Selected Issues Paper

Abstract

Selected Issues Paper

Structural Reforms to Boost External Competitiveness1

Questions, Answers, and Possible Objections

What are the specific questions this chapter tries to answer? Why does Portugal need to maintain an improved external performance on a sustainable basis? Why can such sustainability not be taken for granted and why is it necessary to keep strengthening external competitiveness? Going forward, what should be the structural reform priorities for Portugal?

Why is answering these questions important for this Article IV consultation? Portugal achieved an impressive current account turnaround in the past few years, from a deficit of 10½ percent of GDP in 2010 to a half percent surplus in 2013. While this has helped to stabilize, though at very weak levels, its external stock positions, it came with a cost of large internal slack. Nonetheless, the improved external performance still led to varying degrees of optimism: some sensed structural reforms as less urgent now, while others believed that what was still needed was time, as past reforms had already set Portugal on a right path. Being overly optimistic, however, could entail consequences – the country might face the risk of again building up external imbalances, albeit from a much weaker initial position.

What are the main answers to these questions? To help reduce its still high external stock vulnerabilities, Portugal needs to maintain its improved external performance on a sustainable basis. Such sustainability, however, cannot be taken for granted. When the economy recovers, absent continued strengthening of external competitiveness, the picking up of domestic consumption and higher investment—needed to help re-absorb the labor slack through job creation—will generate pressures that may lead to resurgence of flow imbalances. Adding to the concern is the uncertainty on competitiveness gains associated with the observed gross exports increase. The fact that Portugal continues to lag behind many of its peers and trade competitors in structural areas closely linked to exports suggests that its improved external performance might be of a more temporary nature than hoped for. Going forward, Portugal should continue structural reforms, such as further increasing labor market flexibility and enhancing competitions, to strengthen its external competitiveness.

What are the possible objections to these answers? The growth of exports observed in the past few years, and therefore the improvement in current account balance, could be of a more permanent nature. In particular, the growth of exports had been to a large extent due to a new generation of firms, an indication of past structural reforms bearing fruit.2 The dichotomy of tradable versus non-tradable sectors had become more and more obscure. It might be problematic to use manufacturing industries as a proxy for tradable sectors.

To absorb the still-large internal slack, and to reduce the very high stock of external imbalances at the same time, competitiveness gains achieved in the past few years need to be maintained on a sustainable basis. An investigation of structural factors with strong empirical linkages to external competitiveness suggests, however, that the sustainability of Portugal’s external improvement cannot be taken for granted. The country needs to continue push forward with structural reforms in a few key areas that have been identified during the program.,

A. Portugal’s External Adjustments, 2010–2013

1. Portugal achieved impressive external adjustments in the past few years (Figure 1). During the period from 2010 to 2013 Portugal’s gross exports, as a share of GDP, increased from just over 30 percent to above 40 percent. Such an increase in gross exports brought about a big turnaround in the current account balance, from a deficit of 10½ percent of GDP in 2010, largest among all the EU member states, to a half-percent-of-GDP surplus in 2013. The 11-percent-of-GDP improvement in current account balance was the biggest among all the EU economies during this period.

Figure 1.
Figure 1.

EU Member States: Changes in Gross Exports and Current Account Balances

Citation: IMF Staff Country Reports 2015, 127; 10.5089/9781475555790.002.A006

2. The improved external performance needs to be maintained on a sustainable basis, which requires continued strengthening of external competitiveness.3 Portugal’s stock external position is still among of the weakest in the world, as indicated by both its large negative IIP position and its high level of gross external debt (Figure 2). On the other hand, labor market slack, a broader measure of labor under-utilization, is still around 20 percent, compared to a level below 10 percent prior to the crisis.4 To absorb the labor slack through job creation, the economy will have to lift its growth trajectory through higher investment, which in turn requires continued improvement in external competitiveness to avoid resurgence of flow external imbalances.

Figure 2.
Figure 2.

External Positions

Citation: IMF Staff Country Reports 2015, 127; 10.5089/9781475555790.002.A006

Sources: International Investment Position Statistics (IMF), and World Economic Outlook database (IMF).

B. Why is There Concern About Sustainability?

3. Concerns on sustainability of Portugal’s improved external performance arise, in part, from the asymmetric adjustments in exports and imports. As shown in Figure 1, Portugal’s gross exports increase during 2010–13, 9½ percent of GDP, ranked only 10th among all the EU countries. Its 11-percent-of-GDP improvement in current account balance was nonetheless the largest. This indicates that part of Portugal’s current account improvement was due to import compression caused by the crisis. Once the economy recovers, imports will likely pick up, raising the risk of pushing the small current account surplus into deficit again.

4. Adding to the concern is the uncertainty on competitiveness gains associated with the observed gross exports increase. The illustrative example in Table 1 shows that, with the same observed adjustments in gross exports and imports, different changes in imports of intermediate inputs could give rise to very different pictures of real contributions by exports and imports.

Table 1.

Illustrative Example: Why Gross Exports Could be Misleading?

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5. Studying domestic value-added (DVA) exports can help to isolate the real impact of competitiveness gains on external adjustments. DVA exports exclude imported intermediate inputs from gross exports, thereby reflecting the true external demand for domestic products.5 The differentiation between DVA and gross exports is particularly important to countries where processing trade, such as oil processing and export, plays a big role.6

C. Structural Factors and DVA Exports

6. While data on DVA exports often come with a significant time lag, historical information suggests that levels of countries’ DVA exports are closely linked to a few structural factors.7 The latest DVA exports data are for 2011. Figure 3 shows that, among the EU member states, DVA exports are strongly correlated with a small set of structural indicators:

  • Degree of employment protection: The restrictiveness of employment protection reflects, to certain extent, the rigidity of a country’s labor market The top-left panel of Figure 3 suggests that countries with lower degrees of employment protection tend to export more DVA.

  • Unit wage cost gap between services and manufacturing industries: Since wages are largely driven by sectoral productivities, a bigger such gap would indicate that the development a country’s manufacturing industries is further ahead of its service sectors. Following such a interpretation, the top-right panel of Figure 3 seems to suggest that countries with more developed manufacturing industries (relative to service sectors) tend to export more DVA.

  • Intensity of local competition: More intense local competitions could help boost external competitiveness by forcing domestic producers to raise productivity and cut costs. The bottom-left panel of Figure 3 is an indication of such relationship.

  • Degree of integration with the global value chain8: This indicator can be interpreted as a composite index that captures the “gravity factors” of international trade, for instance, distance to market - countries located closer to major exporters such as Germany tend to be more integrated into the global value chain. It is clear from the bottom-right panel of Figure 3 that countries better integrated into the global value chain tend to export more DVA.

Figure 3.
Figure 3.

EU Member States: Domestic Value-Added Exports and Structural Indicators, 2011

Citation: IMF Staff Country Reports 2015, 127; 10.5089/9781475555790.002.A006

Note: Cyprus, Luxeumberg and Malta are excluded from the sample for particularly large financial sectors in these economies. Croatia is not included for the lack of information on domestic value-added exports.Sources: LAF database, European Commission; Global Competitiveness Index database, World Economic Forum; World Input-Output Database; World Economic Outlook database, IMF; and IMF staff estimations.

Such Empirical Linkages Between DVA Exports And These Structural Factors Are Quite Robust

  • These indicators seem capturing different structural aspects that affect DVA exports. The panel regression results in Table 2 show that, they not only have strong bilateral relationships with DVA exports, their coefficients all remain highly significant when included simultaneously in the same regression.

  • The strength of the empirical linkages does not seem particularly sensitive to the sample periods. In Table 3, the regressions in columns (2) and (4) test the relationships between the structural indicators and DVA exports using pre-crisis samples, while columns (3) and (5) are based on samples covering 2009–11. All the coefficients stay highly significant.

  • The relationships between DVA exports and the structural indicators stay qualitatively the same, even after adding additional control variables, such as income levels, exchange rates, major trade partners’ growth or time dummies to the model (Table 4).9

Table 2.

DVA Exports and Structural Indicators 1/

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Standard errors in parentheses. *** p>0.01, ** p>0.05, * p>0.1.

Cyprus, Malta and Luxeumberg are excluded from the sample. Croatia is not in the regressions because of missing DVA information. The sample covers the period 2003–11. The indicator of local competition intensity became available in 2005. Bulgaria, Latvia, Lithuania and Romania has no information on employment protection.

Table 3.

Robustness Check: Subsample Periods 1/

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Standard errors in parentheses. *** p>0.01, ** p>0.05 * p>0.1.

Cyprus, Malta and Luxeumberg are excluded from the sample. Croatia is not in the regressions because of missing DVA information. The sample covers the period 2003–11. The indicator of local competition intensity became available in 2005. Bulgaria, Latvia, Lithuania and Romania has no information on employment protection.

Table 4.

Robustness Check: Subsample Periods 1/

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Standard errors in parentheses. *** p>0.01, ** p>0.05 * p>0.1.

The regressions are based on the same sample as the baseline, Table 2 column (5).

7. These structural factors also have similar strong relationships with gross exports. Reported in Table 5 are regressions for gross exports, based on the same samples as in Table 2. The results are similar, suggesting that countries with: (i) lower degree of employment protection; (ii) larger unit wage cost gap between services and manufacturing industries; (iii) more intense local competitions; and (iv) better integration into the global value chain, tend to export more.

Table 5.

Gross Exports and Structural Indicators 1/

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Standard errors in parentheses. *** p>0.01, ** p>0.05 * p>0.1.

The regressions are based on the same samples as the corresponding columns in Table 2.

D. Where Does Portugal Stand?

8. The increase in Portugal’s DVA exports during 2010–13 and competitiveness gains achieved in this period are likely much smaller than indicated by the growth in gross exports. The empirical relationship established in the previous section suggests a 2 to 3 percent of GDP increase in Portugal’s DVA exports between 2010 and 2013.10 This implies that the 10-percent-of-GDP growth in gross exports was to a large extent due to increase in imports of intermediate inputs. As illustrated by the example in Table 1, this would also imply that imports compression for domestic consumption and investment had played a bigger role in the current account adjustments than indicated by the small decline in gross imports.

9. The latest information on structural factors identified in the previous section also suggests that the sustainability of Portugal’s external improvement cannot be taken for granted (Figure 4). In 2014, Portugal ranked 21st among the EU countries in terms of labor market efficiency.11 Similarly, the intensity of local competition in Portugal ranked only 22nd among the EU countries. The bottom panels indicate that the key bottlenecks constraining the development of manufacturing industries, or tradable sectors more broadly, are not removed yet – the Portuguese consumers are still paying the highest income-adjusted energy prices, only next to Cyprus, and most of the FDI is still flowing into the non-tradable sectors.

Figure 4.
Figure 4.

Latest Structural Indicators

Citation: IMF Staff Country Reports 2015, 127; 10.5089/9781475555790.002.A006

1 A lower rank corresponds to a more advantageous competitive position.Sources: Banco de Portugal; Eurostat; World Economic Forum; and IMF staff calculations.

E. Summary

Is The Paper Saying That Portugal’s Improved External Performance Is Unsustainable?

10. No. But there are reasonable doubts. Gross exports is a flawed measure of competitiveness gains. DVA exports is a better measure and has exhibited strong and robust empirical linkages with a small set of structural indicators. Investigation on DVA exports suggests that the competitiveness gains achieved by Portugal are likely much smaller than indicated by the growth of gross exports. In addition, the fact that Portugal continues to lag behind many of its peers and trade competitors in these areas suggests that Portugal’s improved external performance is likely of a more temporary nature than hoped for.

What Should Portugal Do?

11. Continue structural reforms to boost external competitiveness. The country needs faster growth, and therefore higher investment, to absorb the labor slack through job creation. Considering the very high external stock imbalances, it should avoid reopening the flow imbalances, which requires continued strengthening of external competitiveness. As a currency union member with limited fiscal space, structural reforms are the only available tool at the sovereign level.

What Structural Reforms Should Portugal Do?

12. The structural factors identified in this paper should not be interpreted narrowly. For instance, in addition to employment protection, there are also other labor market indicators that exhibit strong empirical relationships with DVA exports. Nonetheless, these indicators indeed point to a few key areas, such as labor market flexibility and development of manufacturing/tradable sectors, which are consistent with the policy recommendations during the program.

Appendix I. Data Appendix

Data: Summary Statistics and Sources

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References

  • Koopman & Wang & Wei, 2014. “Tracing Value-Added and Double Counting in Gross Exports,” American Economic Review, American Economic Association, Vol. 104(2), pp 645994, February.

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  • International Monetary Fund (IMF), 2013, IMF Country Report No. 13/18, Washington DC, January.

  • International Monetary Fund (IMF), 2015, IMF Country Report No. 15/21, Washington DC, January.

1

Prepared by Li Zeng and Dmitry Gershenson.

2

Please refer to Box 1 of chapter Taking Stock of Structural Reforms: a Firm-Level Perspective for detailed discussions.

3

There are different measures of external competitiveness. As explained in more details later, it is interpreted in this paper as a country being able to export more domestic value-added, measured as percent share of GDP.

4

For further discussion of labor market slack in Portugal, see Box 1 in IMF Country Report 15/21.

5

Please refer to Figure 1 of Koopman, Wang and Wei (2014) for a more rigorous definition of DVA exports as used in the econometric analysis of this paper, and for more discussions on its applications.

6

Oil processing and export is important to Portugal. According to IMF (2013), between January 2009 and August 2013, fuel exports was the second-largest contributor to the recovery in exports, with an improvement of 1½ percent of GDP that accounted for about a quarter of the cumulative increase in exports.

7

It is DVA exports as share of GDP, instead of as share of gross exports, that is being examined here.

8

It is defined as the percent share of global value chain related exports in gross exports. In the context of Koopman, Wang and Wei (2014), global value chain related exports is the sum of components of (2) to (9).

9

Income levels and exchange rates are not included in the baseline specification because of endogeneity concerns.

10

This is the difference between the fitted values of Portugal for 2010 and 2013, based on the regression reported in column (5) of Table 2. For 2013, the unit wage cost gap between services and manufacturing industries in 2012 (latest available) was used. The range between 2 to 3 percent of GDP reflects different assumptions on the change in degree of integration with the global value chain between 2010 and 2013, from no change to a sharp rise.

11

The labor market efficiency index from the Global Competitiveness Index database is used in the top-left panel because the latest employment protection information from the LAF database is for 2013.

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