Statement by Carlo Cottarelli, Executive Director for Portugal and Ines Lopes, Advisor to the Executive Director, May 6, 2015

EXECUTIVE SUMMARY The recovery is addressing flow imbalances from past current account and fiscal deficits, but stock vulnerabilities from public, private, and external debt remain high. The unemployment rate has retreated from its crisis peak, growth has resumed, and the current account is posting surpluses for the first time in decades. At the same time, a durable rebalancing of the economy has not taken place and the nontradable sector is still dominant. The strength of the economic recovery remains modest, the labor market slack large, and there are still material vulnerabilities, notably, high leverage in the public and corporate sectors, and high external debt. Portugal is benefiting from favorable cyclical tailwinds, but growth is projected to moderate in the medium term. The initiation of ECB’s expanded asset purchase program pushed sovereign yields to record lows and effectively eliminated any remaining financing concerns. It should also help to raise inflation over the forecast horizon. A sharply weaker euro and lower oil prices have improved the short-term outlook. In the medium term, growth is projected to moderate, as several remaining challenges, notably low investment, high leverage, and structural bottlenecks still need to be decisively addressed. The authorities should use this opportunity to strengthen the economy’s resilience and raise its growth potential. Fiscal adjustment should continue, with an emphasis on expenditure rationalization by way of a comprehensive reform of public sector wages and pensions. To maintain financial stability and allow for an efficient allocation of resources in the economy, the authorities should adopt a more proactive approach led by banks to the deleveraging process. Finally, in the context of rigid labor markets and limited domestic competition, the authorities must implement additional structural reforms to absorb the large labor slack and spur economic growth.

Abstract

EXECUTIVE SUMMARY The recovery is addressing flow imbalances from past current account and fiscal deficits, but stock vulnerabilities from public, private, and external debt remain high. The unemployment rate has retreated from its crisis peak, growth has resumed, and the current account is posting surpluses for the first time in decades. At the same time, a durable rebalancing of the economy has not taken place and the nontradable sector is still dominant. The strength of the economic recovery remains modest, the labor market slack large, and there are still material vulnerabilities, notably, high leverage in the public and corporate sectors, and high external debt. Portugal is benefiting from favorable cyclical tailwinds, but growth is projected to moderate in the medium term. The initiation of ECB’s expanded asset purchase program pushed sovereign yields to record lows and effectively eliminated any remaining financing concerns. It should also help to raise inflation over the forecast horizon. A sharply weaker euro and lower oil prices have improved the short-term outlook. In the medium term, growth is projected to moderate, as several remaining challenges, notably low investment, high leverage, and structural bottlenecks still need to be decisively addressed. The authorities should use this opportunity to strengthen the economy’s resilience and raise its growth potential. Fiscal adjustment should continue, with an emphasis on expenditure rationalization by way of a comprehensive reform of public sector wages and pensions. To maintain financial stability and allow for an efficient allocation of resources in the economy, the authorities should adopt a more proactive approach led by banks to the deleveraging process. Finally, in the context of rigid labor markets and limited domestic competition, the authorities must implement additional structural reforms to absorb the large labor slack and spur economic growth.

I. Overview

We welcome the IMF staff report on the 2015 Article IV Consultation, as it provides an updated assessment of the recovering Portuguese economy and draws attention to the challenges that remain to be addressed. However, we also feel that a staff report for an Art. IV consultation – there has not been one since over two years ago – could have focused more on the remarkable progress Portugal achieved in terms of fiscal consolidation, external adjustment, market access, financial stability and implementation of structural reforms. The staff report pays relatively limited attention to these results, focusing primarily on the remaining stock imbalances. Additionally, the policy proposals put forward by staff would have benefited from a more in-depth discussion of the reforms undertaken in 2013-2014 as well as of the challenges faced in their implementation.

The authorities feel that strong compliance with the Economic and Financial Adjustment Program and the continued implementation of sound policies following its completion have been decisive in stabilizing the economy and gradually building stronger foundations for growth in the medium and long term. The authorities also acknowledge that, given the magnitude of the stock imbalances accumulated since the mid-1990’s – namely in terms of indebtedness – the adjustment process will have to continue, underpinned by the consolidation of recent results and renewed commitment for further reforms.

By their own nature, reducing stock imbalances will require time, something that the Fund has clearly recognized.1 Steady adjustment and reform, at a pace that takes into account also the need to sustain the ongoing recovery of economic activity and employment, is critical to successfully reduce remaining imbalances. But the gradual reduction of stock imbalances, in the presence of a faster adjustment of flow imbalances, should not be taken as an example of absence of adjustment. Thus, we were somewhat surprised to see that according to the Table in paragraph 8 of the staff report, progress in achieving fiscal sustainability is assessed solely by looking at the public debt to GDP ratio. The remarkable improvements in terms of budget balance, structural balance or primary balance are not considered at all.

The Government’s commitment to this strategy was reaffirmed in late April, with the formal submission to the European Commission of two key strategy documents: the National Reform Program and the Stability Program.2 In particular, these documents outline Portugal’s strategy for the next four years, in terms of policy intentions for ensuring sustainable growth and on the design of the medium-term fiscal strategy.

II. Economic Activity

The economy continues to recover steadily. Portuguese GDP grew by 0.9 percent in 2014, confirming a turnaround after three years of negative growth. Domestic demand was underpinned by the recovery of private consumption (which grew by 2.1 percent, against -1.5 percent in 2013 and -5.5 percent in 2012) and also investment (as Gross Fixed Capital Formation increased by 2.5 percent, following -6.7 percent in 2013 and -16.6 percent in 2012). This led to an acceleration of import growth (+6.4 percent), which surpassed the sustained increase in exports (+3.4 percent).

While the strong pick-up in private consumption and imports led to a shift in growth composition in 2014, the updated macroeconomic scenario of the Stability Program projects this effect to be temporary and triggered by a relevant improvement in confidence following the most difficult period of the adjustment process. According to the Government’s projections, GDP growth is expected to accelerate in 2015-2019, underpinned by positive contributions both from domestic demand and net exports, continued investment growth and a sustained improvement in the labor market.

The Government’s macroeconomic scenario does not significantly diverge from the one in the staff report for 2015 (as staff’s growth projections have been revised up since the previous PPM staff report), but prospects from 2016 onwards are more optimistic. In 2015, GDP is expected to grow by 1.6 percent. Growth should then accelerate to 2.0 percent in 2016 and 2.4 percent in 2017, maintaining a similar pace in 2018 and 2019. The unemployment rate is expected to reach 13.2 percent in 2015, down from 13.9 percent in 2014 and 16.2 percent in 2013. As this declining trend continues in outer years and employment growth is expected to remain steady, the Stability Program forecasts an unemployment rate of 11.1 percent in 2019.

The external adjustment is also expected to continue in tandem with economic recovery, with the net lending position of the Portuguese economy expected to reach 2.7 percent of GDP in 2019. In addition, the current account balance is forecast to remain in surplus, improving from 0.5 percent of GDP in 2015 to 1.4 percent of GDP in 2019.

III. Fiscal Policy

While taking note of staff’s assessment, the Government reaffirms its firm commitment to respect the 2015 deadline for Portugal to exit the EU’s Excessive Deficit Procedure (EDP). The 2.7 percent of GDP deficit target for this year is also maintained, and reinforced by the statistical authorities’ assessment that the 2014 deficit was lower than forecast in the State Budget.

According to the figures released on April 17, the 2014 General Government deficit stood at 4.5 percent of GDP (EUR 7.717 billion), falling below the 2013 deficit of 4.8 percent of GDP (EUR 8.181 billion). This result was achieved in spite of one-off items, net of which the deficit falls to 3.3 percent of GDP (against 5.1 percent of GDP recorded in 2013). In 2014, Portugal recorded a primary surplus for the second consecutive year, amounting to 0.5 percent of GDP. This result places the total correction in the primary balance between 2010 and 2014 at 8.7 percentage points of GDP.

The fiscal strategy outlined in the Stability Program demonstrates that the Government is committed to pursuing sound policies in the medium-term, so as to ensure the sustainability of public finances and compliance with the EU fiscal framework. The medium-term objective – set for Portugal as a structural deficit of 0.5 percent – is expected to be achieved in 2016, one year earlier than foreseen in the 2014 Fiscal Strategy Document. The General Government balance is targeted to improve from a deficit of 2.7 percent of GDP in 2015 – thus complying with the 3 percent EDP limit – to a surplus of 0.2 percent of GDP in 2019.

Following a near-stabilization in 2014, General Government Gross Debt is set to decline by 6 percentage points in 2015 – reaching 124.2 percent of GDP by end-December – and to continue this trend in the following years, falling to 107.6 percent in 2019. Excluding Central Administration deposits, public debt is expected to decrease from 116.5 percent of GDP in 2015 to 103.8 percent of GDP in 2019.

The improvement in the fiscal accounts recorded over the last few years critically contributed to the recovery of market access and the decline in spreads. The latter reflects a mix of several factors, including the improvements in the fiscal balance and the current account, whose relevance is somewhat underplayed in the staff report, notably in Box 2.

IV. Financial Sector Policies

While important measures have been taken during the Program, the strengthening and stabilization of the financial sector continues to be one of the main objectives of Banco de Portugal. The liquidity position of the Portuguese banks improved quite significantly. The solvency position has also improved, and significant efforts continue to be made by the Portuguese banks in this area.

In line with other sectors of the economy, the banking sector continued to deleverage during 2014, with the loan-to-deposit ratio falling to 107 per cent in December 2014 from 117 percent at end 2013. Deposits remained resilient throughout the year and Central Banks’ financing, mostly comprised of Eurosystem monetary policy operations, continued to decrease - reaching, at end 2014, minimum levels since the beginning of the Program. Credit granted by banks continued to decrease in the residential mortgage segment and in sectors most dependent on domestic demand (notably construction and real estate), while exporting firms continue to benefit from increasing positive (net) flows of credit. There is also evidence pointing to a strong competition across banks with respect to firms with a good risk profile - in 2014, the Portuguese banks have more clearly differentiated credit conditions (notably the interest rate charged) according to the risk profile of the firms. This also applies to loan volumes: the growth rate of loans granted to the firms with the lowest levels of risk increased during 2014, whereas the growth rate of loans underlying the riskiest firms continued to register significant negative values. Finally, the level of deposits and loans was not affected by the resolution measure applied to BES, thus confirming the improved resilience of the system.

In terms of solvency, the Common Equity Tier 1 reached 11.3 percent at end 2014, for the banking system as a whole – in line with average European levels. The decrease observed in the last quarter of 2014 reflected not only low profitability levels but also the revision of the actuarial assumptions followed by some banks’ pension funds, as a consequence of the general decrease in interest rates. In fact, the main challenge faced by the banking sector at the current juncture is to regain profitability. Despite the recent improvement of both return on asset and return on equity ratios, profitability remains at low for most banks. The favorable dynamics in net interest income, the increase in profits underlying financial operations and the ongoing decline in operational costs, have had a positive impact during 2014. However, the still high level of impairments, to a large extent linked with the exposure of banks to non-financial firms, continue to weigh negatively on profits.

Nonetheless, banks’ profitability recovery should 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 relatively moderate potential growth and low interest rates.

Also, the stock of NPLs is still high, especially in the non-financial corporate sector, a sector that despite the aforementioned adjustment is still characterized by high levels of indebtedness. Consequently, the stock of impairments as a percentage of gross loans is one of the highest in Europe (7.7 percent). Several horizontal inspections carried out by Banco de Portugal during the Program, as well as the ECB Comprehensive Assessment, led banks to recognize a significant amount of NPLs and to reinforce the level of impairments, contributing to safeguarding the correct assessment and accounting of credit risk.

Reconciling the need to further deleverage in a controlled way – given the still high level of debt in the economy – and the goal of promoting economic growth will be challenging. Banks will continue to have a key role in this scenario by continuing to promote the reallocation of resources towards the most productive sectors of the economy. Banco de Portugal is following this adjustment process very closely and has contributed to a strategic plan set up by the Portuguese authorities to address the still high levels of indebtedness in the non-financial corporate sector (for further details, please refer to the report of the First Post-Program Monitoring). Further measures to accelerate the deleveraging process in this sector, whose debt decreased quite significantly in 2014, and the cleaning up of banks’ balance sheets, that was reinforced from 2011 onwards, need to be assessed against (i) the impact they will have on debt; (ii) the impact they will have on banks’ profitability and, consequently, on banks’ capital ratios; and, ultimately, (iii) the impact they will have in terms of financial stability and economic growth, taking also into account the credit demand constraints still faced. In this context, one should bear in mind that, at the end of 2014, about 50 percent of non-performing loans granted to firms on banks’ balance sheet were under litigation, thus showing that the swiftness of the judicial system will be key to accelerate the cleaning up of banks’ balance sheet.

V. Structural Reforms

Structural reforms are crucial for ensuring sustainable growth, as they play a central role in increasing external competitiveness and potential growth. The commitment to implementing structural reforms was visible during the Program, with several initiatives being launched in a wide range of sectors, and remained firm after the Program’s completion, as reforms continued to be implemented and new milestones were achieved regularly, as highlighted in the staff report and thoroughly described in the National Reform Program. This medium-term strategy document includes the updated state of play of most ongoing reforms and also describes the Government’s plans going forward.

Regarding product markets, a number of reforms is ongoing and expected to be completed in a near future. In the energy sector, only two measures from the Third Energy Package remain to be fully completed. In the transport infrastructure sector, concessions for urban transportation are proceeding at a good pace: in Porto, the concession was awarded to an international company; while in Lisbon the international tender procedure should be completed by July. The privatizations of CP Carga and EMEF were approved and the process for TAP was relaunched. The merger of Estradas de Portugal and REFER was also formalized, naming the new company Infraestruturas de Portugal. In Public Administration, reforms also continue to occur at a significant pace, namely in the areas of administrative reorganization, courts’ efficiency and payment discipline. Regarding the labor market, the Government remains fully committed to implementing reforms in order to promote job creation and skills’ upgrading, while reinforcing social cohesion.

While the payoff of many of these reforms is already evident and effective, the benefits from other reforms – and new reforms – take longer to materialize. This should not be considered as a failure nor insufficiency of reform, but as a reflection of the expected time lag in full effectiveness.

1

For example, in the chapter devoted to dealing with public debt overhang of October 2012 World Economic Outlook, it was concluded that “reducing public debt takes time, especially in the context of a weak external environment”.

2

This submission occurs under the European Semester – a set of procedures aimed at enhancing policy coordination at EU levels, which is mandatory for all EU Member States which are not under an adjustment program.