Portugal’s economy is in deep recession, and the crisis has opened up a large output gap, with severe consequences for employment and government revenue. While the focus is on the medium- and long-term, this analysis also offers insights on how deep the output gap is. It also highlights ways in which policies and reforms can promote growth over the longer haul and suggests that achieving a 2-percent growth rate over the long term—consistent with moderate convergence growth—is a realistic objective.

Abstract

Portugal’s economy is in deep recession, and the crisis has opened up a large output gap, with severe consequences for employment and government revenue. While the focus is on the medium- and long-term, this analysis also offers insights on how deep the output gap is. It also highlights ways in which policies and reforms can promote growth over the longer haul and suggests that achieving a 2-percent growth rate over the long term—consistent with moderate convergence growth—is a realistic objective.

II. Portugal’s Competitiveness1

Portugal’s loss of external competitiveness in the run-up to Euro adoption is well documented.2 Falling interest rates led to rising investment and consumption that was not matched by productivity growth, with wages and prices rising more rapidly than in trading partners, resulting in sharply deteriorating external balances, and poor growth and employment outcomes. Since the crisis, there has been a strong turnaround in trade and current account balances with little apparent relative price change to date. This raises questions about the sustainability of the adjustment—might recent progress be reversed when the economy begins to recover? This paper assesses the evidence and considers crosscountry experience with adjustment under fixed exchange rate regimes to address this question.

A. How Did Competitiveness Get Out of Line?

1. From the mid-1990s, Portugal’s exchange rate was stabilized in the run-up to the adoption of the euro in 1999. Compared with the decade up to 1994, during 1995–98 the standard deviation of the monthly exchange rate versus the Deutsche Mark fell by half. This exchange rate-based stabilization process allowed inflation to converge to that in the country of the anchor currency in the ERM, Germany—hence, average annual consumer price inflation in Portugal fell from about 11 percent in 1985–94 to 2½ percent in 1995–99. The process of nominal convergence also facilitated steep declines in interest rates, as euro adoption bolstered commitment to permanently low inflation. This in turn led to a rise in investment and growth, and a fall in private saving.

uA02fig01

Variation in the Escudo exchange rate

(Monthly average, percent change year-on-year)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A002

Sources: Banco de Portugal; and WEO.
uA02fig02

CPI inflation

(Percent year-on-year)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A002

2. In tandem, competitiveness was declining. After a large devaluation of the escudo in the early-to-mid 1980s associated with an external crisis, there was a period of relatively strong economic growth and external balances up to 1992. Consumer price-based measures of the real effective exchange rate (REER) showed a sharp real appreciation from 1988 through 1992, possibly reflecting a correction of the previous undervaluation, as well as productivity gains and real convergence with European partners. From 1995, REER measures showed a further steady appreciation through to peaks in 2008/09, of about 17 percent on cost (unit labor cost (ULC)-based REER), and 9–12 percent on price-based (GDP deflator and CPI) measures. This latter period was however also one of generally low growth and worsening external balances. One of the ways in which erosion of competitiveness was evident is the faster increase in average compensation in Portugal (3.7 percent per year between 1995 and 2011) compared with average CPI inflation (2.5 percent). Nor was this faster increase supported by labor productivity gains, which were anemic throughout this period.

uA02fig03

Real effective exchange rate indices

(1995 Q1 = 100)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A002

Sources: Eurostat; European Central Bank; and IFS
uA02fig04

Average annual earnings in private industry and services, Euro Area

(Thousands of euros)1/

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A002

Source: Eurostat1/ Sample varies year to year. Break in series in 2008.

3. Interest rates also declined markedly in the run-up to joining the euro area, with nominal yields on 10-year sovereign debt falling from 19 percent in 1990 to 5 percent in 1999. The real interest rate fell by 5 percentage points to under 1½ percent over the same period. Real bank lending rates fell even more sharply, by 9 percentage points.

4. Put simply, as nominal convergence set in, Portugal’s external position began to deteriorate. The current account position, which had remained in broad balance after the external crisis of the 1980s, eventually reached deficits in excess of 10 percent of GDP in the late 1990s, and 12½ percent of GDP in 2008. The deterioration reflected worsening trade balances, but also the drying up of remittance flows, an important source of external financing for the economy from the 1960s through the late 1980s. Trade deficits were now financed principally through debt, with relatively little net FDI, and the deterioration in the international investment position led to income account deficits adding to deficits on the current account.

uA02fig05

Portugal: Current Account

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A002

Sources: WEO; Banco de Portugal.
uA02fig06

Portugal: IIP

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A002

5. From an investment-savings perspective, the late 1990s saw a pronounced increase in investment and a fall in private savings. Investment rose markedly between 1994 and 2000—from 24 to 28½ percent of GDP while private savings fell 7 percentage points to 17½ percent of GDP. Initially, this was rationalized as reflecting fundamental structural changes—notably access to the European single market and the pay-off from greatly reduced variability in inflation. At the time, it was believed that permanently lower inflation and nominal interest rates also provided scope for higher debt burden than in the past, allowing for the increase in investment to be accommodated.

uA02fig07

Savings-investment balances

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A002

Source: WEO

6. Productivity growth, however, was disappointing, and by 2001 GDP growth was slowing markedly. Investment was concentrated in non-tradable sectors, where average productivity growth was low (Lin and Roudet, 2012). Negative shocks from the entry of China and Eastern European competitors in Portugal’s external markets may also have played a role in worsening outcomes. With little being done to maintain competitiveness and fiscal policy remaining on an expansionary footing (with the exception of a short-lived interval in the mid-2000s), the current account deficit continued to widen to a peak of 12.5 percent of GDP in 2008. The competitiveness challenge during this period is also apparent in a trend decline in export market shares from their peak in 1996 (Amador et al, 2009). Export performance was poor, with export growth averaging around 5 percent per year from 1999–2007, compared with partner country demand of at least a point higher.

uA02fig08

Export Goods Market Shares

(Portuguese exports as a percent of total imports)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A002

Source: IMF Direction of Trade Statistics.

7. The large current account deficits were readily financed by indulgent financial markets. With returns on real sector investments disappointing, FDI inflows declined and deficits were financed with debt creating inflows. By 2005, FDI liabilities accounted for about 15 percent of total external liabilities, while portfolio debt and other investment liabilities accounted for three quarters of the total. The economic record up to the global crisis in 2008 was one of low growth, slowly rising prices and wages, stagnant or rising unemployment and deteriorating external balances.

8. After 2001, growth was sluggish. In this environment, rising unemployment should theoretically have led to falling real wages, eventually feeding through to lower export prices and restoring competitiveness. However, as noted, the steady rise in unemployment was not accompanied by labor cost adjustments, with real compensation remaining stable from 2000 onward. Policy contributed to this outcome, with real increases in public wages and minimum wages and pensions as policymakers sought to bolster demand and address longstanding social pressures under weak financing constraints. The decline in competitiveness ensured that rising trade deficits went in tandem with rising unemployment up to the global crisis in 2008.

uA02fig09

Unemployment and Real Effective Exchange Rate

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A002

Sources: INE; and Eurostat
uA02fig10

Unemployment and Current Account

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A002

Source: INE; and Banco de Portugal.

B. Crisis and External Adjustment

9. Starting in 2008, the crisis has brought about significant external adjustment. The current account deficit has already declined by 10 percentage points of GDP from its peak, largely due to an improvement in the trade balance. Adjustment has been driven by a “sudden stop” in external financing for the highly indebted private and public sectors, and has been comparable to the 1980s crisis episode, where adjustment was supported by nominal devaluation. Households and firms have increased savings to pay off debt, thereby depressing consumption, investment, and imports. Similarly, a significant fiscal consolidation has been underway leading to improvement in the current account.

uA02fig11

Portugal: Sudden Stop Financial Account Inflows

(Billions of euros)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A002

Source: Banco de Portugal
uA02fig12

Portugal: Large current account adjustments

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A002

Source: WEO

10. There is some similarity in the pace and composition of current account adjustment in Portugal, Ireland and Spain. All the periphery countries have undergone significant current account corrections since 2008, except Italy, whose starting deficit was relatively low at 3 percent of GDP. The sharp turnaround in the Portuguese current account deficit has been underpinned by an improvement in the trade balance, and in particular by strong exports and, to a lesser degree, import compression. Of the total adjustment of 10 percentage points of GDP to date, half has come from exports, 40 percent from import compression, and the remainder from transfers and the income account. This is comparable to the adjustment in Spain, where exports also account for half of the total, and Ireland, where exports are rising more than twice as fast as imports as the economy returns to growth. Among the four euro area periphery countries with significant current account adjustment to date, only in Greece has import compression outweighed export growth, explaining 80 percent of the total adjustment.

uA02fig13

Current account adjustment in the periphery Trough in 2008/09 to Q2 2012,

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A002

Source: Haver Analytics.
uA02fig14

Portugal: Trade in Goods and Services, 12-month Balance, to Sept 2012

(Billions of euros)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A002

Source: Banco de Portugal.

11. The strong export performance of recent months in Portugal is all the more impressive given the relatively weak demand conditions in many trading partners. Export volume growth from the trough in 2009 has been 22 percent, while import volumes have fallen by close to 7 percent. Two previous episodes of large reversals in the Portuguese trade deficit have also been export-led, with comparably much larger increases in export volume of around 50 percent in the first four years of adjustment. The first episode in the 1960s occurred in the context of much stronger global growth, and while global growth is similar now to that in the 1980s episode, demand in core European trade partners is weaker, and 1980s episode occurred in the context of a sizeable nominal depreciation.

12. Portuguese exports have grown across a broad range of product categories, with a marked diversification in export destinations. Within product categories, exports of fuels and lubricants have performed strongly—reflecting excess refining capacity and depressed domestic demand—growing by close to 160 percent in nominal terms from the trough. However, this still represents only 7 points of total nominal export growth of 42 percent over this period, with industrial goods and transport equipment contributing 60 percent of total growth. There has also been a steady diversification of export destinations, with the share of the total going to the European Union declining by 5 percentage points to about 70 percent. Angola, China, the US, and Brazil have all grown in importance as export destinations, albeit from small bases. One component of growth arises from reaching a critical mass of transport equipment exports to justify direct shipment to China, rather than via Germany, and thus in large part replaces one destination with another without reflecting increased production of exportable goods. However, exports to Germany have held up even as those to China have grown.

uA02fig15

Volume Growth in Goods and Services Trade

(Percent Change)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A002

Source: WEO

13. Relative price adjustment has been modest and has lagged behind the reversal in the trade balance (see Table II-1). There have been some recent declines in unit labor cost, led by productivity growth through job shedding rather than wage reductions, particularly in tradable sectors. The pattern is similar across Europe, with “core” countries also seeing exports recover from the global crisis and then exceed 2008 levels, while they have shown little change in ULC-based REER measures.

Table II-1

External Adjustment Episodes Under Rigid Nominal Exchange Rates

(Cumulative percent change unless otherwise indicated)

article image
European Commission, AMECO database; European Commission, Price and Competitiveness Project; International Monetary Fund, INS database; International Monetary Fund, WEO database; and Fund staff calculations.

For all but Hong Kong, annual real effective exchange rates vs (rest of) EA17. Data prior to 1994 is relative to EA12.

uA02fig16

Export growth and the REER

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A002

Sources: Eurostat; and Haver Analytics.

14. But is the adjustment permanent? In Portugal, the absence of a strong REER depreciation, the reliance on labor shedding, and the possible impact of economic recovery (rising demand for imports for investment and reversion to selling exportable goods in the internal market) raise questions about whether a durable adjustment is feasible. Reducing the highly negative IIP (-104 percent of GDP in 2011) will require a sustained, sizeable adjustment. In the absence of the exchange rate as a policy tool to adjust relative prices, this also raises questions about the costs of adjustment in lost output.

C. Episodes of Internal Devaluation

15. To explore these questions, ten “internal devaluations” are considered. These are episodes of significant current account adjustment, generally associated with structural reform, where nominal exchange rates were not used. They cover the cases in Denmark, Germany, and the Netherlands, where adjustment was not associated with a sudden stop in capital inflows, as well as in Hong Kong, the Baltics and the ongoing adjustments in Greece, Portugal, and Spain, where financial account pressures have been important in driving adjustment. The episodes cover the period from the beginning of the adjustment up to the time when the current account ceases to improve (a median duration of four years—see Table II-1 and Figures II-13). An important caveat is that while past adjustments were also “successful”, in a sense that the adjustment has been permanent, the same is still not known of the episodes still underway, where cyclical recovery may undo some of the adjustment. Among the key stylized facts that emerge are: (1) current account adjustment occurred without large changes in the REER; (2) outright deflation has not been a feature of adjustment; and (3) growth costs have varied, depending on external demand and economic flexibility.

Figure II-1A.
Figure II-1A.

Internal Devaluation Episodes: Sustained Declines in Relative Prices

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A002

Sources: INS; WEO; and IMF staff calculations.
Figure II-1B.
Figure II-1B.

Internal Devaluation: Limited Relative Price Adjustment

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A002

Sources: INS; WEO; and IMF staff calculations.
Figure II-2.
Figure II-2.

Cost- and Price-Competitiveness: Alternative REER Measure

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A002

Source: European Commission, Price and Cost Competitiveness Project; and IMF staff calculations.1/ Data for Netherlands and Denmark reflect a different methodology. HICP-deflated REER is not available from this source prior to 1994.
Figure II-3.
Figure II-3.

Cumulative Current Account Adjustment

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A002

Source: WEO; and IMF staff calculations.

16. Large cumulative current account adjustments have been achieved with relatively small cumulative headline price-based REER changes:

  • The median peak-to-trough depreciation in the headline CPI-based real effective exchange rates in the ten cases is just under 2½ percent—with the notable exception of Hong Kong’s 20 percent depreciation—against a median current account adjustment of 8 percent of GDP. In cumulative terms, over the full adjustment episodes, the CPI-based REER has generally appreciated, with a NEER appreciation working against a median underlying relative price decline of 2½ percent.

  • ULC-based REERs have depreciated more: the median cumulative depreciation was 5½ percent, with a median peak-to-trough depreciation of 6¾ percent, suggesting that it is relative ULCs that matter for external adjustment. However, it appears that most of the adjustment in relative ULCs was driven by labor shedding, as nominal wages rose, but unemployment increased markedly (text figure). Latvia and Greece are notable exceptions.3

uA02fig17

REER-CPI

(Percent change, data through end-2011)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A002

Source: European Commission, AMECO database; European Commission, Price and Competitiveness Project; IMF, INS database; IMF, WEO database; and Fund staff calculations.
uA02fig18

REER-ULC

(Percent change, data through end-2011)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A002

uA02fig19

Labor Market Adjustment: Nominal Wages

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A002

Source: WEO.

17. Relative price adjustment has generally been effected without the need for domestic deflation. With the notable exception of Hong Kong and Lithuania in the late 1990s, cumulative changes in consumer prices and the GDP deflator have been positive in all other cases. In the context of moderate external inflation, low domestic price growth rather than outright price declines has been enough to generate sufficient relative price adjustment.

18. The growth cost of adjustment episodes varied significantly across countries, with the following factors seeming to be at play:

  • Strong external demand has been a key factor. Rapid export growth has supported GDP growth as domestic demand has adjusted. Median cumulative export growth over the adjustment period was over 35 percent in cases that registered a cumulative rise in output, in sharp contrast to those cases where output declines have been substantial (where cumulative export growth was 10 percent). A decomposition of the current account adjustment by main components highlights that episodes with lower growth cost are export-driven, in the context of robust external demand (Figure II-3).

  • Low cost episodes are characterized by declines in the relative price component (RPI) of the REER over the adjustment episode. These also map to the successful past internal devaluations associated with structural reforms. A key factor in explaining this result may be that lower domestic inflation helped support real disposable incomes. For roughly the same median change in nominal wages (Table II-1, last two columns), efforts to contain domestic price growth have delivered still-positive real disposable income growth, which may have prevented the sharp decline in private consumption observed in cases where inflation containment has proved elusive. However, the paucity of meaningful and long-dated indicators of labor and product market flexibility limit what can be said on the role structural determinants in the cost of adjustment.

  • The low cost adjustments, and particularly those not driven by reversals in external financing, were characterized by structural reform processes, generally aimed at liberalizing labor and product markets. While part of the result is therefore explained by the absence of a financing shock, lower output losses over the medium term may also be related to scope for RPI declines, as noted above, and easier reallocation of resources across the economy.

  • Large adjustments with a high output cost are characterized by a shorter duration. This likely reflects important constraints in this specific set of case studies—adjustments necessitated by sudden stops in capital flows that do not allow for a more gradual adjustment, for example.

uA02fig20

CA Adjustments: Cumulative Output Costs and Relative Price Changes over Adjustment Episodes

(Percent)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A002

Sources: INS; and WEO.
uA02fig21

Cumulative Change in Real Wages and Unemployment Over Adjustment Episodes

(Percent)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A002

Sources: INS; WEO; AMECO; and IMF staff calculations.

D. Assessment

19. The turnaround in Portugal’s external balances in such a short time has been remarkable. To a degree, this has been brought about by the sharp curtailment in the availability of external financing since the global crisis began in 2008. After many years of low and readily available financing, the sudden stop has been an important factor behind the recession. Relative price changes, however, have lagged behind the large swing in the trade balance. With investment at low ebb and unemployment at record highs, the durability of the adjustment once the economy begins to recover can therefore be questioned. In this context, there are essentially two interpretations of the recent sharp turnaround in the external account:

  • The more benign interpretation is that the rapid reversal in the external balances is a sign of a permanent adjustment, with a strong contribution from export growth. One of the factors that had been behind the widening of the current account deficit prior to 2008 was excess domestic demand. But in the wake of the global financial crisis, debt tolerance has dissipated and financing has become durably more expensive. Consequently, both consumption and investment are henceforth unlikely to revert to previous peaks. And with both private and public sector leverage still high, both sectors are likely to maintain higher levels of savings to pay down debt. In this context, large relative price adjustments may not be necessary for the current account adjustment to endure. There has already been some adjustment in competitiveness indicators, and all that is required for the adjustment to endure is a moderate recovery in external demand.

  • A less benign interpretation of the recent current account correction, however, is that it largely reflects the presently weak domestic demand conditions. With investment and consumption subdued, not only has this meant lower import demand but also higher exports of tradable goods that would have otherwise been sold on the domestic market. A good example of the latter is the recent jump in exports of refined fuel—an almost perfectly tradable good—as domestic demand has slumped. With the relative price of tradable relative to nontradable goods not having adjusted all that much, as the economy recovers it will lead to higher imports, somewhat lesser exports and widening of the current account deficit.

20. The implications of these two perspectives in terms of the likely path of wages, prices and the real effective exchange rate are different. Under the more optimistic view, the changes in demand patterns induced by recession and (to some extent, permanently) higher financing costs underpin external adjustment. Large price and wage adjustments may not be needed, particularly if structural reform facilitates resource reallocation. The second view, in contrast, could imply a more prolonged, or a more acute, episode of wage and price adjustment (as for example in the Baltics). In this view, demand for tradables would pick up sharply with incipient economic recovery, running afresh into financing constraints generating new pressures on wages and prices.

21. While it is still too soon to draw definitive conclusions, the evidence so far appears more supportive of the first view. External financing constraints have been tight but have started to ease of late, particularly for the sovereign, with borrowing costs declining markedly in recent months. Larger corporates have also seen their access to external financing being gradually restored. Export growth has been broad-based across products and destinations, and has run ahead of partner country demand indicating market share gains from 2010 onward. While declining capacity utilization and profits since 2011 suggests firms may be substituting foreign for domestic demand rather than increasing production, by the same token there should be scope to maintain presence in foreign markets even as domestic demand recovers.

22. Previous experiences with internal devaluation also suggest large real exchange rate changes are not always necessary for permanent adjustment. As in several such successful cases, structural reforms in Portugal should bolster productivity growth over the longer run. There is some evidence that countries with relatively flexible prices—i.e. where RPI gains were possible—endured lower losses in employment and output. Favorable external demand conditions have been also been an important mitigant, an effect Portugal is mimicking, albeit partially, through diversification to relatively dynamic markets outside the euro area. Combined with lower domestic absorption of tradables, debt reduction efforts, and higher cost of external financing, these developments suggest that relatively slow gains in cost competitiveness could prove sufficient to achieve a durable external adjustment.

23. Structural reforms have an important contribution to make in allowing the adjustment to endure. Reforms contributing to greater flexibility in price setting in product and labor markets could accelerate falls in costs and real exchange rate adjustment. They could also enable a more rapid resource reallocation and productivity rises mitigating the need for aggregate falls in declines and employment. This latter point could describe the structural reform-led adjustments of some of the lower-cost episodes discussed above, such as Germany or the Netherlands, where real compensation fell modestly or not at all. In those cases, real exchange adjustment was accumulated over time with wages and prices rising more slowly than in partner countries, and the product mix shifting towards tradable goods.

References

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1

Prepared by Ivanna Vladkova Hollar and Alvaro Piris.

3

There is limited (and heterogeneous) empirical evidence of the role of cost- vs. price-based real exchange rate measures in explaining external adjustment. For example, Chinn (2006) finds that for the U.S. the sensitivity of exports to the real exchange rate is 2.3 when using the CPI-deflated measure, and smaller (0.7) when specified by unit labor costs. Lafrance, et. al., (1998) shows that real effective exchange rate indices that are computed using unit labor costs explain movements in Canadian net exports and real output significantly better than those based on consumer price indices.

Portugal: Selected Issues Paper
Author: International Monetary Fund. European Dept.