Abstract
This 2009 Article IV Consultation highlights that the global economic crisis has severely affected the Portuguese economy. Output will likely contract by almost 3 percent in 2009, driven by sharp falls in exports and investment. Despite a substantial rise in unemployment to nearly 10 percent, wage growth remained brisk. Encouragingly, some signs of adjustment are emerging, as prices have fallen faster than in the euro area. Executive Directors have encouraged the authorities to prepare a credible fiscal consolidation plan that would prevent further deterioration in fiscal balances.
We thank the staff for their open, constructive, and comprehensive dialogue established with the Portuguese authorities. We consider the staff’s report to be a quality analysis of the recent developments of the Portuguese economy, as well as a thorough discussion of the economic outlook. We broadly agree with the staff’s appraisal and recommendations. However, we would like to highlight some issues and present a few comments on some specific issues.
1. Economic Overview
The economic recovery that started in late 2005, and gathered momentum in the following two years, was interrupted by the international financial crisis, but projections point to a gradual adjustment.
Real GDP growth dropped to 0.0 percent in 2008 and -2.7 percent in 2009. Although significant, the impact of the international financial crisis on the Portuguese economy was less severe than the one recorded on average in the euro area. In 2009, a positive growth differential (1.3 percent) was recorded between Portugal and the euro area—something that has not been observed since 2003—revealing the relative resilience of the Portuguese economy.
However, throughout the report it is mentioned that the adjustment of the Portuguese economy may be sudden and disruptive (most notably in paragraphs 2 and 19). Even though the report acknowledges that the most likely scenario is one of a gradual adjustment, it does not duly emphasize the reasons underlying this conclusion. Five main issues that support a likely scenario of a gradual adjustment should be mentioned: (i) the overall robustness of the financial sector in the European context; (ii) the relatively long maturities of the external debt of the Portuguese economy (issued without currency risk); (iii) the sizeable external assets held by residents, amounting to around 150 percent of GDP; (iv) the non-existence of overvaluation in asset markets, notably in housing prices; and, finally, (v) the fact that Portuguese fiscal accounts stand at a relatively median position in the European context, in particular when the respective medium to long-run sustainability is assessed. The maintenance of these factors will be instrumental in ensuring that a sudden and disruptive scenario does not materialize. This should be the case even if economic imbalances persist in the Portuguese economy.
The economic deceleration occurred during the course of 2008, but it was more incisive starting in the last quarter of 2008, with the deepening of the international financial crisis.
In 2008, the deceleration of economic activity reflected the contraction in Gross Fixed Capital Formation (GFCF) and exports, in a context of growing deterioration of demand prospects in internal and external markets. Private consumption—countering the trend of the other expenditure components—recorded a rate of change similar to that of 2007, thus continuing to show a smoothing behavior. This behavior can be explained inter alia by the increase in disposable income—associated in particular with the labor market conditions—and the maintenance of a significant rate of growth of loans to households. The GDP intra-annual growth profile was characterized by a clearly downward trajectory during 2008, which worsened abruptly and severely during the last quarter of the year, in line with the strong international financial and economic deterioration. The deceleration of GDP in the last quarter was broad-based in terms of its major components, and it is worth highlighting the strong fall in volume in GFCF and in exports of goods and services. Unlike what happened in more recent years, private consumption grew at a rhythm inferior to that of disposable income, implying, for the first time since 2002, an increase in the households’ savings rate, although not yet significant. Finally, the negative evolution of GDP per capita was marked by a negative contribution of total factor productivity, contrasting with positive contributions in the previous years.
The downturn in 2009 reflected, in contrast with 2008, a contraction of private consumption (particularly durable goods) and, as in 2008, a further decline in investment and exports.
The developments in demand reflected the high tension in the financial markets, which implied, on the one hand, a significant increase in the degree of tightening of financing conditions, namely a tightening of the criteria used by banks in the approval of new credit and an increase in risk premiums, despite the decline in interest rates in the money market. On the other hand, it may have contributed, in a large extent, to the collapse of international trade, as well as to the sudden deterioration of the economic agents’ confidence. Regarding the households’ savings rate, there was a significant increase in 2009, reinforcing the slight increase already recorded in 2008. The evolution of the savings rate may have reflected precautionary motives related to the high uncertainty associated with the magnitude and length of the financial crisis and its interaction with the economic activity, namely in what concerns the evolution of wealth and income. As in 2008, the negative evolution of GDP per capita was marked by a negative contribution of total factor productivity.
Since September 2007, year-on-year inflation has been lower than in the euro area.
Inflation, measured by the annual average rate of change in the Harmonized Index of Consumer Prices (HICP), dropped from 2.7 percent in 2008 to -0.9 percent in 2009. This led to a widening of the negative inflation differential with the euro area to -1.5 p.p. at the end of 2009. Since September 2007, inflation in Portugal has been the lowest or one of the lowest in the euro area. The negative inflation recorded in 2009 was a singular fact in the last decades. It was associated, on the one hand, with the strong recessive framework of demand at a global level, which contributed to a substantial decline in the prices of imports, in particular energy prices, and, on the other hand, with the strong contraction of domestic demand, which influenced the domestic pass-through of the decrease in prices at the international level, and contributed to the sharp decline in corporations’ profit margins.
The collapse in demand led to a strong decline in employment and to a record peak in unemployment.
In 2008 there was a small decrease in the unemployment rate (0.4 p.p.) to 7.6 percent, reflecting essentially the growth in total employment due to the acceleration of the Portuguese economy during 2007. However, the unprecedented external shocks that hit the Portuguese economy in late 2008 and early 2009 have put a heavy toll on the activity of many firms. As a result, for the first time in Portugal’s recent history, unemployment stood close to double digits, already in the third quarter of 2009 (9.8 percent), and this rate is expected to increase in 2010.
2009 recorded a fall in the net external borrowing requirements, as a percentage of GDP …
Among the reasons that contributed to the reduction in 2009 of the net external borrowing requirements (as measured by the combined current and capital account deficit as a percentage of GDP) stand out (i) the significant drop in oil prices, which led to an important improvement in the terms of trade, and consequently a reduction in the deficit of energy balance; and (ii) the reduction of interest rates, which led to a temporary inflexion in the upward trend of the income account deficit through its effects on debt service. An increase of the borrowing requirements of the general government sector was observed in contrast to a significant decrease in the borrowing requirements of the private sector, both by corporations and by households. The increase in borrowing requirements of the general government sector reflects—in the current context of a steep decline in economic activity—the growth of expenditure above nominal GDP growth, and the sharp reduction of tax revenues.
… but far from enough to reverse the continuous deterioration of the net international investment position.
Indeed, the high net external borrowing requirements recorded over the last decade have had the effect of a progressive deterioration of the international investment position of the Portuguese economy. The resulting debt service has absorbed progressively larger resources, directly contributing to the widening of the income account deficit. This deficit, which represented about 2 percent of GDP in 2000, reached a figure close to 4.0 percent of GDP in 2009, and is expected to increase in the near future.
However, the fact that resident sectors maintain a significant amount of external assets allows them to withstand disturbances in the international financing markets and, therefore, to sustain in the short-run a discrepancy between domestic savings and investment. Nevertheless, the possibility of a prolonged adjustment allowed by this significant amount of external assets does not eliminate inevitable inter-temporal solvency restrictions that will become active in a more or less distant future.
Portugal has revealed in the past the capacity to diversify exports.
Before the crisis, the Portuguese economy was revealing a deepening in the integration in global trade flows. This evolution was evident in very important structural indicators: first, the degree of openness of the Portuguese economy (measured from the joint weight of exports and imports on GDP), rose again significantly; second, the structure of goods exports by geographical area, in nominal terms, continued to reflect the growing weight of non-EU markets, in particular the Angolan market; and finally, buoyant exports of services are particularly noteworthy (with nominal growth exceeding growth in the euro area), showing an important development in the comparative advantage of the Portuguese economy.
The mention in Box 1 of the staff s report that “one of the key risks for Portugal’s growth outlook” relates to the economic outlook for Spain seems somewhat overdone. Even though the idiosyncratic Spanish economic dynamics is undoubtedly important for Portugal, it is worth mentioning that this importance is second-order compared to the impact stemming from the global economic and financial outlook—which, to be sure, should also impact the Spanish economy in general equilibrium. Actually, the simulations using the 3-country version of the GIMF model presented in that Box confirm this assertion. The baseline results for the model suggest a very minor general equilibrium effect on the Portuguese economy stemming from a 1 percent GDP decline in the Spanish GDP. Only when confidence effects are factored in is this impact magnified. However, the calibration of these confidence effects is naturally ad-hoc and would depend on the underlying shock driving the GDP decline in Spain—a fact that is overlooked in Box 1. Moreover, from a medium-run perspective—and given the high degree of financial and economic integration of the Portuguese economy—a further diversification of Portuguese economic links toward other destinations (something that actually was already taking place before the crisis) is expected.
2. Fiscal Policy, Economic Stimulus, and Exit Strategy
The “impressive fiscal consolidation achieved between 2005 and 2007”, as assessed by staff, …
In September 2005, the Council of the EU decided that Portugal was in excessive deficit and addressed recommendations (with a view to bringing the situation of an excessive deficit to an end by 2008 at the latest). Following a successful fiscal consolidation, the general government deficit declined significantly from 6.1 percent of GDP in 2005 to 3.9 percent of GDP in 2006, and to 2.6 percent of GDP in 2007, therefore below the 3 percent of GDP reference value of the Stability and Growth Pact. During this consolidation process, there was only one marginal one-off operation (related to the renegotiation of a long-term concession for the exploitation of a dam) worth 0.1 percent of GDP in 2007. The structural balance (the cyclically-adjusted balance net of one-off and other temporary measures) improved by some 2 p.p. of GDP in 2006, followed by a further improvement by about 1 p.p. of GDP in 2007, thereby well beyond the fiscal efforts recommended by the Council of the EU (defined as 1.5 percent of GDP in 2006 and of, at least, 0.75 percent of GDP in 2007).
Based on the outcome already achieved in 2007, the decision of the Council of the EU that Portugal was in excessive deficit was abrogated in June 2008, one year before the deadline. In 2008, and despite the drop in economic growth from almost 2 percent in 2007 to 0.0 percent, the fiscal deficit stood at 2.7 percent of GDP, although with recourse to temporary measures (around 1 percent of GDP).
On a long-term perspective, Portugal was among the Member States with the highest expected increase in population ageing-related expenditure in the 2005-2050 period. However, as a result of the reforms in public pension systems in 2006, Portugal was reclassified in October 2007 from a high-risk country to a medium-risk country concerning the sustainability of public finances.
… allowed some fiscal room for maneuver to introduce, in the context of the international crisis, stimulus measures in 2008 and 2009.
As staff mentioned in the report, the “recent consolidation helped the public finances enter the crisis in a relatively strong position by historical standards”. In response to the economic downturn, Portugal adopted a number of discretionary measures, in particular in the context of the European Economic Recovery Plan (EERP). The fiscal stimulus measures were essentially timely, targeted, and temporary.
The measures focused on social protection to the most vulnerable groups of the population, including the employability of young and old workers through a targeted lowering of social contributions in 2009; an increase in public investment mainly based on the modernization of schools; the incentive to investment by means of a tax credit in 2009; and the enhancing of competitiveness and support of exports by backing some specific credit and insurance market mechanisms. All these measures were taken in the context of the EERP and on top of a number of other separate measures that had already been announced by mid-2008—and included in the 2009 State Budget—to support households and firms. Already in March 2008, the Government had announced a reduction of the standard VAT rate by one p.p. from 21 percent to 20 percent from July 2008 onwards.
The expansionary fiscal stance was significant in 2009…
According to the official estimates, the total cost of these stimulus measures represented 1.2 percent of GDP in 2009, which was broadly in line with other euro area countries. Combined with the impact of the recession, the general government deficit is expected to have reached around 8.0 percent of GDP in 2009, reflecting the growth of expenditure above nominal GDP growth, and the sharp reduction of tax revenues.
The major negative impact on revenues was felt on VAT (State VAT receipts dropped by 19.4 percent until November, on a public accounts basis), reflecting the downturn in economic activity, and also, although to a lesser extent, the referred cut in the standard VAT rate and some measures leading to the frontloading of refunds compared to the previous year’s pattern. Revenue from the corporate income tax has also been very negatively affected by the cyclical position of the economy (State corporate income tax receipts declined by 24.9 percent until November, on a public accounts basis).
… and it will be gradually reversed starting in 2010 contributing to the correction of the excessive deficit by 2013.
Within the framework of the Stability and Growth Pact, and following the action already taken to other euro area members earlier in the year, in November 2009 the Council of the EU decided: (i) Portugal, and eight other euro area members, were in excessive deficit and (ii) taking into account the special circumstances—associated essentially with the severe economic downturn in 2009—the deadline for the correction of the excessive deficit was set for 2013.
Accordingly, the Portuguese authorities have to ensure an average annual fiscal effort of 1.25 percent of GDP over the period 2010-2013, which is a quite ambitious challenge. The adjustment should start gradually in 2010 and should be enhanced in the subsequent years. Following the beginning of a new legislative cycle in late October 2009, the 2010 State Budget is being finalized and it will be presented to the parliament this month for approval. Subsequently, an update to the Stability and Growth Programme will also be elaborated and submitted to the European Commission.
The impact of the global crisis and the expansionary fiscal policy on public debt will be significant.
Before the global crisis, the public debt recorded in 2007 (63.6 percent of GDP) finally reversed the past growing trend. However, under the recent adverse circumstances, and also as a consequence of the expansionary fiscal policy, a significant growth of public debt is expected and unavoidable. Careful monitoring of debt levels is of the utmost importance.
3. Financial Sector
In the context of the EU, measures to strengthen the financial sector were made available.
In response to the turmoil in the international financial markets in late 2008, and as part of concerted actions with other European countries, Portugal implemented measures to (i) strengthen the financial institution’s information disclosure and transparency obligations; (ii) strengthen the guarantee of bank deposits (from EUR 25,000 to EUR 100,000 per depositor and per bank); and (iii) make available an amount of up to EUR 20 billion for the granting of State guarantees and to strengthen credit institutions’ capital (not exceeding EUR 4 billion in this latter case). Banks used this financial support in limited amounts and essentially during the peak of the crisis. For the financial markets, almost as important as actually using any financial support, is the possibility of doing so, without actually doing it. These measures had no negative impact in the fiscal accounts.
Banks have continued to perform financial intermediation in a relatively smooth way …
Portuguese banks have been able to adapt to the particularly negative context deriving from the current international economic and financial crisis. In fact, the evolution of bank lending to the non-financial private sector in 2009 was globally in line with the usual determinants governing demand for credit—interest rate and aggregate demand components. Banks even succeeded, to a certain extent, in providing for the greatest financing needs of companies against a backdrop of particularly adverse financing conditions in international markets and a sudden unexpected drop in demand, in the last quarter of 2008 and the first quarter of 2009. The banks have also been reinforcing their own funds in the context of the economic and financial crisis, particularly in the first half of 2009. The reinforcement of their capital position was particularly visible in their Tier 1 capital adequacy ratio, recording a significant concentration at around 8 percent, which corresponded to the minimum value among the main banking groups in June 2009. Most institutions have, therefore, brought forward Banco de Portugal’s recommendation to raise Tier 1 capital adequacy ratio to a value equal to or exceeding 8 percent by September 30, 2009.
… standing in a relatively favorable position in terms of profitability, liquidity, and solvency …
The main issues related to financial stability are analyzed in Part B of Section IV of the staff s report. Unfortunately the analysis does not constitute a balanced account of the vulnerabilities and mitigating factors facing the Portuguese financial sector. In fact, while the report rightly emphasizes the existence of mounting risks—mostly associated with falling profits in the context of the crisis, with increasing credit risk and with the exposure to equity risk—it does not emphasize equally the structural presence of important mitigating factors. Among these stand (i) the reinforcement of the banks’ own funds in the first half of 2009; (ii) the fact that the banks’ financing is fundamentally denominated in euro and for medium to long-term maturities; (iii) the non-overvaluation in the real estate market; (iv) the absence of a subprime segment in mortgage credit in Portugal; (v) the fact that the exposure of Portuguese banks’ asset portfolios to the complex assets that were at the core of the financial crisis is insignificant; (vi) the small weight in total credit of the most vulnerable households in terms of credit risk; (vii) the relatively moderate debt service ratio of households—despite their high indebtedness levels—due to the relatively long maturities of mortgage loans, which are predominant in total credit to households; and (viii) the recent globally favorable evolution of liquidity indicators of Portuguese banks.
This latter issue deserves further elucidation. In fact, even though the liquidity position of Portuguese banks is an important dimension of the assessment of financial stability—in particular in the aftermath of the financial crisis—the staff report is surprisingly silent on this issue. In 2009, and in line with global trends, Portuguese banks started issuing in wholesale debt markets in progressively less unfavorable conditions—namely at longer maturities (3 and 5 years)—and, in a large measure, without government guarantees. This way, the issuance of debt was again the main source of financing of Portuguese banks in 2009. Meanwhile, customer deposits remained an important source of financing for banks, with a notable acceleration of household deposits for maturities over 2 years being recorded in 2009. These are favorable developments in terms of liquidity risk, given the higher stability of these resources. This fact, coupled with the deceleration of credit, implied that the declining trend in the credit-deposit ratio, started in the second half of 2007, continued in 2009. In addition, liquidity gaps—which establish a relation between highly liquid assets and volatile liabilities—recorded an improvement in the maturities up to 3 months in the first half of 2009. The improvement in the gap up to one month was particularly sizeable, with the main banking groups recording positive gaps. In the horizon up to one year, the gap turned more negative, albeit comparing favorably with the situation before the financial crisis. This latter development is however expected to be temporary, in particular if the access to international wholesale debt markets continues to improve, which will allow the lengthening of debt maturities, in line with what has been observed in 2009.
Therefore, it is fair to conclude that the profitability, liquidity, and solvency of the Portuguese banking system currently stand in a relatively favorable position in the European context.
… and revealing a high degree of resilience even under extreme stress tests.
The balance of vulnerabilities and mitigating factors facing the Portuguese financial system has actually been assessed under particularly severe conditions in the stress test exercises undertaken by Banco de Portugal. In one of the scenarios, activity contracts 5.4 percentage points between 2008 and 2011, equity prices fall 30 percent in late 2009, and housing prices fall 10 percent throughout the projection horizon. Even under such stringent circumstances, all banks would observe the overall regulatory requirements throughout the projection horizon. This result stems inter alia from the relative resilience of the banks’ financial position to credit risk, due to the concentration of credit in household mortgages and in large firms, both of which display relatively low probabilities of default. These conclusions are alluded to, but not duly emphasized, in the staff’s report, which instead opts to focus on the vulnerabilities of the system. The sentence in bold in paragraph 33—which summarizes the section—is symptomatic of this assertion: “Financial stability has been maintained, though vulnerabilities—symptomatic of the macroeconomic imbalances—remain”. However, what the exercises indicate is that even under an extreme configuration of shocks stressing the banks’ underlying vulnerabilities, the banking system in Portugal would continue to display a high degree of resilience.