(Percent or percentage point deviation from Baseline; time period = years)

Citation: IMF Staff Country Reports 2007, 342; 10.5089/9781451832297.002.A003

Source: IMF GEM simulations.

14. Simultaneous implementation of both labor and product market reform would permanently increase real wages and would facilitate labor market reform. Product market reform, particularly in goods market, would prompt a significant increase in the capital stock, triggering higher real wages as labor becomes relatively scarce. Reform of the services (nontradable) market, on the other hand, is particularly important in the context of Portugal as lower CPI inflation would induce depreciation of the real effective exchange rate. Labor, goods and services market reforms would yield close to 20 percent in terms of GDP in Portugal. The impact would be even larger if both reforms are jointly implemented in the euro-area. Stand-alone reforms in Portugal would be associated with a sharp increase in real interest rates in Portugal, but synchronized euro area-wide reforms would lead to lower interest rates throughout the area, making the transition easier.

E. Concluding Remarks

15. This chapter suggests large gains could be achieved by increasing labor market flexibility in Portugal. The country faces a significant competitiveness gap. Experiences from Hong Kong SAR and Germany show that labor market flexibility is key in reducing such a competitiveness gap with a fixed exchange rate. Despite some improvement in recent years, an indicator of flexibility based on institutional arrangements points to significant rigidity in Portugal’s labor market compared to other euro area countries, particularly as a result of high employment protection. With more stringent labor market institutions in Portugal, the adjustment in competitiveness could still take many years. GEM simulations illustrate that substantial gains could be achieved by making Portugal’s labor markets more flexible. These simulations also illustrate how labor, goods and services market reforms, not only in Portugal but throughout the euro area, could reduce the costs and speed an improvement in Portugal’s competitiveness.

References

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27

Prepared by Keiko Honjo.

28

For methodologies, see Methodology for CGER Exchange Rate Assessments, IMF, 11/8/06, http://www.imf.org/external/np/pp/eng/2006/110806.pdf.

29

See Chapter I for more detailed analysis of recent export performance.

32

The latest available data from OECD and EIRO were used. Measures of ALMPs and union coordination are multiplied by 1 so that the increase leads to less flexibility.

33

Data and description are available online at http://www.doingbusiness.org/ExploreTopics/EmployingWorkers/

34

For detailed description and calibration of the GEM, see Bayoumi (2004) and Laxton and Pesenti (2003).

35

Labor market markup is defined by real wage = (labor market markup) * (the marginal rate of substitution).

36

Rest of the World is composed of U.S., U.K., Angola, Brazil, Singapore, Denmark, and Sweden, the main extra-EU trading partners for Portugal. Trade shares within the four blocks are based on the 2005 trade flows from the UN COMTRADE statistics.

Portugal: Selected Issues
Author: International Monetary Fund
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    Comparison of Adjustment Path

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    Flexibility Indicator

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    The Impact of Reform in Labor, Goods and Services Markets in Portugal

    (Percent or percentage point deviation from Baseline; time period = years)

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    The Impact of Labor and Product Market Reforms in Portugal

    (Percent or percentage point deviation from Baseline; time period = years)