Portugal—2009 Article IV Consultation Concluding Statement of the Mission
December 2, 2009
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
The global economic crisis has compounded Portugal’s pre-existing, home-grown, problems of anemic productivity growth, a large competitiveness gap, and high levels of debt. While progress has been made in recent years, much more is needed to avoid prolonged growth weakness and to correct unsustainable imbalances. In particular, recent hard-won fiscal credibility needs to be reinforced by concrete actions in a credible medium-term consolidation plan, and comprehensive structural reforms are needed to boost growth and prevent unemployment from plateauing at a high level. This will require broad-based support and determined leadership over many years.
The global economic crisis is severely buffeting the Portuguese economy
1. Output will likely contract by almost 3 percent in 2009, driven by sharp falls in exports and investment―as elsewhere in the euro area, this is the largest output decline in decades. Despite a substantial rise in unemployment, wage growth remained brisk, and, with productivity falling, unit labor costs rose further. Encouragingly, signs of adjustment are emerging, as prices have fallen faster than in the euro area (though coupled with strong real wage growth, this squeezed firms’ profit margins), households are saving more, and the large current account deficit has narrowed somewhat.
2. The policy response has been rapid and supportive. On the financial side, the government raised the coverage limit for deposit insurance and instituted facilities to recapitalize banks and guarantee their borrowing. This helped: only a couple of small financial institutions had to be subject to state intervention, the guarantee scheme has been used only moderately, and no private bank has used the recapitalization scheme. On the fiscal side, support amounted to some 1¼ percent of GDP over 2008-09, with measures including tax reductions, broadening social protection and increasing public investment.
The outlook remains difficult…
3. Economic growth seems set for a weak and fragile recovery of about ½ a percent in 2010. And the outlook is little brighter for the longer term. The economy’s growth potential, already low, has, as in other countries, been further undermined by the global crisis and much of the output loss may well be permanent. With the economy highly indebted, monetary conditions likely to tighten, productivity weak, and the fiscal position needing to consolidate, Portugal is likely to continue with sub-euro area growth and high levels of unemployment. While the most likely scenario is one of gradual adjustment of Portugal’s imbalances, the longer they persist, the greater the risk that the adjustment could become disruptive.
…and calls for an ambitious policy response
4. Alternatively, Portugal could embark on a program of comprehensive reforms to raise its longer-term growth potential, correct its imbalances, and restart the convergence process. Although significant reforms have been undertaken in recent years, much more is needed: the government needs to cut its deficit, firms need to become more efficient and labor more flexible and productive, and households need to save more. This challenging agenda will require broad-based support and determined leadership over many years, with the benefits taking similarly long to materialize.
Deep and lasting fiscal consolidation required
5. Fiscal consolidation is critical to prevent further deterioration and preserve hard-won credibility. Merely relying on the recovery and the impact of previous reforms is not enough. Despite impressive consolidation in 2005-07, the fiscal deficit will likely come in around 8 percent of GDP in 2009, with debt close to 80 percent of GDP. Although projections are fraught with particularly high uncertainty, our estimates indicate that without new measures the deficit will likely increase in 2010 before declining to around 5-6 percent of GDP by 2013, with the debt ratio approaching 100 percent of GDP. While achieving even this adjustment requires considerable spending restraint, it would still leave public finances: poorly positioned to respond to any growth shocks or financial crises; vulnerable to further ratings downgrades, higher spreads and financing problems; contributing to external imbalances; and, far from Portugal’s Medium-Term Objective of a broadly balanced budget.
6. Achieving the government’s deficit target of 3 percent of GDP in 2013 is thus critical, and requires structural consolidation of somewhat more than 1 percent of GDP a year on average. If well-designed, this would help put public finances back onto a sustainable path, reduce the economy's vulnerabilities, improve confidence, and help boost long-term growth potential. Given the economy’s continued weakness in 2010, some back-loading would be appropriate, but a start should still be made. We suggest that the deficit should at least not widen in 2010, which would require at least ½ a percent of GDP tightening compared to unchanged policies. The 2010 public administration wage adjustment will be particularly important both in terms of credibility and supporting consolidation, especially after the large real increase in 2009 and the need to signal wage restraint to the private sector. An overarching need is to quickly adopt a credible medium-term strategy based on realistic projections and concrete measures.
7. The consolidation should focus on reducing primary current spending, especially the public wage bill (building on recent public administration reforms) and social transfers. In particular, eligibility criteria for social benefits should be carefully assessed for effectiveness and health costs will need rigorous management. But the consolidation need is large enough that revenue enhancement should also be considered. Here, the focus should be on broadening the base of taxes by reducing tax expenditures and simplifying their administration. Raising the VAT rate, while generally undesirable, should be an option if other measures fall short. It will also be critical that existing policies that support medium-term consolidation be fully implemented. In this regard, the 2010 pension adjustment exceeding the recently-agreed rule is problematic―it is critical this be a one-off, and the costs should be recouped in future adjustments.
8. Improving fiscal frameworks would support high-quality and durable consolidation. Recent initiatives to develop performance budgeting to increase the low efficiency of public spending should be followed through. It would also be important to introduce a multi-year expenditure rule and a commitment to save any revenue overperformance. Establishing an independent fiscal council (like Sweden's or Belgium's) or a US-style Congressional Budget Office, might also help by providing independent analysis, forecasts and assessments, especially given the need to secure broad-based support. Significant progress has been made in improving the transparency and operating position of public enterprises―this needs to be continued, for example, by extending the coverage of public service agreements, consolidating ownership in the Ministry of Finance, and resuming privatization. Greater involvement of the Ministry of Finance in public-private partnership design and monitoring will also help improve results and contain fiscal risk.
Maintaining financial stability in a weak economy
9. The banking system weathered the global financial crisis relatively well, reflecting pre-existing strengths, such as limited exposure to toxic assets, the absence of a property bubble, retail-based business models, and a sound supervisory/regulatory framework. But some vulnerabilities increased as investment portfolios suffered, credit quality declined, funding large wholesale borrowing requirements became more difficult, and the already high concentration of loans to large exposures rose.
10. Decisive steps have been taken to address these vulnerabilities. The Bank of Portugal (BoP) recommended all banks bring their Tier I capital ratios to 8 percent by September 2009 (which has been substantially met) and implemented a number of other enhancements to the regulatory/supervisory framework. And with the global easing of financial conditions, banks recovered some losses on their investment portfolios and enjoyed renewed access to capital and longer-term financing from private markets. Banks also increased deposits and tightened lending conditions, helping bring credit growth down to more sustainable levels.
11. Reflecting the banking system’s inherent link to the health of the Portuguese economy, profitability will likely remain weak and credit growth subdued. However, stress tests conducted by the BoP suggest the system is capable of absorbing substantial shocks. That said, further pro-active measures to address underlying vulnerabilities should be considered. Many of these are already on the authorities’ agenda and will need to be implemented in the context of the evolving European and international financial architecture, and it will be important to prepare the banking system for the coming changes, for example, via the envisaged industry-wide working group on regulatory reform. There are also some areas where Portugal may benefit from moving further or earlier.
• While for the banking sector as a whole the quality of capital is in line with international norms, current regulations that allow for significant shares of non-core capital in Tier I could be gradually tightened. The BoP had already increased its monitoring of liquidity indicators before the crisis, and the planned introduction of minimum liquidity ratios in 2010 would be a further welcome step. Over time, if private sector indebtedness does not adjust, consideration should be given to other ways to mitigate this macro-prudential vulnerability.
• The implications of the envisaged switch to the “twin peaks” model of financial sector supervision should be carefully assessed and cautiously implemented to build upon the strengths of the existing system.
• The existing toolkit for intervening troubled financial institutions should be reviewed in the light of recent experience. In particular, a special resolution framework for financial institutions could support faster, and less costly, resolution, and there seems scope for greater inter-agency coordination on such issues, for example, via strengthening the Domestic Standing Group (CNEF).
• The BoP already conducts thorough stress tests and intends to do more in the future—more timely and detailed disclosure of the results and methodology would help financial firms, authorities and the wider public in understanding, managing and preparing for these risks, as could increasing the periodicity of financial stability reports and providing multi-year macroeconomic projections. Transparency would also be enhanced by bringing disclosure requirements on loan losses by banks further into line with those of others in the euro area, as planned.
• To increase household saving, schemes such as complementary pensions could be further promoted. The recent survey of financial literacy should be followed up, possibly including establishing a nationally co-ordinated financial literacy campaign.
Comprehensive structural reform vital to improve competitiveness and boost growth
12. Some significant structural reforms have been made in recent years, but productivity growth remains weak, the competitiveness gap large, and Portugal continues to score poorly on various indicators of economic framework conditions. And while many of the problems are long-term, such as the judicial system and low levels of education, making Portugal's still-highly regulated product, service, and labor markets more competitive and flexible would provide a substantial boost and, critically, the right incentives to innovate and invest.
• Product and service markets. The EU Services Directive should be grasped as an opportunity to make a clean sweep of legislation, including at local levels. The SIMPLEX program, which has already shown its usefulness, should be continued with greater focus on a few key problems, such as licensing, as planned. The effectiveness of the competition agency should also be further enhanced, for example, through strengthening the Competition Act.
• Labor markets. The recent labor code revision is an important step and should be carefully implemented and assessed for effectiveness. The unemployment benefit system should be examined to see if it can be made more effective and better-targeted, especially in terms of incentives to find work over time. The planned large increases in the minimum wage now look even more out of line with economic fundamentals and should be reconsidered.
The mission would like to thank its counterparts for their cooperation and the high quality of the discussions. We also thank the authorities for their skillful handling of the administrative aspects of the mission.