Public Information Notice: IMF Concludes Article IV Consultation with Portugal

November 2, 1998

Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.

On October 26, 1998, the Executive Board concluded the Article IV consultation with Portugal1.


Portugal’s economic performance in recent years has been impressive, culminating in participation in European Monetary Union (EMU) from its inception. The rate of economic growth has been exceeding both potential and the average of European Union (EU) countries: GDP growth is estimated at 4 percent in 1997 and projected at 4¼ percent in 1998. The buoyancy of output is largely explained by factors bolstering investment, including a sharp decline in real interest rates; the execution of large-scale special projects—notably the 1998 World Expo; and a sizable public investment program, supported by EU transfers. Job creation has been strong, resulting in one of the lowest unemployment rates in the EU.

The fiscal deficit was more than halved between 1994 and 1997 (to 2½ percent of GDP). The composition of adjustment was unique among the euro-11: over that period, Portugal was the only euro country to show an increase in current primary spending as a share of GDP; this was more than offset by the sharpest rise in the revenue ratio and a marked reduction in the interest bill. The rise in current primary spending reflected in part the priority assigned to certain social objectives (notably an improvement of educational levels), but stemmed mainly from the unchecked dynamics of pension and health expenditures, with the latter in particular regularly exceeding budgeted amounts. For their part, revenues were sustained by improvements in tax administration and the cyclical upswing.

With the economic expansion now in its fifth year, cyclical conditions are comparatively tight: the economy is estimated to begin operating above potential in 1998, earlier than in the rest of the euro-11. Capacity utilization is close to historical highs and the unemployment rate has declined rapidly (to 4.6 percent in the second quarter of 1998), below the level generally deemed to be compatible with stable inflation. Although some of this decline is likely to be temporary, being attributable to Expo 98, labor market conditions are not expected to ease appreciably. At the same time, credit to the private sector has risen rapidly.

The rate of inflation dipped below 2 percent (year-on-year) in early 1998, virtually closing the gap with the EU average. However, with increasingly buoyant demand, it rose steadily thereafter, reaching 3.1 percent in July, and remaining there in August and September—one of the highest rates among prospective EMU members. Nontraded goods prices have been rising at a rate in excess of 4 percent. While contractual wage settlements (at some 3¼ percent) have remained moderate, the increase in unit labor costs is projected to outpace the euro area average in 1998.

As prospects for EMU participation improved over the past two years, monetary conditions eased considerably, and such easing is now exercising its lagged impact on aggregate demand. While the Bank of Portugal has slowed down the pace of interest rate cuts, some further, moderate easing is in store (short-term rates are currently about 50 basis points above Germany’s implied forward rates for early 1999). Long-term nominal interest rates have already broadly converged with those of the euro-11, but are appreciably lower in real terms.

The 1998 budget targeted a general government deficit of 2½ percent of GDP. The government intends to devote higher-than-expected revenues fully to deficit reduction, and the deficit is expected to come in somewhat under the budget target. Nonetheless, the structural fiscal deficit is set to widen slightly, imparting a procyclical expansionary impulse to the economy. The draft 1999 budget sets a deficit target of 2 percent of GDP, which implies a broadly unchanged structural deficit. The privatization program has proceeded with success, enhancing efficiency and lowering the debt ratio to below the Maastricht criterion. The government intends to undertake reforms of the health and pension systems after the general elections to be held by October 1999, and has conducted preparatory work to this end.

Barring a further marked worsening of the global environment, growth is expected to remain high (some 3¾ percent) in 1999: current business and retail surveys reveal buoyant expectations of orders and sales, easier monetary conditions will help support private investment, and the adaptation of Expo 98’s infrastructure to other uses is expected to cushion the effects of the end of the exposition. Initial trade union demands indicate the possibility of intensified wage pressures in 1999, but the government intends to contain civil service wage increases to around targeted inflation (2 percent). The staff projects inflation to exceed this target in 1999 (remaining slightly above 2½ percent).

Executive Board Assessment

Executive Directors commended the authorities for the remarkable adjustments achieved in the drive to Portugal’s participation in EMU as one of its founding members, and for an economic performance that had surpassed the average of the European Union (EU) in some important areas. These efforts had generated a virtuous circle of lower interest rates, vigorous growth, and declining fiscal deficits. Directors emphasized the role of sound economic management, and notably a cautious conduct of monetary policy, in securing these impressive achievements. Nonetheless, they cautioned that important challenges remained. In particular, Portugal was set to enter monetary union with a high level of inflation and a large cyclically-adjusted fiscal deficit compared with the other euro-11 participants. The present challenge was to act decisively to address that situation, while continuing to raise living standards closer to those prevailing in the rest of the EU. To that end, it would be crucial to avoid excess demand conditions that would threaten price stability and external competitiveness; to undertake structural reforms, particularly in the health and pension systems, so as to ensure a robust medium-term fiscal position; and to enhance the economy’s growth potential through greater flexibility in factor and product markets.

Directors noted that the Bank of Portugal’s judicious conduct of monetary policy had contributed to a remarkable degree of inflation convergence with the other euro countries through 1997. In the midst of relatively buoyant cyclical conditions, inflation had, however, edged up steadily thereafter. Several Directors considered that, in the absence of offsetting measures, inflation in 1998 and beyond was likely to remain above the euro average, with adverse effects on competitiveness. In this setting, Directors called for effective actions to control domestic demand, reduce inflationary expectations, and maintain wage moderation. They accordingly supported the Bank of Portugal’s cautious pace of interest rate reductions. However, with the EMU-related easing of domestic monetary conditions inevitably under way, they observed that this strategy was limited in both scope and time, as well as in its macroeconomic impact. Fiscal policy would thus need to move to center stage in containing demand pressures.

In this light, Directors supported the authorities’ efforts aimed at meeting the 1998 expenditure target, while allowing the unanticipated buoyancy of revenues to be reflected fully in a lower-than-budgeted deficit. Several Directors noted, nonetheless, that fiscal policy would still exert an untimely expansionary impact in 1998. They advised a tightening of the stance in 1999, to impart a clear withdrawal of stimulus to contain inflationary pressures, and they urged the authorities to strive for more ambitious and comprehensive fiscal reforms. Some other Directors, however, considered that the worsening of the global environment, together with the maturing of the economic cycle and the end of World Expo 98, could help lessen price pressures. These Directors emphasized that the focus should be on the medium term, while developments in the short term should be closely monitored so that any further tightening measures could be adopted as required. With regard to the medium term, Directors viewed the objective of fiscal balance in times of full resource utilization as an appropriate objective for Portugal.

Directors observed that Portugal’s composition of fiscal adjustment had been unique among the euro-11, with the sharpest rise in the revenue ratio more than offsetting the largest increase in primary current spending. The size of the general government had increased steadily over the past two decades, reaching the OECD average. Directors encouraged the authorities to redirect fiscal adjustment toward reining in the growth of primary current expenditures, particularly through reforms of the health care and pension systems.

Directors stressed that the health care system remained the most significant source of expenditure pressures, and a priority area for early action. Health care spending had risen more rapidly than in other EU countries, moving above the EU average in relation to GDP, without commensurate gains in relative health outcomes, which was a reflection of the system’s inefficiency. While welcoming the initial steps that had been taken, Directors noted that the effort fell short of what would be needed to meet the goal of stabilizing the ratio of health care expenditures to GDP. Bolder action, aimed at streamlining and restructuring the health care system, would thus be required.

In the longer run, pension outlays were set to constitute the main source of pressure on the public finances. Several Directors welcomed the proposal to strengthen the general system by moving to a two-pillar arrangement, but noted that the system’s long-run viability would depend on ambitious settings for the system’s key parameters. Directors stressed that early action on the general system would also facilitate the reform of the civil servants’ pension system, which had already been placing a significant and growing burden on the public finances.

Successful performance in monetary union would also demand flexibility in factor and product markets. Directors welcomed the recent gains in employment, and noted that Portugal was in a relatively better position than its EMU partners in the labor market, owing principally to its greater real wage flexibility. Nonetheless, several Directors pointed to the need to correct those institutional factors, such as high statutory dismissal costs and rigid employment protection laws, that had led to widespread circumvention of the formal requirements, and to a bias in employment creation toward fixed-term contracts and alleged self-employment.

Directors welcomed the success of the privatization program, and encouraged further measures to promote competition through, for example, the creation of a strong and independent antitrust authority, and further steps to liberalize product and factor markets, particularly in retail trade and the professions.

In the financial markets, Directors noted that the rapid pace of change, and heightened competition under EMU, would pose new supervisory challenges. They called for enhanced cooperation between the Bank of Portugal and other supervisory bodies, including through the definition of formalized information-sharing arrangements.

Directors welcomed the progress in data availability and dissemination, and encouraged the authorities to work rapidly toward compliance with the requirements of the Special Data Dissemination Standard.

Several Directors encouraged the authorities to persist in their efforts to raise Portugal’s contribution to development assistance.

Portugal: Selected Economic Indicators

  1994 1995 1996 1997 19981

Real economy (change in percent)  
Real GDP 2.3 2.4 3.6 4.0 4.2
Domestic demand 3.2 2.4 3.6 5.7 4.7
CPI (year average) 5.2 4.1 3.1 2.2 2.7
Unemployment rate (in percent) 6.8 7.2 7.3 6.7 5.1
Gross national saving (percent of GDP) 21.6 23.4 22.3 23.6 24.3
Gross domestic investment (percent of GDP) 24.1 23.5 23.7 25.4 26.2
Public finance (percent of GDP)  
Central government balance -5.1 -4.1 -3.7 -2.8 -2.8
General government balance -6.0 -5.8 -3.3 -2.5 -2.3
Public debt 63.8 66.3 65.3 61.5 58.5
Of which: external debt 9.4 11.6 11.8 14.2 ...
Money and credit (end-period, percent change)  
Total domestic credit2 11.8 12.0 12.0 9.7 13.5
L- (M2 + treasury bills held by the nonbank resident public)2 9.4 8.0 8.8 6.2 7.6
Interest rate (period averages)  
Deposit rate, 91–180 days2 9.3 8.1 5.5 4.6 3.8
Ten-year government bond yield3 11.6 10.0 7.0 5.7 4.5
Balance of payments (percent of GDP)  
Trade balance -9.4 -8.6 -8.6 -9.3 -9.2
Current account -2.5 -0.2 -1.4 -1.8 -1.9
Net official reserves (in US$ billions)3 21.3 21.7 21.4 18.4 19.1
External debt (US$ billions)2 16.2 17.0 16.1 14.2 14.7
Exchange rate regime Participant in ERM
Present rate (October 28, 1998) Esc 169.8 per US$
Nominal effective rate (1990 = 100)2 94.7 96.3 96.5 94.5 93.8
Real effective rate (1990 = 100)2 111.1 114.3 115.4 113.3 114.0

Sources: Bank of Portugal; Ministry of Finance; and IMF staff estimates and projections.

1Staff projections unless otherwise noted.
2Data for 1998 refer to August (year-on-year growth rates for money and credit).
3Data for 1998
correspond to September.

1Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of directors, and this summary is transmitted to the country's authorities. In this PIN, the main features of the Board's discussion are described.


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