Mission Concluding Statement 

Portugal -- 2006 Article IV Consultation; Preliminary Conclusions of the Mission

July 17, 2006

1. Recent months have witnessed important signs of progress in the economic and policy environment, although the challenges that Portugal confronts remain considerable. A modest recovery of output is underway after a largely flat 2005; recent export data are promising, with solid growth over the first five months of the year; and some significant structural reforms have been introduced, while others have moved closer to fruition. Nevertheless, in the face of large fiscal imbalances and a competitive position that has been substantially eroded by low productivity growth and pressures from both Asia and the New Member States, Portugal requires a fundamental transformation of its economy and its public sector. Continued progress with planned structural reforms to strengthen domestic competition, improve the business environment, increase government efficiency and reduce the deficit through expenditure-based measures will be an important factor in this transition. Even with the full implementation of these policies, however, the domestic economic environment is likely to remain difficult, and growth relatively slow, for some time. On the other hand, slippages in the reform agenda would have a severe impact on the credibility of the adjustment effort, increasing its duration and costs.

2. For 2006, we forecast output growth to exceed 1 percent by a small margin. The improving export performance noted above suggests a better external contribution to growth than in previous years, and private investment—which has been languishing—is also expected to strengthen. For 2007, we forecast some further consolidation of the recovery, with growth rising to about 1½ percent. However, the still-weak competitive position and high levels of household debt remain a drag on activity. In addition, while fiscal consolidation is essential for faster medium-term growth, in the short run the impact of ongoing budgetary consolidation will also weigh on growth. Stronger demand from European trading partners would boost prospects, but higher oil prices are a downside risk.

Fiscal Policy

3. The authorities' overall fiscal strategy remains sound, but firm implementation is essential to its success. The commitment to reduce the fiscal deficit below 3 percent of GDP without one-off measures by 2008 primarily by tackling the public wage bill and pension spending is well-founded. The growth of these categories of spending over the last decade is a prime cause of the current high deficit, and international experience shows that expenditure-based fiscal adjustments tend to be more durable and effective than revenue-based ones. Nevertheless, the fiscal program for 2005—which resulted in the achievement of the deficit target of 6.0 percent of GDP despite overruns on social benefits and capital spending—relied primarily on revenue measures. This was in large part a natural consequence of the need to address wage and pension spending through structural reforms, which take time to bear fruit. However, to maximize the credibility of the adjustment effort going forward it is critical that these planned expenditure reforms be introduced without delay and implemented effectively. Moreover, should their budgetary impact fall short of what was anticipated when the government's program was developed, it will be essential that alternative spending cuts be introduced to maintain the expenditure-based focus of medium-term adjustment.

4. Achievement of this year's 4.6 percent of GDP deficit target is likewise crucial for the credibility of the fiscal program, and may require additional measures. Expenditure developments at the state level through June suggest that budget execution has been broadly in line with expectations, and revenue performance has remained strong. However, the mission sees risks of higher spending on social transfers and health care, and by local governments and autonomous funds, that could together add nearly ½ percent of GDP to the deficit. The authorities' commitment to reinforce budget measures if needed to achieve this year's deficit target is therefore welcome. Given the role that revenue measures have played in deficit reduction to date—including in 2006, when the full-year impact of last year's VAT increase will make an important contribution to revenue growth—any additional measures should operate on the expenditure side. Significant recent improvements in tax administration suggest the possibility of revenue overperformance this year. Should such gains be realized, they should be dedicated to further deficit reduction, rather than to increased spending.

5. Structural fiscal reforms now under preparation should be implemented forcefully, but should be assessed cautiously in the 2007 budget. The deficit is programmed to decline by a further 0.9 percent of GDP next year, primarily through expenditure reduction. A number of important reforms are expected to contribute to achieving this goal, although firm estimates of the savings they will generate are not yet available.

• The social security system for private sector workers is to be reformed, following last year's reform of the system for civil servants. Benefits will be indexed to the inflation rate (though relatively low pensions will enjoy a small real increase when output growth is above 2 percent and higher pensions will suffer a small real decline when growth is below that threshold), an explicit link between benefits and changes in life expectancy will be introduced, the already-scheduled shift in the reference period for calculating pensions to encompass a worker's entire career will be accelerated, and disincentives for early retirement will be increased. Savings from this reform will grow over time, but some reduction in spending should be realized even next year.

• The reform of the civil service is intended to reduce the number of career paths and increase flexibility within public employment. It should also help control the drift in the wage bill observed in recent years, which had contributed to the steady growth in primary spending until the system of automatic promotions was frozen as an interim measure last year. Maintaining the practice of replacing only half of all retiring civil servants will also contribute to a rationalization of public employment; an effective monitoring mechanism for this rule should be put in place.

• The reorganization of the public sector ("PRACE") has the potential to lead to a substantial improvement in the efficiency of the public sector. In concert with the reform of the civil service, it may also result in significant increases in labor mobility within the public sector, a reduction in the public wage bill, and, over time, a decline in public employment. This will, however, depend on a willingness at the decision-making level to fully use the flexibility granted to alter staffing levels so as to maximize efficiency. It will be important to ensure that adequate incentives are in place to do so.

• Ongoing reforms of health and education spending, and planned changes to the system of financing local governments, should also contribute to reducing spending pressures next year. The continued conversion of hospitals into public corporate entities, steps to reduce spending on pharmaceuticals, and the consolidation of small primary schools should all yield efficiency gains. The plan to allow municipal governments flexibility to alter tax rates should help reduce the bias to spend in existing arrangements and will complement recent measures that introduced more comprehensive limits on indebtedness and improved reporting requirements.

The 2007 budget should be based on conservative estimates of the yield of these reforms, with additional specific spending measures incorporated in the budget to achieve the deficit target.

6. Additional fiscal adjustment will be needed beyond 2008 to ensure long-term sustainability. Forecasts of age-related spending, including recently by the EC, point to large increases in pension and health expenditure in the coming years. Based on updated projections for long-term health and pension spending that take account of the pension reform, and on realistic forecasts for output growth, the authorities should commit to a path of further deficit reduction that would result in achieving a fiscal position consistent with long-run debt sustainability by 2013, when current forecasts suggest that age-related spending will begin accelerating rapidly. Preliminary calculations by the mission suggest that this would require a budget surplus of at least ½ percent of GDP. The adequacy any target would need to be re-evaluated periodically in light of developments with output and health and pension spending.

7. Reforms to budgetary systems and the tax code could strengthen medium-term fiscal performance. A binding multiyear budget framework, with explicit expenditure ceilings for outer years, would improve budget execution by providing spending units with a clearer picture of the resources that will be available to them in the future. A pilot program that moves in this direction is being considered for implementation in 2009. In addition, consideration should be given to simplifying the tax code over time in a revenue-neutral manner, for example by eliminating intermediate rates for some goods under the VAT and lowering the maximum rate, or further phasing out tax benefits under the income tax and cutting the tax rate. Such a reform would decrease the cost of compliance with the system, facilitate tax administration, and reduce distortions, but its implementation might need to await a firmer resolution of current fiscal difficulties.

Revitalizing Growth and Restoring Competitiveness

8. Strengthening the business environment should remain a priority. Bureaucratic requirements have been streamlined under the SIMPLEX program, eliminating barriers to investment and greatly accelerating the process of opening new firms and registering trademarks. For 2007, the intention to implement a more-targeted approach to SIMPLEX is appropriate, and the plan to focus on licensing requirements is particularly welcome, as many investors consider these to be especially burdensome in Portugal. Reforms to address delays in the operation of the legal system should also be a high priority. Measures to remove bureaucratic and regulatory impediments are a highly cost-effective means of promoting private investment and growth. The government's Technological Plan can also contribute to raising productivity growth, including by stimulating greater private investment in R&D, promoting training, and encouraging contacts between firms and universities. The impact of the Technological Plan will be enhanced, however, by further progress in improving the business environment.

9. Increased competition and efficiency in domestic markets would boost the competitiveness of Portuguese enterprises by reducing prices and promoting innovation and investment. Recent progress in key network sectors could be especially important, as prices in these sectors are relatively high, raising production costs throughout the economy. Measures have been introduced to increase competition in energy, although their immediate impact on prices will be reduced by the decision to pass on to consumers the costs arising from existing electricity supply contracts (PPAs) and by the policy to increase the share of renewables in generation. The introduction of greater competition in telecommunications is on the way, and efforts of the Competition Authority have also contributed to creating a more competitive environment, including within the liberal professions. The authorities' decision to reinvigorate the privatization process to reduce the role of the state in the economy and enhance economic efficiency is welcome, as is their intention to dedicate receipts to debt reduction.

10. Additional steps to raise labor market flexibility are still needed. The continued steady growth of labor costs even in the face of increases in the unemployment rate in recent years, high rates of long-term unemployment, and heavy reliance on fixed term-contracts and self-employment, all testify to the presence of significant rigidities in labor markets, as do standardized international measures of employment protection. These rigidities slow the movement of labor to fast-growing sectors, discourage investment in worker training, and raise serious equity concerns by contributing to a dual labor market. In part to avoid the legal requirements related to dismissals, firms have made considerable use of negotiated, voluntary dismissal packages. Recent steps to limit recourse to these arrangements will make prevailing employment protection legislation more binding, further strengthening the case for an overhaul of the legal framework. Reforms of the collective bargaining system to allow greater flexibility at the enterprise level would also be desirable. Recently-agreed changes to the unemployment compensation system to broaden the definition of "acceptable employment," promote more active job-seeking by the unemployed, and link the duration of an individual's benefits to the length of his contribution period should encourage more rapid reintegration by the jobless into employment. Plans to strengthen coordination between the social protection system and the education and training network, providing incentives for the unemployed to upgrade their skills, are also welcome.

The Financial Sector

11. Portugal's financial system is sound and well supervised. The recent Financial Sector Assessment Program (FSAP) found that Portugal's financial sector has weathered the economic slowdown well. Banks have diversified their sources of income, rationalized operating costs, and enhanced risk management procedures. As a result, Portugal's banking sector compares favorably with those of other EU countries in terms of asset quality, efficiency, and profitability, and capital adequacy is about the EU average. The financial soundness of the insurance sector has improved, reflecting a deepening of the market, better alignment of premiums to risk in some categories, positive investment yields, and some rationalization in personnel costs. The infrastructure for the settlement of payments and securities transactions is well developed and technologically advanced to minimize potential risks. The overall prudential regulatory framework is sound and the supervision of financial institutions as well as of payments and settlement systems is professional and active, comparing very well with international standards.

12. Risks are being closely monitored, and remain manageable. Relatively high levels of household and corporate debt, the concentration of bank lending to the real estate sector and to a limited number of large corporates, and the exposure of banks' employee pension schemes to the stock market call for continuous vigilance. However, stress tests show that given comfortable profitability and solvency buffers, the capacity of the financial system to absorb even severe disturbances to the macroeconomic environment is quite strong.

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The mission would like to thank its counterparts for their time, for the high quality of the discussions, and for the gracious hospitality they extended to us. We also thank the authorities for their skillful handling of the administrative aspects of the mission.