Portugal: Growth Needs Further Reforms
September 22, 2016
- IMF review mission finds Portuguese economic recovery slowing
- Structural reforms must progress for competitiveness, investment
- Banks liquid but asset quality weak, lending sluggish
While Portugal is recovering after the crisis, its economy continues to suffer from meager growth, weak investment, and competitiveness challenges. Its banking sector holds too many nonperforming loans and public debt remains high.
At the end of a review of the state of the country’s economy, mission chief Subir Lall talked to IMF News on three particular recommendations of the team (see chart).
State finances: undo the undoing
Lall: With low growth and low investment but high sovereign debt, what Portugal needs at this point is a cumulative fiscal consolidation of 1 percent of GDP over two years. This would offset the fiscal loosening of 2015 and what the IMF staff projects for this year. With this proposed adjustment, we are confident that debt would finally get on a steady downward path, making Portugal more resilient to possible shocks. It would also allow for more fiscal flexibility in the future.
Structural reforms: flexibility, but not at expense of temporary workers
Lall: Labor markets are a key area for reform. That unemployment has declined since the peak of the crisis is certainly very welcome news. But it is still high, especially among the youth. Portugal has to rejig its labor market, which is currently characterized by a combination of onerous and rigid permanent contracts and flexible but precarious temporary contracts. The way to do so is to make permanent contracts more flexible while improving the benefits available for those on temporary contracts, so that the two kinds of contracts converge. The goal is to bridge the gap, ensuring that there is a fair labor market for all, which boosts incentives for employment creation.”
Banking sector: time to try something else
Lall: Banks are still struggling with the legacy problem of high nonperforming loans, mainly among small and medium-sized enterprises. This issue is clearly linked to growth. When growth is sluggish, dealing with nonperforming loans takes longer. And because of bad debts, many companies are not in a position to invest because banks are reluctant to lend more to them or to new firms. This perpetuates a vicious cycle of high nonperforming loans, excessive leverage, and low growth.
We think banks have to deal with the problem decisively, get rid of their legacy loans, and allow for new lending to new companies and new sectors that will be the engines of growth in the future.
Banks need to create room on their balance sheets to be able to write off nonperforming assets. We have recommended a centralized effort to raise bank capital to allow the writing off of bad debt. Many of the debts are small, but when added together, they tie up banks’ balance sheets, while new companies are unable to borrow easily to finance their investment plans.
But banks also need to cut costs to improve profitability, and some have been making concerted efforts. The branch network, for instance, is probably too big in some cases than is needed to serve the financial service needs of the Portuguese population.
Lessons from the 2011-14 IMF program in Portugal
The IMF carried out its ex-post evaluation of the 2011-14 program in parallel with the review of the current state of the economy, and concluded that the program was a qualified success. The rescue package—€26 billion from the IMF, coupled with €52 billion from European partners—stabilized the economy, but sustainability remained a work in progress. It averted a systemic crisis and enabled Portugal to return to market financing, but left much unfinished business: the sovereign and private debt overhangs, bank and corporate fragilities, and elusive competitiveness.
The evaluation team, led by Adrienne Cheasty, found that the ‘big decisions’ in the program were justified, but that its efforts to protect growth came with costs.
● Sovereign debt restructuring was never a realistic option—at the outset for fear of contagion and later because of clear gains from returning to markets.
● Large upfront fiscal adjustment was thus the only practical strategy to restore market confidence that the debt was sustainable; fiscal targets were relaxed to the extent possible in the face of disappointing growth—but reversals of measures eroded the quality of adjustment and undermined the competitiveness strategy.
● Keeping banks open to avoid additional stress when not confronted with a banking crisis was justifiable given the information available.
● But the strategy of supporting growth by not deleveraging too abruptly left Portugal in gridlock, with banking sector weaknesses and a stagnating private sector.
● Labor market reforms were key to pursuing Portugal’s competitiveness goals.