Public Information Notice No. 99/98

Public Information Notice: IMF Concludes Article IV Consultation with Portugal

October 22, 1999

On October 8, 1999, the Executive Board concluded the Article IV consultation with Portugal.¹

Background

Portugal's successful pursuit of a well-focused economic policy strategy enabled the country to join the euro area as a founding member. In the process, economic performance over the past several years has been impressive: strong output and employment growth; a decline in unemployment rates to one of the lowest levels in the euro area; and a marked deceleration of inflation. In 1998, economic growth--close to 4 percent, little changed from the previous year--continued to outpace the euro-area average and was led by strong domestic demand. Declining real interest rates contributed to an acceleration of private sector credit that supported strong demand for housing and consumer durables as well as investment activity, which also benefited from the Lisbon World Exposition (Expo 98). As a result, the unemployment rate declined further. However, owing to emerging capacity constraints, inflation edged up again from the historically low levels recorded earlier, and the current account deficit widened noticeably.

Monetary conditions have eased markedly in the context of entry into European Economic and Monetary Union (EMU). With an almost 3 percentage point reduction in repo rates since the beginning of 1998, short-term real interest rates declined by roughly the same magnitude and were near zero in the second quarter of 1999. The EMU-related drop in interest rates has triggered strong growth of household and, more recently, enterprise credit. Banks financed the private sector credit boom through short-term interbank loans from mostly euro-area foreign credit institutions, as well as by selling or redeeming more liquid, lower-yield assets, notably government paper.

Following sizable cuts in the general government deficit during 1996-97, fiscal adjustment stalled in 1998. Despite a narrowing of the fiscal deficit to 2.1 percent of GDP (versus a budget target of 2.4 percent), with output growth above potential the cyclically adjusted deficit remained unchanged at 2.2 percent of GDP, the weakest balance in the euro area. Supported by structural funds from the European Union (EU), public capital expenditure rose to the equivalent of some 6½ percent of GDP, one of the highest levels in the euro area.

The easing of monetary conditions contributed to a widening of the inflation differential vis-à-vis other euro-area countries and a further rise in the external current account deficit. With the unemployment rate below 5 percent since the spring of 1998, compensation increased by an estimated 5¾ percent. This contributed to a rise in consumer price inflation to 2.2 percent on a harmonized basis (2.8 percent on a national basis) in 1998, 1¼ percentage points above the euro-area average. Concomitantly, the current account deficit (including capital transfers) widened by more than 1 percentage point to 4¼ percent of GDP in 1998, one of the highest levels among industrial countries. Both strong import growth, fueled by buoyant domestic demand, and a weakening in external demand, the effects of which outweighed an Expo 98-related boom in tourism, contributed to this development. The current account deficit was financed predominantly by rising net foreign liabilities of the banking sector. At the same time, the foreign direct investment (FDI) balance turned negative as the increased internationalization of Portuguese firms led to a surge in FDI outflows.

The 1999 budget targets a general government deficit of 2 percent of GDP. However, higher-than-budgeted revenues and interest savings are likely to more than compensate for overruns on current expenditures, including for wages and health care, resulting in a deficit of about 1.6 percent of GDP. This would impart a significant withdrawal of stimulus to economic activity, equivalent to some ½ percent of GDP.

For 1999, a slowdown in external demand, the end of Expo 98, the gradual abatement of the effects of the earlier monetary easing, and the renewed fiscal adjustment efforts are expected to moderate growth to about 3 percent. Most indicators (including those for industrial production, construction, and external trade) suggest that the slowdown began in the last quarter of 1998, as Expo 98 came to an end, and exports weakened and business confidence declined (as elsewhere in the euro area). Retail sales and consumer credit growth suggest, however, that consumption and construction have remained relatively robust into the summer. The outlook also stabilized following the European Central Bank's rate cut in April and the weakening of the euro. With growth in 1999 in line with potential, inflation is likely to stabilize near current rates and would be some ¼ percentage point lower (year-on-year, national basis) than in 1998. However, the current account is expected to weaken somewhat further on account of divergent cyclical trends vis-à-vis major partner countries.

Executive Board Assessment

Executive Directors commended the authorities for the steady pursuit of stability-oriented policies that had yielded impressive results, including vigorous output and employment growth, markedly lower inflation, and declining fiscal deficits. Directors emphasized the crucial role of sound policies in realizing these achievements, which had culminated in Portugal's participation as a founding member of the euro area. With currency union, interest rates had declined sharply, and economic policies needed to attend to signs of emerging macroeconomic imbalances--including the brisk growth of private sector credit, tight labor market conditions, and a persistent inflation differential vis-à-vis euro-area countries. Looking ahead, Directors were generally of the view that further fiscal consolidation and an acceleration of structural reforms were essential for a rapid and sustained convergence to European Union (EU) income levels.

Directors noted that monetary conditions had eased considerably with Portugal's entry into monetary union, and that they were very accommodative in view of its relatively advanced cyclical position. This had contributed to a boom in private sector credit, rising levels of household indebtedness, strong domestic demand, and a widening external current account deficit. The accommodative monetary stance was also partly reflected in the continued inflation differential.

Directors welcomed the authorities' intention to limit the general government budget deficit in 1999 to well below the original 2 percent of GDP target. In light of macroeconomic developments, and the unexpected buoyancy of tax receipts stemming in part from impressive improvements in tax administration, many Directors argued that a relatively more ambitious fiscal target was well within reach, and suggested limiting the deficit to 1½ percent of GDP. Directors were also concerned about spending overruns in several areas of current expenditure, and urged that expenditure control be tightened.

Turning to the medium term, Directors considered budgetary balance over the cycle as a prudent objective, and many Directors viewed it as achievable by 2002 if economic growth unfolded as currently projected. This would lead to a rapid decline in the public debt-to-GDP ratio ahead of the most adverse trends in population aging, and would meet the requirements of the Stability and Growth Pact. Moreover, it would provide room for discretionary measures in the event of a cyclical downturn. Pursuing a steady pace of fiscal consolidation and a closing of the budget deficit by 2002 would call for a deficit target of 1 percent of GDP in 2000. Many Directors saw this target as providing adequate demand restraint. Although a few Directors did not consider setting a target beyond that in the Stability and Growth Pact an immediate priority, they nevertheless cautioned that some additional fiscal adjustment could be needed if credit growth did not slow or the external current account did not narrow as currently projected.

Directors noted that the key economic challenge facing Portugal was to secure continued, and preferably even more rapid, real economic convergence with other EU countries. They stressed that policies needed to focus on quickening the pace of catch-up in productivity levels. Directors viewed an adequate level of public investment as an important element of a growth-oriented strategy. Given the constraints of the Stability and Growth Pact, and the need to maintain a competitive tax environment, Directors emphasized that the growth of current expenditure would need to be contained, in particular through steps to rein in the wage bill and measures to improve efficiency and expenditure control in the health sector. Directors also urged reform of the pension system, which loomed as a major source of expenditure pressure over the longer run. Reforms should center on containing benefits and placing the existing public system on a sound financial footing.

Directors stressed that a strengthening of the education system and job training will be pivotal for accelerating convergence in living standards. They noted that Portugal still lagged behind other OECD countries in educational attainment levels for the current school age cohort, despite high levels of public spending. Steps to improve the efficiency of education expenditure were urgently needed.

Directors noted that current indicators of banking sector performance compared well with those of other EU countries. Nevertheless, the boom in private sector credit, financed in part with short-term interbank loans from foreign credit institutions, required careful supervision and possible further steps to ensure that credit standards were being maintained. Some Directors also suggested that market discipline would be enhanced by raising disclosure requirements for banks regarding their risk management and internal control policies and practices. Furthermore, effective supervision would be facilitated by the early implementation of plans to strengthen and formalize cooperation between the different supervisory agencies of the financial sector.

Directors lauded the successful implementation of the ambitious privatization program and the concomitant increase in competition in Portuguese markets. However, a few Directors were concerned that privatization proceeds were being used to support public enterprises. They stressed the need to reflect all enterprise support in a transparent manner in the fiscal accounts, and to use privatization proceeds primarily to reduce public debt. Several Directors suggested that a fully autonomous and adequately funded anti-trust authority would be helpful for further strengthening and safeguarding competition.

Directors observed that macroeconomic surveillance and policymaking were hampered by statistical weaknesses, notably in the national income accounts and employment statistics, and urged that these shortcomings be addressed quickly.