Statement by Andrea Montanino, Executive Director for Portugal and José Cardoso, Advisor to Executive Director, January 11, 2013

Mounting funding pressures has tipped Portugal into an acute economic crisis in 2011. The roots of the crisis could be traced to Portugal’s failure to adapt to the rigors of monetary union. With economic institutions, policies, and incentives ill-adapted to the opportunities, Portugal’s external stability risks also rose gradually. However, the current account has improved substantially with financial imbalances being corrected across private and public sectors. Fiscal adjustment also made substantial progress, while structural reforms have been progressing.


Mounting funding pressures has tipped Portugal into an acute economic crisis in 2011. The roots of the crisis could be traced to Portugal’s failure to adapt to the rigors of monetary union. With economic institutions, policies, and incentives ill-adapted to the opportunities, Portugal’s external stability risks also rose gradually. However, the current account has improved substantially with financial imbalances being corrected across private and public sectors. Fiscal adjustment also made substantial progress, while structural reforms have been progressing.

1 – Overview

We welcome the IMF staff reports. We note the broad appreciation of the efforts undertaken by the Portuguese authorities in implementing the program. Indeed the program is helping to correct the structural imbalances in the Portuguese economy, namely in terms of fiscal consolidation, indebtedness of the private sector, and external accounts.

The Portuguese authorities remain fully committed to the program while recognizing the need to address social and political tensions that are being fuelled by the prolonged recession and mounting unemployment. The authorities recognize that efforts to alleviate the costs of the adjustment are necessary, and are working towards the resumption of growth. The structural reforms foreseen in the program will contribute to improving the growth potential, but their benefits will only materialize in the medium term. In the shorter term, the possibility of providing policy stimulus to the economy is limited by the ongoing adjustment. However, easing the cost of financing of the private sector, which now is elevated, could provide a substantial stimulus going forward. This involves, inter alia, taking steps for the return of the sovereign to the financial markets at an acceptable cost. Recent market developments have been encouraging in this respect as some large firms and banks have been able to effectively access the international bond markets. The support of our international partners and progress in the resolution of the euro area crisis is playing a key role in this process. In particular, addressing the current fragmentation of financial markets which are impairing the transmission mechanism of monetary policy in a number of euro area countries, including Portugal, would have important beneficial consequences, as highlighted in the IMF report. Progress on this front would improve confidence and reduce uncertainty, thus creating a favorable environment for a turnaround in investment in the near term.

The recovery of investment also depends on the creation of a more favorable business environment. In this context, the Government is reforming the Corporate Income Tax that should be aligned with international best practices. The broad objectives of the reform will be discussed with the troika during the 7th review and will be implemented towards the end of the year. By making the system more efficient and expanding the tax base, this reform should lead to lower effective tax rates on corporations in 2014.

More generally, the authorities recognize that, although the budget consolidation is excessively tilted to the revenue side in 2013, the expenditure review under way should allow for a rebalancing of the program in 2014 so that the fiscal consolidation will be achieved mainly via expenditure reduction. The expenditure review should lead to savings that will allow some room for lowering the tax burden that will be positive for growth in the medium term. Indeed, a moderate recovery in economic activity is forecasted for 2014. This recovery could be reinforced by positive effects of the structural reforms that may start to be felt during this year.

2 – Fiscal Policy

While final figures on the end-2012 fiscal outturns are not yet available, it is now clear that there will be a major correction of the fiscal balance in 2012. This is not apparent in the headline figures as the deficit will rise from 4.4 percent of GDP in 2011 (which was lower than the program target of 5.9 percent) to an expected 5 percent of GDP in 2012, in line with the revised target. However, it should be noted that the 2011 budget balance included around 3 percent of GDP of temporary measures, while the 2012 budget includes around 1 percent of GDP of temporary measures. A better gauge of the progress is the structural deficit which, according to the IMF staff’s estimates, will decline by 2.4 percent of GDP in 2012, after showing a reduction of 2.5 percent of GDP in 2011. This is a very significant structural adjustment that shows that the fiscal consolidation has proceeded at a good pace, even against an unfavorable and deteriorating external environment.

Since the end of the review mission, we have proceeded with the work on the expenditure review. A technical mission of the IMF was held in December to help organize the work that is now ongoing with the line Ministries. The government is promoting an open discussion with the political parties and with the civil society on the role of the state that should lead to a more consensual approach to the exercise. If necessary, some of the identified measures will be frontloaded to address implementation risks.

The government has also taken decisive steps to structurally change the fiscal framework. At year-end, the Council of Ministers approved three important law proposals that will significantly enhance public financial management in Portugal.

The first was the revised Budget Framework Law, where the government transposed the new requirements of the European fiscal framework (fiscal compact). The new law gives more prominence to the structural balance and to the correction of excessive debt in line with the Treaty on Stability Coordination and Governance in the Economic and Monetary Union. The Law proposal specifies a comprehensive set of rules that significantly enhance fiscal discipline and transparency. It requires the government to take action when the deficit or the debt deviates from given thresholds. The structural balance rule states that the structural balance cannot be less than the annual goal set in the Stability and Growth Program. In addition, until the medium-term objective is reached, the annual adjustment in the structural balance cannot be less than 0.5 percent of GDP, and the growth rate of public expenditure, net of extraordinary measures on the revenue side, cannot exceed the reference rate medium-term GDP growth potential, as defined in the Stability and Growth Program. In turn, the debt rule implies that when the debt ratio, corrected by the cycle, is above 60 percent of GDP, the gap between the actual debt ratio and 60 percent needs to be reduced at a rate of 1/20th per year on a three-year average.

The second and third draft laws approved in December were the local and regional finance laws. The new legislation will enhance the fiscal discipline of these sectors, which in the past have been an important source of budgetary slippages. With the approval of these laws, Portugal will have completed the main legislative reforms on the budgetary framework. While constant improvement of the legislative instruments is needed, now the emphasis will be on the operationalization and enforcement of the reinforced budgetary framework.

3 – Financial Sector Policies

The Portuguese banking system has been strengthening its resilience to the challenges underlying the adjustment process of the Portuguese economy. These include the ongoing sovereign debt crisis in the euro area, against the background of an economic contraction in the area. On the other hand, the Portuguese economy has benefited markedly from the ECB’s announcement of the Outright Monetary Transactions programme, which has eased conditions in the sovereign debt markets in the euro area as well as in other financial market segments. In Portugal, this trend also benefited from the progress in the fiscal consolidation front, which is also contributing toward the improvement of international investors’ risk perception regarding the Portuguese State and systemic risk in the banking system.

The strengthening in the banks’ resilience has been materializing on several dimensions. First, banks are gradually converging to a more-balanced structural liquidity position. In particular, the liquidity position of the Portuguese banks, when measured by liquidity gaps of up to one year, has improved substantially since the start of 2012, reflecting the permanent nature of financing from the ECB over this timeframe and the reinforcement of the available collateral in the context of the new eligibility rules for monetary policy operations. Reference should also be made to the gradual reduction of the loans-to-deposits ratio implying the convergence toward a financial structure less vulnerable to liquidity shocks arising from changes in international investors’ risk perceptions. In this context, the new platform for interbank unsecured lending developed by Banco de Portugal, which started operating on September 3, 2012, is working smoothly, facilitating the redistribution of liquidity among domestic banks. Portuguese banks’ access to the international financial markets is, however, still limited. This notwithstanding some Portuguese banks have recently issued debt in the medium- and long-term international financial markets, which marks a quite favorable development in this domain.

Second, banks have been strengthening their own funds through equity market issues, capital subscribed by the State – or hybrid instruments eligible as Core Tier 1 – and earnings retention. This allowed banks to comply with the EBA’s Core Tier 1 capital requirements for end-June 2012 as well as with the solvency requirements set by Banco de Portugal for end-2012. In addition, by end-2012, a small bank resorted to the Bank Solvency Support Facility established under the Programme, amounting to €1.1 billion. A total of €5.6 billion – out of the €12 billion available in the Facility – have thus been used to capitalize private banks in Portugal. The most recent stress test exercise, conducted by Banco de Portugal in November 2012, in tandem with the quarterly Funding and Capital Plans, confirmed the resilience of all participating banks. This exercise continued to reveal the importance of the capital increases carried out in June 2012, as banks were able to absorb the severe adverse scenario and yet still keep a core tier 1 ratio above 6 percent.

Third, the supervision of the banking system and the regulatory framework continued to be strengthened. Several initiatives are worth highlighting in this respect. On the one hand, with a view to discouraging evergreening of problematic loans, Banco de Portugal published an Instruction aimed at ensuring the identification in the banks’ information systems of restructured credits due to financial difficulties of the borrower. In parallel, a supervisory mechanism was put in place which requires banking institutions to report those restructured loans on a quarterly basis, therefore allowing a more accurate evaluation of the credit portfolio quality of the banking system. Banco de Portugal is currently analyzing the data received (banks were required to report historical quarterly information since June 2011). On the other hand, as part of its regular prudential supervision activity, Banco de Portugal has been closely monitoring banks’ exposures to the construction and real estate sectors, which have been particularly affected by the current macroeconomic downturn. A new On-site Inspections Programme was thus launched, aimed at assessing the adequacy of impairment levels recorded by the eight largest banking groups with regard to their exposure to the sectors in question. For the eight groups as a whole, and with reference to June 30, 2012, the Programme estimated a need to reinforce the value of impairments recorded for the exposure analyzed by €861 million, so as to reach robust provisioning levels. The estimated impact of this reinforcement on the aggregate Core Tier 1 ratio projected for end-December 2012 was negligible, and did not compromise Banco de Portugal’s capital ratio requirement of 10 percent as of the end of the year.

Finally, the deleveraging of the banking sector has continued. Since mid-2010, the loan-to-deposits ratio of the eight largest banking groups in Portugal was reduced from around 160 percent to around 125 percent. This compares with an indicative objective of 120 percent in 2014 for the banks individually considered. The decline of the loans-to-deposits ratio has been occurring in a context in which household deposits are still recording positive growth rates but, as expected, have been decelerating throughout 2012. Despite the maintenance of restrictive credit market conditions – rooted inter alia in heightened risk perception levels by banks – the evidence suggests that banks have not induced sizeable supply-side constraints on credit flows to the most dynamic and productive segments of the economy, including exporting firms. However, albeit declining, bank lending interest rates remained high, as highlighted in the IMF staff report. In addition, there is a high degree of heterogeneity in firms’ access to the credit market. In particular, the diversification of sources of financing – notably credit from non-residents and bond market issuances – is not available for SMEs. It is therefore important to safeguard that the deleveraging of the banking sector occurs in tandem with the deleveraging in the corporate sector. In this regard, authorities have been working on proposals to promote alternative sources of financing for firms. Moreover, it is also worth underlining the idea of setting-up a vehicle – in a European context – to reduce the weight of legacy mortgage credit in banks’ balance sheets. This would allow banks to immediately deleverage through a stock adjustment, without impacting the financing of the economy. Further, it would allow banks to restructure the asset side of the balance sheet and would contribute to a smoother functioning of the monetary transmission mechanism in the euro area.

4 – Structural Reforms

The government remains committed to pressing ahead with structural reforms that promote the potential growth of the Portuguese economy. The IMF report provides an accurate description of the main measures being taken.

With regard to the product market, during the 6th review the Government discussed measures that aim to reduce the costs of the use of ports which should help foster export competitiveness.

In the context of the ongoing structural reform of the labor market, and following the revised Labour Code that came into force in August, new restrictions on automatic extensions of collective agreements were set. This resolution helps to promote competitiveness of enterprises by requiring a minimum representativeness to proceed with the extension of specific conditions (for example, wage conditions) for smaller companies.

In health, we keep implementing our policy, closely monitoring all measures of cost control, rationalizing supply, and implementing operational improvements that have been approved in recent months. Measures, such as the compulsory e-prescription, and changes in pharmacies’ margins, in international reference price system, and in pricing of generics are already yielding results and will produce important savings.

An important agreement was reached with health professionals that allowed a review of the current legal framework for the organization on working time and mobility of staff. This is also a step to improve the coverage of primary care services, which will reduce the use of emergency care in unnecessary cases. We are working on an action plan for the reorganization and rationalization of the hospital network in 2013.

Upon the adoption of the new Urban Lease, Renovation Works, and Urban Rehabilitation laws, all necessary regulations have been published to allow for the extraordinary update of the rents, for the establishment of sunset clauses in all of the old lease agreements (signed before 1990), and for the extrajudicial eviction procedures for breach of contracts.

The horizontal legal framework on public professional associations was approved in Parliament, which is an important step in liberalizing the exercise and activity of highly regulated professions. The full transposition of the EU Services Directive is proceeding rapidly, whereas the transposition of the Qualification Directive has already been completed.

Following the conclusion of the independent report on the main regulatory authorities, a new regulatory architecture is being prepared with the drafting of the regulatory framework law nearing an end.

We remain committed to following the necessary reforms to have a judicial system that contributes to improving our business environment, having a faster resolution of conflicts, and reducing the backlog cases. Upon the new Insolvency Code and the new Arbitrage Law having come into force, and also the implementation of several measures to reduce the backlog of enforcement cases, new important steps were taken, with the conclusion of the new judicial map and of the revised Code of Civil Procedure, which were submitted to Parliament.

Reducing the administrative burden for companies by simplifying licensing procedures at all levels remains a priority.

With regard to the privatization process, the government successfully concluded the important privatization of the airport concession ANA. The outcome exceeded expectations and will generate overall revenue to the state of €3.08 billion. The program goal of €5 billion in privatization proceeds is thus well within reach. The TAP privatization did not go ahead as planned, as the single bidder did not present the necessary assurances required for the transaction. The government will work to launch a new tender for the privatization of TAP as soon as possible. We reaffirm our commitment to continuing with the privatization program, which we consider to be an important tool for opening up the Portuguese economy, and to bringing new investment that will increase Portugal’s competitiveness in the medium term.

5 – Final Remark

The government is fully committed to pursuing the agenda of structural transformation of the Portuguese economy in order to improve competitiveness and the potential GDP growth rate. This transformation will lead to jobs creation, sustainable economic growth, and prosperity.