## _cr07341 - EXECUTIVE SUMMARY ## Source details **Canonical URL:** [_cr07341 - EXECUTIVE SUMMARY](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr07341.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr07341.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr07341.pdf.json) --- ### Background and Recent Developments - A modest recovery is finally underway, led by strong external demand. - Corporate investment shows signs of strengthening, but overall domestic demand remains weak. - Decisive action is being taken to address fiscal imbalances accumulated during the 1990s. - The government that came to power in March 2005 has started expenditure-based fiscal consolidation, reformed the pension system (both private and public), and improved the business environment. ### Key Challenges - Underlying economic situation remains difficult: - Productivity growth continues to lag. - The loss of competitiveness has not been regained. - The income convergence process with the EU is in reverse. - Root causes traced to: - Low levels of human capital, investment in R&D, and ICT penetration. - Shortcomings in the business environment. - Insufficient competition in domestic markets. - Labor market rigidities. - Sustained large current account deficit and corresponding external indebtedness reflect weak competitiveness, sustained high private sector borrowing and declining household savings, and the large fiscal deficit. - As a euro-area member with a robust financial sector, external financing remains readily available. ### Staff Views and Policy Priorities - Use the current favorable economic setting to further streamline the public sector and to boost productivity and competitiveness. - Specific policy guidance: - Adhere to expenditure plans. - Lock-in the revenue overperformance. - Make the labor market more flexible. - Increase contestability of the nontradable sector. - Authorities broadly agreed with staff analysis; they concurred with the need to lock-in the revenue overperformance but stressed caution in setting targets and the uncertainty of the revenue strength. ### Outlook: A Modest and Fragile Recovery - Recent performance: - Growth rose to 1.3 percent in 2006 (still the lowest in the euro area), led by strong external demand and a notable rebound in export growth. - Employment and participation rates have risen, but unemployment has also increased. - Inflation has remained consistently higher than the euro average despite a still-significant output gap and sluggish domestic demand. - Credit and balance sheet dynamics: - Household debt: at end-2006, household debt was around 125 percent of disposable income, the second highest in the euro area. - Credit acceleration driven mainly by non-mortgage lending; corporate lending driven by debt restructuring and M&A activity rather than investment. - Some corporate balance sheet restructuring has occurred, but still-high enterprise debt may restrain investment rebound. - Staff central scenario and projections: - Continuing but modest structural adjustment and gradually strengthening growth. - Staff projects growth of around 2 percent in 2007 and 2008. - Over the medium-term, staff foresees growth increasing to around 2¼ percent leading to a closing of the output gap by 2012—before settling down to potential rates of about 2 percent. ### Box 1 — Exports: 2006 Performance and Outlook - Exports of goods and services grew at almost 9 percent in real terms in 2006 compared to an average of 2½ percent in the previous five years. - Surge led by strong demand in Portugal’s main trading partners (especially Spain, Germany, and the U.S), with contributions from smaller partners (Angola and Singapore). - Pick-up mainly due to faster growth in exports of machinery and transport equipment, manufactured material, as well as tourism and transport services; clothing and footwear sectors remained stagnant. - The loss of market share in recent years appears to have stopped (though a similar pause occurred in 2002–03 before falling again). - Longer-run indicators still suggest a significant competitiveness gap; given recent competitiveness losses, premature to expect sustained market share gains despite 2006 pickup. ### Risks to the Outlook - Short term: - Private investment may not pick up as strongly as projected. - Exports could grow more strongly, benefiting from more favorable global demand. - Longer term: - Main risk is that the pace of reform will slacken. - Balance sheet problems may depress household consumption and investment. - Authorities were more optimistic, especially about private investment prospects; business investment excluding construction grew by 3 percent in 2006 and authorities saw growth accelerating to 3 percent by 2010. ### Policy Challenges and Competitiveness Assessment - Consensus: raising long-term growth potential requires maintaining the reform momentum and building on gains already made. - Staff estimates indicate a real exchange rate overvaluation of some 10–20 percent. - Fiscal consolidation, household balance sheet adjustment, and product market reforms should help narrow the gap, but staff considered the real exchange rate overvalued at the current juncture. ### A. Streamlining the Public Sector — Fiscal Outcomes and Recommendations - Fiscal consolidation outcomes: - Overall balance improved from a deficit of 6 percent of GDP in 2005 to 3.9 percent of GDP in 2006 (without one-off measures), compared to a budget target of 4.6 percent of GDP. - Improvement was mostly due to lower spending. - Fiscal overperformance, 2006 (percent of GDP): - SGP (December 2005) fiscal balance: -6.0 (2005) to -4.6 (2006), Diff. 1.4 - Actual fiscal balance: -6.1 (2005) to -3.9 (2006), Diff. 2.2 - Revenue: 41.5 (2005) to 42.3 (2006), Diff. 0.8 - Expenditure: 47.5 (2005) to 46.2 (2006), Diff. -1.4 - Structural balance SGP (December 2005): -4.8 (2005) to -3.3 (2006), Diff. 1.5 - Structural balance Actual (Auth. Apr 07): -4.9 (2005) to -2.7 (2006), Diff. 2.2 - Contributors to improvement: - Primary current spending fell in 2006 after a decade of almost one percentage point of GDP increases a year; most reduction due to a lower wage bill (which remains the highest in the euro area). - Capital spending came in well under budget as local governments scaled investment back from election-related higher levels of 2005. - Deficit overperformance relative to budget was driven by revenue strength towards the end of the year; marked improvement in tax administration is a contributing factor. - Updated deficit and structural balance targets (SGP Dec. 06 vs Updated Apr. 07): - Fiscal balance (percent of GDP) — SGP Dec. 06: 2006 -4.6; 2007 -3.7; 2008 -2.5; 2009 -1.5; 2010 -0.4 - Fiscal balance (percent of GDP) — Updated targets (Apr. 07): 2006 -3.9; 2007 -3.3; 2008 -2.4; 2009 -1.5; 2010 -0.4 - Structural balance (percent of GDP) — SGP Dec. 06: 2006 -3.4; 2007 -2.6; 2008 -1.8; 2009 -1.3; 2010 -0.5 - Structural balance (percent of GDP) — Updated targets (Apr. 07): 2006 -2.7; 2007 -2.2; 2008 -1.6; 2009 -1.2; 2010 -0.5 - Staff recommendations: - Front-load consolidation further given revenue strength and uncertainties; additional tightening by about ¼ percentage point of GDP in both 2007 and 2008 was suggested. - Save continued revenue overperformance; monitor local government budget execution and capital spending shortfalls. - Long-term sustainability: - Recent social security reforms imply public debt would remain below 60 percent of GDP through 2040 if the underlying MTO position is achieved and maintained; debt ratio would exceed 90 percent of GDP by 2050 (compared to nearly 200 percent of GDP before the reform). ### B. Boosting Productivity and Competitiveness — Labor Market and Wages - Wage moderation and labor market flexibility essential given EMU membership. - Staff concern: decision to increase the minimum wage by 5.3 percent a year annually on average between 2007–11 is potentially problematic: - Minimum wage binding for 5 percent of total employment and substantially higher in sectors facing intensive competitive pressures (textiles 15 percent). - Staff recommendations on labor market reform: - Use the labor code review to: - Ease employment protection legislation (especially for individuals). - End automatic extension of collectively agreed contracts to firms not part of the agreement. - Make procedures less cumbersome. - Participation and skills: - “New Opportunities” program has boosted training and skill levels; staff cautioned on maintaining training quality as numbers increase. ### Competition in Nontradable Sector and Product/Service Market Reforms - Increasing competition in the nontradable sector is key to improving productivity and ensuring wage moderation translates into lower prices rather than higher mark-ups. - Business environment reforms: - Government’s “SIMPLEX” program substantially eased procedures to create companies; further simplification of permit systems, especially at local level, recommended. - Network industries and energy: - Electricity consumers have been able to choose suppliers since September; electrical and gas grid company about to be privatized. - Immediate consumer price impact muted by decisions to pass on costs from existing contracts and policy to increase renewables. - Recommendation: avoid actions such as recent capping of regulated price increases; meeting end-2008 target for full gas liberalization important. - Competition Authority and telecoms: - Competition Authority actions in pharmaceutical and telecommunication sectors noted positively. - Planned spin-off of the cable network operator from Portugal Telecom in September welcomed; effectiveness may depend on future ownership structures. ### Financial System Soundness and FSAP Follow-up - Financial system remained sound; FSAP found system could withstand even severe macroeconomic disturbances. - Indicators and risks: - Capital adequacy about average; profitability aided by economic pick-up and Basel II adoption. - Nonperforming loans remain low; loan-to-value ratios in line with other EU countries. - High household and corporate debt remain main sources of risk; bank lending concentrated in real estate and a limited number of large corporates. - Supervisory improvements: - Bank of Portugal strengthened supervisory capacity with a new risk rating system (MAR), completion of the Household Wealth Survey, and enhanced housing price statistics. - Bank of Portugal plans bottom-up stress tests every other year; next round due early 2008. - Staff recommendation: close monitoring of key risk areas and regular updating of FSAP results. ### Staff Appraisal — Fiscal Consolidation and Competitiveness - Decisive action taken: expenditure-based fiscal consolidation, pension reform, and business environment improvements. - Remaining challenges: significant external competitiveness gap, reversed income convergence with the EU, labor market rigidities, and anemic productivity growth. - Policy implication: further reforms needed to regain competitiveness and increase long-term growth potential; strengthen productivity and foster wage moderation. ### Key Policy Recommendations (selected) - Save continued revenue overperformance; consider modestly more ambitious deficit targets for 2007 and 2008 (about ¼ percent of GDP each year) to front-load adjustment. - Follow through on central administration restructuring and move significant numbers of civil servants to the special mobility pool. - Move to performance-based, medium-term budgeting (but monitor timetable feasibility). - Ease employment protection, end automatic extension of collective agreements, and simplify procedures. - Strengthen competition in domestic markets, especially network industries and some service sectors; improve judicial framework for debt recovery. - Avoid capping regulated price increases in energy; meet gas liberalization target of end-2008. - Continue vigilant monitoring of household and corporate debt and bank lending concentrations; implement FSAP follow-up. ### Selected Exact Key Economic Indicators (selected exact figures) - Real GDP: 0.8 (2002); -0.7 (2003); 1.3 (2004); 0.5 (2005); 1.3 (2006); 1.8 (2007); 2.0 (2008 projection); 2.0 Q1 07 - Real domestic demand: 0.0 (2002); -2.0 (2003); 2.4 (2004); 0.8 (2005); 0.3 (2006); 1.0 (2007); 1.3 (2008 projection); 0.1 Q1 07 - Private consumption: 1.3 (2002); -0.1 (2003); 2.5 (2004); 2.2 (2005); 1.2 (2006); 1.3 (2007); 1.4 (2008 projection); 1.2 Q1 07 - Unemployment rate: 5.0 (2002); 6.3 (2003); 6.7 (2004); 7.6 (2005); 7.7 (2006); 7.4 (2007); 7.1 (2008 projection); 8.4 Q1 07 - Consumer prices (harmonized index): 3.7 (2002); 3.3 (2003); 2.5 (2004); 2.1 (2005); 3.0 (2006); 2.5 (2007); 2.4 (2008 projection); 2.6 Jun07 - Current account (percent of GDP): -8.1 (2002); -6.1 (2003); -7.7 (2004); -9.7 (2005); -9.4 (2006); -9.2 (2007); -9.1 (2008 projection) - Government revenues (percent of GDP): 41.4 (2002); 42.5 (2003); 43.1 (2004); 41.5 (2005); 42.3 (2006); 41.8 (2007); 41.6 (2008 projection) - Government expenditures (percent of GDP): 44.2 (2002); 45.4 (2003); 46.4 (2004); 47.5 (2005); 46.2 (2006); 45.1 (2007); 44.0 (2008 projection) - Overall balance (percent of GDP): -2.9 (2002); -2.9 (2003); -3.3 (2004); -6.1 (2005); -3.9 (2006); -3.3 (2007); -2.4 (2008 projection) - Government debt, Maastricht definition (percent of GDP): 55.5 (2002); 56.8 (2003); 58.2 (2004); 63.6 (2005); 64.8 (2006); 65.0 (2007); 64.7 (2008 projection) - Household debt (percent of disposable income): 90 (2001); 97 (2002); 104 (2003); 110 (2004); 117 (2005); 125 (2006) - Net international investment position (percent of GDP): -47.4 (2001 memorandum); -56.3 (2002); -60.0 (2003); -64.9 (2004); -70.4 (2005); -79.4 (2006); -84.4 (2007); -89.0 (2008); -92.9 (2009); -96.3 (2010); -99.1 (2011); -101.7 (2012) ### Financial Sector and FSAP Follow-up (selected exact figures) - Risk-based capital asset ratio (consolidated banking system, percent): 9.5 (2001); 9.8 (2002); 10.0 (2003); 10.4 (2004); (2005 IAS sample) 10.2; (2006 IAS sample) 11.3; 10.9 (2006 1/) - NPLs to gross loans (percent): 2.2 (2000); 2.2 (2001); 2.2 (2002); 2.3 (2003); 2.4 (2004); 2.0 (2005); 1.5 (2006); 1.3 (2006 1/) - Loans as percent of deposits (percent): 116.0 (2000); 122.7 (2001); 129.5 (2002); 129.1 (2003); 128.3 (2004); 130.9 (2005); 137.5 (2006); 145.6 (2006 1/) - Nonfinancial corporate debt (percent of GDP): 96 (2001); 96 (2002); 99 (2003); 99 (2004); 103 (2005); 105 (2006) ### Recommended Next Steps and Consultation Cycle - It is recommended that the next consultation occur on the standard 12-month cycle. - Portugal is encouraged to increase its ODA to 0.7 percent of GNI. - Statistical priorities: improve timeliness and quality of employment and wage compensation data and sectoral balance sheet data. *Source: _cr07341 - EXECUTIVE SUMMARY* ### EXECUTIVE SUMMARY ### _cr07341 - EXECUTIVE SUMMARY ### Background and Recent Developments - A modest recovery is finally underway, led by strong external demand. - Corporate investment shows signs of strengthening, but overall domestic demand remains weak. - Decisive action is being taken to address fiscal imbalances accumulated during the 1990s. - The government that came to power in March 2005 has started expenditure-based fiscal consolidation, reformed the pension system (both private and public), and improved the business environment. ### Key Challenges - Underlying economic situation remains difficult: - Productivity growth continues to lag. - The loss of competitiveness has not been regained. - The income convergence process with the EU is in reverse. - Root causes traced to: - Low levels of human capital, investment in R&D, and ICT penetration. - Shortcomings in the business environment. - Insufficient competition in domestic markets. - Labor market rigidities. - The sustained large current account deficit and corresponding external indebtedness reflect weak competitiveness, sustained high private sector borrowing and declining household savings, and the large fiscal deficit. - As a euro-area member with a robust financial sector, external financing remains readily available. ### Staff Views and Policy Priorities - The current favorable economic setting should be used to further streamline the public sector and to boost productivity and competitiveness. - Specific policy guidance: - Adhere to expenditure plans. - Lock-in the revenue overperformance. - Make the labor market more flexible. - Increase contestability of the nontradable sector. ### Authorities’ Views - Authorities broadly agreed with staff analysis, overlapping considerably with their own. - They concurred with the need to lock-in the revenue overperformance but stressed caution in setting targets and the uncertainty of the revenue strength. - On competitiveness, authorities acknowledged a problem but downplayed the significance of standard indicators. - On the labor market, authorities intend to increase flexibility, while arguing that rigidity is somewhat overstated. ### Overview: Boom to Bust - Late 1990s boom: - Prospect of adopting the euro reduced real interest rates, fueling investment and consumption and loosening fiscal stance. - Resulted in rapid growth of GDP, employment, wages, debt, and the current account deficit. - Post-2000 bust: - Balance sheets became stretched; expected productivity gains failed to materialize. - Corporates cut investment and employment; growth slumped. - Erosion of competitiveness and negative external developments led exports to flag and reversed convergence. - Wages and productivity: - Wage growth moderated to the euro area average after 2000, but real wage increases continued to outpace labor productivity growth, raising unit labor costs. ### Outlook: A Modest and Fragile Recovery - Recent performance: - Growth rose to 1.3 percent in 2006 (still the lowest in the euro area), led by strong external demand and a notable rebound in export growth. - Employment and participation rates have risen, but unemployment has also increased. - Inflation has remained consistently higher than the euro average despite a still-significant output gap and sluggish domestic demand, suggesting rigidities in product and labor markets. - Credit and balance sheet dynamics: - Household debt: at end-2006, household debt was around 125 percent of disposable income, the second highest in the euro area. - Credit acceleration driven mainly by non-mortgage lending; corporate lending driven by debt restructuring and M&A activity rather than investment. - Some corporate balance sheet restructuring has occurred, but still-high enterprise debt may restrain investment rebound. - Staff projections and scenario: - Central scenario: continuing but modest structural adjustment and gradually strengthening growth. - With fiscal consolidation broadly as envisaged by the government’s SGP commitments and modest further structural reforms, a gradual recovery in competitiveness and productivity is projected. - External sector expected to contribute positively given strong external demand (though exports are projected to lose slightly more market share). - Domestic demand likely to remain subdued; consumption constrained by weak employment growth and high indebtedness, though credit growth has picked up. - Staff projects growth of around 2 percent in 2007 and 2008, in line with official and Commission estimates. - Over the medium-term, staff foresees growth increasing to around 2¼ percent leading to a closing of the output gap by 2012—before settling down to potential rates of about 2 percent. ### Box 1 — Portugal’s Exports: Blip or Recovery? - Export performance in 2006: - Exports of goods and services grew at almost 9 percent in real terms in 2006 compared to an average of 2½ percent in the previous five years. - Surge led by strong demand in Portugal’s main trading partners (especially Spain, Germany, and the U.S), with contributions from smaller partners (Angola and Singapore). - Pick-up mainly due to faster growth in exports of machinery and transport equipment, manufactured material, as well as tourism and transport services; clothing and footwear sectors remained stagnant. - The loss of market share in recent years appears to have stopped (though a similar pause occurred in 2002–03 before falling again). - Longer-run indicators and outlook: - A wide range of indicators still suggests Portugal has a significant competitiveness gap. - Since the beginning of the decade: Portugal continues to move away from low-tech exports (clothing and footwear), although slower than in the 1990s; Portugal’s export share continues to slip in the EU market but has been growing outside the EU. - Given robust external demand, the 2006 export response bodes well for gradual recovery, but given competitiveness losses of recent years, it seems premature to expect gains in market share. *Source: _cr07341 - EXECUTIVE SUMMARY* ### 8. Risks to near-term growth outlook appear balanced, but are skewed to the ### 8. Risks to near-term growth outlook appear balanced, but are skewed to the ### Risks to the outlook - Short term: - Private investment may not pick up as strongly as projected. - Exports could grow more strongly, benefiting from more favorable global demand. - Longer term: - Main risk is that the pace of reform will slacken. - Balance sheet problems may depress household consumption and investment. - Authorities’ view: - Authorities were more optimistic, especially about private investment prospects. - Business investment excluding construction grew by 3 percent in 2006. - Authorities saw growth accelerating to 3 percent by 2010 and emphasized substantial foreign investment plans in the pipeline. ### Policy challenges (III. POLICY CHALLENGES) - Consensus: raising long-term growth potential requires maintaining the reform momentum and building on gains already made. - Priorities: - Further streamline the public sector. - Boost productivity and competitiveness. - Rationale: - Streamlining the public sector would help regain competitiveness by moderating wage growth and improving the efficiency of public services. - Greater competitiveness would spur growth and employment, easing fiscal adjustment. - Letting reform slip would increase the duration and costs of adjustment. - Competitiveness assessment: - Staff estimates indicate a real exchange rate overvaluation of some 10–20 percent. - This gap is consistent with developments in relative unit labor costs, the current account and export market share. - Fiscal consolidation, household balance sheet adjustment, and product market reforms should help narrow the gap, but staff considered the real exchange rate overvalued at the current juncture. ### A. Streamlining the Public Sector - Political framing: - Quote: "Good results only mean that we are...able to reach the end of the path faster. But there is still road ahead of us." — Prime Minister Sócrates, Budget address, 2007 - Fiscal consolidation outcomes: - Overall balance improved from a deficit of 6 percent of GDP in 2005 to 3.9 percent of GDP in 2006 (without one-off measures), compared to a budget target of 4.6 percent of GDP. - Improvement was mostly due to lower spending. - Fiscal overperformance, 2006 (percent of GDP): - SGP (December 2005) fiscal balance: -6.0 (2005) to -4.6 (2006), Diff. 1.4 - Actual fiscal balance: -6.1 (2005) to -3.9 (2006), Diff. 2.2 - Revenue: 41.5 (2005) to 42.3 (2006), Diff. 0.8 - Expenditure: 47.5 (2005) to 46.2 (2006), Diff. -1.4 - Structural balance SGP (December 2005): -4.8 (2005) to -3.3 (2006), Diff. 1.5 - Structural balance Actual (Auth. Apr 07): -4.9 (2005) to -2.7 (2006), Diff. 2.2 - Contributors to improvement: - Primary current spending fell in 2006 after a decade of almost one percentage point of GDP increases a year; most of the reduction was due to a lower wage bill (which remains the highest in the euro area). - Capital spending came in well under budget as local governments scaled investment back from election-related higher levels of 2005. - Deficit overperformance relative to budget was driven by revenue strength towards the end of the year; marked improvement in tax administration is a contributing factor. - Updated deficit targets (authority revisions, Apr. 2007): - Fiscal balance (percent of GDP): - SGP Dec. 06: 2006 -4.6; 2007 -3.7; 2008 -2.5; 2009 -1.5; 2010 -0.4 - Updated targets (Apr. 07): 2006 -3.9; 2007 -3.3; 2008 -2.4; 2009 -1.5; 2010 -0.4 - Structural balance (percent of GDP): - SGP Dec. 06: 2006 -3.4; 2007 -2.6; 2008 -1.8; 2009 -1.3; 2010 -0.5 - Updated targets (Apr. 07): 2006 -2.7; 2007 -2.2; 2008 -1.6; 2009 -1.2; 2010 -0.5 - Authorities intend to reduce the structural deficit by at least ½ percent of GDP a year until meeting the Medium-term Objective (MTO) of 0.5 percent of GDP in 2010. - Staff recommendations and assessment: - Staff welcomed intention to accelerate consolidation but argued for further front-loading given revenue strength and uncertainties about fiscal reforms and political pressures. - Staff saw a case for additional tightening by about ¼ percentage point of GDP in both 2007 and 2008 to maintain envisaged pace of structural deficit reduction. - Staff supported the new mechanism to better monitor local government budget execution but warned to monitor any large shortfalls of capital spending versus budget. - Authorities’ caution: - Authorities concerned about sustainability of revenue buoyancy due to high volatility in corporate tax. - Authorities signaled intention to lower the deficit further if revenue overperformance persists and noted contingency measures on spending. - Long-term sustainability: - Recent social security reforms imply that if the underlying (non age-related primary balance) MTO position is achieved and maintained, public debt would remain below 60 percent of GDP through 2040. - Debt ratio would exceed 90 percent of GDP by 2050 (compared to nearly 200 percent of GDP before the reform). - The SGP reference level for the deficit of 3 percent of GDP would also be breached in the 2030s. - Long-term projections depend on assumptions that could prove optimistic, e.g., health-care inflation. - Public administration restructuring: - Number of central administration structures has been cut by a quarter. - New public employment framework submitted to parliament. - Recruitment kept to less than half of departures. - Process entering critical phase of identifying weaker-performing civil servants and moving them into a special mobility pool (with progressively lower pay to encourage exit). - Tax policy stance: - With consolidation performing better than expected, government faced pressure to reduce the tax burden; staff and officials agreed it should be resisted. - Given Portugal’s fiscal situation and relatively low revenue ratio, no room exists for discretionary tax reductions in the near term. - Some tax laws should be simplified and procedures streamlined to improve competitiveness, especially for small and medium-sized firms. - Budgetary process reform: - Interim report of program budgeting committee envisages moving to performance-based, medium-term budgeting with expenditure ceilings. - Staff agreed this would enhance efficiency and quality of public spending and improve transparency and credibility, but suggested full roll-out by 2010 may be unduly demanding. ### Box 2: Making the Tax System More Pro-Growth (summary of source box) - System origins and structure: - Tax system roots in late-1980s tax reform; VAT and income tax introduced for EU accession in 1992. - Tax burden has increased but remains low compared to other industrialized countries and below the EU average. - System relies more on consumption taxes than the European average. - Tax administration improvements: - Updated registers; better electronic filing; improved audit results; more reliable databases; greater use of cross-checking. - Reform directions (balanced approach given consolidation needs): - Strengthen economic efficiency by broadening the tax base to allow possible revenue-neutral rate reductions. - Increase system simplicity and predictability. - Reduce administrative and compliance costs. - Enhance tax administration with greater focus on taxpayer services and reduction in noncompliance. ### B. Boosting Productivity and Competitiveness - Presidential framing: - Quote: “The problems have been diagnosed...what the Portuguese expect...is action and more action...we need to increase our productivity and to be more competitive.” — President Silva, Inaugural Address, 2006 - Wage restraint and labor market flexibility: - Given EMU membership, competitiveness must be restored in part through sustained wage moderation. - Experience from other economies highlights the importance of wage moderation but adjustment can take many years. - For Portugal, indicators suggest significant labor market rigidities; despite high unemployment and widespread temporary contracts, real wages have not fallen. - Staff view: recent decision to increase the minimum wage by 5.3 percent a year annually on average between 2007–11 is potentially problematic. - Minimum wage is binding for 5 percent of total employment and is substantially higher in sectors facing intensive competitive pressures (textiles 15 percent). - High employment protection combined with a higher wage floor could make restructuring more challenging. - Authorities’ response: - Minimum wage had eroded in recent years and poverty remains a pressing issue. - Authorities saw labor market as more flexible in practice than indicators suggest and emphasized focus on enhancing labor productivity and human capital rather than restraining wage growth. - Staff recommendations on labor market reform: - Use the labor code review to: - Ease employment protection legislation (especially for individuals). - End automatic extension of collectively agreed contracts to firms not part of the agreement. - Make procedures less cumbersome. - Labor market participation and skill upgrading: - Changes to unemployment benefit broaden definition of “acceptable” employment and promote active job-seeking. - “New Opportunities” program has boosted training and skill levels; staff welcomed take-up and outcomes but cautioned on maintaining training quality as numbers increase. ### Box 3: The Importance of Labor Market Flexibility in Regaining Competitiveness (summary of source box) - International examples: - Hong Kong SAR: adjustment after 1997 shock took about six years with highly flexible labor market, nominal wage growth turned negative especially in manufacturing; REER depreciated by about 5 percent a year. - Germany: adjustment after early-1990s cost pressures took about 12 years with less flexible markets; REER depreciated about 2 percent a year via sustained reduction in real wages. - Implications for Portugal: - Portugal has broadly followed Germany’s path; unit labor cost of manufacturing continues to rise and REER has barely moved. - A 10–20 percent competitive gap implies adjustment could still take about 5–8 years, assuming equal labor productivity growth but lower nominal wage growth in Portugal relative to the euro area by 2 percent annually. *Source: _cr07341 - 8. Risks to near-term growth outlook appear balanced, but are skewed to the* ### 26. Staff and the authorities concurred that increasing domestic competition in the ### _cr07341 - 26. Staff and the authorities concurred that increasing domestic competition in the ### Competition in the nontradable sector and productivity - Finding: Increasing domestic competition in the nontradable sector was key to improving productivity. - Rationale: - Increased competition in the nontradable sector is critical to ensuring that real wage moderation in the tradable sector results in lower prices rather than higher mark-ups. - Lower prices could foster support for labor market reform. - Key areas to be addressed: the business environment, network sectors, and energy. ### Business environment reforms - Finding: Substantial improvement generated by the government’s “SIMPLEX” program was welcomed by all interlocutors; it greatly eased procedures to create companies. - Recommendation: Initiatives to simplify the permit system, especially at the local level, should further enhance the business environment. ### Competition Authority, telecommunications, and cable operator restructuring - Finding: Agreement that the Competition Authority should continue to advocate and enforce competition; recent actions in the pharmaceutical and telecommunication sectors were noted positively. - Development: The planned spin-off of the cable network operator from Portugal Telecom in September was welcome. - Caveat: Staff suggested the effectiveness for enhancing competition may depend on whether the two network operators share the same ownership structure going forward. ### Energy sector liberalization and prices - Finding: Progress continues to be made on increasing competition in the energy sector and integration with Spain is accelerating. - Developments: - Electricity consumers have been able to choose their suppliers since September. - The electrical and gas grid company is about to be privatized. - Constraint on price impact: - Immediate impact on electricity prices will be muted by the decision to pass on to consumers the costs arising from existing electricity supply contracts and the policy to increase the share of renewables in generation. - Recommendation: Promoting competition is critical; actions such as the recent capping of regulated price increases should be avoided. - Gas sector target: Meeting the target of end-2008 for full liberalization will be important. ### Financial system soundness and FSAP follow-up - Finding: Portugal’s financial system remained sound. - Observations: - Intensified competition has resulted in banks granting somewhat more favorable lending terms and a slight deterioration in banks’ liquidity ratios. - Average loan-to-value ratios are in line with other EU countries. - Nonperforming loans remain low. - The banking sector compares favorably with other EU countries in terms of asset quality, efficiency, and profitability (capital adequacy is about average). - Profitability has been helped by the economic pick-up; banks have rationalized operating costs and enhanced risk management procedures in adopting Basel II. - Interest rates have risen and unemployment inched higher, but increases are modest. - The FSAP exercise last year found the financial system could withstand even severe macroeconomic disturbances. - Risks: - High household and corporate debt remains the main source of risk. - Bank lending concentrates on the real estate sector and on a limited number of large corporates. - Banks’ employee pension schemes are exposed to stock market fluctuations. - Authorities’ actions and staff views: - Progress made in implementing FSAP recommendations (Table 8). - Bank of Portugal has strengthened supervisory capacity with a new risk rating system, completion of the Household Wealth Survey, and enhanced housing price statistics. - Staff stressed the need to update FSAP results regularly. - Bank of Portugal plans bottom-up stress tests every other year; the next round is due early 2008. - Forthcoming results of the wealth survey will help identify key vulnerable subgroups of households. ### Staff appraisal — fiscal consolidation and competitiveness - Overall assessment: - Decisive action is being taken to correct fiscal imbalances accumulated during the 1990s; substantial expenditure-based fiscal consolidation is underway; the pension system has been reformed; the business environment has been enhanced. - Challenges: - The economic situation remains challenging and a significant external competitiveness gap persists. - The income convergence process with the EU has reversed. - Labor market rigidities and anemic productivity growth cast doubt about the ability to substantially lower unit labor costs. - Policy implication: Further reforms are needed to regain competitiveness and increase long-term growth potential; strengthening productivity and policies to foster wage moderation are essential. ### Fiscal performance and recommendations - Finding: The ambitious fiscal deficit reduction target for 2006 was surpassed. - Drivers: Improvement mainly driven by expenditure reduction, especially the wage bill, and to a lesser extent by unexpected revenue strength late in the year. - Recommendation: Revenue overperformance is continuing and should be saved; the government’s intention to do so is welcome. - Policy suggestion: Somewhat more ambitious deficit targets for 2007 and 2008 (by about ¼ percent of GDP), front-loading the adjustment, seem warranted given the continuing revenue boom, uncertainties about budgetary implications of current fiscal reforms, and the need to make remaining adjustment in 2009 and 2010 to achieve the MTO more credible. ### Public administration and budgeting reforms - Recommendation: Following through on central administration restructuring will be important for achieving fiscal consolidation goals and improving productivity; moving significant numbers of civil servants to the special mobility pool is a forthcoming critical phase. - Recommendation: The plan to move to performance-based budgeting is welcome and could greatly improve the efficiency and quality of public spending, though care should be taken to ensure the timetable is not unduly demanding. ### Labor market reform recommendations - Recommendation: Government’s intention to set up a commission to study labor market reform is encouraging and should be quickly followed by concrete measures. - Specific measures advocated: - Ease employment protection legislation (especially for individual dismissals). - End the automatic extension of collectively agreed contracts to firms not part of the agreement. - Make procedures less cumbersome. - Monitoring: The impact on labor market functioning of the recent decision to sharply increase the minimum wage in coming years should be carefully monitored. ### Product and service market reform recommendations - Finding: Strengthening ongoing product and service market reform could appreciably boost competitiveness and consumer welfare and lend support for reform in general. - Progress: SIMPLEX program progress is important; simplifying the permit system, especially at the local level, should further enhance the business environment. - Priority areas: Continued progress in increasing competition in domestic markets, especially in network industries and some service sectors; improving the working of the judicial system should be a priority. ### Energy sector and consumer price impact (staff view) - Finding: Progress continues on increasing competition in the energy sector, but the immediate impact on consumers is likely to be limited. - Recommendation: Actions such as the recent capping of regulated price increases should be avoided. ### Financial system monitoring (staff view) - Finding: The financial system remains sound and well supervised; some risks have increased slightly, though the system’s capacity to absorb even severe macroeconomic disturbances is strong. - Recommendation: Close monitoring of key risk areas by the Bank of Portugal should help ensure continued financial system health; progress on following up last year’s FSAP is welcome. ### External assistance and statistics - Recommendation: Portugal is encouraged to increase its ODA to 0.7 percent of GNI. - Statistics: Statistical data provision is adequate for surveillance, but improvements in timeliness and quality of employment and wage compensation data and sectoral balance sheet data should be a priority (Appendix II). *Source: IMF staff report content provided in the supplied PDF excerpt.* ### 45. It is recommended that the next consultation occur on the standard 12-month cycle. ### 45. It is recommended that the next consultation occur on the standard 12-month cycle. ### Recommendation - It is recommended that the next consultation occur on the standard 12-month cycle. ### Key economic indicators (selected exact figures) - Real GDP: 0.8 (2002); -0.7 (2003); 1.3 (2004); 0.5 (2005); 1.3 (2006); 1.8 (2007); 2.0 (2008 projection); 2.0 Q1 07 - Real domestic demand: 0.0 (2002); -2.0 (2003); 2.4 (2004); 0.8 (2005); 0.3 (2006); 1.0 (2007); 1.3 (2008 projection); 0.1 Q1 07 - Private consumption: 1.3 (2002); -0.1 (2003); 2.5 (2004); 2.2 (2005); 1.2 (2006); 1.3 (2007); 1.4 (2008 projection); 1.2 Q1 07 - Unemployment rate: 5.0 (2002); 6.3 (2003); 6.7 (2004); 7.6 (2005); 7.7 (2006); 7.4 (2007); 7.1 (2008 projection); 8.4 Q1 07 - Consumer prices (harmonized index): 3.7 (2002); 3.3 (2003); 2.5 (2004); 2.1 (2005); 3.0 (2006); 2.5 (2007); 2.4 (2008 projection); 2.6 Jun07 - Current account (percent of GDP): -8.1 (2002); -6.1 (2003); -7.7 (2004); -9.7 (2005); -9.4 (2006); -9.2 (2007); -9.1 (2008 projection) - Gross national savings: 17.1 (2002); 16.8 (2003); 15.3 (2004); 12.7 (2005); 12.6 (2006); 12.5 (2007); 12.5 (2008 projection) - Gross domestic investment: 25.2 (2002); 22.9 (2003); 23.0 (2004); 22.5 (2005); 22.0 (2006); 21.7 (2007); 21.6 (2008 projection) - Government revenues (percent of GDP): 41.4 (2002); 42.5 (2003); 43.1 (2004); 41.5 (2005); 42.3 (2006); 41.8 (2007); 41.6 (2008 projection) - Government expenditures (percent of GDP): 44.2 (2002); 45.4 (2003); 46.4 (2004); 47.5 (2005); 46.2 (2006); 45.1 (2007); 44.0 (2008 projection) - Overall balance (percent of GDP): -2.9 (2002); -2.9 (2003); -3.3 (2004); -6.1 (2005); -3.9 (2006); -3.3 (2007); -2.4 (2008 projection) - Government debt, Maastricht definition (percent of GDP): 55.5 (2002); 56.8 (2003); 58.2 (2004); 63.6 (2005); 64.8 (2006); 65.0 (2007); 64.7 (2008 projection) - Net international investment position (percent of GDP): -47.4 (2001 memorandum) ; -56.3 (2002) ; -60.0 (2003) ; -64.9 (2004) ; -70.4 (2005) ; -79.4 (2006) ; -84.4 (2007) ; -89.0 (2008) ; -92.9 (2009) ; -96.3 (2010) ; -99.1 (2011) ; -101.7 (2012) ### External sector and balance of payments (selected exact figures) - Current account (billions of euros): -12.8 (2001); -11.0 (2002); -8.5 (2003); -11.1 (2004); -14.5 (2005); -14.6 (2006); -15.0 (2007); -15.4 (2008); -15.6 (2009); -15.7 (2010); -15.9 (2011); -16.2 (2012) - Trade balance (billions of euros): -15.5 (2001); -14.1 (2002); -12.6 (2003); -15.0 (2004); -16.8 (2005); -16.6 (2006); -16.2 (2007); -16.2 (2008); -16.2 (2009); -15.8 (2010); -15.4 (2011); -15.1 (2012) - Exports fob (billions of euros): 27.3 (2001); 27.5 (2002); 28.4 (2003); 29.7 (2004); 30.7 (2005); 34.7 (2006); 37.6 (2007); 40.0 (2008); 42.2 (2009); 44.7 (2010); 47.7 (2011); 50.7 (2012) - Imports fob (billions of euros): 42.9 (2001); 41.6 (2002); 41.0 (2003); 44.8 (2004); 47.5 (2005); 51.3 (2006); 53.8 (2007); 56.2 (2008); 58.4 (2009); 60.6 (2010); 63.2 (2011); 65.8 (2012) - Services, net (billions of euros): 2.9 (2001); 3.3 (2002); 3.6 (2003); 4.0 (2004); 3.8 (2005); 4.9 (2006); 5.5 (2007); 5.9 (2008); 6.2 (2009); 6.5 (2010); 6.9 (2011); 7.3 (2012) - Income (billions of euros): -3.9 (2001); -3.2 (2002); -2.3 (2003); -2.9 (2004); -3.8 (2005); -5.4 (2006); -6.9 (2007); -7.8 (2008); -8.4 (2009); -9.2 (2010); -10.2 (2011); -11.3 (2012) ### Fiscal accounts and medium-term fiscal projections (selected exact figures) - Total revenues (percent of GDP): 40.1 (2001); 41.4 (2002); 42.5 (2003); 43.1 (2004); 41.5 (2005); 42.3 (2006); 41.8 (2007); 41.6 (2008); 41.4 (2009); 41.4 (2010) ; 41.4 (2011) ; 41.4 (2012) - Total expenditures (percent of GDP): 44.4 (2001); 44.2 (2002); 45.4 (2003); 46.4 (2004); 47.5 (2005); 46.2 (2006); 45.1 (2007); 44.0 (2008); 42.9 (2009); 41.8 (2010); 41.9 (2011); 41.9 (2012) - Primary balance (excluding one-off measures, percent of GDP): -1.3 (2001); -1.3 (2002); -2.5 (2003); -2.8 (2004); -3.4 (2005); -1.1 (2006); -0.4 (2007); 0.4 (2008); 1.3 (2009); 2.3 (2010); 2.2 (2011); 2.0 (2012) - Structural balance (excluding one-off measures, percent of GDP): -5.6 (2001); -5.1 (2002); -5.2 (2003); -5.3 (2004); -5.5 (2005); -3.2 (2006); -2.6 (2007); -1.9 (2008); -1.1 (2009); -0.1 (2010); -0.3 (2011); -0.5 (2012) - Public debt (Maastricht definition, percent of GDP): 52.9 (2001); 55.5 (2002); 56.8 (2003); 58.2 (2004); 63.6 (2005); 64.8 (2006); 65.0 (2007); 64.7 (2008); 63.4 (2009); 61.1 (2010); 59.0 (2011); 56.9 (2012) - Nominal GDP (in millions of euros): 129,309 (2001); 135,434 (2002); 138,582 (2003); 144,223 (2004); 148,928 (2005); 155,216 (2006); 162,740 (2007); 170,019 (2008); 177,570 (2009); 185,234 (2010); 193,491 (2011); 202,165 (2012) ### Financial sector and vulnerability highlights - Risk-based capital asset ratio (consolidated banking system, percent): 9.5 (2001); 9.8 (2002); 10.0 (2003); 10.4 (2004); (2005 IAS sample) 10.2; (2006 IAS sample) 11.3; 10.9 (2006 1/) - NPLs to gross loans (percent): 2.2 (2000); 2.2 (2001); 2.2 (2002); 2.3 (2003); 2.4 (2004); 2.0 (2005); 1.5 (2006); 1.3 (2006 1/) - Loans as percent of deposits (percent): 116.0 (2000); 122.7 (2001); 129.5 (2002); 129.1 (2003); 128.3 (2004); 130.9 (2005); 137.5 (2006); 145.6 (2006 1/) - Household debt: Percent of disposable income: 90 (2001); 97 (2002); 104 (2003); 110 (2004); 117 (2005); 125 (2006) - Household debt: Percent of GDP: 64 (2001); 68 (2002); 73 (2003); 78 (2004); 83 (2005); 88 (2006) - Nonfinancial corporate debt (percent of GDP): 96 (2001); 96 (2002); 99 (2003); 99 (2004); 103 (2005); 105 (2006) ### FSAP and Fund recommendations (implementation status highlights) - Short-term stability issues: continue to monitor household debt, corporate debt, banks’ lending concentrations, banks’ external borrowing and associated pricing and liquidity risks. - Results of the new round of the wealth survey will become available in the second half 2007. - Refinement of statistics for corporate cohorts and development of credit risk analytical tools were introduced. - Supervisory and macro-prudential attention to bank lending concentration issues, analytical tool development, enhanced measurement and management requirements, and public disclosure of banks' policies were pursued. - Liquidity risk monitoring and assessment continues as central in financial stability analysis. - Capital adequacy and Basel II: Banco de Portugal aims to ensure alignment between capital levels and banks' risk profile; Portuguese regulation already foresees the possibility to impose additional capital requirements. - Housing market statistics: private sources resumed production of house price indexes in October 2006 with improved raw data and methodology. - Risk measurement and supervisory capacity: banks' risk management systems enhanced following Basel II adoption; Banco de Portugal strengthening capacity, including adoption of MAR risk rating system. - Stress testing: new run of stress-tests encompassing materially relevant risks to the banking system programmed for early 2008. - Structural and longer-term issues: improve judicial framework for debt recovery; enhance financial independence of securities and insurance supervisors (CMVM and ISP); transfer management of guarantee fund for Motor Third Party and workers compensation from ISP to other organizations. - CMVM surplus appropriation by government eliminated for 2006; commitment to include permanent provision and revise Ministerial Order on CMVM supervisory fees. - ISP proposal to amend its charter to enhance financial independence to be submitted in July 2007. - Public commitment to transfer guarantee fund management; decision on new operational structure expected by end of 2007. - Refinements to supervisory and safety-net arrangements: - Full implementation of the new system for risk profile assessment (MAR) is underway with staged implementation (end-2007 and end-2008). - ISP finalizing a proposal to amend insurance law expected to be approved by end-2007. *Prepared by the European Department; Staff Report for the 2007 Article IV Consultation—Informational Annex; August 8, 2007.* ### Appendix I. Portugal: Fund Relations ### Appendix I. Portugal: Fund Relations (As of June 30, 2007) ### I. Membership and Fund Resources - Membership status: Joined March 29, 1961; accepted the obligations of Article VIII, Sections 2, 3, and 4 effective September 12, 1988. - Quota: 867.40 SDR Million (100.00 percent of Quota). - Fund holdings of currency: 797.10 SDR Million (91.89 percent of Quota). - Reserve position in Fund: 70.32 SDR Million (8.11 percent of Quota). - SDR Department: - Net cumulative allocation: 53.32 SDR Million (100.00 percent of Allocation). - Holdings: 76.67 SDR Million (143.80 percent of Allocation). ### II. Recent and Outstanding Arrangements - Outstanding purchases and loans: None. - Latest financial arrangement: - Type: Stand-by - Approval Date: Oct. 7, 1983 - Expiration Date: Feb. 28, 1985 - Amt Approved: 445.00 SDR Million - Amt Drawn: 259.30 SDR Million - Projected payments to Fund: None. ### III. Exchange and Data Arrangements - Exchange rate arrangements: - Portugal’s currency is the euro, which floats freely and independently against other currencies. - Exchange restrictions: - Portugal maintains an exchange system that is free of restrictions on the making of payments and transfers for current international transactions, except for restrictions maintained for security reasons and notified pursuant to Executive Board Decision No. 144-(52/51). - Data dissemination: - Portugal subscribes to the SDDS, and economic data are adequate to conduct effective surveillance. ### IV. Article IV Consultations and Technical Assistance - Article IV consultation cycle: Standard 12-month consultation cycle. - Last Article IV consultation discussions concluded: October 18, 2006. - 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. - Resident representative: None. *Italic line: Appendix II and additional statistical details follow in the source document.* --- ### Appendix II. Portugal: Statistical Issues ### I. Overall Assessment - Data provision to the Fund is adequate for surveillance purposes. - Despite recent improvements, statistical weaknesses continue to hamper assessment of economic developments. - Portugal subscribes to the Special Data Dissemination Standard (SDDS); metadata have been posted on the Dissemination Standards Bulletin Board. - Publication policy: High degree of openness and extensive use of the Internet; Bank of Portugal, Ministry of Finance, and National Statistics Office (INE) provide long- and short-term indicators and data. ### II. Real Sector Statistics - Improvement: Fall of 2000 — INE published a full set of national accounts based on ESA95 methodology, including quarterly GDP estimates. - Shortcomings: - Timely and high-quality monthly and quarterly data on output, employment, and total wage compensation are lacking, hampering within-year labor market monitoring. - Unemployment data suffer from statistical problems caused, inter alia, by frequent revisions to the measurement of unemployment and sampling rotations. ### III. Fiscal Sector Statistics - Transition to ESA95 led to a number of revisions that sizably altered revenue and expenditure and hampered cross-year comparisons. - From 2001 onward, budgets presented consistent with recent national and fiscal accounting methodology changes. - Intra-year budget data availability: Only on a cash basis. - Publication timing: - 2002: INE began publishing Social Security Fund data monthly with a 45 days delay. - 2003: INE began publishing Autonomous Funds data quarterly with a 75 days delay. - Except for local and general government, data broadly meet SDDS timeliness standards. - Quarterly general government statistics on an accrual basis available as derived from national accounts statistics. ### IV. External Sector and Balance of Payments - Data provided according to IMF’s fifth edition of the Balance of Payments Manual. - External trade data meet timeliness standards, though revisions are frequent and sizeable. - Portfolio investment collection system threshold: €500 million. - Authorities estimate about 1.5 percent of transactions are not captured monthly by this threshold. - They state that this simplification does not significantly hamper monthly balance of payments quality because transactions below the threshold are included in the first release of the annual balance of payments data and monthly numbers are revised accordingly. --- ### Portugal: Table of Common Indicators Required for Surveillance (As of June 29, 2007) — Selected Items and Frequencies - Exchange Rates — Latest Observation: 07/06/29 — Frequency of Data: D — Frequency of Reporting: D — Frequency of Publication: D - International Reserve Assets and Reserve Liabilities of the Monetary Authorities — Latest Observation: 05/07–06/07 — Frequency of Data: M — Frequency of Reporting: M — Frequency of Publication: M - Reserve/Base Money — Latest Observation: 05/07 — Frequency of Data: M — Frequency of Reporting: M — Frequency of Publication: M - Broad Money — Latest Observation: 05/07 — Frequency of Data: M — Frequency of Reporting: M — Frequency of Publication: M - Central Bank Balance Sheet — Latest Observation: 05/07 — Frequency of Data: M — Frequency of Reporting: M — Frequency of Publication: M - Consolidated Balance Sheet of the Banking System — Latest Observation: 05/07 — Frequency of Data: M — Frequency of Reporting: M — Frequency of Publication: M - Interest Rates — Latest Observation: 06/07 — Frequency of Data: W — Frequency of Reporting: W — Frequency of Publication: W - Consumer Price Index — Latest Observation: 05/07 — Frequency of Data: M — Frequency of Reporting: M — Frequency of Publication: M - Revenue, Expenditure, Balance and Composition of Financing — General Government — Latest Observation: 05/07 — Frequency of Data: M — Frequency of Reporting: M — Frequency of Publication: M - Revenue, Expenditure, Balance and Composition of Financing — Central Government — Latest Observation: 05/07 — Frequency of Data: M — Frequency of Reporting: M — Frequency of Publication: M - Stocks of Central Government and Central Government-Guaranteed Debt — Latest Observation: 05/07 — Frequency of Data: M — Frequency of Reporting: M — Frequency of Publication: M - External Current Account Balance — Latest Observation: 04/07–06/07 — Frequency of Data: M — Frequency of Reporting: M — Frequency of Publication: M - Exports and Imports of Goods and Services — Latest Observation: 04/07–06/07 — Frequency of Data: M — Frequency of Reporting: M — Frequency of Publication: M - GDP/GNP — Latest Observation: 2007 Q1 — Date Received: 06/07 Q — Frequency of Data: Q — Frequency of Reporting: Q — Frequency of Publication: Q - Gross External Debt — Latest Observation: 2007 Q1 — Date Received: 06/07 Q — Frequency of Data: Q — Frequency of Reporting: Q — Frequency of Publication: Q --- ### Statement by the IMF Staff Representative (September 28, 2007) — Key Findings and Updates - Overall thrust: Information since the staff report does not alter the thrust of the staff appraisal. - Recent economic developments: - Output growth slowed slightly to 1.6 percent year-on-year in the second quarter (1.9 percent quarter-on-quarter annualized). - Unemployment declined to 7.9 percent. - Labor costs edged up to 3.7 percent year-on-year in the second quarter. - Harmonized inflation declined to 1.9 percent year-on-year in August. - Current account deficit continued to narrow. - Domestic demand: Strengthened as investment rebounded after nine consecutive quarters of decline, and private consumption firmed. - Exports: Growth remained robust but slowed somewhat. - Fiscal accounts through August: Revenue collection remained strong, boosted primarily by corporate tax receipts; spending remained subdued but likely to pick up later in the year in line with the budget. - Financial sector and market tensions: - Portugal weathered recent tensions relatively well, though risks remain. - Interbank rates and bank credit default spreads increased and bank equity prices fell; Portuguese bank equity prices remain above end-2006 levels. - Bank of Portugal survey found banks’ liquidity comfortable and exposure to US sub-prime mortgage markets and to asset-backed commercial paper conduits negligible. - Several banks issued new bonds since mid-August. - Risk: Protracted tensions in international capital markets, especially in the euro area, given Portuguese banks’ reliance on significant foreign borrowing. - Growth outlook revision: - Staff revised down the 2008 forecast from 2 percent to 1¾ percent (with no change for 2007). - Greater downside risks noted in the current World Economic Outlook could slow export growth; protracted tensions in financial markets could tighten credit conditions. --- ### Statement by Arrigo Sadun, Executive Director for Portugal and José Cardoso, Advisor to Executive Director (September 28, 2007) — Authorities’ Views and Macroeconomic Overview ### I. General Remarks - Authority assessment: Staff report is balanced and broadly corresponds to authorities’ analysis. Staff recommendations align with authorities’ priorities: streamlining the public sector and enhancing overall productivity growth. - Financial system: Staff’s evaluation of soundness and favorable assessment of FSAP implementation are highlighted. ### II. Macroeconomic Developments and Projections - Growth: - Portuguese economy grew 1.3 percent in 2006 (after 0.5 percent in 2005). - Projections point to gradual acceleration in 2007 and 2008. - Projected acceleration in 2007–2008 is based on significant recovery of total factor productivity growth and acceleration of corporate investment amid robust export growth. - GDP growth expected to converge to the level of the euro area in 2009, but 2007–2008 acceleration is insufficient to resume real catching-up with European partners in that period. - Structural issues: - Average economic growth over the current business cycle has been considerably lower than in previous cycles, reflecting low trend productivity growth. - Note on data series: GDP per capita corrected for PPP as a percentage of the EU average has a break in 2003 due to methodology change affecting computation of rents and the Portuguese PPP exchange rate series; this amplifies the fall observed and should qualify the executive summary sentence that “convergence process with the EU is in reverse.” - Exports: - Exports of goods and services were buoyant in 2006 and, to a lesser extent, in H1 2007, contrasting with losses of 10 p.p. in real export market shares in the two previous years. - Structural features of export adaptation: geographic diversification, decline in traditional low-tech goods share, and higher share of services. - Product highlights: machinery and appliances and, to a lesser extent, vehicles improved; clothing and footwear exports continued to fall. - Nominal exports of goods and services decelerated from around 14 percent in Q4 2006 to around 9 percent in Q2 2007. - Exports of goods: decelerated from 12.7 percent in Q4 2006 to 7.0 percent in Q2 2007. - Exports of services: year-on-year growth of 15.0 percent in Q2 2007, broadly unchanged relative to Q4 2006. - Authorities and staff agree high degree of uncertainty concerning near-term evolution of exports. - Corporate investment: - Historical context: Rise in corporate investment to around 18 percent of GDP in 2000 from around 14 percent in 1996; decline to around 15 percent of GDP in 2005. - Forecasts for 2007 and 2008 point to a significant recovery in corporate investment, supported by robust global demand, productive restructuring, and productivity gains in industry since 2000. - Authorities argue high enterprise debt levels should not, by themselves, restrain investment; supported by INE Investment Survey where firms report financing conditions are not a relevant limiting factor. - Data on profitability, solvency, and low number of recorded defaults corroborate this view. - Caveat: Recent turmoil in financial markets tilts investment projection risks to the downside; impact depends on persistence of instability in money and credit markets, degree of repricing of credit risk, and degree of tightening of credit availability — elements surrounded by high uncertainty. *Italic line: Statements and detailed analyses are from the source document.* ### 3. Fiscal Policy ### 3. Fiscal Policy ### 3.1 Recent Developments - Government commitment since March 2005: abstain from one-off fiscal measures and address structural causes of fiscal imbalances. - Background: expansionary and pro-cyclical fiscal policy until 2000; deterioration of structural primary balance driven mainly by expansion of primary current expenditure, only partially offset by higher tax burden. - 2002: slightly restrictive and pro-cyclical fiscal policy with one-off short-term measures insufficient to reverse upward trend in primary current expenditure, notably pensions. - 2005: Portugal recorded an excessive deficit situation; structural primary balance reached lowest value since participation in the euro area. - 2006: budget policy “remarkably more restrictive” than euro area as a whole; structural balance converged towards euro area average. - Structural primary deficit reduction in 2006: 2.4 p.p. of GDP, from 2.8 percent to 0.4 percent of GDP, achieved through a rise in revenue (particularly tax revenue) and a reduction in primary expenditure. - Primary current expenditure as a percentage of GDP decreased for the first time since 1997: 0.7 p.p. of GDP. - General government deficit reduction in 2006: 2.2 p.p. of GDP (increase in revenue of 0.8 p.p. of GDP and reduction of expenditure of 1.4 p.p. of GDP), from 6.1 percent to 3.9 percent of GDP; better than Stability Program objective of 4.6 percent of GDP. - Structural deficit reduction of 2.2 p.p. of GDP exceeded Council of the EU recommendation of 1.5 percentage points of GDP. - Current revenue in 2006: increased 7.1 percent; tax revenue expanded 6.1 percent, translating into an increase by 0.7 p.p. of GDP. - Key revenue measures behind 2006 outturn: discontinuing of tax incentives in 2005 State Budget; new marginal personal income tax rate of 42 percent in 2006 State Budget; increase of standard VAT rate from 19 to 21 percent in July 2005; improved tax administration collection procedures. - Reversal in primary current expenditure trend in 2006 driven by mid-2005 fiscal consolidation measures: containment of government wage bill and current transfers in kind to households (medicine and diagnostic co-payments enforcement; conventions with health service providers); pensions expenditure continued to increase strongly. - Pensions expenditure drivers in 2006: - annual increase in pensions: approximately 2.3 percent in the general contributive system; - convergence of minimum pensions in the general system towards values indexed to the national minimum wage (process ended in 2006); - composition effect: new pensions on average far higher than pensions ceased to be paid. - Government wage bill decreased by 0.7 p.p. of GDP due to net fall in civil servants, ingoings/outgoings impact on average wage, and freeze of automatic progressions; slightly offset by a 1.5 percent increase in civil servants wage scale. - End-2005 conversion of five National Health Service hospitals into or inclusion in public corporate entities: moves hospitals out of general government sector into non-financial corporate sector, reducing government wage bill and intermediate consumption and increasing transfers in kind from general government to households. - Public debt and interest: - Primary deficit reduced from 3.4 percent to 1.1 percent of GDP, but persistence of a deficit kept public debt rising; - 2006 public debt rose 1.2 p.p. of GDP to 64.8 percent of GDP; - Expenditure on government debt interest increased only slightly as a percentage of GDP; implicit interest rate virtually unchanged due to high share of fixed-rate debt and redemption of Treasury bonds at rates higher than current. - 2007 State Budget adopted November 2006: targeted general government deficit of 3.7% of GDP (confirmed in December 2006 Stability Program update). - March 2007: government revised deficit target downward by 0.4 p.p. of GDP to 3.3 percent of GDP; adjustment in structural budget 0.4 p.p. of GDP to 2.2 percent of GDP. - Government stance: no room for discretionary near-term tax reductions; commitment to adopt necessary structural reforms and avoid one-off measures; medium-term objective of a structural balance of -0.5 percent of GDP in 2010 as set in the Stability Program. ### 3.2 Tax System - Clarifications related to “Streamlining the Public Sector” and Selected Issues Paper II “Making Portugal’s Tax System More Pro-Growth”: - Local government capital expenditure outturns are usually below budget; 2006 not an exception. Decline in investment expenditure as a percentage of GDP significantly contributed to the fiscal improvement in 2006. - Several charts in the report miss year references and/or data sources; suggested chart revision for primary current spending to better reflect Portugal’s relative position (indexing to 1995=100 can mislead since Portugal had fast growth from that base). - VAT productivity commentary: - Report states VAT productivity in Portugal has been high, although declining. - Caveat: indicator definition penalizes countries with higher share of VAT receipts from reduced rates; recommendation: if information available, use only VAT receipts stemming from the standard rate. - Measure not adequate to assess VAT productivity evolution when rates change: standard VAT rate increased from 17 to 19 percent in mid-2002 and from 19 to 21 percent in mid-2005 while reduced rates stayed unchanged, mechanically causing indicator decline and potentially misleading interpretation. - Arrears securitization: - Report text states “value of arrears recovered reached 1 percent of GDP in 2006. While about 70 percent of the arrears are securitized (...)”. - Available information points to a figure close to 0.2 percent of GDP for the value of recovered arrears which were securitized in 2006. - Municipal surcharge in corporate income tax: - From 2007 onwards, the municipal surcharge may go up to 1.5 percent of the annual taxable profit and not to 10 percent of the corporate income tax generated in each municipality as before. ### 4. Labor Market and Competitiveness - Unemployment: - Unemployment rate: 7.9 percent in Q2 2007 (7.3 percent in same quarter a year earlier and 7.7 percent in 2006 as a whole). - Long-term unemployment: over 49 percent of total unemployment in Q2 2007 (51.7 percent in 2006). - Factors affecting unemployment and labor market: - Possible misalignment between professional skills of unemployed and new job offers during productive restructuring. - High financial coverage and significant potential duration of unemployment benefit payments may contribute to increase in long-term unemployment. - Changes in unemployment benefit policy introduced in early 2007 intended to increase job-search incentives for unemployed with shorter contribution careers. - “New Opportunities” initiative aims to make upper secondary level the minimum standard for youth and adults; two major targets up to 2010: (i) enroll youth in vocational education and training courses; (ii) qualify adults lacking opportunities due to past underinvestment in education. - Wages and rigidity: - Despite rising unemployment and long-term unemployment share, no significant adjustment in private sector aggregate wages. - Degree of wage rigidity in Portugal among the highest in the EU; in a context of low inflation and low productivity growth, nominal wage rigidity leads firms to adjust employment rather than wages. - Curbs on changing number of workers based on market conditions contribute to firm closures that could otherwise redeploy. - Policy implications and assessment of Selected Issues Paper III: - Need for labor market policies that increase corporate efficiency and incentives to labor supply to improve adaptability to shocks and to facilitate resource reallocation during changing comparative advantages. - Agreement with Selected Issues Paper III on the importance of some labor market reforms; commendation of the DSGE model analysis quality. - Critique: model experiment linking improved competitiveness to changes in steady-state mark-ups in labor and goods markets is unconvincing because labor productivity stays basically unaltered in steady-state; improving competitiveness requires gradual change in specialization pattern and increases in productivity of tradable goods and services. - Real exchange rate measures as competitiveness indicators need clearer recognition of methodological caveats and large uncertainty, especially given sectoral structural change, euro-area integration, and global integration. - Caution advised for exercises using historical 10-year averages (e.g., Table 7 “External debt sustainability framework”) because averages include pre-euro area periods with different macroeconomic regimes. ### 5. Social Security Reform - Four representative measures of 2006 social security reform: - (i) earlier transition to pension formula considering the whole contributive career and increasing the accrual rate for lower wages; - (ii) new rule for updating pensions as a function of consumer inflation, the real growth of GDP, and the pension amount; - (iii) bigger financial penalty for early retirement (retirement prior to legal retirement age); - (iv) introduction of a “sustainability factor” linking calculation of new pensions to evolution of life expectancy at age 65. - Impact and classification: - Banco de Portugal estimates the reform makes a significant contribution to improving sustainability of Portuguese public finances and should allow reclassification of Portugal from a “high-risk” country to a “medium-risk” country under the European Commission methodology. - To achieve reclassification, Portugal must proceed with the ambitious budgetary consolidation objectives set out in the Stability Program. ### 6. Financial System - Banking system role and resilience: - Banking system is key to financial stability due to its role in intermediation. - Developments confirm capacity to adjust to low trend growth and to absorb adverse shocks. - 2006 FSAP stress tests indicate high level of resilience; own funds adequate to absorb extreme but plausible shocks. - 2006–H1 2007 developments: - Banking system profitability remained high; solvency at comfortable levels. - Default indicators remained low, although flow of non-performing loans increased in the household sector. - Identified global risks (Banco de Portugal Financial Stability Report 2006, published June 2007): - persistence of macroeconomic imbalances globally; - cooling of real estate markets in several countries; - increased financial leveraging of non-financial corporations; - sensitivity of financial markets to abrupt increases in volatility; - growing transfer of credit risk to several financial system participants. - August market turmoil and implications: - Since beginning of August, high volatility in international financial markets related to negative developments in US sub-prime mortgage and leveraged loan markets and related credit markets. - Potential unfavorable impacts on banking activity in H2 2007: asset portfolio valuation and constraints on banks’ medium- to long-term financing. - Strong indebtedness of Portuguese banks in international financial markets is a relevant risk amid global instability. - Evidence suggests direct exposure of Portuguese banks to US sub-prime mortgages is limited, but reduced market liquidity and higher private debt spreads, if prolonged, may affect Portuguese bank activity. - Despite relatively comfortable short-horizon liquidity, continued instability in international debt markets likely to lead to slowdown of credit to private sector and possible restructuring of lending term structure with higher proportion of short-term loans. *Source: _cr07341 - 3. Fiscal Policy* ### 7. Expected Impact of the Current Financial Turmoil on Economic Activity ### 7. Expected Impact of the Current Financial Turmoil on Economic Activity ### Outlook and projections - Real GDP growth is projected to strengthen to about 1.8 percent in 2007 and 2008. - Projections assume a significant recovery of total factor productivity growth and an acceleration of corporate investment, supported by robust growth of total exports of goods and services. - The recent turmoil in financial markets has tilted the balance of risks concerning the projections of investment to the downside. - The ultimate impact depends on: - how quickly normalcy returns to money and credit markets; - the degree of repricing of credit risk; and - the degree of tightening of credit availability. - A prolonged period of heightened uncertainty about the global demand outlook and of less supportive financial conditions could cause a downward revision of the investment outlook for the Portuguese economy. - Current downside risks to global demand also translate directly into downside risks for Portuguese exports of goods and services. ### Short-term macroeconomic context (2006–2008) - Growth and demand: - Growth rose to 1.3 percent in 2006, led by strong external demand and a rebound in export growth. - Domestic demand remained relatively weak in 2006 despite strengthening corporate investment. - Real GDP (change in percent): 2002: 0.8; 2003: -0.7; 2004: 1.3; 2005: 0.5; 2006: 1.3 (estimate); 2007: 1.8 (projection); 2008: 1.8 (projection). - Domestic demand (change in percent): 2002: 0.0; 2003: -2.0; 2004: 2.4; 2005: 0.8; 2006: 0.3; 2007: 1.0; 2008: 1.3. - Labor market and inflation: - Unemployment rate (percent): 2002: 5.0; 2003: 6.3; 2004: 6.7; 2005: 7.6; 2006: 7.7; 2007: 7.4; 2008: 7.1. - CPI (year average, harmonized index): 2002: 3.7; 2003: 3.3; 2004: 2.5; 2005: 2.1; 2006: 3.0; 2007: 2.5; 2008: 2.4. - Savings and investment: - Gross national saving (percent of GDP): 2002: 17.1; 2003: 16.8; 2004: 15.3; 2005: 12.7; 2006: 12.6; 2007: 12.7; 2008: 12.6. - Gross domestic investment (percent of GDP): 2002: 25.2; 2003: 22.9; 2004: 23.0; 2005: 22.5; 2006: 22.0; 2007: 21.9; 2008: 21.7. ### Fiscal developments and policy stance - Fiscal balance: - The overall fiscal balance improved from a deficit of 6.1 percent of GDP in 2005 to 3.9 percent of GDP in 2006, outperforming the original deficit target of 4.6 percent of GDP. - General government balance (percent of GDP): 2002: -4.2; 2003: -5.2; 2004: -5.4; 2005: -6.1; 2006: -3.9; 2007: -3.3; 2008: -2.4. - Primary balance (percent of GDP): 2002: -1.3; 2003: -2.5; 2004: -2.8; 2005: -3.4; 2006: -1.1; 2007: -0.4; 2008: 0.4. - Public debt (percent of GDP): 2002: 55.5; 2003: 56.8; 2004: 58.2; 2005: 63.6; 2006: 64.8; 2007: 65.1; 2008: 64.9. - Fiscal drivers and reforms: - Improvement mostly driven by much-needed reduction in primary spending. - Authorities lowered deficit targets for 2007 and 2008 following stronger-than-expected fiscal outturns in 2006. - Restructuring of the central administration is central to achieving fiscal consolidation goals and improving productivity. - Recent reforms to the social security system have significantly improved long-term sustainability. - Important steps to move to performance-based budgeting are underway. - Executive Directors’ fiscal recommendations and assessments: - Directors welcomed expenditure-based consolidation and buoyant revenue growth, and recommended saving any revenue overperformance and taking contingency measures in case of spending overruns. - Several Directors considered that somewhat more ambitious deficit targets for 2007 and 2008 seem warranted. - Emphasis on following through with central administration restructuring to achieve envisaged fiscal consolidation and boost productivity. - Directors saw no room for a discretionary reduction in the tax burden in the near term but recommended further simplification of some tax laws and procedures and a prudent timetable for moving to performance-based budgeting and a medium-term budgeting framework. ### Financial sector resilience and risks - System soundness: - Portugal’s financial system remains sound and well supervised and appears to have weathered recent tensions relatively well. - Intensified competition has resulted in a slight deterioration in banks’ liquidity ratios. - Average loan-to-value ratios are in line with other EU countries, and nonperforming loans remain low. - The Financial Sector Assessment Program (FSAP) found the financial system could withstand even severe macroeconomic disturbances. - Risks: - High household and corporate debt remains the main source of risk to the financial system. - Some risks have risen in light of recent international financial market disturbances, including concern over large foreign borrowing by banks and high indebtedness of the corporate and household sectors. - Tighter credit conditions and still-high enterprise debt levels may restrain any rebound in investment. - Supervisory actions and improvements: - Bank of Portugal has strengthened supervisory capacity with adoption of a new risk rating system. - A Household Wealth Survey has been finished, and housing price statistics have been enhanced. - Directors advised continued vigilance by supervisory authorities and welcomed progress implementing last year’s FSAP recommendations. ### External sector and balance of payments - External deficits and trade: - Trade balance (percent of GDP): 2002: -10.4; 2003: -9.1; 2004: -10.4; 2005: -11.3; 2006: -10.7; 2007: -10.0; 2008: -9.6. - Current account (including capital transfers) (percent of GDP): 2002: -6.6; 2003: -4.2; 2004: -6.2; 2005: -8.5; 2006: -8.6; 2007: -8.4; 2008: -8.4. - Reserves and exchange rate: - Net official reserves (in U.S.$ billions, end of period): 2002: 15.9; 2003: 11.5; 2004: 10.7; 2005: 10.9; 2006: 9.4. - Exchange rate regime: euro-area member. - Present rate (September 28, 2007): U.S.$1.42 per euro. - Nominal effective rate (2000=100): 2002: 101.3; 2003: 104.6; 2004: 105.4; 2005: 105.6; 2006: 105.8. - Real effective rate (2000=100): 2002: 104.9; 2003: 109.6; 2004: 110.6; 2005: 110.7; 2006: 111.4. ### Executive Board assessment and structural policy recommendations - Overall assessment: - Directors welcomed the modest economic recovery in 2006, decisive fiscal action, social security reform, and improvements in the business environment. - Directors recognized the underlying economic situation remains challenging, with weak external competitiveness and the need for higher trend growth and income convergence with the European Union. - Directors noted that downside risks to the near-term outlook have risen due to international financial market disturbances and the projected slowdown in the United States. - Structural reform priorities and recommendations: - Build on reform momentum to further consolidate public finances, streamline the public sector, and boost productivity and competitiveness. - Implement a comprehensive structural reform strategy to significantly enhance competitiveness and growth, including: - Strengthening productivity by enhancing contestability in the nontradable sector. - Addressing the cost side of competitiveness through policies that foster wage moderation. - Address labor market rigidities more fully: - Welcome the “New Opportunities” program to upgrade skills and the commission to consider labor market reform. - Directors urged concrete follow-up measures, stressing the need to ease employment protection legislation, end the automatic extension of collective contracts, and make procedures less cumbersome. - Concern was expressed about the authorities’ recent decision to sharply increase the minimum wage. - Strengthen product and service market reforms to boost competitiveness and consumer welfare, including enhancing competition in network industries and some service sectors and strengthening the judicial system. *Source: IMF Executive Board conclusions on the 2007 Article IV consultation with Portugal (Public Information Notice No. 07/126, October 11, 2007).* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr07341.pdf_