Statement by Andrea Montanino, Executive Director for Portugal and José Cardoso, Advisor to Executive Director, June 12, 2013

Portugal's program implementation is on track despite difficult economic conditions and significant legal challenges. The markedly weaker economic outlook provides a strong case for recalibrating the program’s fiscal targets. This strong adjustment effort needs to be consolidated by sustained fiscal structural reforms. Continued vigilance is warranted to secure financial stability. A more competitive economy for sustainable recovery requires addressing nominal rigidities forcefully. Program success also hinges on continued external support and effective crisis management policies at the euro area level.

Abstract

Portugal's program implementation is on track despite difficult economic conditions and significant legal challenges. The markedly weaker economic outlook provides a strong case for recalibrating the program’s fiscal targets. This strong adjustment effort needs to be consolidated by sustained fiscal structural reforms. Continued vigilance is warranted to secure financial stability. A more competitive economy for sustainable recovery requires addressing nominal rigidities forcefully. Program success also hinges on continued external support and effective crisis management policies at the euro area level.

1 - Overview and Fiscal Policy

We welcome the IMF staff report on the seventh review and, in particular, the recognition of the progress made under the adjustment program.

The strong implementation of the program has resulted in a progressive correction of the macroeconomic imbalances in the Portuguese economy. Fiscal consolidation has continued, as indicated by the improvement of the primary structural balance, from -6% of GDP in 2010 to a surplus of 0.2% in 2012. In addition, the current and capital account balance turned positive in 2012, which constitutes a major correction relative to the deficit of 9% of GDP in 2010. As a result, the Portuguese economy turned from a net borrowing position to a net lender, thus creating conditions to reduce the accumulated external debt. In terms of financial developments, the deleveraging process has continued and financial stability has been preserved.

At this stage of the program, conditions have become more challenging, in particular due to the weakening of external demand, the rising level of unemployment and the demanding task of implementing the deep reforms in the functioning of the State implied by, but not limited to, the Public Expenditure Review (PER). Priority should be given to restart growth and create employment, and achieve a broad political and social consensus on the program going forward.

Fiscal consolidation is going to proceed as indicated in the medium-term budgetary strategy document published at the end of April. During the seventh review, the authorities agreed with the mission to revise the fiscal deficit targets upwards to 5.5% in 2013 (from 4.5%), 4.0% in 2014 (from 2.5%) and 2.5% in 2015 (from 2.0%). This revision was based on the notion that the fiscal adjustment should be achieved in structural terms and, as shown in the IMF report, the new targets deliver the appropriate fiscal correction over the medium-term.

The focus on structural balance is important to take into account the social and economic costs of the adjustment. In practice, however, it is challenging to achieve the appropriate pace of consolidation. Indeed, the implementation of excessive austerity measures can generate negative confidence effects that could result in detrimental macroeconomic implications, thus creating risks to the fiscal adjustment. It is precisely to avoid these risks that the nominal targets of the program have been changed twice (the first time during the fifth review). It should be noted that such changes took into account the debt levels and the financing conditions of the sovereign. It is the authorities’ view that the improvement in financing conditions that the Treasury has enjoyed in recent periods, as illustrated by the 10-year bond issuance in May 2013, has created the necessary room for the adjustment of the fiscal targets without adversely affecting market access. On the contrary, there is clear evidence that the recent adjustments in the deficit targets have been well received by market participants, thus reinforcing the idea that, within certain limits, having a smother but more credible fiscal adjustment path could even be conducive to an improvement in financing conditions for the sovereign even if the debt level is somewhat higher.

Going forward, it is the authorities’ view that further room for allowing automatic stabilizers to work should be considered in case economic activity disappoints, taking into account the financing conditions of the sovereign.

As mentioned in the staff report, the Constitutional Court ruling of April 5 implied that the government had to identify new measures to make up for a fiscal gap in 2013 of about 0.8 percentage points of GDP in order to complete the review. This was done in the supplementary budget which was submitted to Parliament on May 31.

As regards the broad exercise of the PER, while some of the measures identified were already included in the 2013 budget, the bulk of the measures will be taken in 2014. The government has initiated contacts with the Social partners regarding the structural changes in the Public Administration. The legislative acts on the PER legislative measures are well on track to meet the structural benchmark deadlines in the MEFP. The provision that measures may be replaced by other measures of equivalent value and quality provides important flexibility not only to address eventual Constitutional risks of the measures but also to provide room for achieving political and social consensus.

2 - Economic Activity

According to the Portuguese national institute (INE) data for 2013Q1, the quarterly GDP rate of change was -0.4% (-4% y-o-y), indicating a slowdown of the recession compared with the last quarter of 2012 (-1.8% q-o-q). The GDP figures in 2013Q1 are close to the euro area average (-0.2% q-o-q) and the fall is milder than in other euro area countries. Figures for the second quarter generally suggest some improvement relative to the first quarter.

The IMF staff report states that while important progress has been achieved in implementing structural reforms in labor and product markets, progress on price-competitiveness has so far been modest. While the Portuguese authorities remain fully open to new proposal to tackle barriers to competitiveness, the evolution of the external adjustment process seems to contradict the assertion that lack of price competitiveness gains is a major obstacle to the external rebalancing of the Portuguese economy. In fact, markups in both tradable and nontradable sectors have been declining, but a steeper decline has been experienced in the latter. In addition, unit labor costs have also been declining, thus resulting in competitiveness gains. To this end, the government believes that the labor reforms that have been put in place (and some still undergoing) have played an important role, by providing companies a broader set of tools to improve their competitiveness and to adjust to market cycles. We note furthermore, that the full effect of supply-side reforms is not immediate, as demonstrated by various past comparative analyses, also by the IMF.

It is difficult to assess whether the nominal adjustment that has been witnessed has occurred at the appropriate speed or if a faster adjustment would have been preferable. Nevertheless, it seems that, besides issues related to price competitiveness, the removal of past incentives for the maintenance of strong domestic demand, such as easy access to credit and expansionary fiscal policies, is a major force explaining the rebalancing. As the conditions that allowed the accumulation of imbalances before the sudden stop are unlikely to return soon, the external adjustment can be expected to proceed while prices and wages continue their gradual nominal adjustment. Thus, although part of the adjustment may be cyclical, a large part is likely to be structural and thus more sustainable.

3 - Initiatives to Promote Growth

Creating the conditions for a resumption of economic growth is a key concern of the government. In this regard, the government has recently taken several measures aiming at reducing financial constraints and providing incentives to promote investment. The government decided to provide a temporary and targeted investment tax credit in Corporate Income Tax (CIT), in order to boost investment. The benefit will amount to 20% of the investment made, with a limit of up to 70% of CIT collection. The eligible investments will have to take place between June 1 and December 31, 2013. Additionally, the government is proceeding with the objective of creating a financial development institution that will propose action plans for financing and industrial development, including corporate recapitalization plans and a wide range of financial instruments. It is expected to be fully operational in 2014. The government is reviewing the commercial paper legal framework to facilitate the expansion of the market. The aim is to diversify the current financing alternatives for firms, in particular for SMEs. Government guaranteed credit lines will be reviewed aiming at enhancing their effectiveness. Finally, the government approved a VAT Cash Accounting Scheme, to be operational in October, whereby businesses can now account for VAT on the basis of payments received and made (rather than tax invoices issued and received), thus helping reduce firms’ liquidity needs.

The reduction of financial constraints in the Portuguese economy is linked to the access of the sovereign to the financial markets. In this regard, the process of returning to full market access by the sovereign should be seen as part of the strategy for growth. Conditions in the bond markets improved significantly, and therefore the Portuguese State was able to take another important step to regain full bond market access on May 7th, issuing a new 10-year bond line which follows a previous tapping of an existing bond maturing in 2017. The issuance was very successful, attracting strong demand from abroad and with a composition of investors more tilted to longer-term investors that can provide a more stable investor base.

Other initiatives are being studied. The Memorandum for “Growth, Employment and Industrial Development” specifies the intention of the government to put a strong emphasis in improving financial conditions for viable firms, namely those who have an orientation for the tradable sector.

4 - Financial Sector Policies

The Portuguese economy is going through a long and encompassing adjustment process. Unlike other countries severely hit by the global financial crisis, the Portuguese financial sector was not at the centre of the tensions, having remained broadly resilient throughout the global turmoil. Nevertheless, the Portuguese banking system is not insulated from the major adjustment process of the economy. During the last two years, the banking system underwent substantial changes, visible in a widespread strengthening of core solvency ratios, a significant improvement of the liquidity situation, a consistent reduction of leverage, improved transparency and a stronger regulatory framework. Profitability has been hurt by the deterioration of the economic situation, low money market rates and the need to deleverage. Restoring adequate bank profitability and improving the financial autonomy of the corporate sector are the major challenges going forward.

Core solvency ratios of Portuguese banks improved markedly during the last two years, thus improving the system’s loss absorption capacity and reinforcing its financial strength. In December 2012, the average Core Tier 1 ratio of the Portuguese banking system stood at 11.5%, increasing 2.8 percentage points since December 2011. This significant increase reflected mainly the capitalization operations of the main banking groups during the first half of the year. More specifically, three of the main banking groups issued hybrid instruments eligible as Core Tier 1, subscribed by the State, amounting to nearly €5 billion. In the second half of the year, two banking groups increased their regulatory capital. At the end of 2012, seven of the eight largest Portuguese banking groups had a Core Tier 1 ratio above the 10% goal defined in the adjustment program. The remaining institution was recapitalized in January 2013, thus restoring required solvency levels.

The liquidity indicators of Portuguese banks have generally improved during the last year and the collateral buffers available for Eurosystem’s financing operations were strengthened. The new platform for interbank unsecured lending developed by Banco de Portugal, which started operating in September 2012, is working smoothly, facilitating the redistribution of liquidity among domestic banks. Furthermore, amidst improved market sentiment, there was a gradual decrease of banks’ risk premia, with some banks regaining access to senior medium term debt markets. Nevertheless, it is premature to consider that banks’ access to wholesale debt markets is normalized, as the volumes issued are relatively small, while the spreads remain at historically high levels. This evolution has occurred in a context in which household deposits continue to display a significant resilience, observed since the onset of the financial crisis, even taking into account that recent developments in capital markets have been favorable to the investment of savings in alternative products. Reference should also be made to the very pronounced reduction in interest rates on new deposits, following the very high levels attained in the second half of 2011 which motivated prudential initiatives from Banco de Portugal, aimed at curbing aggressive practices susceptible of harming the whole system.

Bank profitability has been under significant pressure. Impairments have increased as a result of the ongoing recession. Net interest income is also under downward pressure as a result of several factors, namely the current low profitability of the residential mortgages portfolio, contracted in the past at fixed spreads; the persistence of high funding costs, namely in the deposit base and in hybrid instruments; and the low level of short term interest rates, which compresses the margin associated to sight deposits. Bank profitability is also affected by high operational costs in a context of lower demand for financial services over the medium term.

In a context of high risk perception by banks, the reduction in bank lending was consistent with the ongoing deleveraging of the resident non-financial private sector and the structural adjustment of banks’ balance sheets to a more sustainable financing structure. Debt levels in the case of households have been on a declining path since 2009, while the indebtedness levels of non-financial corporations remain very high, both from a historical viewpoint and in comparison to other countries in the euro area. Against this background, it is critical to balance the need to deleverage in the financial and non-financial sectors with the need to ensure that the most productive and competitive sectors of the economy retain access to finance. While some firms are over-indebted and need to significantly strengthen their financial autonomy, others need access to funding to invest in productive and viable projects and, in many cases, to export. This difficult balance is being closely monitored by Banco de Portugal. In the context of a contraction of activity in 2013, credit risk will continue to materialize and banks will need to maintain a prudent policy to recognize the ensuing losses. To address this issue Banco de Portugal issued an Instruction aimed at identifying the level and dynamics of restructured loans in the banks’ balance sheets. Going forward, the reduction of the level of risk perception by banks will be instrumental to revive lending flows to the private sector.

Banco de Portugal has implemented several measures over the last few years to strengthen the confidence in the Portuguese banking system and ensure that it continues to perform its vital intermediation function. Under the adjustment program, larger banks regularly submit funding and capital plans, which are thoroughly assessed, and quarterly stress-testing exercises have been implemented. The supervisory function of the Bank was enhanced in several dimensions, including a reinforcement of the resources involved in on and off-site supervision and the implementation of thorough asset quality review programs. The monitoring of developments of the delinquency in the loan portfolio is a particularly important concern at the current juncture. In this regard, it is worth emphasizing that, although credit in default and non-performing credit are climbing to successively higher levels, in particular in the case of loans to non-financial corporations and to households with purposes other than for the acquisition of housing, new episodes of default are stabilizing, when assessed in terms of flows. In 2012, Banco de Portugal implemented a thorough assessment of credit portfolios related to construction and commercial real estate exposures. In 2013, further inspections will be implemented, focusing on impairments recorded by the main banking groups and on credit risk management practices. Going forward, the use of macroprudential instruments will be particularly useful in mitigating the future build-up of risks and in enhancing the resilience of the economy to unforeseen shocks.

The regulatory framework of the financial system was also significantly improved in the recent past. New legislation was enacted on bank access to capitalization operations with recourse to public investment; preventive early intervention and resolution; deposit guarantee schemes; or prevention and management of non-compliance situations.

In the context of the banks’ recapitalization process, the on-going negotiations with the European Commission (DG-Competition) must ensure that the banks’ restructuring plans are implemented such that the viability of the individual institutions is not put at stake and that the overall process does not raise systemic effects jeopardizing financial stability and the regular financing of the economy.

Overall, the thorough asset quality reviews already undertaken, the strengthening of supervisory practices and the improvement of the regulatory framework have placed the Portuguese banking system on a favorable position to address the challenges posed by the creation of the Single Supervisory Mechanism.

5 - Structural Reforms

The government remains fully committed to its structural reform agenda, key in boosting the growth potential of the Portuguese economy. Proof is the regular introduction of new policy initiatives, such as a more ambitious agenda in the area of licensing and new programs of legislative simplification. The IMF report provides a description of the main measures being taken.

In what concerns the product market reforms, measures with a view to reduce costs in the use of ports were discussed. Namely the reduction of 20% of the port cargo tariff (TUP-Carga). The government is committed to this process of fostering export competitiveness through potential further reductions and by ensuring that the savings gained from the implementation of the new port labor law trickle down.

In the health sector, we continue monitoring all measures of cost control, rationalizing supply and implementing operational improvements. Following difficult negotiations with the pharmaceutical industry, we were also able to achieve the objective of limiting spending on drugs to 1.25% of GDP. The main objectives for the reorganization and rationalization of the hospital network were presented and the government remains committed to this endeavor, which will produce significant savings. Measures such as the compulsory e-prescription, changes in pharmacies’ margins, in international reference price system and in pricing of generics, continue to yield results. The approval of the new list of countries of reference for pharmaceutical pricing is expected to yield circa 7% in savings.

We reaffirm our commitment to continue with the privatization program which we consider an important tool for opening up the Portuguese economy and attracting new investment that will increase Portugal’s competitiveness in the medium-term. As such, the government is working to ensure that binding offers for companies such as CTT (postal company) and EGF (waste management) are received by the end of 2013 and the privatization of TAP (airline company) is launched during this year. Furthermore, the restructuring of Águas de Portugal is underway with a view to establishing a concession in 2014.

As stated in the report, reforms to improve the efficiency of the judicial system continue to progress well. In fact, the Code of Civil Procedure was already approved by the Parliament in April 19, 2013 and subsequently submitted to the President of the Republic to be promulgated.

We are committed on implementing the initiatives to tackle excessive licensing procedures, regulations and other administrative burdens to remove the bottlenecks to growth and to cut companies operating costs.

Portugal: Seventh Review Under the Extended Arrangement and Request for Modification of End-June Performance Criteria—Staff Report; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Portugal
Author: International Monetary Fund. European Dept.