## _cr05375

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---

### Recent developments and prospects
- Portugal confronts a difficult economic environment: domestic demand is weak, external competitiveness has been eroded, and the fiscal deficit needs to be reduced substantially over the next four years. High levels of private indebtedness also cast a shadow over medium-term prospects.
- Growth projections:
  - Growth is unlikely to exceed ½–¾ percent this year and 1¼–1½ percent in 2006.
- The authorities saw scope for a more robust medium-term recovery than did the staff, though it was agreed that recovery would be gradual.

### Securing fiscal consolidation — diagnosis, measures, and risks
- Mid-year audit and 2005 outlook:
  - A mid-year audit projected a 2005 fiscal deficit of about 6½ percent of GDP, absent new measures; the 2005 budget had called for a deficit of 2.8 percent.
  - One-off measures in the original budget equaled nearly 1½ percent of GDP and were excluded from the audit projections.
  - Projected increase in the deficit reflected more realistic estimates for expenditures (including health care, pensions and personnel) and non-tax revenues, implying an increase in the structural deficit (net of one-offs) of about 1¾ percent of GDP relative to the original budget and about 1¼ percent of GDP relative to the 2004 outturn.
- Authorities’ near-term measures announced to reduce the deficit to 6.0 percent of GDP in 2005:
  - Increased the top VAT rate by 2 percentage points (to 21 percent) in July, expected to increase revenues by about 0.3 percent of GDP in 2005.
  - Measures to reduce tax evasion forecast to yield about 0.3 percent of GDP in 2005.
  - Plans to introduce a new income tax bracket on annual incomes exceeding €60,000 (bringing the top marginal rate to 42 percent) and to increase fuel and tobacco taxes, all with effect from 2006.
- Authorities’ medium-term plan (endorsed by the Ecofin Council of the EU):
  - Reduce the fiscal deficit from a baseline of about 6½ percent of GDP this year (before recent measures) to 3 percent by 2008.
  - Medium-term adjustment pillars (some elements undefined):
    - (i) pension reform, including a convergence of the rules governing public sector pensions to those prevailing for private sector workers; the system for public workers closed to new entrants; retirement age for public employees to be raised by six months annually over the next decade until it reached 65; pension benefits for civil servants hired before 1993 would also be reduced.
    - (ii) further reforms to the pension system for private sector workers; a working group had been formed and its report is to be issued before end-year.
    - (iii) reforms to modify the career path for civil servants and to enhance public sector efficiency: freeze of automatic promotions as a temporary measure; new rules by end-2006 to streamline career paths, allow greater staff allocation flexibility, link pay/promotions to performance; policy of replacing only half of departing civil servants; planned ministry-level audits to identify efficiency measures and cost reductions.
  - Of the targeted 1.5 percent of GDP deficit reduction for 2006, about 0.9 percentage points will come from revenue measures already implemented or announced; spending cuts totaling about 0.6 percent of GDP are called for, including from pension and public administration reforms under study.
- Staff assessment and cautions:
  - Key elements of the strategy remain to be defined; staff stressed the need to resolve these uncertainties as soon as possible.
  - Staff saw the overall pace of deficit reduction as being appropriate but argued for greater expenditure containment measures this year.
  - Staff analytical work indicates deficit reductions of 1 percent of GDP annually could reduce short-term growth by as much as ¾ percent.
  - Staff noted the structural deficit net of one-off measures would still increase by about ¾ percent of GDP in 2005, and that the authorities’ revenue projections rely on a relatively optimistic growth forecast (0.8 percent) and uncertain tax-administration returns.
  - From a medium-term perspective, staff warned growth forecasts could prove optimistic and additional measures of up to ¾ percent of GDP by 2008 could be needed to achieve deficit targets.
  - Staff stressed anchoring deficit targets in a multiyear budget framework and recommended early clarification of unspecified expenditure measures for 2006.
- Long-term sustainability simulations:
  - Staff simulations show that without additional deficit reduction beyond 2009, public debt would rise sharply over the medium term; an additional 3 percentage points of GDP of fiscal adjustment would be needed after 2008.
  - Box 4 summary:
    - Even if current deficit-reduction targets are realized, reforms equivalent to an additional 3 percent of GDP in budgetary savings after 2008 will be required to ensure debt sustainability.
    - Baseline scenario (deficit reduced to 3 percent of GDP by 2008, no subsequent adjustment) shows the debt ratio more than doubling to 140 percent of GDP over the next two decades and continuing to rise thereafter.
    - Alternative scenario where structural balance is achieved by 2012 and non-age related spending is kept constant as a percentage of GDP shows the debt ratio declining steadily over the next four decades before rising modestly near the end of the projection period.
    - Scenarios do not include impact of any pension reforms to be introduced as part of the current adjustment program.

### Strengthening competitiveness and growth drivers
- Diagnosis:
  - Increasing labor productivity identified as key to resuming income convergence and improving competitiveness.
  - Labor utilization is relatively high, but labor productivity has fallen to only 55 percent of that of the euro area over the last few years.
  - Decline in labor productivity growth could reflect sectoral shifts, slowdown in capital deepening, or cyclical factors.
- Authorities’ initiatives:
  - improve general education and vocational training;
  - encourage research and development;
  - promote IT and R&D spending (noted R&D and IT spending well below European averages);
  - strengthen competition in product markets;
  - reduce red-tape and bureaucratic impediments to doing business.
- Staff–authorities divergence:
  - Disagreement on the priority to be accorded further labor market reform; authorities argued labor markets were more flexible in practice than standardized measures suggest.
  - Staff emphasized more fundamental reforms to enhance human capital and returns to innovation; agreed R&D/IT initiatives would have limited impact without improvements in education, training, and the business environment.
- Education and competitiveness specifics:
  - OECD-PISA results (2003) rank Portugal among the bottom six OECD countries in math, science and reading literacy, despite public spending per student above the EU average.
  - Recent reforms: new curricula, increased emphasis on technical training, closed/consolidated very small schools, planned increases in teachers’ classroom time, reduced teacher rotation across schools, planned increases in incentives for worker training (low by OECD standards).
  - Competition and product markets: new competition authority (created March 2003) constrained by slow legal system; unified electricity market with Spain delayed; derogation until 2007 to implement EU directives for liberalizing the natural gas market.
- Box 3 (Minimizing output costs of fiscal adjustment) — implications:
  - Literature finds expansionary contractions share features: initial conditions matter; pace and balance matter; not all spending measures have same impact.
  - For Portugal: euro-area membership removes interest rate and exchange rate channels; high private indebtedness could inhibit expansionary effects. Intended structure of adjustment focusing on expenditure control could help limit output costs; swift clarification of remaining elements needed to maximize confidence effects.

### Labor market, business environment, and structural reform priorities
- Labor market:
  - Authorities cite the new labor code (adopted end-2003) that: allowed for more flexible working hours; facilitated reallocation of labor across regions; revised collective bargaining procedures (introduction of expiry clauses); increased firm-level flexibility on fixed-term contracting and dismissal.
  - Authorities argue extensive use of fixed-term contracts and self-employment helps firms adjust employment and that further labor market flexibilization was not a priority.
  - Staff concerns: fixed-term contracts and questionable self-employment are poor substitutes for fundamental reform, create a segmented labor market, and likely contribute to low on-the-job training.
  - Data/indicators noted by staff: restrictions on individual dismissals are the tightest in the OECD (text assertion); restrictions on collective dismissals exceed the EU average (text assertion).
- Business environment and investment impediments:
  - World Bank Doing Business Indicators and a recent World Bank review of governance rank Portugal in the bottom third of the EU in market-friendliness of its regulatory environment and efficiency of its public service.
  - Improvements: It is now possible to create a new firm in only one day; costs of compliance with the corporate tax system reduced through enhanced internet use.
  - Remaining concerns: considerable delays in the granting of permits and licenses; slow pace of the legal system.

### Financial sector resilience and vulnerabilities
- Key vulnerabilities:
  - High private indebtedness: private sector credit-to-GDP ratio reached about 144 percent (end-2004).
  - Household debt at end-2004: 118 percent of disposable income (EU average: 80 percent).
  - Non-financial enterprises’ debt at end-2004: 98 percent of GDP.
  - Loan concentration: real estate loans account for about 60 percent of banks’ total loan portfolio (detailed series: share of real estate sector in private credit rose from 47.3 percent in 2000 to 54.0 percent in June 2005).
  - Borrower concentration: about 6 percent of borrowers holds about 80 percent of bank credit.
  - High share of loans at floating interest rates.
- Banking sector indicators and developments:
  - Bank profitability remained solid; capitalization improved though Tier I ratio lower than elsewhere in the euro area; liquidity improved.
  - NPLs remained low: share of nonperforming loans in total loans around 1.8–2.4 percent in recent years.
  - Bank of Portugal preliminary estimates: unrealized losses in the investment portfolio of the four largest banking groups amounted to €445 million in 2004 (2.9 percent of their own funds).
  - Policy action: authorities decided to undertake a Financial Sector Assessment Program in 2005.
- Staff recommendations:
  - continue careful monitoring of high household and corporate debt and concentrated lending;
  - intensify oversight of risk management practices;
  - use FSAP to perform a more in-depth review.

### External position, financing, and debt dynamics
- Recent trends:
  - Current account deficit (excluding capital transfers) widened to 7.2 percent of GDP last year.
  - External deficit projection: staff projected the external deficit (excluding capital transfers) would reach just over 8 percent of GDP in 2005.
  - Financing expected through medium- and long-term bank borrowing.
- External debt sustainability (Table 4 baseline):
  - Baseline: External debt (percent of GDP, 2000–2010): 120.3; 135.5; 140.1; 147.7; 154.0; 159.1; 163.1; 166.6; 169.8; 173.0; 176.0
  - Gross external financing need (in percent of GDP): 38.1; 38.1; 36.4; 31.4; 33.3; 35.0; 35.2; 35.5; 35.8; 36.5; 36.9
  - Net international investment position (end-period, percent of GDP): -38.0; -42.1; -46.5; -51.4; -57.2; -62.2; -65.7; -68.2; -70.0; -71.2; -71.9
- Staff warning:
  - Moderate investment growth and budget consolidation alone would be insufficient to stabilize the external debt to GDP ratio over the next few years.
  - Successful implementation of the deficit reduction program, an increase in private savings, and improvement in competitiveness are necessary to prevent substantial rises in external indebtedness.

### Outlook, selected indicators, and program projections
- Short-term growth and inflation:
  - Real GDP rose 1.2 percent in 2004 but contracted in Q3 and Q4 on a quarterly basis.
  - Preliminary data show year-on-year GDP growth of 0.3 percent in the first half of 2005.
  - Inflation: VAT increase effective July 1 expected to add about ¼ percentage point to inflation this year and slightly more in 2006.
  - Inflation projected at about 2½ percent over the coming year and half, held down by the output gap and increased import penetration.
- Staff vs authorities medium-term growth projections:
  - Authorities’ projection: output growth rising to 2½ percent by 2008 (a full percentage point above estimated potential) and 3 percent by 2009.
  - Staff projection: growth around 2 percent in 2008–09, noting deleveraging, competitiveness adjustments, and fiscal consolidation would weigh on growth.
- Key fiscal and macro projections (as presented):
  - Overall balance 1/ (In percent of GDP): 2004: -3.0; 2005 Est.: -6.0; 2006: -4.5; 2007: -3.8; 2008 — Proj.: -2.7
  - Structural balance 2/: 2004: -2.2; 2005 Est.: -4.8; 2006: -3.2; 2007: -2.5; 2008 — Proj.: -1.6
  - Net of all one-off measures 3/: 2004: -4.4; 2005 Est.: -5.0; 2006: -3.5; 2007: -2.7; 2008 — Proj.: -1.8
  - Memorandum items:
    - GDP growth (in percent): 2004: 1.2; 2005 Est.: 0.5; 2006: 1.2; 2007: 1.7; 2008: 1.9
    - One-off measures 2/: 2004: 2.2; 2005 Est.: 0.2; 2006: 0.3; 2007: 0.2; 2008: 0.2
    - Revenues (net of one-off measures): 2004: 41.3; 2005 Est.: 41.3; 2006: 42.2; 2007: 42.4; 2008: 42.6
    - Primary expenditures: 2004: 43.8; 2005 Est.: 44.5; 2006: 43.6; 2007: 43.0; 2008: 42.1
    - Public Sector Debt: 2004: 59.4; 2005 Est.: 65.6; 2006: 66.6; 2007: 67.7; 2008: 67.8
- Domestic economy selected indicators (2000–06):
  - Real GDP: 3.8, 2.0, 0.5, -1.2, 1.2, 0.5, 1.2
  - Real domestic demand: 3.2, 1.7, -0.1, -2.6, 2.2, 1.7, 1.3
  - Private consumption: 3.6, 1.1, 1.2, -0.4, 2.5, 2.1, 1.2
  - Gross fixed investment: 3.5, 1.3, -5.0, -10.1, 0.6, -0.6, 2.8
  - Unemployment rate: 3.9, 4.0, 5.0, 6.3, 6.7, 7.4, 7.7
  - Output gap: 3.4, 3.0, 1.5, -1.3, -2.0, -3.0, -3.3
  - Compensation per worker (whole economy): 6.6, 5.6, 3.9, 2.6, 2.6, 2.8, 3.0
  - Unit labor costs (whole economy): 4.9, 5.6, 3.9, 3.3, 1.6, 2.5, 2.1
  - Consumer prices (national index): 2.9, 4.4, 3.6, 3.3, 2.4, 2.3, 2.5
- External accounts selected indicators (2000–06 projections):
  - Trade balance (in percent of GDP): -12.5, -11.9, -10.0, -8.7, -10.3, -12.0, -11.3
  - Current account including capital transfers (in percent of GDP): -8.6, -8.8, -5.8, -3.2, -5.6, -6.5, -5.8

### Statistical and surveillance issues
- Data provision:
  - Portugal subscribes to the Special Data Dissemination Standard (SDDS); relevant metadata have been posted on the Dissemination Standards Bulletin Board.
  - Portugal has taken a flexibility option regarding the timeliness of reporting wages.
  - Publication policy: high degree of openness with extensive Internet use; Bank of Portugal, Ministry of Finance, and INE operate multiple websites with long- and short-term economic indicators and data.
- Principal statistical weaknesses:
  - Shortcomings in timely and high quality monthly and quarterly data on output, employment, and total wage compensation hamper monitoring.
  - Unemployment data suffer statistical problems (frequent revisions, sampling rotations).
  - Frequent and sizeable revisions to external trade data reduce usefulness.
  - Portfolio investment collection uses a simplified threshold of €500 million; authorities estimate about 2 percent of transactions are not captured monthly by this threshold but are included in the annual release.
- Ongoing improvements:
  - Revisions of quarterly employment data, rebasing national accounts to 2000, and improvements in series on industrial production prices and import prices.

### Staff appraisal — priorities and policy recommendations
- Overarching challenge:
  - Restart Portugal’s per capita income convergence in the context of large fiscal and external imbalances, slow growth, and weak competitiveness.
- Fiscal recommendations:
  - Contain spending in 2005 to limit deterioration and provide a cushion if revenues fall short.
  - Be willing to take additional measures—ideally on the expenditure side—if needed to achieve deficit targets, including observing the Maastricht deficit criterion by 2008.
  - Define and implement bedrock spending reforms (public administration and retirement system for private sector workers) and reflect them in the 2006 budget.
  - Address rising pension and health care spending from population aging.
  - Consider reforms to local government financing arrangements—possibly including binding expenditure limits.
- Structural and competitiveness priorities:
  - Pursue reforms to improve product and labor markets, enhance the business environment, and strengthen human capital development.
  - Complement R&D and IT initiatives with education, training, and competition improvements.
  - Reduce delays in the legal system and accelerate granting of licenses and permits.
  - Enhance competition in key sectors like telecommunications and transportation.
- Labor market:
  - Additional steps to raise labor market flexibility are needed; address segmentation from temporary contracts and dubious self-employment; reform strong protection for some workers and instability for others.
- Financial sector:
  - Continue careful monitoring of high household and corporate debt and concentrated lending; use FSAP for a detailed review.
- Trade and aid:
  - Actively support progress under the Doha round and increase ODA toward the UN target level.

*Source: _cr05375 - Executive Summary and selected sections*

### Executive Summary ......................................................................................................

### _cr05375 - Executive Summary ......................................................................................................

### Recent developments and prospects
- Portugal confronts a difficult economic environment: domestic demand is weak, external competitiveness has been eroded, and the fiscal deficit needs to be reduced substantially over the next four years. High levels of private indebtedness also cast a shadow over medium-term prospects.
- Growth projections:
  - Growth is unlikely to exceed ½–¾ percent this year and 1¼–1½ percent in 2006.
- The authorities saw scope for a more robust medium-term recovery than did the staff, though it was agreed that recovery would be gradual.

### Key policy requirements
- Broad agreement between the authorities and the staff on:
  - the need for deficit reduction based on credible expenditure control measures; and
  - the need for structural reforms to unlock Portugal’s growth potential.

### Securing fiscal consolidation
- Authorities’ plan: reduce the fiscal deficit from a baseline of about 6½ percent of GDP this year (before recent measures) to 3 percent by 2008.
- Medium-term adjustment pillars (authorities’ strategy):
  - (i) pension reform, including a convergence of the rules governing public sector pensions to those prevailing for private sector workers;
  - (ii) further reforms to the pension system for private sector workers;
  - (iii) reforms to modify the career path for civil servants and to enhance public sector efficiency.
- Staff assessment:
  - Key elements of the strategy remain to be defined; staff stressed the need to resolve these uncertainties as soon as possible.
  - Staff saw the overall pace of deficit reduction as being appropriate but argued for greater expenditure containment measures this year.
  - The authorities’ medium-term growth projections appear optimistic; staff noted additional measures may be needed to achieve deficit targets in later years.

### Strengthening competitiveness
- Initiatives identified by authorities include:
  - improve general education and vocational training;
  - encourage research and development;
  - strengthen competition in product markets;
  - reduce red-tape and bureaucratic impediments to doing business.
- Staff–authorities divergence:
  - disagreement on the priority to be accorded further labor market reform; authorities argued labor markets were more flexible in practice than standardized measures suggest.

### Safeguarding the financial sector
- Available indicators suggest the financial sector has been resilient during the slowdown.
- Vulnerabilities:
  - high private indebtedness;
  - risk concentrations, especially to the real estate sector.
- Planned follow-up:
  - a more in-depth financial sector review under the Financial Sector Assessment Program (FSAP), to be initiated in 2005.

### Overview and key issues (historical drivers and policy evaluation)
- Boom and bust drivers:
  - euro-related drop in interest rates led to substantial increases in consumption and investment, fueled by bank credit;
  - a rise in primary fiscal spending further amplified the expansion; current account deficit reached 10 percent of GDP in 2000–01.
- Post-boom adjustment:
  - domestic demand growth slowed in 2001 and turned negative in 2002–03 as firms and households worked off imbalances.
  - sharp increase in the fiscal deficit led to a violation of the SGP ceiling in 2001, precluding a countercyclical fiscal response.
- Structural concerns:
  - productivity and competitiveness have continued to slide; per capita GDP relative to the euro-area average stands barely above its level a decade earlier.
- Policy strategy critique:
  - measures to bring the deficit within SGP limits relied on substantial one-offs (increase in the VAT rate and freeze in public sector wage increases) and did not sustainably address the source of fiscal problems: the 6 percent of GDP rise in current spending over the last 10 years.
  - progress in structural reforms has been slow, leaving sizable fiscal and external imbalances and high private indebtedness.

### Economic developments and outlook (selected indicators and projections)
- 2004–2005 activity:
  - Real GDP rose 1.2 percent in 2004 but contracted in Q3 and Q4 on a quarterly basis.
  - Preliminary data show year-on-year GDP growth of 0.3 percent in the first half of 2005.
  - Private consumption proved resilient owing to low interest rates and lengthening tenors on bank lending; investment and export growth remained weak.
- Competitiveness indicators:
  - ULC- and CPI-based REER have appreciated steadily (ULC appreciation owing to wage growth and stagnant productivity);
  - export shares have fallen; FDI has contracted; employment shifted from tradables to nontradables.
- External position:
  - current account deficit (excluding capital transfers) widened to 7.2 percent of GDP last year.
- Labor market:
  - unemployment rate reached a seven-year high of 7.5 percent in 2005:Q1, falling to 7.2 percent in 2005:Q2.
- Short-term growth outlook:
  - growth was unlikely to exceed ½–¾ percent this year and 1¼–1½ percent in 2006.
  - household debt at end-2004: 118 percent of disposable income (about double its level seven years earlier; EU average: 80 percent).
  - private nonfinancial corporate sector indebtedness had largely stabilized as a percentage of GDP since 2001.
- Inflation and monetary conditions:
  - VAT increase effective July 1 expected to add about ¼ percentage point to inflation this year and slightly more in 2006.
  - inflation projected at about 2½ percent over the coming year and half, held down by the output gap and increased import penetration.
- External deficit projection:
  - staff projected the external deficit (excluding capital transfers) would reach just over 8 percent of GDP in 2005.
  - financing expected through medium- and long-term bank borrowing.
- Divergence on medium-term growth:
  - authorities’ projection: output growth rising to 2½ percent by 2008 (a full percentage point above estimated potential) and 3 percent by 2009.
  - staff projection: growth around 2 percent in 2008–09, noting deleveraging, competitiveness adjustments, and fiscal consolidation would weigh on growth.
- Staff warning on external debt:
  - moderate investment growth and budget consolidation alone would be insufficient to stabilize the external debt to GDP ratio over the next few years (Table 4).
  - successful implementation of the deficit reduction program, an increase in private savings, and improvement in competitiveness are necessary to prevent substantial rises in external indebtedness.
  - fiscal adjustment and productivity-enhancing structural reforms are critical to ensuring long-term fiscal and external sustainability.

*Source: _cr05375 - Executive Summary*

### 9.      Discussions focused on measures to ensure the sustainability of the fiscal

### _cr05375 - 9.      Discussions focused on measures to ensure the sustainability of the fiscal

### Fiscal Policy — diagnosis and immediate measures
- A mid-year audit projected a 2005 fiscal deficit of about 6½ percent of GDP, absent new measures; the 2005 budget had called for a deficit of 2.8 percent.
- One-off measures in the original budget equaled nearly 1½ percent of GDP and were excluded from the audit projections.
- The projected increase in the deficit also reflected more realistic estimates for expenditures (including health care, pensions and personnel) and non-tax revenues, implying an increase in the structural deficit (net of one-offs) of about 1¾ percent of GDP relative to the original budget and about 1¼ percent of GDP relative to the 2004 outturn.
- Authorities announced measures intended to reduce the deficit to 6.0 percent of GDP in 2005:
  - Increased the top VAT rate by 2 percentage points (to 21 percent) in July, expected to increase revenues by about 0.3 percent of GDP in 2005.
  - Measures to reduce tax evasion forecast to yield about 0.3 percent of GDP in 2005.
  - Plans to introduce a new income tax bracket on annual incomes exceeding €60,000 (bringing the top marginal rate to 42 percent) and to increase fuel and tobacco taxes, all with effect from 2006.
- Authorities and staff agreed these revenue-side measures would not address the roots of fiscal difficulties, which are persistent increases in spending on wages, pensions, and health care. Revenue measures in the short term would be the balance of adjustment, but not substitutes for fundamental spending-side reforms.

### Fiscal Policy — medium-term strategy and structural measures
- Authorities’ plan (endorsed by the Ecofin Council of the EU) seeks to reduce the deficit to 3 percent of GDP by 2008, without one-off measures.
  - Based on staff growth projections, this implies annual underlying adjustment of 1 percent of GDP in the next three years, somewhat front loaded in 2006.
- Medium-term adjustment oriented around three main pillars (some elements undefined):
  - Converge rules governing public sector pensions to those for private sector workers (less generous). The system for public workers closed to new entrants; retirement age for public employees to be raised by six months annually over the next decade until it reached 65. Pension benefits for civil servants hired before 1993 (previously exempted) would also be reduced.
  - Further reforms to the pension system for private sector workers to reduce costs and ensure long-run viability; a working group had been formed and its report is to be issued before end-year.
  - Reforms to enhance public sector efficiency and modify career paths for civil servants: freeze of automatic promotions as a temporary measure, new rules by end-2006 to streamline career paths, allow greater staff allocation flexibility, link pay/promotions to performance; policy of replacing only half of departing civil servants; planned ministry-level audits to identify efficiency measures and cost reductions.
- Staff assessment and caveats:
  - Staff saw overall pace of adjustment as broadly appropriate but argued for greater spending restraint in 2005 and noted additional measures might be needed in later years.
  - Staff analytical work indicates deficit reductions of 1 percent of GDP annually could reduce short-term growth by as much as ¾ percent.
  - Staff noted the structural deficit net of one-off measures would still increase by about ¾ percent of GDP in 2005, and that the authorities’ revenue projections rely on a relatively optimistic growth forecast (0.8 percent) and uncertain tax-administration returns.
  - The mission called for greater expenditure control in 2005 to contain deterioration and provide a cushion against revenue shortfalls.
  - From a medium-term perspective, the staff warned growth forecasts could prove optimistic and additional measures of up to ¾ percent of GDP by 2008 could be needed to achieve deficit targets.
- Authorities’ stance and implementation risks:
  - Authorities doubted scope for further expenditure containment in 2005 but were prepared to take measures if needed; considered revised budget expenditure ceilings tight.
  - Main 2005 risk identified as higher spending by regional and local governments (elections later in year); reforming local government finances is a high priority but not implemented in 2005.
  - Staff suggested introducing binding expenditure limits on local governments as a viable reform option.
  - Authorities planned to introduce, with the 2006 budget, spending goals for the remainder of the legislature and to seek ways to increase Public-Private Partnerships to protect investment in public infrastructure.
  - Authorities were hesitant to prejudge pension reform commission findings; staff flagged scope to further reduce early retirement options and limit pension indexation.
- A quick clarification of unspecified expenditure measures for 2006 was underscored:
  - Of the targeted 1.5 percent of GDP deficit reduction for 2006, about 0.9 percentage points will come from revenue measures already implemented or announced; spending cuts totaling about 0.6 percent of GDP are called for, including from pension and public administration reforms under study.
  - Progress in studies sufficient to incorporate reform impacts in the 2006 budget was considered critical; anchoring deficit targets in a multiyear budget framework was recommended.

### Fiscal Policy — long-term sustainability and simulations
- Authorities and staff agreed medium-term near-budget-balance needed to create a cushion for population aging.
- Staff simulations show that without additional deficit reduction beyond 2009, public debt would rise sharply over the medium term; an additional 3 percentage points of GDP of fiscal adjustment would be needed after 2008.
- Box 4 fiscal sustainability summary:
  - Even if current deficit-reduction targets are realized, reforms equivalent to an additional 3 percent of GDP in budgetary savings after 2008 will be required to ensure debt sustainability.
  - Baseline scenario (deficit reduced to 3 percent of GDP by 2008, no subsequent adjustment) shows the debt ratio more than doubling to 140 percent of GDP over the next two decades and continuing to rise thereafter.
  - Alternative scenario where structural balance is achieved by 2012 and non-age related spending is kept constant as a percentage of GDP shows the debt ratio declining steadily over the next four decades before rising modestly near the end of the projection period.
  - Scenarios do not include impact of any pension reforms to be introduced as part of the current adjustment program.

### Key fiscal statistics and program projections (as presented)
- 2004 (In percent of GDP) / 2005 Est. / 2006 / 2007 / 2008 — Proj.
- Overall balance 1/ -3.0 -6.0 -4.5 -3.8 -2.7
- Structural balance 2/ -2.2 -4.8 -3.2 -2.5 -1.6
- Net of all one-off measures 3/ -4.4 -5.0 -3.5 -2.7 -1.8
- Memorandum items:
  - GDP growth (in percent) 1.2 0.5 1.2 1.7 1.9
  - One-off measures 2/ 2.2 0.2 0.3 0.2 0.2
  - Revenues (net of one-off measures) 41.3 41.3 42.2 42.4 42.6
  - Primary expenditures 43.8 44.5 43.6 43.0 42.1
  - Public Sector Debt 59.4 65.6 66.6 67.7 67.8
- Notes as presented:
  - 1/ Authorities' fiscal deficit targets.
  - 2/ In percent of staff's estimate of potential GDP.
  - 3/ Includes asset sales and the transfer of pension funds.

### Box 3 (Minimizing output costs of fiscal adjustment) — implications for Portugal
- Literature finds expansionary contractions share features:
  - Initial conditions matter (large persistent fiscal deficit, high public debt, difficult economic circumstances).
  - Pace and balance matter: large, front-loaded, and expenditure-based adjustments are less damaging to growth than backloaded, protracted, or revenue-based ones, due to stronger effects on agents’ expectations.
  - Not all spending measures have same impact: cuts in current spending are less damaging than cuts in investment; cuts in public wage bill can enhance external competitiveness by putting downward pressure on private sector wages.
- For Portugal:
  - Portugal shares some initial conditions with countries that experienced expansionary contractions, but euro-area membership removes interest rate and exchange rate channels; high private indebtedness could inhibit expansionary effects.
  - Intended structure of adjustment focusing on expenditure control could help limit output costs, but remaining elements must be clarified rapidly to maximize confidence effects.
  - Plans to address the public sector wage bill could positively impact competitiveness, supported by strong correlation between public and private wages in Portugal.

### Enhancing Growth and Competitiveness — diagnosis and priorities
- Increasing labor productivity identified as key to resuming income convergence and improving competitiveness.
  - Labor utilization is relatively high (employment rate and hours per worker above euro-area average), but labor productivity has fallen to only 55 percent of that of the euro area over the last few years.
  - Decline in labor productivity growth could reflect sectoral shifts, slowdown in capital deepening, or cyclical factors.
  - Structural reforms to correct deficiencies in product markets and the business environment seen as critical to restart convergence.
- Authorities’ program emphasized promotion of R&D and IT to boost growth; acknowledged spending on R&D and IT well below European averages and potential for greater private investment.
- Staff emphasized more fundamental reforms to enhance human capital and returns to innovation as a greater priority; agreed that R&D/IT initiatives would have limited impact without improvements in education, training, and the business environment.

### Enhancing Growth and Competitiveness — education, competition, and productivity
- Education:
  - OECD-PISA results (2003) rank Portugal among the bottom six OECD countries in math, science and reading literacy, despite public spending per student above the EU average.
  - Recent reforms: new curricula, increased emphasis on technical training, closed/consolidated very small schools, planned increases in teachers’ classroom time, reduced teacher rotation across schools, planned increases in incentives for worker training (low by OECD standards).
- Competition and product markets:
  - New competition authority (created March 2003) has begun operations but constrained by Portugal’s slow legal system.
  - Introduction of unified electricity market with Spain delayed; authorities remain committed and expect significant reduction in electricity costs over time.
  - Portugal granted derogation until 2007 to implement EU directives for liberalizing the natural gas market; government pledged to complete process before this deadline.
  - After substantial privatizations over last two decades, authorities saw limited room for further privatization.
- Productivity trends and diagnosis (Box 5):
  - Since mid-1990s productivity growth (output per labor hour) has trended downward.
  - Contributing factors: sectoral shift toward services (lower productivity growth), slowdown in capital deepening in late 1990s, a slowdown/negative turn in TFP growth since 2000, possible decline in investment efficiency with rising share to real estate.
  - Very poor productivity performance of recent years could reflect cyclical factors but also structural issues.

*Source: _cr05375 - 9.      Discussions focused on measures to ensure the sustainability of the fiscal*

### 22.      Problems with Portugal’s business environment were also seen as a major

### 22.      Problems with Portugal’s business environment were also seen as a major impediment to investment.

### Business environment and investment impediments
- World Bank’s Doing Business Indicators and a recent World Bank review of governance rank Portugal in the bottom third of the EU in:
  - market-friendliness of its regulatory environment
  - efficiency of its public service
- Authorities’ measures and outcomes:
  - It is now possible to create a new firm in only one day.
  - Costs of compliance with the corporate tax system have been reduced, including through enhanced use of the internet.
- Remaining investor concerns:
  - considerable delays in the granting of permits and licenses for new plants and products
  - slow pace of Portugal’s legal system (authorities acknowledged and are working to address it)

### Labor market, employment protection, and reforms
- Authorities’ position:
  - disputed international indicators of high labor market rigidities, arguing markets displayed considerable de facto flexibility.
  - cited the new labor code (adopted end-2003) that:
    - allowed for more flexible working hours
    - facilitated reallocation of labor across regions
    - revised collective bargaining procedures (introduction of expiry clauses)
    - increased firm-level flexibility on fixed-term contracting and dismissal
  - argued that restrictions on collective dismissals were less burdensome than on individual dismissals (staff noted collective-dismissal restrictions still above average)
  - extensive use of fixed-term contracts and self-employment helps firms adjust employment
  - concluded further labor market flexibilization was not a priority
- Staff concerns and evidence:
  - experience with the new code too limited for definitive assessment
  - fixed-term contracts and questionable self-employment are poor substitutes for fundamental reform
    - create a segmented labor market
    - likely contribute to low level of on-the-job training
  - data and indicators (from OECD/World Bank) show:
    - restrictions on individual dismissals are the tightest in the OECD (text assertion)
    - restrictions on collective dismissals exceed the EU average (text assertion)

### Financial sector issues and vulnerabilities
- Credit and indebtedness:
  - private sector credit-to-GDP ratio reached about 144 percent ― the highest value in the EU.
  - household debt at end-2004: 118 percent of disposable income (well above the EU average of 80 percent).
  - non-financial enterprises’ debt at end-2004: 98 percent of GDP.
- Credit growth dynamics (2004):
  - growth of bank credit to enterprises slowed
  - loans to households expanded rapidly, with mortgage lending rising at double-digit rates
- Banking sector performance and structure:
  - bank profitability remained solid (declining net interest income partially offset by fees/commissions and cost-cutting)
  - capitalization improved (higher growth of own funds), though Tier I ratio lower than elsewhere in the euro area
  - liquidity improved; assets exceed liabilities at tenors up to three months (remaining maturity basis)
  - NPLs remained low due to favorable interest rates, significant write-offs, and improved risk management
  - competition remains strong despite significant consolidation over the last decade
- Concentration and risk factors:
  - loans concentrated across sectors: real estate loans account for about 60 percent of banks’ total loan portfolio
  - borrower concentration: about 6 percent of borrowers holds about 80 percent of bank credit
  - high share of loans at floating interest rates
  - potential triggers for deterioration: sharp drop in growth, rise in unemployment, or rise in interest rates could impair loan quality and bank profitability
- Accounting and prudential framework changes:
  - application of IFRS standards significant but smoothed over time
  - Bank of Portugal preliminary estimates: unrealized losses in the investment portfolio of the four largest banking groups, calculated by applying the IFRS rules, amounted to €445 million in 2004 (2.9 percent of their own funds).
  - in some cases these losses can be recognized for prudential purposes over a period up to 2010
  - central bank intensified oversight of risk management in preparation for Basle II
- Policy action:
  - authorities decided to undertake a Financial Sector Assessment Program this year (welcomed by staff)

### Other issues
- Trade and industry:
  - textile sector significantly affected by elimination of quotas under the Multi Fiber Agreement
  - between 2000 and 2004 employment in the textile industry fell by about 70,000
  - authorities prioritize putting the Doha round of trade negotiations firmly on track
- Official development assistance:
  - Portugal’s ODA as a percentage of GNI has remained lower than in the majority of advanced economies
- AML/CFT and evaluations:
  - authorities state AML/CFT legislation is consistent with EU directives and FATF recommendations
  - a mutual evaluation by FATF will take place in January 2006
- Statistical improvements underway:
  - revisions of quarterly employment data to facilitate assessment of productivity developments
  - rebasing national accounts data to 2000
  - improvements in series on industrial production prices and import prices

### Staff appraisal: policy recommendations and priorities
- Overarching challenge:
  - restart Portugal’s per capita income convergence as soon as possible in the context of large fiscal and external imbalances, slow growth, and weak competitiveness
  - requires sustainable fiscal adjustment and measures to improve product and labor markets, enhance the business environment, and strengthen human capital development
- Fiscal strategy and recommendations:
  - authorities’ fiscal strategy correctly emphasizes medium-term expenditure containment and sets an appropriate pace of adjustment
  - planned pace: deficit falling to 3 percent of GDP by 2008
  - staff recommends containing spending in 2005 to limit deterioration and provide a cushion if revenues fall short
  - over the medium term, growth forecasts underlying authorities’ plans may be optimistic
  - authorities should be willing to take additional measures—ideally on the expenditure side—if needed to achieve deficit targets, including observing the Maastricht deficit criterion by 2008
  - definition and implementation of bedrock spending reforms (public administration and retirement system for private sector workers) essential and should be reflected in the 2006 budget
  - further medium-term actions needed to address rising pension and health care spending from population aging
  - greater use of Public-Private Partnerships could help raise spending efficiency, with caution on risk transfer, transparent recording, and controlling future budget commitments
  - reforms to local government financing arrangements—possibly including binding expenditure limits—could help reduce medium-term fiscal pressures
- Structural and competitiveness reforms:
  - planned structural reforms to improve labor productivity are essential to income convergence
  - initiatives to promote R&D and IT spending should be complemented by reforms in education and training, business environment, and competition
  - maintain priority on reducing delays in the legal system and accelerating granting of licenses and permits
  - enhance competition in key sectors like telecommunications and transportation where relatively high costs undermine competitiveness
- Labor market recommendations:
  - additional steps to raise labor market flexibility are needed
  - address segmentation caused by extensive use of temporary contracts and dubious self-employment
  - reform to reduce strong protection for some workers and instability for others to improve mobility, equity, and on-the-job training
- Financial sector monitoring:
  - continue careful monitoring of high household and corporate debt and concentrated lending
  - Financial Sector Assessment Program will provide opportunity for a more detailed review
- Trade and aid:
  - Portugal encouraged to actively support progress under the Doha round and to increase its ODA toward the UN target level

*Source: _cr05375 - 22.      Problems with Portugal’s business environment were also seen as a major*

### 39.      It is proposed that the next Article IV consultation take place on the standard 12-

### _cr05375 - 39.      It is proposed that the next Article IV consultation take place on the standard 12-

### Domestic economy (Selected indicators, 2000–06)
- Real GDP: 3.8, 2.0, 0.5, -1.2, 1.2, 0.5, 1.2
- Real domestic demand: 3.2, 1.7, -0.1, -2.6, 2.2, 1.7, 1.3
- Private consumption: 3.6, 1.1, 1.2, -0.4, 2.5, 2.1, 1.2
- Gross fixed investment: 3.5, 1.3, -5.0, -10.1, 0.6, -0.6, 2.8
- Foreign sector contribution: 0.2, 0.1, 0.7, 1.6, -1.3, -1.4, -0.2
- Employment: 1.9, 1.8, 0.5, -0.4, 0.1, 0.1, 0.6
- Unemployment rate: 3.9, 4.0, 5.0, 6.3, 6.7, 7.4, 7.7
- Output gap: 3.4, 3.0, 1.5, -1.3, -2.0, -3.0, -3.3
- Compensation per worker (whole economy): 6.6, 5.6, 3.9, 2.6, 2.6, 2.8, 3.0
- Unit labor costs (whole economy): 4.9, 5.6, 3.9, 3.3, 1.6, 2.5, 2.1
- Consumer prices (national index): 2.9, 4.4, 3.6, 3.3, 2.4, 2.3, 2.5
- Consumer prices (harmonized index): 2.8, 4.4, 3.7, 3.3, 2.5, 2.3, 2.5
- GDP deflator: 2.8, 4.1, 4.2, 2.7, 2.7, 2.5, 2.7

### External accounts (Selected indicators, 2000–10; and 2000–06 projections)
- Export volume (goods): 8.4, -0.2, 2.0, 4.7, 4.0, 1.6, 4.4
- Import volume (goods): 6.1, 1.2, -0.4, -0.6, 6.4, 6.3, 2.3
- Export unit value (goods and services): 5.2, 1.2, 0.2, -2.6, 1.2, 0.8, 3.1
- Import unit value (goods and services): 8.3, 0.2, -1.9, -2.3, 2.0, 1.6, 1.7
- Trade balance (in percent of GDP): -12.5, -11.9, -10.0, -8.7, -10.3, -12.0, -11.3
- Capital transfers (net, € billions): 1.7, 1.2, 2.0, 2.7, 2.2, 2.3, 2.4
- Current account including capital transfers (€ billions): -10.3, -11.2, -7.7, -4.3, -8.0, -9.5, -8.8
- Current account including capital transfers (in percent of GDP): -8.6, -8.8, -5.8, -3.2, -5.6, -6.5, -5.8
- Nominal effective exchange rate: -2.9, 0.6, 0.8, 2.8, 0.5, ...... 
- Real effective exchange rate (CPI based): -2.4, 2.5, 2.4, 4.0, 0.7, ......

### Balance of payments (2000–10, billions of euros and percent of GDP)
- Current account (2000–2010): -12.0, -12.4, -9.7, -7.0, -10.2, -11.8, -11.2, -10.5, -10.0, -9.7, -9.5
- Trade balance (2000–2010): -15.0, -15.3, -13.4, -11.8, -14.6, -17.4, -17.0, -16.5, -16.2, -16.0, -15.8
- Exports fob (2000–2010): 27.3, 27.5, 28.1, 28.7, 30.0, 30.7, 33.1, 34.8, 36.7, 38.8, 41.5
- Imports fob (2000–2010): 42.3, 42.8, 41.5, 40.6, 44.6, 48.2, 50.1, 52.3, 54.8, 57.4, 59.4
- Services, net (2000–2010): 2.2, 2.9, 3.3, 3.5, 4.1, 4.1, 4.5, 4.9, 5.3, 5.7, 6.1
  - Services exports (2000–2010): 9.8, 10.5, 10.9, 10.8, 11.9, 12.3, 13.1, 13.7, 14.4, 15.2, 16.0
  - Services imports (2000–2010): 7.6, 7.6, 7.6, 7.3, 7.7, 8.2, 8.6, 8.8, 9.1, 9.5, 9.9
- Tourism (services component): 3.3, 3.8, 3.8, 3.7, 4.0, 4.2, 4.5, 4.8, 5.0, 5.3, 5.5
- Income (2000–2010): -2.7, -3.8, -2.6, -1.5, -2.5, -1.3, -1.7, -2.0, -2.4, -2.8, -3.2
- Current transfers, net (2000–2010): 3.6, 3.7, 2.9, 2.9, 2.8, 2.9, 3.0, 3.1, 3.2, 3.4, 3.4
- Capital account (2000–2010): 1.7, 1.2, 2.0, 2.7, 2.2, 2.3, 2.4, 2.5, 2.6, 2.6, 2.7
- Financial account (2000–2010): 10.9, 11.3, 7.0, 4.7, 9.4, 9.5, 8.8, 8.0, 7.4, 7.2, 6.8
  - Direct investment (2000–2010): -1.6, 0.1, 1.7, -0.7, -4.1, -0.1, -0.4, -0.5, -0.6, -0.7, -0.7
  - Portfolio investment, net (2000–2010): -2.1, 2.1, 3.1, -5.1, 1.2, 0.3, 0.5, 0.5, 0.5, 0.6, 0.6
  - Other investment, net (2000–2010): 14.6, 9.7, 3.3, 4.6, 10.8, 9.3, 8.8, 8.1, 7.5, 7.3, 7.0
- Reserve assets (2000–2010): -0.4, -1.0, -1.1, 5.8, 1.5, 0.0, 0.0, 0.0, 0.0, 0.0, 0.0
- Memorandum: Net international investment position (end-period, 2000–2010): -38.0, -42.1, -46.5, -51.4, -57.2, -62.2, -65.7, -68.2, -70.0, -71.2, -71.9

### General government finances (Table 3, 2000–06; millions of euros and percent of GDP)
- Total revenues (millions of euros, 2000–2006): 49,045; 51,810; 55,979; 58,775; 61,365; 60,328; 64,211
- Current receipts (millions of euros, 2000–2006): 47,388; 49,630; 53,641; 55,102; 56,245; 58,154; 62,102
- Tax revenue (millions of euros, 2000–2006): 28,506; 29,599; 31,796; 32,444; 32,739; 34,710; 37,434
- Social security contributions (millions of euros, 2000–2006): 13,682; 14,738; 15,872; 16,750; 17,576; 17,907; 18,612
- Capital revenue (millions of euros, 2000–2006): 1,657; 2,180; 2,338; 3,672; 5,120; 2,174; 2,109
- Total expenditures (millions of euros, 2000–2006): 52,512; 57,229; 59,741; 62,658; 65,594; 69,069; 71,039
- Interest payments (millions of euros, 2000–2006): 3,670; 3,882; 3,894; 3,808; 3,832; 4,125; 4,892
- Capital expenditures (millions of euros, 2000–2006): 5,997; 6,923; 5,770; 6,088; 6,226; 5,891; 5,367
- Overall balance (millions of euros, 2000–2006): -3,467; -5,420; -3,762; -3,884; -4,229; -8,741; -6,828
- Overall balance (percent of GDP, 2000–2006): -2.9; -4.2; -2.8; -2.9; -3.0; -6.0; -4.5
- Structural balance, excluding asset sales (percent of GDP): -4.5; -5.4; -4.5; -4.6; -4.4; -5.0; -3.5
- Primary balance (percent of GDP): 0.2; -1.2; 0.1; -0.1; -0.3; -3.2; -1.3
- Public debt, Maastricht definition (percent of GDP): 51.2; 53.6; 56.1; 57.7; 59.4; 65.6; 66.6
- Nominal GDP (in millions of euros, 2000–2006): 120,302; 127,767; 133,826; 135,822; 141,115; 145,366; 151,082
- Change in nominal GDP (in percent): 6.7; 6.2; 4.7; 1.5; 3.9; 3.0; 3.9
- Real GDP growth (in percent): 3.8; 2.0; 0.5; -1.2; 1.2; 0.5; 1.2

### Public sector debt sustainability (Table 5, 2000–10)
- Public sector debt (percent of GDP, 2000–2010): 51.2; 53.6; 56.1; 57.7; 59.4; 65.6; 66.6; 67.7; 67.8; 67.1; 65.0
- Foreign-currency denominated share (percent of GDP): 3.8; 3.4; 4.0; 2.0; 2.1; 2.3; 2.4; 2.4; 2.4; 2.4; 2.3
- Change in public sector debt (percent of GDP, 2000–2010): -0.9; 2.4; 2.6; 1.5; 1.7; 6.3; 1.0; 1.0; 0.2; -0.7; -2.1
- Primary deficit (percent of GDP, 2000–2010): -0.3; 1.2; -0.3; -0.1; 0.3; 3.2; 1.3; 0.5; -0.2; -1.1; -2.4
- Revenue and grants (percent of GDP): 40.6; 40.2; 41.9; 43.1; 43.5; 41.5; 42.5; 43.0; 43.0; 43.2; 43.0
- Primary (noninterest) expenditure (percent of GDP): 40.3; 41.4; 41.6; 43.0; 43.8; 44.7; 43.8; 43.6; 42.8; 42.1; 40.6
- Automatic debt dynamics (percent of GDP): 0.4; 0.2; 0.3; 1.6; 0.4; 1.1; 0.7; 0.5; 0.4; 0.3; 0.3
- Gross financing need (percent of GDP, 2000–2010): 17.0; 18.4; 19.5; 21.7; 22.3; 26.6; 26.3; 25.9; 25.4; 24.4; 22.6
- Key macro assumptions (baseline projections): Real GDP growth (percent) 3.8; 2.0; 0.5; -1.2; 1.2; 0.5; 1.2; 1.7; 1.9; 2.2; 2.5

### External debt sustainability (Table 4, 2000–10)
- Baseline: External debt (percent of GDP, 2000–2010): 120.3; 135.5; 140.1; 147.7; 154.0; 159.1; 163.1; 166.6; 169.8; 173.0; 176.0
- Change in external debt (percent of GDP): 20.0; 15.1; 4.6; 7.6; 6.3; 5.1; 3.9; 3.5; 3.2; 3.2; 3.0
- Identified external debt-creating flows (percent of GDP): 6.1; 5.0; -5.1; -6.6; -0.6; 1.5; -0.4; -1.1; -1.3; -1.2; -1.1
- Current account deficit, including capital transfers and excluding interest payments (percent of GDP): 4.2; 3.4; 1.4; -0.6; 1.8; 2.4; 1.5; 0.9; 0.4; 0.2; -0.1
- Exports (percent of GDP): 30.8; 29.8; 29.1; 29.1; 29.7; 29.6; 30.6; 30.5; 30.5; 30.6; 30.8
- Imports (percent of GDP): 41.5; 39.5; 36.7; 35.3; 37.1; 38.8; 38.9; 38.3; 37.9; 37.7; 37.5
- Net nondebt creating capital inflows (negative, percent of GDP): 1.6; 2.7; -4.0; -5.6; 0.6; -0.5; -0.6; -0.6; -0.6; -0.6; -0.6
- Automatic debt dynamics (percent of GDP): 0.3; -1.2; -2.6; -0.4; -2.9; -0.3; -1.3; -1.4; -1.1; -0.8; -0.4
- Gross external financing need (in billions of U.S. dollars): 42.3; 43.6; 46.1; 48.3; 58.3; 63.5; 64.5; 67.6; 71.0; 75.1; 78.8
- Gross external financing need (in percent of GDP): 38.1; 38.1; 36.4; 31.4; 33.3; 35.0; 35.2; 35.5; 35.8; 36.5; 36.9
- Net international investment position (end-period, percent of GDP): -38.0; -42.1; -46.5; -51.4; -57.2; -62.2; -65.7; -68.2; -70.0; -71.2; -71.9

### Financial sector and vulnerability indicators (selected, 2000–05)
- Official reserves (in billions of U.S. dollars, end-of-period): 14.1; 15.3; 15.9; 11.5; 10.7; 11.0 (March)
- Official reserves in months of imports: 4.3; 4.8; 4.9; 3.0; 2.3; 2.2 (March)
- Public sector debt (Maastricht definition): 51.2; 53.6; 56.1; 57.7; 59.4; 65.6
- Money market rate (period average in percent): 4.4; 4.3; 3.3; 2.3; 2.1; 2.1 (August)
- Stock market index (PSI 20, 1992=3000): 10,404; 7,832; 5,825; 6,747; 7,600; 7,699 (August)
- Foreign assets of the financial sector (in billions of U.S. dollars): 52.9; 53.2; 60.8; 73.0; 93.4; 93.2 (May)
- Foreign liabilities of the financial sector (in billions of U.S. dollars): 73.2; 84.3; 105.1; 121.8; 149.1; 151.3 (May)
- Share of real estate sector in private credit (percent): 47.3; 47.9; 49.5; 51.4; 53.1; 54.0 (June)
- Share of nonperforming loans in total loans (percent): 2.1; 2.1; 2.1; 2.1; 1.8; 1.9 (June)
- Capital adequacy: Regulatory capital to risk-weighted assets: 9.2; 9.5; 9.8; 10.0; 10.4
- ROE (percent): 15.1; 14.9; 11.7; 13.9; 12.8
- NPLs to gross loans (percent): 2.2; 2.2; 2.3; 2.4; 2.0
- Specific provision to NPLs (percent): 67.7; 66.8; 62.8; 73.0; 83.4
- Liquid assets to total assets (percent): ...; 15.3; 12.5; 17.1; 15.4
- Customer deposits to total (non-interbank) loans (percent): 86.2; 81.5; 77.2; 77.4; 77.9

### Fiscal accounts and one-offs
- Asset sales, including UMTS receipts, transfer of the postal pension fund and securitization are netted out for purposes of calculating structural balances.
- Excluding one-off measures (total balance, percent of GDP, 2000–2006): -3.2; -4.2; -4.2; -5.3; -5.2; -6.2; -4.8
- Structural balance (memorandum): -4.5; -5.4; -4.5; -4.6; -4.4; -5.0; -3.5

### Fund relations and Article IV cycle (Appendix I)
- Membership Status: Joined March 29, 1961.
- Portugal accepted the obligations of Article VIII, Sections 2, 3, and 4 effective September 12, 1988.
- Quota (SDR Million, Percent Quota): Quota 867.40 (100.00); Fund holdings of currency 638.86 (73.65); Reserve position in Fund 228.55 (26.35)
- SDR Department: Net cumulative allocation 53.32 (100.00); Holdings 69.16; 129.71
- Outstanding Purchases and Loans: None
- Latest Financial Arrangements: None
- Projected Payments to Fund: None
- Exchange rate arrangements: Entered final stage of EMU on January 1, 1999, at a rate of 200.482 Portuguese escudos per 1 euro; official currency changed to the euro on January 1, 2002.
- Portugal maintains an exchange system free of restrictions on current international transactions, except specified restrictions enumerated in the text.
- Article IV Consultation: Portugal is on a standard 12-month consultation cycle. The last Article IV consultation discussions were concluded at EBM/03/29, 03/26/03.
- Technical Assistance (selected): 1998 STA Finalize Metadata for DSBB 9/98; 1998 STA Revision of Monetary Statistics 11/98
- ROSC: Fiscal Transparency, Date of Issuance December 1, 2003, Country Report No. 03/373

*Source: Table and appendix data as provided in the content unit.*

### 1.      Data provision to the Fund is adequate for surveillance purposes. Portugal

### _cr05375 - 1.      Data provision to the Fund is adequate for surveillance purposes. Portugal

### Data provision and publication practices
- Portugal subscribes to the Special Data Dissemination Standard (SDDS); relevant metadata have been posted on the Dissemination Standards Bulletin Board.
- Portugal has taken a flexibility option regarding the timeliness of reporting wages.
- Publication policy: high degree of openness with extensive Internet use; Bank of Portugal, Ministry of Finance, and National Statistics Office (INE) operate multiple websites with long- and short-term economic indicators and data.

### Principal statistical weaknesses affecting surveillance
- Considerable statistical weaknesses continue to hamper an assessment of economic developments despite some recent improvements.
- Shortcomings in timely and high quality monthly and quarterly data on output, employment, and total wage compensation hamper monitoring of within-year labor market developments.
- Unemployment data suffer from statistical problems caused, inter alia, by frequent revisions to the measurement of unemployment and sampling rotations.
- Frequent and sizeable revisions to external trade data reduce their usefulness.
- Portfolio investment collection uses a simplified threshold of €500 million; authorities estimate about 2 percent of transactions are not captured monthly by this threshold, but such transactions are included in the first release of the annual balance of payments data and monthly numbers are revised accordingly.

### Real sector statistics
- INE published a full set of national accounts based on ESA95 methodology in fall 2000, including quarterly GDP estimates.
- The authorities are rebasing national account statistics to 2000.
- The Bank of Portugal continues to produce separate estimates of the annual national accounts.

### Fiscal sector statistics and reporting issues
- Fiscal sector data underwent a number of revisions during the transition to ESA95, sizably altering revenues and expenditures and hampering comparisons across years.
- The 2001–04 budgets were presented fully consistent with recent changes in national and fiscal accounting methodology.
- Intra-year budget data are available only on a cash basis.
- INE started publishing:
  - Social Security Fund data monthly with 45 days delay (since 2002).
  - Autonomous Funds data quarterly with 75 days delay (since 2003).
- Except for local and general government, data broadly meet SDDS timeliness standards.
- A project is underway concerning quarterly general government statistics on an accrual basis, but no firm timetable is in place for publication.

### External sector and balance of payments
- Trade and balance of payments data are provided according to the IMF’s Fifth Edition of the Balance of Payments Manual.
- Although external trade data meet timeliness standards, frequent and sizeable revisions hamper usefulness.
- Portfolio investment threshold: €500 million; authorities estimate about 2 percent of transactions not captured monthly by this threshold; all transactions below threshold are included in the first release of the annual balance of payments data and monthly numbers are revised accordingly.
- Gross external debt: reported above 150 percent of GDP since 2004 in gross terms; net external debt does not go beyond 40 percent of GDP (as stated by the authorities).

### Table of Common Indicators Required for Surveillance (selected items, as of August 29, 2005)
- Exchange Rates: Latest Observation 8/29/05; Date Received 08/05; Frequency of Data/Reporting/Publication: D/D/D.
- International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Latest Observation 06/05; Date Received 08/05; Frequency: M/M/M.
- Reserve/Base Money: Latest Observation 06/05; Date Received 08/05; Frequency: M/M/M.
- Broad Money: Latest Observation 06/05; Date Received 08/05; Frequency: M/M/M.
- Central Bank Balance Sheet: Latest Observation 07/05; Date Received 08/05; Frequency: M/M/M.
- Consolidated Balance Sheet of the Banking System: Latest Observation 07/05; Date Received 08/05; Frequency: M/M/M.
- Interest Rates: Latest Observation 06/05; Date Received 08/05; Frequency: W/W/W.
- Consumer Price Index: Latest Observation 06/05; Date Received 08/05; Frequency: M/M/M.
- Revenue, Expenditure, Balance and Composition of Financing – General Government: Latest Observation 06/05; Date Received 08/05; Frequency: M/M/M.
- Revenue, Expenditure, Balance and Composition of Financing – Central Government: Latest Observation 06/05; Date Received 08/05; Frequency: M/M/M.
- Stocks of Central Government and Central Government-Guaranteed Debt: Latest Observation 06/05; Date Received 08/05; Frequency: M/M/M.
- External Current Account Balance: Latest Observation 2005 Q2; Date Received 08/05; Frequency: Q/Q/Q.
- Exports and Imports of Goods and Services: Latest Observation 2005 Q2; Date Received 07/05; Frequency: Q/Q/Q.
- GDP/GNP: Latest Observation 2005 Q1; Date Received 07/05; Frequency: Q/Q/Q.
- Gross External Debt: Latest Observation 2005 Q1; Date Received 07/05; Frequency: Q/Q/Q.

### IMF staff updates and short-term indicators (Statement by IMF Staff Representative, October 14, 2005)
- Short-term indicators mixed; no indication that a sustained recovery is in the works.
- Consumer confidence posted its fourth consecutive monthly decline in September; confidence indicators for manufacturing and services were stable at low levels.
- Industrial production rose 1.9 percent in August (month-on-month, seasonally adjusted); the Bank of Portugal’s coincident indicator for that month deteriorated slightly.
- Harmonized consumer prices rose 2.5 percent year-on-year in August; core inflation was 1.8 percent.
- Gap between Portuguese and euro-zone annual inflation rates: 0.3 percentage points in August.
- Political development: Portugal's governing Socialist party was defeated in local elections held October 8; Social Democrats won 158 municipalities, Socialists won 109, others won 41. Government pledged to continue its reform program.

### Authorities’ statement and priorities (Statement by Arrigo Sadun and Luis Saramago, October 14, 2005)
Key points and policy objectives:
- Portugal has experienced slower growth and higher unemployment following an EMU-related boom; recovery of growth and real convergence to the EU average depend on sustained fiscal consolidation and increased competitiveness.
- Government committed to a medium-term fiscal strategy and structural measures; Stability and Growth Program aims for a deficit below 3 percent of GDP in 2008 and further less beyond, focusing on expenditure restraint and refraining from one-off measures.
- Structural reforms planned across business environment, education, IT use, R&D, energy, legal system, and public administration to foster productivity and potential output.
- Recent reforms include: possibility of creating a firm in one hour; increase in classroom time for teachers; enhanced competition to promote broadband internet use; simplified legal proceedings for low-value debt claims.
- Fiscal measures introduced to bring the 2005 deficit down to 6 percent of GDP include a rise of the top VAT rate, freezing of automatic civil service promotions, a new income tax top rate, and increases in fuel and tobacco taxes; tax administration efficiency has increased.
- Authorities pledged to reduce the deficit below 3 percent of GDP in three years and to 1.5 percent by 2009 (as stated in the revised Stability and Growth Program endorsed by the EU Council on September 20).
- Expenditure measures under consideration: alignment of the social security regime for public servants with the general regime; audit-based reform of public administration; efficiency-enhancing measures for the National Health System; reform of local finances; preparation of a multi-year budget framework; heightened efficiency criteria for public investment.
- Authorities stand ready to take additional measures if macroeconomic assumptions embedded in the Program do not materialize.

### Debt, financial sector, and vulnerabilities (authorities’ assessment)
- Current public debt: rose from 51.2 percent of GDP in 2000 to 59.4 percent in 2004; expected to start declining by 2008.
- The rise in public debt is just now breaching the Maastricht criterion, stands below the euro area average, and spreads to relevant benchmarks remain historically low.
- Household debt tripled as a percentage of disposable income in the last ten years, reaching one of the highest levels for OECD countries; household wealth stands at about 500 percent of disposable income.
- Credit growth slowed markedly since 2001 and is overwhelmingly long-term and housing-related.
- Interest burden is now about as heavy as it was a decade ago.
- External debt rose steadily and was above 150 percent of GDP in gross terms since 2004; net external debt does not go beyond 40 percent of GDP.
- Banking sector: indicators of solvability, liquidity and credit quality improved again in 2004; profitability remained comfortable amid strong competition. Insurance sector improvements noted. Preparations for IFRS and Basle II are on-track; authorities look forward to first FSAP mission by year-end.

*Source: _cr05375 - 1.      Data provision to the Fund is adequate for surveillance purposes. Portugal*

### 7.2 percent in the second quarter. Due in part to weak demand, inflation fell to just over

### _cr05375 - 7.2 percent in the second quarter. Due in part to weak demand, inflation fell to just over

### Economic performance and outlook
- Inflation fell to just over 2 percent in the first half of 2005.
- Real GDP is projected to grow by about ½ percent in 2005 and 1¼ percent in 2006.
- Poor productivity growth has weakened external competitiveness, causing export shares to shrink.
- The current account deficit (excluding capital transfers) widened to 7.2 percent of GDP last year.
- High private indebtedness, especially among households, weak competitiveness, and planned significant fiscal consolidation are expected to constrain growth in the near future.

### Public finances and consolidation strategy
- Extensive use of one-off measures kept the budget deficit within the SGP ceiling of 3 percent of GDP over the last few years, but did not address the steady rise in current expenditure over the last decade.
- An independent audit forecasted a deficit of about 6½ percent of GDP this year without one-off measures.
- Authorities announced intention to reduce the deficit below 3 percent of GDP without one-off measures by 2008.
- In July, a series of revenue measures—including an increase in the VAT rate—were introduced, with a view to reducing the 2005 deficit to 6 percent of GDP.
- Over time, expenditure measures, especially pension and civil service reforms, are expected to constitute the bulk of the adjustment effort.
- Some key elements of the consolidation effort remain to be defined.
- Directors commended the fiscal strategy emphasizing medium-term expenditure containment and an appropriately ambitious pace of adjustment.
- Directors supported the decision to largely abandon one-off measures and noted that bringing the deficit below 3 percent of GDP by 2008 would strike an appropriate balance.
- Directors were encouraged by the authorities’ willingness to take additional measures—ideally on the expenditure side—if needed to achieve the deficit targets.
- Directors cautioned that the fiscal adjustment planned for the next four years is but the first stage of a longer process of deficit reduction that should aim at achieving overall budget balance.
- Directors noted the looming rise in pension and health care spending from population aging and the need for durable measures to improve quality and efficiency of public expenditure.
- Directors supported consideration of reforms to local government financing arrangements—including possible binding expenditure limits.

### Revenue and expenditure composition of adjustment
- Adjustment in 2005 has come primarily from revenue measures.
- Key expenditure-side elements still being defined include reforms of the public administration and of the retirement system for private sector workers.
- Directors stressed that early definition and implementation of these bedrock spending reforms will be essential and that sufficient progress to allow these reforms to be reflected in the 2006 budget will be critical for credibility.

### Structural reforms and competitiveness
- Directors underscored the need to pursue sustainable fiscal adjustment and measures to improve product and labor markets, enhance the business environment, and strengthen human capital development.
- Directors praised initiatives to promote research and development and information technology spending, and ongoing and planned reforms to the education and training system and to the business environment.
- Directors welcomed measures to reduce the time required to open a new business and called for reducing delays in the legal system and accelerating licensing and permit processes.
- Directors stressed the need to enhance competition in key sectors like telecommunications and transportation, where relatively high costs undermine competitiveness.
- Directors called on authorities to pursue additional steps to raise labor market flexibility and improve the responsiveness of wages to productivity and skill differentials.
- Directors observed that restrictions on collective dismissals exceed the EU average, and those on individual dismissals are the tightest in the OECD.
- Directors cautioned that extensive use of temporary contracts and self-employment can create a segmented labor market, raising equity concerns and hampering productivity growth.

### Financial sector resilience and risks
- Strong growth of bank lending to households, especially for mortgages, led to a continued increase in the private sector credit-to-GDP ratio, which reached about 144 percent by the end of 2004.
- The banking sector has proven resilient to the economic downturn: indicators point to improved capitalization, solid profitability and low levels of Non-Performing Loans.
- Directors welcomed the resiliency of the financial sector to the economic slowdown and noted banks have remained adequately capitalized and liquid, profitability has been solid, and the quality of banks’ loan portfolios has remained broadly stable.
- Directors cautioned about potential vulnerabilities arising from high household and corporate debt and the concentration of loans across sectors and enterprises.
- Directors welcomed the authorities’ commitment to continue to monitor developments carefully, to intensify oversight of risk management practices, and to undertake a Financial Sector Assessment Program this year.

### External policy and development
- Directors encouraged the authorities to actively support progress in multilateral trade liberalization under the Doha round.
- Directors encouraged increasing Portugal’s overseas development assistance toward the UN target level of 0.7 percent of gross national income.

### Selected economic indicators (2001–06) — key figures preserved exactly as in source
- Real GDP (change in percent): 2001: 2.0; 2002: 0.5; 2003: -1.2; 2004 1/: 1.2; 2005 1/: 0.5; 2006 1/: 1.2
- Domestic demand (change in percent): 2001: 1.7; 2002: -0.1; 2003: -2.6; 2004 1/: 2.2; 2005 1/: 1.7; 2006 1/: 1.3
- CPI (year average, harmonized index): 2001: 4.4; 2002: 3.7; 2003: 3.3; 2004 1/: 2.5; 2005 1/: 2.3; 2006 1/: 2.5
- Unemployment rate (in percent): 2001: 4.0; 2002: 5.0; 2003: 6.3; 2004 1/: 6.7; 2005 1/: 7.4; 2006 1/: 7.7
- Gross national saving (percent of GDP): 2001: 17.8; 2002: 18.2; 2003: 17.9; 2004 1/: 15.9; 2005 1/: 14.7; 2006 1/: 15.4
- Gross domestic investment (percent of GDP): 2001: 27.5; 2002: 25.5; 2003: 23.0; 2004 1/: 23.1; 2005 1/: 22.8; 2006 1/: 22.9
- General government balance (percent of GDP): 2001: -4.2; 2002: -2.8; 2003: -2.9; 2004 1/: -3.0; 2005 1/: -6.0; 2006 1/: -4.5
- Primary balance (percent of GDP): 2001: -1.2; 2002: 0.1; 2003: -0.1; 2004 1/: -0.3; 2005 1/: -3.2; 2006 1/: -1.3
- Public debt (percent of GDP): 2001: 53.6; 2002: 56.1; 2003: 57.7; 2004 1/: 59.4; 2005 1/: 65.6; 2006 1/: 66.6
- Total domestic credit (end-period, percent change): 2001: 11.6; 2002: 6.5; 2003: 1.7; 2004: 4.5; 2005: ...; 2006: ...
- National contribution to euro area M3 2/ : 2001: 6.8; 2002: -1.1; 2003: 4.2; 2004: 5.7; 2005: ...; 2006: ...
- Deposit rate, up to 2 years 3/ (end-period): 2001: 3.3; 2002: 2.9; 2003: 2.0; 2004: 2.0; 2005: ...; 2006: ...
- Ten-year government bond yield (end-period): 2001: 5.0; 2002: 4.5; 2003: 4.5; 2004: 3.6; 2005: ...; 2006: ...
- Trade balance (percent of GDP): 2001: -11.9; 2002: -10.0; 2003: -8.7; 2004 1/: -10.3; 2005 1/: -12.0; 2006 1/: -11.3
- Current account (including capital transfers, percent of GDP): 2001: -8.8; 2002: -5.8; 2003: -3.2; 2004 1/: -5.6; 2005 1/: -6.5; 2006 1/: -5.8
- Net official reserves (in US$ billions, end of period): 2001: 15.3; 2002: 15.9; 2003: 11.5; 2004: 10.7; 2005: ...; 2006: ...
- Exchange rate (Present rate August, 2005): US$1.23 per €1
- Nominal effective rate (2000 = 100): 2001: 100.6; 2002: 101.4; 2003: 104.2; 2004: 104.8; 2005: ...; 2006: ...
- Real effective rate (2000 = 100): 2001: 102.5; 2002: 105.0; 2003: 109.1; 2004: 109.9; 2005: ...; 2006: ...

*Source: IMF staff estimates, projections, and Executive Board assessment as presented in the document.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05375.pdf_