Statement by Andrea Montanino, Executive Director for Portugal and Ines Lopes, Advisor to Executive Director

This paper discusses Portugal’s Tenth Review Under the Extended Arrangement. The short-term outlook has improved and program implementation remains on track, notwithstanding another adverse Constitutional Court ruling. Stronger domestic demand is supporting a pick-up in activity and lower unemployment. The end-September 2013 quantitative performance criteria (PCs) were met, and preliminary estimates suggest that the end-December 2013 targets were also met. Risks to attaining the objectives of the program remain high. IMF Staff supports the authorities’ request for completion of the tenth review and for waivers of applicability of the end-December PCs.

Abstract

This paper discusses Portugal’s Tenth Review Under the Extended Arrangement. The short-term outlook has improved and program implementation remains on track, notwithstanding another adverse Constitutional Court ruling. Stronger domestic demand is supporting a pick-up in activity and lower unemployment. The end-September 2013 quantitative performance criteria (PCs) were met, and preliminary estimates suggest that the end-December 2013 targets were also met. Risks to attaining the objectives of the program remain high. IMF Staff supports the authorities’ request for completion of the tenth review and for waivers of applicability of the end-December PCs.

1. Overview

We welcome the IMF Staff Report on the 10th review, we particularly appreciate the stocktaking of the continuous progress in all dimensions of the Program and the recognition of the improvement in the short-term economic outlook.

The two prior actions set for the conclusion of this review, following the Constitutional Court ruling of December 19th, have been met. The supplementary budget enacting the necessary changes to the existing extraordinary solidarity contribution on pensions (CES) was approved in Parliament on February 7th (final vote). The document will be sent to the President of the Republic, who will have a maximum of twenty days to approve. The decree law on the increase in the beneficiaries’ contributions to the special health insurance schemes (ADSE, SAD and ADM) was approved by the Council of Ministers on January 30th, therefore meeting the expected date in the MEFP. The entry into force of this measure also depends on a final decision by the President of the Republic, but it is expected to be in force by March 1st. By completing these measures in the agreed timeframe, the Portuguese Government reaffirmed its firm commitment to the Program’s targets and to the fiscal consolidation effort as a whole.

Over the past two and a half years, strong compliance with the Program has translated into important progress in the adjustment and allowed for a gradual recovery of economic activity. In early 2014, signs are encouraging at several levels. On the fiscal side, preliminary results from the 2013 budget execution indicate that the 5.5% of GDP deficit target has been met by a comfortable margin. Additionally, the Treasury’s financing conditions continue to improve, with the strong downward correction in yields having paved the way for a successful issuance of a 5-year bond. Finally, monthly economic indicators continue to recover steadily, confirming that recession may have in fact bottomed out in early 2013.

While the authorities acknowledge these positive developments, they are also aware of the risks that lie ahead. Firstly, although economic activity seems to be gradually recovering throughout the euro area, uncertainty remains high. In particular, if recovery is not sustained, the performance of the Portuguese economy, which is increasingly leaning on export growth, could be strongly affected. Secondly, while Treasury bond yields in secondary markets and 5-year CDS spreads continue to decrease–standing close to mid-2010 levels–the evolution of financing conditions remains sensitive to changes in market sentiment, which could be strongly influenced by US monetary policy or the progress towards Banking Union in Europe. Finally, at the internal level, risks of future adverse rulings by the Constitutional Court do remain, namely in what relates to 2014 fiscal consolidation measures. Nevertheless, as mentioned in the Staff Report, the Portuguese Government has designed all supporting legislation so as to ensure that the adjustment effort is equitable and, thus, that the concerns previously raised by the Constitutional Court are attended to. In addition, as demonstrated–yet again–with the rapid response to the December ruling, the Portuguese Government remains confident that these challenges can be overcome by swiftly implementing compensatory measures and stands by the commitment to pursue with fiscal adjustment in the short and in the long run.

2. Economic Activity

While the structural transformation is still ongoing, the performance of the Portuguese economy seems to be gradually improving. The second and third quarter marked two consecutive quarters of GDP growth, which was underpinned by stronger domestic demand, representing an important turnaround in the economy since the beginning of the Program. Additionally, quantitative and qualitative indicators suggest that economic activity continued to recover in the fourth quarter and in early 2014.

The Portuguese authorities acknowledge that the adjustment has come at a high economic and social cost, which is most evident in the increase in the unemployment rate. Notwithstanding, recent developments seem to confirm that there is a reversion of this trend. In fact, and according to INE’s data that was only available after the closure of the Staff Report, the unemployment rate stood at 15.3% in Q4-2013, which compares with 16.9% in the same quarter of 2012 and 15.6% in the previous quarter (Q3-2013). This result also confirms that the unemployment rate has now fallen for three consecutive quarters. In addition, data from INE place the average unemployment rate in 2013 at 16.3%, which is 0.2 percentage points below the 10th review projection, and 1.1 percentage points below the combined 8th and 9th review estimate. The latter hence represents a significant downward revision in under five months and contributes to the further improvement of the short-term economic outlook.

External adjustment also continues to progress at a good pace, as Eurostat data indicate the current account balance registered a surplus for two consecutive quarters in 2013 (Q2 and Q3). The authorities are aware that the adjustment needs to advance further so as to effectively reduce the stock of external debt, but remain confident that the positive performance of exports–which now represent about 40% of GDP–will continue to underpin the correction of the external deficit.

3. Fiscal Policy

Preliminary data, which, once again, was known after the closing of the Staff Report, indicate that the 2013 General Government deficit was €7151.5 million, hence significantly below the end-December target of €8900 million. This important result derives from the solid performance of tax revenue and social security contributions and from the tight control of public expenditure.

Compared to 2012, State tax revenue grew by 13.1% (or €4212 million) in net terms, thus exceeding the estimated increase in the Second Supplementary Budget by 4.2 percentage points. More importantly, this outcome was underpinned by the growth of current tax revenue. In fact, when excluding the effect of the outperforming debt recovery scheme, tax collection still increased by 10.1%. While an important part of this result derives from the increase in tax rates, it also reflects an improvement in economic activity compared to previous forecasts, as well as important gains from the ongoing fight against tax fraud and evasion.

Social security recorded a surplus in 2013, which is partly justified by the effect of transfers from the State Budget, but also results from a 2.5% increase in social security contributions and stabilization in unemployment benefits expenditure. Contributory revenue does however include the revenues obtained through the extraordinary debt recovery scheme. Excluding this effect, social security contributions would have grown by 0.7% compared to 2012.

On the expenditure side, confirming the Government’s determination to reduce costs and promote fiscal discipline, preliminary data indicate that Central Administration expenditure stood €1260 million below the estimate included in the Second Supplementary Budget. In addition, while compensation of employees did increase by 10.4%, this reflects the reinstatement of the 13th and 14th monthly payments and higher contributions of public entities to social protection schemes. Excluding these effects, compensation of employees would have declined by 4.2% relative to 2012, mainly due to the reduction in the number of civil servants.

As for the balances of Local and Regional Administration, it should be referred that these were strongly influenced by the repayment of debt, including the settlement of arrears. Excluding these effects, both subsectors would have registered a surplus.

Overall, these results clearly prove the authorities’ determination and commitment towards fiscal consolidation effort during the Economic Adjustment Program and afterwards, with a view to effectively assure the sustainability of public finances. In addition, the 2013 budget execution also reinforces the confidence that the 4% of GDP deficit target for 2014 will be met and that the structural adjustment continues to advance so as to achieve the medium-term objective as defined in the Fiscal Compact framework.

Finally, while the level of gross public debt in 2013 has been revised upwards, it is important to acknowledge that it mainly reflects the accumulation of higher cash buffers than estimated at the time of the last review. In fact, the path of public debt excluding Central Government deposits has been revised downwards. Additionally, it is still expected that the public debt ratio will start to decrease in the current year, as foreseen in earlier projections.

4. Financial Sector Policies

The Program involved the adoption of measures aimed at an orderly deleveraging process, reinforcing banks’ capitalization, improving the accuracy of valuations in banks’ books and strengthening supervision. As a result, the banking system is now more transparent, better capitalized and has a more comfortable liquidity position. This occurred in a setting of challenging domestic economic conditions, as well as a demanding external environment. Financial fragmentation and a subdued economic activity persisted in the euro area, alongside an encompassing adjustment process in the Portuguese economy.

The core tier 1 ratio of the banking system increased further, reaching 12.2 percent in the third quarter of 2013, as compared to 11.9 percent in June 2013 (9.6 percent in December 2011 and 8.1 percent in December 2010). This occurred notwithstanding the overall negative profitability on account of compressed net interest income and high levels of loan impairments. Credit impairments were reinforced following asset quality reviews. Nevertheless, the non-performing loans ratios of some segments of the corporate sector appear to be stabilizing and coverage levels have remained broadly stable.

The deleveraging process has also further progressed, with the ratio of credit to deposits of the banking system declining from 123 percent in June 2013 to 121 percent in September 2013 (from high levels of 158 percent in December 2010). The recent decline results mainly from the reduction in credit granted, as deposits showed a year-on-year stabilization, despite the challenging juncture. Developments in credit hide important heterogeneity. In fact, the sectors displaying the highest decrease are the ones most dependent on domestic demand (domestic trade, construction and real estate development), while credit to exporting firms present a steady growth path. This is consistent with the desirable shift of resources to the most productive sectors, most notably the tradable sector.

The major challenge banks are now facing is the return to sustainable profitability levels. Domestic operations are likely to remain constrained by the low short term interest rates, weighing on net interest income, and still elevated loan impairments may continue to impact on the profit and loss account. A gradual return to profitability is expected as the projected economic recovery materializes and banks’ efforts to reduce their operational costs bear fruit.

Banks have continued to submit to Banco de Portugal funding and capital plans and stress test exercises on a quarterly basis and the stress testing framework has been further strengthened with the development by Banco de Portugal of a new top-down stress testing methodology.

Several additional initiatives will ensure that Portuguese banks are still in a better position for the Comprehensive Assessment in the context of the SSM.

First, the asset quality reviews undertaken over the last three years allowed banks to accumulate experience and apply best practices on the prompt identification of credit impairments. Banco de Portugal is preparing guidelines in order to improve the infrastructure in place concerning the recognition of losses and public disclosure of information on asset quality and credit risk management and governance.

Second, the regulation on identification and marking of restructured loans due to financial difficulties of the borrower has been amended in order to reflect even more conservative criteria. This amendment is pursuant to the fulfillment of the provisions of the draft implementing technical standards on non-performing loans and forbearance developed by the European Banking Authority.

Finally, in view of the recent developments in real estate markets, Banco de Portugal reviewed the requirements on real estate valuations and required banks to maintain a conservative stance in collateral valuations. In addition, valuations of all real estate received in lieu of payment and whose last valuation occurred before end July 2012 had to be updated.

5. Structural Reforms

The Portuguese Government remains committed to an ambitious reform agenda and to the constant and careful monitoring of its impacts.

As was recognized in the Staff Report, over the last 2 ½ years, a large number of structural measures in various areas were implemented: labor market, education, judicial system, competition & regulation, business environment, regulated professions. Currently, most measures included in the memoranda are now in place, some in its early days and others already showing concrete impact in the economy.

As we have already noted in this statement, there has been a reversal in the labor market, performance, and we believe that the implemented reforms have supported the decrease in unemployment–according to Eurostat data, from 17.7% in March to 15.4% in December 2013. These very profound changes were achieved with minimum social unrest due to the tripartite agreement, which served as a basis for the revised labor code, and was signed by the Government, all the employers’ associations and the confederation of labor unions UGT.

More specifically, in the context of employment protection, the reduction in severance payments, which entered into force on October 1st, brought the value from 30-36 days/year in the beginning of the program to a value aligned with the EU average (12 days/year). Following the proposed changes in the law regarding individual dismissals and the recent Constitutional Court ruling on specific provisions, the Portuguese Government is actively negotiating alternative options and will shortly present a new proposal to ensure that the successful labor market reform continues.

Overall, as noted in the past, the authorities’ view of the labor market is not in full alignment with the one expressed in the staff report, but we note some progress towards a convergence of views. The Portuguese Government believes that more time is needed to assess the impact of recent reforms, not only in employment protection but also in wage-setting mechanisms and in reduction of unemployment benefits, in order to guarantee the expected results in terms of job creation and enhanced competitiveness in the economy. This recommends restraint in privileging a dominant explanatory variable from the usual ones: wage rigidity, structural change, reallocation of resources, or credit constraints. More specifically, views of “persistent nominal rigidities” or “modest improvement in the overall price competitiveness” are, in the view of the Government, not supported by the data. The recent positive surprise in employment creation in a context of a still moderate recovery may suggest that reforms are starting to have some positive effect. Despite some differences in views, the authorities agree with the staff that this issue is central and that unemployment is still very high. Authorities will continue to monitor closely developments in the labor market and fine tune reforms as needed.

While reforming the labor market has been a priority, the significant changes achieved in other sectors of the economy should not be disregarded.

The competition framework and the regulatory environment have improved and several measures were taken with these purposes: the by-laws of 18 public professional associations and related regimes are being adapted to the horizontal legal framework on public professional associations; a new regulatory architecture was approved by the framework law governing national regulators, and each of the national regulators by-laws were adjusted and all drafts were submitted to IMF/EC/ECB evaluation; full transposition of the Services Directive is near completion (only 5 out of nearly 70 diplomas still need to be adjusted).

The removal of the bottlenecks of the Portuguese economy as well as the improvement of the business environment has also been targeted in the reform agenda. Several reforms were recently implemented aimed at removing excessive licensing procedures, regulations and other administrative burdens: a new Base Law of Soil and Territorial Planning, which is now in Parliament, was recently approved; the legal regime for Environment Impact Evaluation was changed in order to increase the speed of approval and reduce associated monetary and time costs and; the new fast-track applications regime for the licensing of planned investment projects was approved. A new legal regime on touristic licensing, which aims to simplify licensing procedures, as well as to reduce its related costs, was also approved. At this point in time, and in order to tackle remaining vulnerabilities, a comprehensive review and cost--benefit analysis of bureaucratic procedures of licensing with higher impact in the economy is being performed. A regulatory simplification rule–the “one-in, one-out” rule–by which the public body proposing a new regulation generating costs for business or citizens needs to eliminate existing regulations of equivalent cost is also being prepared. It should also be noted that all the foreseen reforms in the judicial system have been approved by the Portuguese Government and are under implementation.

In the energy sector, with the liberalization of both the electricity and gas market already in place, the goal of ensuring the sustainability of the National Electricity System (NES) is maintained. Adding to the measures announced in May 2012, which resulted in reductions of various types of public subsidies in the amount of €2.1 Bn, several measures have been presented (actually, two of them have already been implemented). Their aim is to address the pressures in the NES, namely the drop in demand that has resulted from lower than expected economic activity. A major new measure presented in the context of the 2014 budget was the introduction of a levy on the energy operators which will be used for fiscal consolidation purposes and for the sustainability of the NES.

The Portuguese Government considers that the privatization program was and is an important tool for opening up the Portuguese economy and attracting new investment that will increase Portugal’s competitiveness in the medium-term. Currently, the program has already surpassed the initial overall financial objective. Work is proceeding on schedule towards the privatization of EGF (Waste Management) and the decree-law for the privatization was approved in late January. Furthermore, the restructuring of Águas de Portugal is underway.

In the postal sector, following the amendment of the decree-law laying down the framework of the postal concession contract, the CTT concession contract was renegotiated and also amended, leading into the company’s successful IPO.

Lastly, in the health sector, operational improvements geared at cost control and efficiency continue to be implemented such as the publication of clinical and prescription guidelines. Following the difficult but successful negotiations with the pharmaceutical industry limiting the state’s drug expenditure in to 1% of GDP in 2013, this goal continues throughout 2014. The reorganization plans for the hospital network and the improvement of the expenditure control mechanisms so as to fully eliminate arrears in the health sector (which decreased from a monthly accumulation rate of 76 million Euros in 2012 to 34 million Euros in 2013) are being continued.