Statement by Carlo Cottarelli, Executive Director for Portugal and Ines Lopes, Advisor to Executive Director, January 23, 2015

The three year Fund-supported program that expired at end-June 2014 succeededin stabilizing Portugal’s economy and restoring access to sovereign debt markets. Following the deep downturn of 2011–12, the economy has expanded in six of the last seven quarters, albeit at a moderate pace. The cumulative fiscal consolidation over the past three years has been substantial, and the current account is now in surplus.Regained policy credibility and benign market conditions have facilitated the resumption of market access at declining yields.But private consumption is driving the recovery, while the necessary rebalancing of the economy remains elusive. With post-crisis labor slack still extensive, attaining higher growth through private investment and export-led growth continues to be constrained by high corporate debt and weak external competitiveness.Moreover, the momentum for reforms and fiscal adjustment appears to have flagged over the past six months. Notwithstanding past structural reform efforts aimed at improving competitiveness, the slow expansion despite the high labor slack suggests that the unfinished agenda is substantial. Corporate debt is also excessively high, acting as a brake on investment and job creation. While the fiscal targets for 2014 seem well within reach, significantly more ambitious expenditure reforms will be needed to comply with the government’s own medium-term budget framework.Recently regained policy credibility and benign market conditions provide a welcome but only limited window of opportunity to press ahead with necessary reforms. With elections due by October 2015, building consensus around these reforms will prove difficult in the short term. In this context, discussions focused on three key areas necessary to maintaining economic and financial stability and improving medium- term growth prospects: (i) enhancing competitiveness through further reforms to improve the functioning of labor and product markets, and making progress on corporate deleveraging; (ii) safeguarding financial sector stability in a low profitability andlow growth environment; and (iii) ensuring fiscal stability in a low profitability andlow growth environment; and (iii) ensuring fiscal sustainability against the backdrop ofvulnerable debt dynamics and large financing needs.

Abstract

The three year Fund-supported program that expired at end-June 2014 succeededin stabilizing Portugal’s economy and restoring access to sovereign debt markets. Following the deep downturn of 2011–12, the economy has expanded in six of the last seven quarters, albeit at a moderate pace. The cumulative fiscal consolidation over the past three years has been substantial, and the current account is now in surplus.Regained policy credibility and benign market conditions have facilitated the resumption of market access at declining yields.But private consumption is driving the recovery, while the necessary rebalancing of the economy remains elusive. With post-crisis labor slack still extensive, attaining higher growth through private investment and export-led growth continues to be constrained by high corporate debt and weak external competitiveness.Moreover, the momentum for reforms and fiscal adjustment appears to have flagged over the past six months. Notwithstanding past structural reform efforts aimed at improving competitiveness, the slow expansion despite the high labor slack suggests that the unfinished agenda is substantial. Corporate debt is also excessively high, acting as a brake on investment and job creation. While the fiscal targets for 2014 seem well within reach, significantly more ambitious expenditure reforms will be needed to comply with the government’s own medium-term budget framework.Recently regained policy credibility and benign market conditions provide a welcome but only limited window of opportunity to press ahead with necessary reforms. With elections due by October 2015, building consensus around these reforms will prove difficult in the short term. In this context, discussions focused on three key areas necessary to maintaining economic and financial stability and improving medium- term growth prospects: (i) enhancing competitiveness through further reforms to improve the functioning of labor and product markets, and making progress on corporate deleveraging; (ii) safeguarding financial sector stability in a low profitability andlow growth environment; and (iii) ensuring fiscal stability in a low profitability andlow growth environment; and (iii) ensuring fiscal sustainability against the backdrop ofvulnerable debt dynamics and large financing needs.

I. Overview

We welcome this first post-program monitoring staff report, including staff’s assessment of the achievements in regaining stable market access and actively managing the debt profile. At the same time, the report could have better reflected other key results achieved since 2011, notably in terms of external rebalancing and fiscal adjustment. We also feel that the repeated suggestion that the electoral cycle is hindering the reform process is inappropriate. Elections are a welcome feature of democratic regimes and should not be presented as disruptive events to reform processes.

Broadly, the economy’s adjustment process has proceeded well. Strong compliance with the Economic and Financial Adjustment Program was crucial for securing a timely return to market access and pivotal to initiate the correction of long-standing economic imbalances. While public, private and external indebtedness is still high, decisive steps have been taken to address these issues and important progress was made in strengthening the primary budget balance and current account balance trajectories. Notwithstanding the stabilization results reached thus far, the Portuguese authorities remain committed to continuing the reform process and to implementing sound policies in the post-program period so as to foster further adjustment and secure the transition to more sustainable economic growth and job creation.

II. Economic Activity

Following the turnaround in early 2013, economic recovery continued in 2014. Given the abrupt adjustment in internal demand in the early stages of the Program, consumption decisions that had been delayed for a long period have now resumed, namely regarding durable goods. The subsequent strong pick-up in private consumption and imports led to a shift in growth composition, which is likely to be of a temporary nature and triggered by improved confidence following the most difficult period of the adjustment process. Nevertheless, the external adjustment is still proceeding. Indeed, recent data from Statistics Portugal (INE) confirm that Portugal’s net lending position towards the rest of the world improved to 1.9 percent of GDP in the year ending in the third quarter of 2014, from 1.6 percent of GDP in the year ending in the second quarter. Also, exports continue to grow, albeit at a somewhat slower pace than in previous years, remaining the single fastest growing component of aggregate demand. National accounts’ data for the third quarter of 2014 show that, in year-on-year terms, Portuguese GDP grew by 1.1 percent, accelerating from 0.9 percent in the second quarter and in line with the Government’s projection of 1.0 percent for annual growth in 2014.

III. Fiscal Policy

While taking note of the risks highlighted by staff, the Government continues to stand by the fiscal forecasts underlying the 2015 State Budget, also in light of recent economic developments and the available data on 2014 budgetary execution.

Regarding 2014, the Government forecasts an overall General Government deficit of 4.8 percent of GDP (this includes some of the one off items not included in the General Government balance definition of Table 1 of the staff report) and remains confident that final data will confirm that this target has been met. Data on budgetary execution on a cash basis up to November – released after the conclusion of the IMF mission – indicates the deficit amounted to €6.42bn, confirming a €2.77bn decrease vis-à-vis the same period in 2013, due both to higher revenue and lower expenditure. On a national accounts basis, according to the latest INE data, the General Government deficit in the first three quarters of 2014 amounted to 4.9 percent of GDP, with a significant year-on-year reduction of 0.8 percentage points and in line with the Government’s annual estimate. This figure does not reflect any impact from the capitalization of Novo Banco (NB) by the Portuguese Resolution Fund. INE will revisit the decision on the treatment of this capitalization in the fiscal accounts in March, with the next regular notification under the Excessive Deficit Procedure.

The Government also reaffirms its firm commitment to respect the 2015 deadline for Portugal to exit the EU’s Excessive Deficit Procedure and maintains the 2.7 percent of GDP deficit target for this year. On this basis, economic and fiscal developments will continue to be closely monitored by the authorities so as to timely adjust the strategy if needed.

The staff report projects a larger fiscal deficit for 2015. We regard the staff’s deficit projections as too pessimistic, among other things as they do not adequately take into account the improved revenue collection efficiency resulting from the structural reforms in tax administration introduced during the Program. The staff also argues that fiscal policy will be procyclical in 2015, as the structural fiscal balance will weaken by 0.3 percent of GDP (Table 2b). In this respect, we note that staff reaches this conclusion only because to compute the structural balance, staff assumes that the potential growth rate of the Portuguese economy is extremely low, indeed negative (-0.2 percent in 2015; Table 1). In our view, the significant limitations in computing this variable in the current economic context would warrant some cautions in drawing such strong policy conclusions from this mechanistic result. For example, if the structural balance were to be computed using the medium-term potential growth rate, the structural balance would improve even in the staff’s more pessimistic scenario (and a fortiori under the Government’s fiscal projections).

IV. Financial Sector Policies

The stabilization of the financial sector was one of the main objectives of the Economic and Financial Adjustment Program that expired at end-June 2014. In fact, the program envisaged several measures to strengthen the levels of liquidity and solvency in the banking sector and to reinforce banks’ supervision. Significant efforts were made to achieve these objectives, notably by reinforcing banks’ capital ratios and by improving transparency and accuracy of valuations in banks’ balance sheets, as well as by ensuring an orderly deleveraging process.

In terms of solvency, the Common Equity Tier 1 (CET1) reached 12.6 percent in the third quarter of 2014, for the Portuguese banking system as a whole (excluding NB) - well above the regulatory minimum. In the first three quarters of 2014, the aggregate profitability of the Portuguese banking system was significantly affected by the exceptionally large losses reported by Banco Espírito Santo (BES). Excluding BES/NB, profitability would have been positive (ROA of 0.2% and ROE of 2.2%). The strengthening in net interest income, the increase in profits related to financial operations and the reduction in operating costs have contributed to this positive result. In addition, a slight decrease in the flow of impairments has been observed during this period. Despite these positive signals, we recognize that the profitability prospects remain one of the main challenges faced by the banking sector in Portugal.

The deleveraging process in the banking sector continued in the first three quarters of 2014, with the loan-to-deposit ratio falling to 107 per cent in September 2014 (excluding NB), after levels as high as 158 per cent in December 2010 and 140 per cent at the Program’s outset. Credit continues to decrease in residential mortgage market and in sectors most dependent on domestic demand, while exporting firms have been benefitting from increasing flows of credit. Deposits continue to be the most important funding source for Portuguese banks and continue to show a remarkable resilience, which was not affected during the most volatile period that followed the resolution measure applied to BES. In the third quarter of 2014, Central Banks’ financing, mostly comprised of Eurosystem monetary policy operations, decreased to minimum levels since the beginning of the Program. In particular, Eurosystem refinancing decreased by 13 percent during the third quarter of 2014 and by around 45 percent when compared with the peak recorded in July 2012. The significant reduction in Eurosystem refinancing was mostly based on the above-mentioned deleveraging process undertaken by the Portuguese banks, but also on a slight increase in market-based funding sources (essentially, secured money market funding and wholesale debt issuances).

Financial stability has been maintained despite the failure of a large and systemic banking group (BES), confirming the authorities’ capacity to intervene decisively. Making use of the resolution powers conferred upon it, Banco de Portugal has created a bridge bank (NB) and transferred thereto the majority of the business of BES, while ensuring appropriate burden sharing, in line with current EU rules and internationally accepted principles.

On October 26, the ECB published the results of the Comprehensive Assessment. The results of the AQR and the baseline scenario of the stress test (2014-2016) showed the resilience of the Portuguese banks included in the exercise and the adequacy of their capitalization levels. In both cases, all banks registered capital ratios above the 8 percent threshold. Under the adverse stress test scenario, which is deemed unlikely, the CET1 ratio projected for Banco Comercial Português (BCP) in December 2016 falls short of the 5.5 percent threshold. The institution identified a set of measures to cover the shortfall detected, which were, in the meantime, approved by the ECB.

In spite of the positive signals reflected in the improved results reported by most of the main credit institutions – an improvement partly based on a restructuring and cost containment effort – some challenges still remain, in an economic context characterized by low growth and still high levels of indebtedness in both public and private sectors. Banks’ profitability recovery must not involve excessive risk-taking, nor excessive concentration levels in certain activities or markets. It will be important for institutions to adjust their business models to a macroeconomic context that may involve low potential growth, low interest rates, and, in the specific case of the banking sector, increasing competition due to the creation of the Banking Union.

V. Structural Reforms

The authorities disagree with staff’s assessment of a loss in reform momentum and reaffirm their commitment to pursue the structural reform agenda in the post-program period.

It should first be clarified that the dissolution of ESAME (paragraph 20 of the staff report) was the expected outcome of the Program’s completion, as the entity had originally been set up to monitor and coordinate the Program’s execution. The coordination of the structural reform agenda was then transferred to the Ministry of Finance, where a permanent dedicated team closely monitors all reforms.

More generally, important measures continue to be implemented in several areas – not only after the Program’s completion, but also following the first post-program monitoring mission. The following paragraphs summarize the latest developments. They demonstrate that the implementation of structural reforms remains a key priority for the Portuguese authorities.

After the introduction of the Corporate Income Tax reform in 2014, two new tax reforms were put in place. The Personal Income Tax reform and the Environmental Tax Reform were approved in Parliament in December and entered into force, as initially foreseen, on January 1st, 2015. Altogether, these three reforms allow for increased stability and predictability of the tax system, thus playing an important role in the ongoing economic recovery.

Most of the 18 professional associations’ by-laws under review are now in the final stage of approval by the Government and are expected to be submitted to Parliament soon. Progress has also been registered in the review of regulators’ by-laws in accordance with the new framework law (Law 67/2013, of August 28th).1

It should also be noted that recent amendments to the housing lease law were a result of the recommendations of the independent Monitoring Committee established to supervise the reform. Given the magnitude of the reform introduced by Law 31/2014 of August 14th, it was necessary to perform an interim impact assessment of the law and subsequently introduce amendments, namely to improve procedures and to modify the transitional arrangements for non-residential lease agreements. In general, the strengthening of the protection of non-residential tenants reflected the need to ensure balanced rights and obligations of landlords and tenants and to protect the most vulnerable groups, while continuing to foster economic activity and employment, within the terms of the Memoranda. These adjustments did not affect negatively the goals of the Program.

The Government remains equally committed to energy sector and labor market reforms as during the Program.

Regarding the energy sector, the authorities continue to implement measures to address excessive rents, reduce the electricity tariff debt and limit price increases. The third package of measures, with an impact in all sectors (fuel, gas and electricity) is in fact already contributing to a reduction of energy prices both for corporations and households. The introduction of the new eligibility criteria and the increase in the discount applicable in the social tariff of electricity allowed a decrease in the prices paid by these beneficiaries up to 34 percent. The fuel sector is becoming more transparent and competitive with the low cost legislation and the reference prices. The Government is concluding the measure regarding the long term natural gas sale and purchase agreements (take or pay) which will lead to a decrease in the natural gas tariffs between 3 percent and 5 percent. Additionally, a review of the regulatory model was presented by the energy regulator (ERSE) in December, so as to accommodate recent developments in the legal framework and the features of the electricity market.

As for the labor market and in particular the survival period of collective agreements, the following amendments should also be noted: the minimum duration in which a collective agreement remains in-force after being denounced decreased from 18 months to 12 months (and 6 months after September 2015, depending on the social partners’ agreement) and a maximum duration of 18 months for the negotiation process was also introduced. The expiration (“caducidade”) of the collective agreement was reduced from 5 to 3 years (and, 2 years after September 2015, depending on the social partners’ agreement). Moreover, the suspension of collective agreement is now allowed, under certain conditions, by agreement of the parties (trade unions and employers associations). Collective bargaining is more dynamic due to these amendments: new contracts have been negotiated, especially on overtime work payments in line with the conditions in force during the Program as a result of the temporary measures foreseen in the Memoranda. In the last two years the number of firm level agreements has increased within the collective agreements that have been negotiated. In addition, the authorities highlight that the new option of extending agreements to the whole sector aims precisely at fostering improved collective bargaining. The existence of a sole criterion that defined a threshold of 50 percent of workers representation by employers’ associations had stalled the collective bargaining process. In contrast, the new criterion (30 percent of micro and SMEs representativeness within the employer’s association) is fostering the willingness of social partners to negotiate new collective agreements.

Regarding the minimum wage, we believe that there is no overall evidence that it has been growing persistently beyond productivity. The assessment presented by staff hinges on the specific base year chosen for the calculation, as well as on the benchmark used to assess the level of the minimum wage, namely the real GDP adjusted for working-age population, rather than (or at least together with) real productivity (see Box 2).

In conclusion, the structural transformation of the Portuguese economy arising from a wide range of reforms is not only ongoing, but also expected to continue.

1

Joining the previously approved by-law for the Transport Sector Authority (AMT), the following by-laws were recently approved by the Council of Ministers: Securities Market Commission (CMVM), Insurance and Pension Funds’ Regulator (ASF, former ISP), Communications Regulator (ANACOM) and Civil Aviation Authority (ANAC).