I - Overview

The staff report of the 3^rd Post-Program Monitoring mission provides an updated assessment of the recovering Portuguese economy and draws attention on challenges that remain to be addressed. However, we feel that a more balanced assessment—highlighting not only the remaining challenges but also some important results that were achieved in the most recent period—would have been more appropriate, especially with regard to fiscal prospects and the Government’s policy actions in the area of structural reforms. A more balanced assessment, using fewer adjectives and adverbs, would also have conveyed better the constructive policy discussions that were held in Lisbon.

In particular, we would like to underscore the following positive developments:

• Growth in 2015 continued at a rate that compares relatively well with that of other countries in the euro area, supported not just by consumption but also higher private investment.

• The process of strengthening in the fiscal accounts is continuing, including in 2016: the relaxation highlighted in the staff report simply reflects assumptions on potential growth that is not observable and, in our view, underestimated by staff.

• Confidence indicators remain strong, something well depicted by figure 2, but not mentioned in the staff report.

• While spreads have increased somewhat, this has been caused by an increased risk aversion in international financial markets, rather than by weaker performance of the Portuguese economy. Actually, a very successful auction took place on March 23^rd, with strong demand resulting in a yield of 3.36 percent on a 15 year maturity.

• Bank liquidity and profitability indicators have improved.

The Portuguese Government is fully committed to economic and fiscal policies that promote competitiveness, economic growth and social cohesion, while ensuring sound and sustainable public finances. This commitment has been welcomed by our European partners.

Also, the Portuguese authorities reaffirm their willingness to work in an open, frank and constructive way with the IMF, contributing to increase the staff’s understanding of the Portuguese economic and social conditions.

II - Economic Activity

In 2015, economic activity in Portugal continued its gradual recovery, along with a mild improvement in the labor market and the adjustment of the external accounts. However, recent developments proved that the adjustment goals on unemployment, inequality and poverty require further measures to promote inclusive growth which require an effective answer from the Government as well as from partner international institutions.

Real GDP growth was 1.5 percent, in acceleration with respect to 2014. Internal demand had an important contribution, with GFCF growing 5.4 percent (2.8 percent in 2014) and private consumption by 2.7 percent (2.3 percent in 2014). The staff report could have highlighted that private investment increased by 3.5 percent, a further acceleration with respect to 2014.

Concerning the labor market, 2015 registered an increase of 1.2 percent of the employed population and a significant decrease of the unemployed population (-11.0 percent). The unemployment rate in 2015 stood at 12.2 percent, 1.4 percentage points lower than in the end of 2014.

The external accounts also improved with the current account rising from 0.1 percent of GDP in 2014 to 0.5 in 2015, being the goods component more dynamic than services one. Alongside, 2015 was marked by a continued depreciation of the real effective exchange rate, albeit at a rate lower than in the euro area.

After a 0.5 percent contraction of the measured labor productivity in 2014, the first nine months of 2015 were marked by an improvement in this indicator (0.3 percent). Looking ahead these positive trends are expected to continue, including by staff as the staff report projects growth in 2016 at the same level as in 2015, unemployment to further edge down and the current account surplus to rise. It is not clear why these actual and expected results (in the context of a decline of fiscal deficit and public debt even in the more pessimistic staff projections) are seen by staff as conducive to higher risk.

III - Fiscal Policy

The Portuguese Government reaffirms its full commitment to ensure the sustainability of public finances as well as the compliance with its national engagements and the EU fiscal framework, including, as a priority, exiting from Excessive Deficit Procedure in 2016.

The 2016 State Budget introduces a fiscal policy aimed at continuing the fiscal adjustment process, while fostering the recovery in households’ disposable income, increased social cohesion and sustained economic growth. It projects a headline deficit of 2.2 percent of GDP (against a deficit that, based on new estimates that are now available, was of 3.0 percent of GDP in 2015, net of the one-off cost of support to BANIF). It should be noted that even under the most pessimistic staff projection of the 2016 deficit, there would be an improvement in headline terms. Rather, the staff report argues that there will be a fiscal relaxation on 0.5 percentage point of GDP. This is entirely due to the very low potential growth rate (0.2 percent in 2016) used for computing short-term potential output growth by staff (and other institutions), something we commented already in the past. We also project a primary balance of 2.3 percent of GDP, with a strong improvement vis-à-vis 2015. The Portuguese authorities are fully committed to achieving this ambitious target and will ensure a very tight budget execution to warrant it. Indeed, it should be stressed the success in the strict execution of the Budget in January and February 2016. This execution will continue to be closely monitored.

Regarding the General Government Gross Debt-to-GDP ratio, in 2016 it is expected a decrease by 1.1 percentage points. This conservative figure still includes a relative high cash buffer (of around 7.5 percent of GDP) and does not include the proceeds from the sale of Novo Banco nor the sale of assets received from BANIF resolution measure. Again, debt is projected to decline even in the more pessimistic staff projections.

IV - Structural reforms

The authorities are fully committed to address the structural bottlenecks that reduce the productivity and competitiveness of the economy. The 2016 State Budget guarantees fiscal stability and places the priority in simplifying regulations and reducing red tape costs. The staff report mentions the rolling back of some measures introduced during the Fund-supported program. There is no backtracking on the labor code. However in line with the provisions of the Memorandum of Understanding, as well as Constitutional requirements, only temporary measures such as the Personal Income Tax Extraordinary Surcharge and the Public Sector wage cuts are being gradually rolled back.

The Portuguese Government is analyzing ways to effectively tackle private sector indebtedness, a structural issue that was not adequately answered during the Fund-supported program. A Mission Unit to explore solutions for firms’ capitalization, especially SMEs, has also been established.

On pensions, it should be pointed out that in the 2016 State Budget pension expenditure is planned to decrease in percentage of GDP, despite the reduction of the Special Contribution for Solidarity and updating of minimum pensions (pensions below or equal to €628.82 will be adjusted by 0.4 percent). Also, the Government is committed to ensure that any future reforms of the pension system will be directed at reinforcing its sustainability, including through the diversification of revenue sources.

Regarding labor market reforms, the Government will reinforce life-long learning and redirect active market policies towards more vulnerable groups.

The Portuguese Government disagrees with the evaluation made by the staff report concerning privatizations. The EGF privatization process was not interrupted, CP Carga privatization was concluded and EID privatization was resumed. Public Sector concessions processes were hampered by legal aspects which were clearly explained to the staff during the PPM mission.

Additionally, the Portuguese Government has resumed the process of administrative modernization and associated reduction in red tape costs, which was abandoned during the Fund-supported program. In this regard the Government has revamped the ‘Simplex Program’ aiming at identifying constraints and opportunities in administrative modernization of public services. A framework for ensuring that new legislation does not involve excessive administrative costs also involving an ex ante analysis of costs and benefits is also being introduced.

These measures clearly show that the Government is committed to structural reforms. We trust that these initiatives, among others, will be adequately evaluated by the Fund staff and its results reported in future staff reports.

V - Financial Sector Policies

While some important challenges still remain and are shared by many other banking systems in Europe, the Portuguese banking sector is adjusting.

The liquidity of the Portuguese banking system continued to improve throughout 2015, with further improvements in a long lasting process that began in 2010 with a noticeable downward adjustment in the loan-to-deposit ratio. It should be highlighted that throughout the whole Economic and Financial Assistance Program period and, more recently, during the period of higher turbulence in financial markets, also associated with the resolution measures applied in Europe in December 2015, the deposit base of Portuguese banks showed resilience, a sign of confidence of the public on the system as a whole. Further, in 2015 the access of Portuguese banks to the Eurosystem funding has declined, despite the stabilization that occurred at end year. It should also be highlighted that after four years of negative results, the banking sector as a whole achieved positive profitability levels in 2015. Finally, the capital ratios have also improved, when compared to 2014, mainly driven by the resolution measure applied to Banco Espírito Santo, completed in December 2015, and by the decrease in risk weighted assets.

However, the Portuguese banking system still faces significant challenges. Against the background of the current macroeconomic scenario—characterized by low growth, very low nominal interest rates and low inflation—and high non-performing loans, bank profitability remains under pressure. In fact, in 2015, even though most banks returned to profits after several years of losses, the level of profits has remained low and explained, in part, by nonrecurring factors. On the positive side, deposit interest rates have declined, leading to a recovery in the net interest income, and administrative costs have been cut through restructuring efforts (albeit further efforts are needed—as banks continue to adapt to the current macroeconomic scenario characterized by low levels of demand for financial services, restructuring should involve further downsizing and reallocation of human resources).

Aggregate lending continues to decrease, contributing to the deleveraging of the economy, even though with significant heterogeneity among different sectors/debtors. In fact, credit to construction and real estate sectors continued to decline in 2015, while credit to manufacturing and exporting companies increased. In addition, credit is being channeled to those companies with the better credit quality, while there is evidence of price discrimination according to the risk profile of the debtor. In the same period, the stock of credit to households for house purchase continued the deleveraging path initiated in 2011.

The uncertainty of the global economic outlook represents an additional challenge for banks. In particular, the indirect exposure of Portuguese banks to emerging economies, as Angola, is significant and, as such, the evolution of non-performing loans (NPLs) is likely to be affected by the vulnerabilities observed in these economies. In fact, NPLs on banks’ balance sheet continue to be a concern given the potential impact on the banks’ solvency and on their ability and willingness to finance the economy. Although some progress is visible in terms of the reduction of new NPLs, the efforts to address the NPL stock must continue. In particular, given the existing constraints and the links between them, our comprehensive strategy, comprising measures on supervision, legal, judicial and fiscal levels, to address this issue must be reinforced.

VI - Conclusion

The authorities believe that some reforms implemented under the Fund-supported Program must be allowed time and stability to produce effects, whilst the unintended effects of the adjustment, such as rising inequality and emigration, must be corrected. Economic growth, social cohesion and sound public finances are goals to be met in equilibrium.

The Portuguese authorities look forward for the forthcoming Article IV consultation and the 4^th PPM mission, which will constitute a good opportunity to closely work with the Fund staff to deepen our dialogue and promote a closer mutual understanding.