## _cr1018 ## Source details **Canonical URL:** [_cr1018](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr1018.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr1018.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr1018.pdf.json) --- ### Executive summary and staff appraisal - Output likely to contract by almost 3 percent in 2009. - Economic growth projected about ½ a percent in 2010. - Fiscal consolidation judged critical to prevent further deterioration and preserve credibility: - Fiscal deficit projected at around 8 percent of GDP in 2009. - Without new measures, the deficit will likely increase in 2010 before declining to around 5–6 percent of GDP by 2013, with the debt ratio approaching 100 percent of GDP. - Achieving the government’s deficit target of 3 percent of GDP in 2013 is critical. - At least ½ a percent of GDP tightening compared to unchanged policies would be required to ensure the deficit does not widen in 2010. - The 2010 public administration wage adjustment will be key for credibility and consolidation. - Consolidation should focus on reducing primary current spending (public wage bill and social transfers) and base-broadening revenue measures; raising the VAT rate should be an option if other measures fall short. - Fiscal framework improvements recommended: introduce a medium-term expenditure ceiling and an independent fiscal agency. - Banking sector recommendations: bring Tier I capital ratios to 8 percent by September 2009; tighten capital quality regulations; introduce liquidity ratios; consider a special resolution framework; enhance inter-agency coordination. - Structural reforms stressed: implement EU Services Directive opportunities, streamline licensing, strengthen competition agency, assess labor code revision, examine unemployment benefit targeting, reconsider planned large minimum wage increases. - Next Article IV consultation proposed on the regular 12-month cycle. ### The problems: low productivity, weak competitiveness, and high debt - Core diagnosis: - Low productivity growth and weak competitiveness have depressed growth and undermined adjustment capacity. - Brisk wage and price growth contributed to competitiveness losses and reversed income convergence. - Large fiscal and external imbalances from the pre-euro boom were not unwound, producing heavy indebtedness and banking vulnerabilities. - The global financial crisis exacerbated pre-existing domestic problems. A. Low productivity and competitiveness - Portugal’s growth performance sluggish since early 2000s; anemic contribution from total factor productivity. - Structural constraints: labor market rigidities, strict regulation discouraging investment, lack of competition in nontradable sectors, weak business environment, low FDI, specialization in traditional low-skill products, relatively poor human capital. - Competitiveness gap: - Staff estimates competitiveness gap at some 10–40 percent based on current account norms and other estimations. - Real effective exchange rate measures appreciated substantially from the early 1990s; exports lost market share. B. High debt - Portugal identified as one of the most indebted in the euro area: - Government debt rose sharply over the past decade; corporate leverage increased; household debt among the highest in the euro area. - Sovereign spreads reached some 175 basis points over German 10-year bonds early in 2009 before moderating. - Corporate expected default frequencies rose with increased leverage and weakened repayment capacity. C. The global crisis (2009) - 2009 recession described as the most severe in decades; output likely to contract by almost 3 percent in 2009. - Exports and investment sharply declined; despite higher unemployment, wage growth remained brisk and productivity fell, raising unit labor costs. - Signs of adjustment: prices have fallen faster than in the euro area, households are saving more, and the current account deficit narrowed somewhat. - Banking system: limited exposure to toxic assets and absence of a property bubble but emerging vulnerabilities include investment portfolio losses, declining credit quality, more difficult wholesale funding, and concentration in large exposures. ### Policy response to the crisis (measures and impacts) - Financial measures (selected items and amounts as presented): - Deposit Insurance: Increased to €100,000.00. - Debt Securities Guarantee: 2.0 (table context shows "0 5.0" in Percent of GDP column). - Capital Injection: 4.0 (table shows "42.4" under "Amount (€billion)" and "40.0" under "Percent of GDP" in original layout—numerical values preserved as presented). - Total program figures shown as 2012.0 and 45.0 in table context. - Footnote: The maximum amount of 20 billion Euros is allocated to both the guarantee and capital reinforcement schemes, with the latter not exceeding 4 billion Euros. - Impact of fiscal measures (Percent of GDP): - Total (+ stimulus): 0.2 (2008), 1.0 (2009), 1.2 (Total) - Revenue: -0.2 (2008), -0.5 (2009), -0.6 (Total) - Lower tax on houses 1/: -0.1 (2008), -0.1 (2009) - Reduction in VAT rate: -0.2 (2008), -0.2 (2009), -0.3 (Total) - CIT reduction for SMEs: -0.1 (2009) - Reduction of social contributions: -0.2 (2009) - Expenditure: 0.0 (2008), 0.5 (2009), 0.5 (Total) - Public investment: 0.1 (2009) - Employment and Social protection: 0.2 (2009) - Support for SMEs, exporters: 0.0 (2009) - School modernization: 0.1 (2009) - Net stimulus over 2008–09 approximately 1¼ percent of GDP; expenditure measures largely temporary while tax reductions were largely permanent. - Pre-crisis consolidation (2005–07): government reduced structural balance by over 3 percentage points of GDP to around 3 percent of GDP, notably by cutting compensation via public sector reforms and raising the standard VAT rate. ### Political economy - Socialist Party re-elected in September 2009 but lost overall majority. - Consensus among main parties to comply with the SGP in general, but pressure for further stimulus is strong. - Presidential election in 2011 noted as potential constraint on significant new reforms. ### Outlook and scenarios - Staff baseline: modest adjustment, weak growth, and continuing unsustainable imbalances. - Domestic demand likely to remain subdued due to weak labor market and growing debt service burden. - Weak profitability and uncertainty to dampen investment rebound. - Continued deterioration in credit quality and rising funding costs will likely make banks more risk averse, constraining credit supply. - Fiscal policy would consolidate from 2011. - Modest structural reforms projected to foster gradual recovery in competitiveness and productivity but insufficient to restart income convergence or substantially reduce large current account deficit. - Both external indebtedness and public debt ratios expected to continue worsening. Selected projected figures (various sources and staff columns preserved verbatim where given): - Real GDP: 1.9 (2007), 0.0 (2008), -2.7 to -3.4 (2009 across sources), -2.8 to -2.7 (2010 across sources); staff projection shows -2.7 (2009) and 0.8 (2010) in one column. - Private consumption: 1.6 (2007), 1.7 (2008), -0.9 to -1.4 (2009 across sources), -1.0 to -0.9 (2010 across sources). - Gross fixed investment: 3.1 (2007), -0.7 (2008), -13.1 to -15.2 (2009 across sources), 0.4 to -4.1 (2010 across sources). - Exports: 7.8 (2007), -0.5 (2008), -11.8 to -14.7 (2009 across sources), 1.7 to 0.7 (2010 across sources). - CPI inflation: 2.5 (2007), 2.7 (2008), -0.9 to 0.1 (2009 across sources), -0.2 to -1.0 (2010 across sources); staff showing -0.9 (2009) and 0.7 (2010) in some columns. - Current account (percent of GDP): -9.4 (2007), -12.1 (2008); staff and model norms include values -11.5, -9.410, -5.926, -3.139 for various norms and estimates; projected current account values range around -8.6 to -10.7. ### Risk of a more disruptive ("forced adjustment") scenario - Staff “forced adjustment” scenario assumes a permanent increase in Portugal’s risk premium of 175 bps (as at the peak of the recent crisis), using the IMF’s GIMF Model. - Longer persistence of imbalances raises the risk that adjustment will be sudden and disruptive, affecting all sectors. - Contagion risks from other highly indebted advanced countries could exacerbate a disruptive adjustment. - Under forced-adjustment: economy-wide deleveraging, more compressed domestic demand, faster current account adjustment; higher bond yields make consolidation substantially more difficult, requiring additional measures to offset higher interest costs and, without additional structural reform, growth and unemployment outcomes deteriorate. Spillovers from Spain to Portugal (trade and financial linkages): - Spain accounts for an export share of goods of 25–30 percent. - Spain accounts for around 15 percent of tourism receipts and around 15 percent of service exports. - At end-March 2009, 30 percent of foreign claims of Portugal’s banks were on Spanish institutions. - Network analysis estimates an initial default from Spanish banks would produce an estimated capital loss to Portuguese banks of 25 percent of their initial capital. - Gameiro (2008) finds correlation of equity risk premia between Portuguese and Spanish markets of 0.71. - GIMF simulations: - A 1 percent decline in Spain’s GDP lowers Portugal’s GDP by nearly 0.2 percent in the first year. - Including adverse confidence effects could increase the impact to close to 0.4 percent. ### Fiscal sector: near- and medium-term outlook (unchanged policies) - Unchanged policies project further deterioration in 2010: - Fiscal deficit projected to increase to 8.6 percent of GDP in 2010. - Structural deficit projected to be over 7 percent of GDP in 2010. - Timing and composition (Percent of GDP): - Total (+ stimulus): 2009: 1.0; 2010: 0.5; 2011: -0.9 - Revenue change (total): -0.5 in 2009; 0.0 in 2010; 0.2 in 2011 - Lower tax on houses: -0.1 (Permanent) - Reduction in VAT rate: -0.2 (Permanent) - CIT reduction for SMEs: -0.1 (2009) and -0.1 (2010) (Permanent) - Reduction of social contributions: -0.2 (2009) and 0.2 (2010) (Temporary) - Expenditure change (total): 0.5 in 2009; 0.5 in 2010; -0.7 in 2011 - Public investment: 0.1 (2009), 0.1 (2010), -0.2 (2011) (Temporary) - Pension and other benefits indexation: 0.2 (Permanent) - Staff projections (percent of GDP, 2008–2014): - Overall balance: 2008: -2.7; 2009: -8.0; 2010: -8.6; 2011: -7.3; 2012: -6.6; 2013: -5.7; 2014: -5.0 - Structural balance: 2008: -3.5; 2009: -6.6; 2010: -7.1; 2011: -6.4; 2012: -6.0; 2013: -5.5; 2014: -5.0 - Changes in structural balance: 2008: -0.3; 2009: -3.2; 2010: -0.4; 2011: 0.7; 2012: 0.5; 2013: 0.5; 2014: 0.5 - Memorandum items: - Output gap (percent): 2008: 0.4; 2009: -2.6; 2010: -2.1; 2011: -1.6; 2012: -1.0; 2013: -0.4; 2014: -0.1 - Unemployment rate (percent): 2008: 7.6; 2009: 9.6; 2010: 11.0; 2011: 10.3; 2012: 9.5; 2013: 8.9; 2014: 8.5 - General government debt (percent of GDP): 2008: 66.3; 2009: 75.8; 2010: 83.3; 2011: 89.2; 2012: 93.8; 2013: 97.1; 2014: 99.4 - Gross financing needs: - Reach about 14 percent of GDP (€23.6 billion) in 2011, nearly 40 percent of total tax revenue. - With current policies, deficit would decline only to 5¾ percent of GDP in 2013, with debt ratio close to 100 percent of GDP. ### Downside risks to modest fiscal consolidation scenario - Challenges to spending restraint: - Savings from recent public administration and social security reforms are uncertain. - Transfers in kind (health expenditure) have increased on average 10 percent a year since 2005. - Large civil service compensation increase in 2009 was 2.9 percent (against inflation expected at 2.5 percent at the time). - Revenue risks: - Portugal depends more heavily on consumption taxes than euro area peers. - Indirect tax collection fell by 2½ percent of GDP in 2009 relative to 2007. - Reduction of the standard VAT rate by 1 percentage point in 2008–09 partly accounts for the decline (impact of 0.3–0.4 percent of GDP a year). - Weak prospects for consumption growth due to household balance-sheet adjustment increase downside risks to revenue. ### Longer-term outlook, aging, and intertemporal balance - Aging costs: - EU Aging Working Group projects aging-related costs to rise by 3½ percent of GDP between 2007 and 2060 in Portugal (assumes labor productivity growth at 1.7 percent). - Recent decision to deviate from indexation formula for pensions (grant 1–1¼ percent increase in 2010 for lower pensions and a freeze for others) is problematic. - Balance-sheet approach and required consolidation: - Without consolidation, starting from a primary deficit of 4 percent of GDP in 2011 and using EC projected aging costs, Portugal’s intertemporal financial position would imply a negative net worth of some 180 percent of GDP in 2010 (222 percent excluding nonfinancial fixed assets). - Eliminating this gap would require an upfront permanent improvement in the primary balance of more than 5 percentage points of GDP. - Impact of permanent adjustments starting 2011 on net worth (Percent of GDP): - No adjustment (2011): Net worth 1/: -179; Financial net worth: -222 - Adjustment (permanent from 2011): - 1 percent of GDP: -145; -188 - 2 percent of GDP: -111; -155 - 3 percent of GDP: -78; -121 - 4 percent of GDP: -44; -87 - 5 percent of GDP: -10; -54 - 1/ Includes nonfinancial fixed assets. ### A more ambitious consolidation strategy: recommendations - Objective: - Structural consolidation of somewhat more than 1 percent of GDP a year on average over the government's term would achieve the government’s deficit target of 3 percent of GDP by 2013. - Implementation guidance: - Some back-loading appropriate given continued weakness in 2010, but start should be made; deficit should at least not widen in 2010, requiring at least ½ a percent of GDP tightening compared to unchanged policies. - 2010 public administration wage adjustment is particularly important for credibility. - Quickly adopt a credible medium-term strategy based on realistic projections and concrete measures. - Policy focus: - Reduce primary current spending, especially the public wage bill and social transfers. - Carefully assess eligibility criteria for social benefits and rigorously manage health costs. - Consider revenue enhancement focused on broadening tax bases by reducing tax expenditures and simplifying administration. - Raising the VAT rate should be an option if other measures fall short. - Fully implement existing policies that support medium-term consolidation; any 2010 exceptions should be one-offs with costs recouped in future adjustments. - Strengthen fiscal frameworks: - Follow through on performance budgeting initiatives. - Introduce a multi-year expenditure rule and commit to saving revenue overperformance. - Consider establishing an independent fiscal council or similar independent analysis body. - Improve transparency and operating position of public enterprises, extend public service agreements, consolidate ownership in the Ministry of Finance, resume privatization, and increase Ministry of Finance involvement in PPPs early in design. ### Financial sector: mitigating vulnerabilities and fostering the adjustment - Broad vulnerabilities: - Large current account deficit largely intermediated by banks borrowing abroad; Portuguese banks rely heavily on foreign wholesale financing. - Private sector credit and indebtedness are high; bank financing to the private sector represents some 200 percent of GDP. - Banking sector structure and funding: - Bank concentration: top five banks represent two-thirds of banking sector assets. - Portuguese banks expanded balance sheets in 2008 and subsequently increased reliance on wholesale funding; bank leverage increased over the past year relative to European peers. - Capital and profitability (end-2008): - Overall capital adequacy ratio at end-2008: 9.4 percent. - Tier 1 capital ratio at end-2008: 6.6 percent. - Credit risk and asset exposures: - NPLs increasing quickly, particularly for corporate loans and consumer credit. - Banks’ credit portfolios heavily exposed to real estate: 60 percent of the total loan book is tied to real estate. - Concentration risk considerable and has risen. Key recommended measures for the banking sector: - Gradually tighten regulations allowing significant shares of non-core capital in Tier I. - Introduce minimum liquidity ratios in 2010. - Consider macroprudential responses if private sector indebtedness does not adjust. - Carefully assess and cautiously implement switch to the “twin peaks” model; keep BdP responsible for consolidated supervision. - Review legal toolkit for intervening in troubled financial institutions; consider a special resolution framework and strengthen inter-agency coordination (e.g., Domestic Standing Group (CNEF)). - Increase transparency around stress testing: more timely and detailed disclosure of results and methodology; consider increasing periodicity of financial stability reports and providing multi-year macroeconomic projections. - Bring disclosure requirements on loan losses into line with euro-area peers. - Promote schemes to increase household saving, including complementary pensions; follow up financial literacy survey and consider a nationally coordinated financial literacy campaign. ### Authorities’ views (summary) - Broad agreement with near-term outlook; some differences on medium-term growth impacts from recent reforms. - BdP noted risk of protracted growth weakness reflecting household balance-sheet adjustment. - Ministry of Finance saw somewhat stronger recovery in outer years reflecting recent structural reforms. - Authorities committed to achieving the 3 percent of GDP deficit target by 2013 and noted progress on fiscal frameworks, performance and medium-term budgeting, public enterprise performance, public administration reforms, and social security reforms. - Authorities skeptical of the role of an independent fiscal council, stressing accountability of existing institutions. ### Productivity and competitiveness: GIMF modeling, calibration, and simulation results - Model used: three-country version of IMF’s GIMF (DSGE with overlapping generations) calibrated for Portugal, Spain, and rest of euro area. - Markup calibration (Portugal): - Wage markup (Portugal) = 1.25 - Tradable goods price markup = 1.10 - Nontradable goods price markup (Portugal) = 1.25 - Comparative markups table (as presented): - Portugal 1.25 1.10 1.25 - Spain 1.28 1.10 1.20 - Euro area 1.15 1.10 1.15 - Reform experiment: reduce nontradable goods and wage markups in Portugal by 5 percentage points; fiscal adjustment to achieve balanced budget in 7 years via public spending reductions. - Simulation scenarios: percent deviations from baseline at 5 Years, 10 Years, and Long Run. Selected simulation results (percent deviation from baseline): - Fiscal adjustment - GDP -1.9 -1.1 2.0 - Consumption -2.5 -0.9 6.4 - Capital stock (utilized) -2.2 -1.5 1.6 - Hours worked -0.3 0.5 2.0 - Real wages (firms) -3.6 -1.5 -1.0 - Labor market reform - GDP 0.6 1.1 1.3 - Consumption -1.4 -0.2 1.2 - Capital stock -0.3 0.4 0.7 - Hours worked 1.3 1.5 1.3 - Real wages (firms) -2.1 -0.8 -1.0 - Product market reform (nontradable) - GDP 1.1 1.9 2.7 - Consumption -2.3 -0.8 1.7 - Capital stock 0.7 2.4 3.6 - Hours worked 1.8 1.5 1.6 - Real wages (firms) 0.1 1.9 2.0 - Fiscal adjustment and labor market reform - GDP -1.2 -0.1 3.2 - Consumption -3.9 -1.1 7.6 - Capital stock -2.4 -1.0 2.3 - Hours worked 1.1 1.9 3.3 - Real wages (firms) -5.8 -2.2 -2.0 - Fiscal adjustment and product market reform - GDP -0.7 0.7 4.6 - Consumption -4.9 -1.8 8.2 - Capital stock -1.4 1.0 5.1 - Hours worked 1.5 2.0 3.6 - Real wages (firms) -3.6 0.6 0.9 - Simultaneous reforms - GDP 0.0 1.8 5.8 - Consumption -6.2 -2.2 9.2 - Capital stock -1.6 1.6 5.8 - Hours worked 2.9 3.2 5.0 - Real wages (firms) -5.9 -0.3 0.2 Interpretation and policy implications from simulations: - Fiscal adjustment alone causes short-run contraction but raises long-run output by about 2 percent versus baseline. - Labor market reform raises long-run employment and output; real wages paid by firms fall permanently under modeled scenarios. - Product market reform produces sustained price effects, real exchange depreciation, and strong capital accumulation benefits. - Combining fiscal consolidation with product and labor market reforms yields substantially larger long-run gains (simultaneous reforms: GDP 5.8 percent above baseline in long run). - Credibility and sequencing matter: announcing reforms can reduce transitional costs; simultaneous implementation facilitates political feasibility when unemployment is high. - Recommendations: combine fiscal consolidation with structural reforms that reduce markups by about 5 percentage points; ensure credible communication and consider synchronized euro-area reforms to lower transition costs. Caveats: - Results depend on reform design, implementation, and initial conditions. - Analysis abstracts from productivity growth; complementary reforms and productivity gains could amplify benefits. - Short-run adjustment costs and distributional impacts warrant careful sequencing and social mitigation measures. ### Risks to the banking sector and further stability measures - Banking risks: - Investment portfolios susceptible to interest and equity risk. - Wholesale funding accounted for 40 percent of total assets at end-2008 (compared with 30 percent for EU banks). - Maturity profile shortened; wholesale borrowing with maturity < two years accounted for over 40 percent of outstanding amount as of September 2009 (up from around 10 percent a decade ago). - Stress tests: - BdP stress tests suggest banks would withstand large shocks under baseline and extreme scenarios, though some capital increases would be needed under extreme scenarios to meet BdP’s Tier 1 recommendations. - Favorable stress-test results reflect substantial capital increases by banks in 2009. - Measures taken: - Government guarantee and recapitalization program; extension of deposit guarantee; recommendation to raise Tier I ratios. - Banks raised €3.3 billion in capital since the beginning of 2009. - Majority of banks (accounting for more than 87 percent of banking sector assets) reached Tier 1 ratios over 8 percent by end-September. - Further proactive recommendations: - Tighten regulations on non-core capital in Tier I, introduce minimum liquidity ratios, consider macroprudential tools, assess “twin peaks” implementation cautiously, consider special resolution framework, strengthen inter-agency coordination, increase transparency around stress testing, align loan-loss disclosure with euro-area standards, promote household saving and financial literacy. ### Structural reform progress and recommendations - Authorities’ view: SIMPLEX programs progressing; EU Services Directive on track for approval at end-2009; Competition Agency reorganized; labor code revision increased flexibility and lowered OECD employment protection assessment; public investment strategy focusing on tradable and R&D spending; significant recent education and health reforms. - Minimum wage developments: - Agreement to increase statutory minimum wage at an annual rate of about 5.3 percent over 2007–11. - The statutory minimum wage covers about 5 percent of the workforce. - Increases of about 5.6 percent in 2008 and 2009; another 5.6 percent increase in 2010 to €475/monthly as planned. - Staff recommendations: - Prioritize full implementation and rigorous assessment of existing reforms (product market simplification, labor code changes, Competition Agency reorganization, education and health reforms). - Target public investment to tradable and R&D spending where Portugal has comparative advantage. - Monitor labor-market flexibility measures and minimum-wage dynamics. ### APPENDIX I: Fund relations, mission, and PIN highlights - Staff mission: J. Daniel (head), K. Honjo, P. Kunzel, P. Sodsriwiboon visited Lisbon November 19–30, 2009; Mr. Cardoso (OED) attended most meetings. - Membership: Joined March 29, 1961; accepted Article VIII obligations effective September 12, 1988. - Quota and SDR positions (SDR Million / Percent of Quota or Allocation) preserved as presented: Quota 867.40 100.00; Fund holdings of currency 682.35 78.67; Reserve position in Fund 185.07 21.34; Net cumulative allocation 806.48 100.00; Holdings 833.18 103.31. - Article IV consultation cycle: standard 12-month cycle; last Article IV consultations concluded on October 1, 2008. - PIN executive summary (Executive Board conclusion, January 15, 2010) key points: - Output likely to contract by almost 3 percent in 2009; growth set for a weak recovery of about ½ a percent in 2010. - Unemployment rose to nearly 10 percent. - Stimulus measures of some 1¼ percent of GDP over 2008–09. - Fiscal deficit increased to around 8 percent of GDP in 2009; debt close to 80 percent of GDP. - Government aims to achieve deficit target of 3 percent of GDP by 2013, requiring structural consolidation of around 1 percent of GDP a year on average. - Banking system weathered the crisis relatively well; authorities recommended all banks bring Tier I capital ratios to 8 percent. - Executive Board recommended ambitious policy response: credible fiscal consolidation plan starting in current year, focus on reducing public wage bill and social transfers, revenue base-broadening, strengthen financial sector legal toolkit, and implement structural reforms (EU Services Directive, cut red tape, strengthen Competition Act, assess labor reforms and unemployment benefit incentives, align minimum wage adjustments with fundamentals). Portugal: Selected Economic Indicators, 2004–10 (key figures verbatim) - Real economy (change in percent): - Real GDP: 2004 1.5; 2005 0.9; 2006 1.4; 2007 1.9; 2008 0.0; 2009 -2.7; 2010 0.5 - Domestic demand: 2004 2.7; 2005 1.6; 2006 0.7; 2007 1.7; 2008 1.3; 2009 -2.9; 2010 0.3 - CPI (year average, harmonized index): 2004 2.5; 2005 2.1; 2006 3.0; 2007 2.4; 2008 2.7; 2009 -0.9; 2010 0.8 - Unemployment rate (percent): 2004 6.7; 2005 7.6; 2006 7.7; 2007 8.0; 2008 7.6; 2009 9.6; 2010 11.0 - Gross national saving (percent of GDP): 2004 15.5; 2005 13.1; 2006 12.2; 2007 12.8; 2008 10.2; 2009 8.9; 2010 8.5 - Gross domestic investment (percent of GDP): 2004 23.1; 2005 22.6; 2006 22.2; 2007 22.2; 2008 22.3; 2009 18.8; 2010 18.7 - Public Finance (percent of GDP): - General government balance: 2004 -3.4; 2005 -6.1; 2006 -3.9; 2007 -2.6; 2008 -2.7; 2009 -8.0; 2010 -8.6 - General government balance 2/ (excludes one-off measures): 2004 -5.5; 2005 -6.1; 2006 -3.9; 2007 -2.7; 2008 -3.4; 2009 -8.1; 2010 -8.6 - Primary balance 2/: 2004 -2.8; 2005 -3.5; 2006 -1.2; 2007 0.1; 2008 -0.5; 2009 -5.0; 2010 -5.2 - Public debt: 2004 58.3; 2005 63.6; 2006 64.7; 2007 63.6; 2008 66.3; 2009 75.8; 2010 83.3 - Balance of payment (percent of GDP): - Trade balance: 2004 -10.3; 2005 -11.0; 2006 -10.8; 2007 -10.8; 2008 -12.8; 2009 -10.2; 2010 -10.1 - Current account (including capital transfers): 2004 -6.1; 2005 -8.3; 2006 -9.2; 2007 -8.1; 2008 -10.5; 2009 -8.6; 2010 -8.9 - Exchange rate (December 7, 2009): U.S.$1.48 per euro - Real and nominal effective rates (2000=100): - Nominal effective rate: 2004 100.2; 2005 100.0; 2006 100.2; 2007 101.5; 2008 103.4 - Real effective rate: 2004 100.1; 2005 100.0; 2006 100.7; 2007 102.4; 2008 103.6 ### Statement by Portugal’s Executive Director (selected points) - Argued for gradual adjustment citing: - (i) overall robustness of the financial sector in the European context; - (ii) relatively long maturities of external debt (issued without currency risk); - (iii) sizeable external assets held by residents, amounting to around 150 percent of GDP; - (iv) non-existence of overvaluation in asset markets, notably housing prices; - (v) Portuguese fiscal accounts at a relatively median position in the European context for medium- to long-run sustainability. - Noted macro developments: Real GDP growth 2008 0.0 percent; 2009 -2.7 percent; inflation (HICP) dropped from 2.7 percent in 2008 to -0.9 percent in 2009; household savings rate increased; unemployment rose to record peaks. *Source: _cr1018 - 1. Productivity Indicators (PDF chapter content).* ### 1. Productivity Indicators ........................................................................................... ### _cr1018 - 1. Productivity Indicators ### Executive summary and staff appraisal - The global economic crisis is severely buffeting the Portuguese economy; output will likely contract by almost 3 percent in 2009. - Economic growth seems set for a weak and fragile recovery of about ½ a percent in 2010. - Fiscal consolidation is critical to prevent further deterioration and preserve credibility: - Fiscal deficit projected at around 8 percent of GDP in 2009. - Without new measures, the deficit will likely increase in 2010 before declining to around 5–6 percent of GDP by 2013, with the debt ratio approaching 100 percent of GDP. - Achieving the government’s deficit target of 3 percent of GDP in 2013 is critical. - At least ½ a percent of GDP tightening compared to unchanged policies would be required to ensure the deficit does not widen in 2010. - The 2010 public administration wage adjustment will be key for credibility and consolidation. - Consolidation should focus on reducing primary current spending, especially the public wage bill and social transfers, while also considering revenue enhancement focused on base-broadening; raising the VAT rate should be an option if other measures fall short. - Improvements to fiscal frameworks recommended: introduce a medium-term expenditure ceiling and an independent fiscal agency. - Banking sector: BdP recommended banks bring Tier I capital ratios to 8 percent by September 2009; further measures suggested include tightening capital quality regulations, introducing liquidity ratios, considering a special resolution framework, and enhancing inter-agency coordination. - Structural reform remains vital: implement EU Services Directive opportunities, streamline licensing, enhance competition agency, assess labor code revision, examine unemployment benefit targeting, reconsider planned large increases in the minimum wage. - Next Article IV consultation proposed on the regular 12-month cycle. ### The problems: low productivity, weak competitiveness, and high debt - Core diagnosis: - Low productivity growth and weak competitiveness have depressed growth and undermined adjustment capacity. - Combined with brisk wage and price growth, competitiveness suffered and the income convergence process reversed. - Large fiscal and external imbalances from the pre-euro boom were not unwound, producing heavy indebtedness and banking vulnerabilities. - The global financial crisis has exacerbated pre-existing domestic problems. A. Low productivity and weak competitiveness - Portugal’s growth performance has been sluggish since the early 2000s; anemic contribution from total factor productivity. - Structural factors cited: labor market rigidities, strict regulation discouraging investment, lack of competition in nontradable sectors, weak business environment, low FDI, specialization in traditional low-skill products, relatively poor human capital. - Competitiveness gap: - Staff estimates competitiveness gap at some 10–40 percent based on current account norms and other estimations. - Priced-based and cost-based real effective exchange rate measures appreciated substantially from the early 1990s; exports lost market share. B. High debt - Portugal identified as one of the most indebted in the euro area: - Government debt rose sharply over the past decade; corporate leverage increased; household debt among the highest in the euro area. - Debt dynamics reflected in sustained large current account deficits financed mainly by bank borrowing from abroad and a negative net international investment position (exact NFA figure not restated in text excerpt). - Sovereign spreads and corporate risk: - Sovereign spreads reached some 175 basis points over German 10-year bonds early in 2009 before moderating. - Corporate expected default frequencies rose with increased leverage and weakened repayment capacity. C. The global crisis - 2009 recession described as the most severe in decades; output likely to contract by almost 3 percent in 2009 (somewhat lower than the euro area average), driven by sharp declines in exports and investment. - Despite higher unemployment, wage growth remained brisk and productivity fell, raising unit labor costs. - Signs of adjustment: prices have fallen faster than in the euro area, households are saving more, and the current account deficit has narrowed somewhat. - Banking system resilience and rising risks: - Pre-existing strengths: limited exposure to toxic assets, absence of a property bubble, retail-based business models, sound supervisory/regulatory framework. - Emerging vulnerabilities: investment portfolio losses, declining credit quality, more difficult wholesale funding, increased concentration in large exposures. ### Policy response to the crisis (measures and impacts) - Financial measures taken by the government (selected items and amounts as presented): - Deposit Insurance: Increased to €100,000.00. - Debt Securities Guarantee: 2.0 (Percent of GDP column shows "0 5.0" in the table context—table layout preserved as presented). - Capital Injection: 4.0 (Government made €4 billion available to banks seeking to strengthen their capital; table shows "42.4" under "Amount (€billion)" and "40.0" under "Percent of GDP" in original layout—retain numerical values exactly as presented). - Total program figures shown as 2012.0 and 45.0 in table context. - Footnote: The maximum amount of 20 billion Euros is allocated to both the guarantee and capital reinforcement schemes, with the latter not exceeding 4 billion Euros. - Impact of fiscal measures (Percent of GDP): - Total (+ stimulus): 0.2 (2008), 1.0 (2009), 1.2 (Total) - Revenue: -0.2 (2008), -0.5 (2009), -0.6 (Total) - Lower tax on houses 1/: -0.1 (2008), -0.1 (2009) - Reduction in VAT rate: -0.2 (2008), -0.2 (2009), -0.3 (Total) - CIT reduction for SMEs: -0.1 (2009) - Reduction of social contributions: -0.2 (2009) - Expenditure: 0.0 (2008), 0.5 (2009), 0.5 (Total) - Public investment: 0.1 (2009) - Employment and Social protection: 0.2 (2009) - Support for SMEs, exporters: 0.0 (2009) - School modernization: 0.1 (2009) - Net stimulus over 2008–09 approximately 1¼ percent of GDP; expenditure measures largely temporary while tax reductions were largely permanent. - Fiscal consolidation progress before crisis: - Between 2005–07, government reduced structural balance by over 3 percentage points of GDP to around 3 percent of GDP, notably by cutting compensation via public sector reforms and raising the standard VAT rate. ### Political economy - Political landscape: - Socialist Party re-elected in September 2009 but lost overall majority. - Consensus among main parties to comply with the SGP in general, but pressure for further stimulus is strong. - Presidential election in 2011 noted as potential constraint on significant new reforms. ### Outlook and scenarios - Staff baseline scenario: - Modest adjustment, weak growth, and continuing unsustainable imbalances. - Domestic demand likely to remain subdued due to weak labor market and growing debt service burden. - Weak profitability and uncertainty to dampen investment rebound. - Continued deterioration in credit quality and rising funding costs will likely make banks more risk averse, constraining credit supply. - Fiscal policy would consolidate from 2011. - Modest structural reforms projected to foster gradual recovery in competitiveness and productivity, but not sufficient to restart income convergence or substantially reduce large current account deficit. - Both external indebtedness and public debt ratios expected to continue worsening. - Selected projected figures (from comparison table in text): - Real GDP: 1.9 (2007), 0.0 (2008), -2.7 to -3.4 (2009 across sources), -2.8 to -2.7 (2010 across sources); staff projection shows -2.7 (2009) and 0.8 (2010) in one column. - Private consumption: 1.6 (2007), 1.7 (2008), -0.9 to -1.4 (2009 across sources), -1.0 to -0.9 (2010 across sources). - Gross fixed investment: 3.1 (2007), -0.7 (2008), -13.1 to -15.2 (2009 across sources), 0.4 to -4.1 (2010 across sources). - Exports: 7.8 (2007), -0.5 (2008), -11.8 to -14.7 (2009 across sources), 1.7 to 0.7 (2010 across sources). - CPI inflation: 2.5 (2007), 2.7 (2008), -0.9 to 0.1 (2009 across sources), -0.2 to -1.0 (2010 across sources), with staff showing -0.9 (2009) and 0.7 (2010) in some columns. - Current account (percent of GDP): -9.4 (2007), -12.1 (2008); staff and model norms shown with values including -11.5, -9.410, -5.926, -3.139 for various norms and estimates; projected current account values range around -8.6 to -10.7 in different rows and columns. ### Key recommendations (policy priorities) - Fiscal policy: - Begin consolidation despite weak 2010 outlook; avoid widening the deficit in 2010. - Focus consolidation on reducing primary current spending (public wage bill and social transfers). - Pursue base-broadening revenue measures; consider raising the VAT rate if necessary. - Ensure the deviation from the pension formula for 2010 is a one-off and recoup costs in future adjustments. - Adopt a credible medium-term strategy based on realistic projections and concrete measures. - Improve fiscal frameworks: medium-term expenditure ceiling and independent fiscal agency. - Financial sector: - Consider pro-active measures beyond Tier I ratio targets, including tightening capital quality, introducing liquidity ratios, special resolution framework, and enhanced inter-agency coordination. - Carefully assess and cautiously implement the envisaged switch to the “twin peaks” model. - Structural reforms: - Use the EU Services Directive to reform legislation and licensing. - Strengthen the competition agency. - Assess effectiveness of labor code revision. - Examine unemployment benefit targeting. - Reconsider planned large minimum wage increases. *Source: _cr1018 - 1. Productivity Indicators (PDF chapter content).* ### 19. Portugal’s vulnerabilities give rise to the risk of a more disruptive scenario. ### 19. Portugal’s vulnerabilities give rise to the risk of a more disruptive scenario. ### Risk of a more disruptive scenario - Staff “forced adjustment” scenario assumes a permanent increase in Portugal’s risk premium of 175 bps (as at the peak of the recent crisis), based on simulations using the IMF’s Global Integrated Monetary and Fiscal (GIMF) Model. - Longer persistence of income and spending imbalances raises the risk that the adjustment will be sudden and disruptive, affecting all sectors of the economy. - Contagion risks from other highly indebted advanced countries—especially in the region—could further exacerbate a disruptive adjustment. - Under the forced-adjustment scenario, economy-wide deleveraging, more compressed domestic demand and faster current account adjustment occur; higher bond yields make consolidation substantially more difficult, requiring additional measures to offset higher interest costs and, without additional structural reform, growth and unemployment outcomes deteriorate. ### Spillovers from Spain to Portugal - Trade linkages: - Spain accounts for an export share of goods of 25–30 percent; Spain is Portugal’s most important trading partner. - Spain accounts for around 15 percent of tourism receipts and around 15 percent of service exports. - Financial linkages: - At end-March 2009, 30 percent of foreign claims of Portugal’s banks were on Spanish institutions. - Network analysis estimates an initial default from Spanish banks would produce an estimated capital loss to Portuguese banks of 25 percent of their initial capital. - Analysis by Gameiro (2008) suggests strong correlation of equity risk premia between Portuguese and Spanish markets (0.71). - GIMF simulations: - A 1 percent decline in Spain’s GDP reflecting a temporary but persistent shock to consumption and investment lowers Portugal’s GDP by nearly 0.2 percent in the first year. - Factoring in potential adverse effects on consumer and investment confidence arising from developments in Spain, the impact would likely be bigger (close to 0.4 percent) and longer-lived, with the level of GDP remaining below the baseline for a prolonged time. ### Authorities’ views on outlook and reforms - Authorities broadly shared staff’s near-term outlook, with some differences on medium-term growth impacts from recent reforms: - BdP officials saw a risk of protracted growth weakness over the medium-term reflecting adjustment in household balance sheets. - Ministry of Finance and other officials saw a somewhat stronger recovery in outer years reflecting recent structural reforms. - Authorities emphasized commitment to achieving the 3 percent of GDP deficit target by 2013 and noted progress on fiscal frameworks, performance and medium-term budgeting preparation, public enterprise performance improvements, public administration reforms, and social security reforms. - Authorities were not convinced that an independent fiscal council could play a major supporting role, stressing accountability and credibility of existing institutions. ### The policy agenda: smoothing the adjustment - Comprehensive reforms are needed to raise longer-term growth potential, correct imbalances, and restart the convergence process. - Required actions: - Government to reduce its deficit. - Firms to be more efficient. - Labor to be more flexible and productive. - Households to save more. - GIMF model simulations: such reforms could significantly improve output and labor market outcomes (mainly by boosting investment), but the adjustment period would be lengthy and require broad-based support and determined political leadership over many years. ### Fiscal sector: near- and medium-term outlook (unchanged policies) - Unchanged policies point to a further deterioration in 2010: - Fiscal deficit projected to increase to 8.6 percent of GDP in 2010. - Structural deficit projected to be over 7 percent of GDP in 2010. - Timing and composition (summary from timing table): - Total (+ stimulus): 2009: 1.0; 2010: 0.5; 2011: -0.9 (percent of GDP) - Revenue change (total): -0.5 in 2009; 0.0 in 2010; 0.2 in 2011 - Lower tax on houses: -0.1 (Permanent) - Reduction in VAT rate: -0.2 (Permanent) - CIT reduction for SMEs: -0.1 (2009) and -0.1 (2010) (Permanent) - Reduction of social contributions: -0.2 (2009) and 0.2 (2010) (Temporary) - Expenditure change (total): 0.5 in 2009; 0.5 in 2010; -0.7 in 2011 - Public investment: 0.1 (2009), 0.1 (2010), -0.2 (2011) (Temporary) - Pension and other benefits indexation: 0.2 (Permanent) - Staff projections (percent of GDP, 2008–2014): - Overall balance: 2008: -2.7; 2009: -8.0; 2010: -8.6; 2011: -7.3; 2012: -6.6; 2013: -5.7; 2014: -5.0 - Structural balance: 2008: -3.5; 2009: -6.6; 2010: -7.1; 2011: -6.4; 2012: -6.0; 2013: -5.5; 2014: -5.0 - Changes in structural balance: 2008: -0.3; 2009: -3.2; 2010: -0.4; 2011: 0.7; 2012: 0.5; 2013: 0.5; 2014: 0.5 - Memorandum items: - Output gap (percent): 2008: 0.4; 2009: -2.6; 2010: -2.1; 2011: -1.6; 2012: -1.0; 2013: -0.4; 2014: -0.1 - Unemployment rate (percent): 2008: 7.6; 2009: 9.6; 2010: 11.0; 2011: 10.3; 2012: 9.5; 2013: 8.9; 2014: 8.5 - General government debt (percent of GDP): 2008: 66.3; 2009: 75.8; 2010: 83.3; 2011: 89.2; 2012: 93.8; 2013: 97.1; 2014: 99.4 - With current policies, the deficit would decline only to 5¾ percent of GDP in 2013, with the debt ratio close to 100 percent of GDP. - Gross financing needs: - Reach about 14 percent of GDP (€23.6 billion) in 2011, nearly 40 percent of total tax revenue. ### Downside risks to modest fiscal consolidation scenario - Challenges to spending restraint: - Savings from recent public administration and social security reforms are uncertain. - Transfers in kind (health expenditure) have increased on average 10 percent a year since 2005. - Large civil service compensation increase in 2009 was 2.9 percent (against inflation expected at 2.5 percent at the time), casting doubt on feasibility of containing the wage bill. - Revenue risks: - Portugal depends more heavily on consumption taxes than euro area peers. - Indirect tax collection fell by 2½ percent of GDP in 2009 relative to 2007. - Reduction of the standard VAT rate by 1 percentage point in 2008–09 partly accounts for the decline (impact of 0.3–0.4 percent of GDP a year). - Weak prospects for consumption growth due to household balance-sheet adjustment increase downside risks to revenue. ### Longer-term outlook and intertemporal balance - Aging costs: - EU Aging Working Group projects costs associated with aging to rise by only 3½ percent of GDP between 2007 and 2060 in Portugal (lower than other European countries), but underlying assumptions (labor productivity growth at 1.7 percent) could be optimistic relative to recent average of about 1 percent. - Recent decision to overrule the indexation formula and grant 1–1¼ percent increase in 2010 for lower pensions and a freeze for others instead of indexing to negative CPI inflation is problematic. - Balance-sheet approach and required consolidation: - Without consolidation, starting from a primary deficit of 4 percent of GDP in 2011 and using European Commission projected aging costs, Portugal’s intertemporal financial position would imply a negative net worth of some 180 percent of GDP in 2010 (222 percent excluding nonfinancial fixed assets). - Eliminating this gap would require an upfront permanent improvement in the primary balance of more than 5 percentage points of GDP. - Impact of permanent adjustments starting 2011 on net worth (Percent of GDP): - No adjustment (2011): Net worth 1/: -179; Financial net worth: -222 - Adjustment (permanent from 2011): - 1 percent of GDP: -145; -188 - 2 percent of GDP: -111; -155 - 3 percent of GDP: -78; -121 - 4 percent of GDP: -44; -87 - 5 percent of GDP: -10; -54 - 1/ Includes nonfinancial fixed assets. ### A more ambitious consolidation strategy: recommendations - Objective: - Structural consolidation of somewhat more than 1 percent of GDP a year on average over the government's term would achieve the government’s deficit target of 3 percent of GDP by 2013. - Implementation guidance: - Some back-loading is appropriate given continued weakness in 2010, but a start should be made; the deficit should at least not widen in 2010, requiring at least ½ a percent of GDP tightening compared to unchanged policies. - 2010 public administration wage adjustment is particularly important for credibility and supporting consolidation. - Quickly adopt a credible medium-term strategy based on realistic projections and concrete measures. - Policy focus: - Reduce primary current spending, especially the public wage bill and social transfers. - Carefully assess eligibility criteria for social benefits and rigorously manage health costs. - Consider revenue enhancement focused on broadening tax bases by reducing tax expenditures and simplifying administration. - Raising the VAT rate should be an option if other measures fall short. - Fully implement existing policies that support medium-term consolidation; any 2010 exceptions should be one-offs with costs recouped in future adjustments. - Strengthen fiscal frameworks: - Follow through on performance budgeting initiatives. - Introduce a multi-year expenditure rule and commit to saving revenue overperformance. - Consider establishing an independent fiscal council or similar independent analysis body. - Continue improving transparency and operating position of public enterprises, extend public service agreements, consolidate ownership in the Ministry of Finance, resume privatization, and increase Ministry of Finance involvement in PPPs early in design. ### Financial sector: mitigating vulnerabilities and fostering the adjustment - Broad vulnerabilities: - Large current account deficit largely intermediated by banks borrowing abroad; Portuguese banks rely heavily on foreign wholesale financing. - Private sector credit and indebtedness are high; bank financing to the private sector represents some 200 percent of GDP. - Banking sector structure and funding: - Bank concentration: top five banks represent two-thirds of banking sector assets. - Despite the crisis, Portuguese banks expanded balance sheets driven by rapid growth in deposits in 2008 and subsequently increased reliance on wholesale funding; bank leverage has increased over the past year relative to European peers. - Capital and profitability: - Falling profits have dented banks’ capital positions. - Overall capital adequacy ratio at end-2008: 9.4 percent. - Tier 1 capital ratio at end-2008: 6.6 percent. - Solvency ratios, though above regulatory minima, remained below the EU average; rating agencies downgraded individual banks during the past year. - Credit risk and asset exposures: - NPLs have been increasing quickly, particularly for corporate loans and consumer credit. - Banks’ heightened risk aversion: rising credit spreads, slower credit growth, decreased maturity of credit granted, higher collateral requirements. - Banks’ credit portfolios heavily exposed to real estate: 60 percent of the total loan book is tied to real estate. - Concentration risk is considerable and has risen as banks increased lending to more creditworthy corporates (debt restructuring, inventory financing). *Source: IMF staff report excerpt.* ### 38. Other risks remain. Portuguese ### _cr1018 - 38. Other risks remain. Portuguese ### Risks to the banking sector - Portuguese banks’ investment portfolios are susceptible to both interest and equity risk. - Banking sector reliance on wholesale funding remains substantial, accounting for 40 percent of total assets at end-2008 compared to 30 percent for the EU banks as a whole. - The maturity profile of outstanding bank debt has shortened in recent years. - As of September 2009, wholesale borrowing with maturity of less than two years accounted for over 40 percent of the outstanding amount (up from around 10 percent a decade ago), though issuance of longer maturities has picked up again in 2009. ### Capital adequacy and liquidity - Capital adequacy ratios have been relatively low (Capital Adequacy Ratios, 2008; Overall and Tier 1 shown in source charts). - Despite mounting risks, stress tests conducted by the BdP suggest banks would withstand large shocks: - Under a baseline stress test scenario, capital buffers would remain well above regulatory minima for the next two years. - Under a more extreme scenario (continued deterioration in international economic conditions, heightened global uncertainty and risk perception towards the Portuguese economy), overall regulatory requirements would still be observed, but some capital increases would be needed to bring Tier 1 capital in line with BdP’s recent recommendation on Tier 1 capital ratios. - The relatively favorable stress-test results mainly reflect the offsetting impact of substantial capital increases by banks in 2009. - Looking forward, the liquidity profile of banks may deteriorate as the temporary increase in assets eligible as collateral for ECB monetary policy operations expires, though this risk for Portuguese banks is judged to be very low. ### Measures taken to foster stability and adjustment - Authorities’ decisive measures that have helped ensure financial stability: - Government guarantee and recapitalization program. - Extension of the deposit guarantee framework. - Recommendation to raise Tier I ratios. - Enhancements to the regulatory and supervisory framework. - Banks successfully raised €3.3 billion in capital since the beginning of 2009. - The majority of banks (accounting for more than 87 percent of banking sector assets) reached Tier 1 ratios over 8 percent by end-September. ### Further proactive measures recommended - Gradually tighten current regulations that allow for significant shares of non-core capital in Tier I, despite overall capital quality being in line with international averages. - Introduce minimum liquidity ratios in 2010 (BdP had already increased monitoring of liquidity indicators before the crisis). - If private sector indebtedness does not adjust, consider other ways to mitigate this macro-prudential vulnerability. - Carefully assess and cautiously implement the envisaged switch to the “twin peaks” model of financial sector supervision, ensuring BdP remains responsible for consolidated supervision and an autonomous agency handles consumer protection. - Review the existing toolkit for intervening in troubled financial institutions; consider a special resolution framework to support faster, and less costly, resolution and strengthen inter-agency coordination (for example, via strengthening the Domestic Standing Group (CNEF)). - Increase transparency around stress testing: - BdP already conducts thorough stress tests and intends to do more. - More timely and detailed disclosure of results and methodology would help firms, authorities and the public. - Consider increasing the periodicity of financial stability reports and providing multi-year macroeconomic projections. - Bring disclosure requirements on loan losses by banks further into line with those of others in the euro area. - To increase household saving, further promote schemes such as complementary pensions. - Follow up the recent survey of financial literacy, possibly including establishing a nationally co-ordinated financial literacy campaign. ### Authorities’ views - Authorities agreed that high debt levels of households and firms continue to weigh on financial sector prospects and that some risks have risen. - They view the adjustment process as underway: household indebtedness has stabilized and the household savings rate has increased. - Credit growth continued to decline despite lower interest rates, reflecting a sharp reduction in aggregate demand and, to a lesser extent, banks’ heightened risk aversion. - Although non-performing loans were rising, authorities argued credit risk would be mitigated by the fact that housing prices have held up and were not subject to the boom-bust cycles experienced in other countries during the crisis. - Authorities emphasized banks’ resilience and improved balance sheets due to successful capital raising in 2009. - They noted wholesale funding conditions had improved from the crisis peak, spreads for the sovereign and private sector had declined, Portuguese banks’ recourse to exceptional ECB facilities had been modest, and banks had managed to attract longer-term deposits. - BdP indicated liquidity monitoring had been intense and banks’ liquidity positions were strong. - Authorities broadly agreed with the financial sector reform agenda but stressed reforms must be closely coordinated with European-level changes. - BdP expressed concern that more detailed publication of individual stress tests might be counterproductive and that the NPLs concept reported by Portuguese banks was adequate given the lack of a clear global standard. ### Productivity and competitiveness (context for financial vulnerabilities) - Productivity growth remains weak and the competitiveness gap large. - Portugal scores poorly on various indicators of economic framework conditions. - Long-term problems include the judicial system and low levels of education. - Recommendations to improve competitiveness: - Use the EU Services Directive as an opportunity to reform legislation, including at local levels. - Continue the SIMPLEX program with greater focus on key problems such as licensing. - Enhance the effectiveness of the competition agency, for example through strengthening the Competition Act. - Carefully implement and assess the recent labor code revision. - Examine the unemployment benefit system to improve effectiveness and targeting, especially incentives to find work over time. - Reconsider planned large increases in the minimum wage, which now look even more out of line with economic fundamentals. *Sources: Bank of Portugal, ECB and staff estimates.* ### 48. The authorities emphasized the important progress on structural reforms in ### _cr1018 - 48. The authorities emphasized the important progress on structural reforms in ### Structural reform progress (authorities' view) - Product markets: - The SIMPLEX programs "continue to bear fruit." - The EU services directive "remains on track for approval at end-2009." - "The Competition Agency had been effectively reorganized." - Labor market: - "The revision to the labor code introduced greater flexibility, especially for working-time adaptability." - The revision "substantially lowered the OECD’s assessment of employment protection for Portugal." - Public investment and sectoral reforms: - Strategy to enhance public investment in tradable and R&D spending, "focusing on where Portugal has a comparative advantage and world trade is growing," is expected to "enhance competitiveness." - "Significant recent reforms of the education and health sectors" are noted as contributing to competitiveness. - Implementation priority: - While acknowledging the potential importance of other reforms, the authorities "stressed the need for fully implementing and assessing the impact of existing reforms." ### Labor income and minimum wage developments (agreements and measures) - At end-2006, "the government and the social partners signed an agreement to increase the statutory minimum wage at an annual rate of about 5.3 percent over 2007–11." - Coverage: "The statutory minimum wage covers about 5 percent of the workforce." - Actual increases: - "Following the increases of about 5.6 percent in 2008 and 2009, the government has recently approved another 5.6 percent increase in 2010 to €475/monthly as planned." ### Productivity and competitiveness findings (staff and source data summaries) - Productivity drivers of income gap: - Portugal's income gap was "mostly in productivity," reflecting "weak TFP growth" and "low labor productivity growth." - OECD data note: "The latest available data for Portugal's total factor productivity growth were up to 2005." - Sectoral productivity dynamics: - "Productivity growth fell in most sectors" (chart summary across sectors such as Construction, Agriculture, Health care, Textiles, etc.). - Competitiveness indicators (chart summaries from OECD, BoP, IMF staff calculations): - Real export and import growth, REER (HICP and ULC Total Economy), FDI inflows (average 2003–2007) and other indicators are presented to show relative competitiveness performance. ### Policy implications and sequencing emphasis - Prioritize full implementation and rigorous assessment of reforms already enacted (product market simplification, labor code changes, Competition Agency reorganization, education and health reforms). - Target public investment on tradable and R&D spending "where Portugal has a comparative advantage and world trade is growing" to boost competitiveness. - Monitor and evaluate labor-market flexibility measures and their interaction with minimum-wage dynamics (given the stipulated increases and coverage). ### Key numeric facts and statistics (verbatim from source) - Agreement to increase statutory minimum wage "at an annual rate of about 5.3 percent over 2007–11." - "The statutory minimum wage covers about 5 percent of the workforce." - "Increases of about 5.6 percent in 2008 and 2009." - "Another 5.6 percent increase in 2010 to €475/monthly as planned." - OECD data caveat: "The latest available data for Portugal's total factor productivity growth were up to 2005." *Source: IMF staff text and figures as presented in the content unit.* ### 1. Securing fiscal sustainability and introducing comprehensive structural reforms ### 1. Securing fiscal sustainability and introducing comprehensive structural reforms ### Challenges and context - Key challenges: securing fiscal sustainability and introducing comprehensive structural reforms to resolve macroeconomic imbalances and boost growth potential. - Recent reforms noted: public sector administration reform, revisions to the labor code, SIMPLEX programs to cut red tape. - Remaining problem: a considerable competitiveness gap persists; the global financial crisis has further undermined Portugal’s medium-term growth perspectives. - Risks: persistent weakness in Spain (Portugal’s key trading partner) and a euro-area recovery ahead of Portugal could raise interest rates and exacerbate difficulties. - Required adjustment: a sustained period of adjustment is needed to close the competitiveness gap and restore public finance sustainability. ### Evidence on competition margins - Literature suggests substantial scope to improve competition in labor and product markets via enhanced flexibility, reduced regulatory/administrative burden, and improved competition policy and law enforcement. - Product market: large benefits from greater competition in the nontradable sector, including network industries and retail distribution; scope of administered prices in services larger in Portugal than most OECD countries. - Labor market: indicators point to scope for higher labor mobility and wage flexibility; high employment protection legislation raises costs and dampens labor demand and job creation; relatively generous unemployment benefits likely contribute to longer-term unemployment. - Expected outcome of reforms: promoting greater competition in product and labor markets would increase employment and income levels, unlocking growth potential. ### Model and methodology - Model used: three-country version of the IMF’s Global Integrated Monetary and Fiscal model (GIMF), a dynamic stochastic general equilibrium (DSGE) model with overlapping generations. - Calibration: model calibrated for Portugal, Spain, and the euro area excluding Portugal and Spain. - Fiscal policy in model: aims at stabilizing the government debt-to-GDP ratio over the long term by adjusting expenditure or taxes; public investment is productive, enhancing private sector productivity; governments levy lump-sum taxes, a consumption tax, a labor income tax, and a capital income tax. - Market structure: incorporates rigidities in labor and product markets reflecting barriers to competition; monopolistic competition implies wages and prices include markups over marginal rate of substitution and marginal cost of production respectively. - Definitions: - Labor market markup: Real wage = (labor market markup) * (the marginal rate of substitution) - Price markup: Price = (goods market markup) * (marginal cost of production) ### Calibration of markups - Wage and price markups set for Portugal: - Wage markup (Portugal) = 1.25 (i.e., 25 percent over marginal rate of substitution) - Tradable goods price markup = 1.10 (i.e., 10 percent) - Nontradable goods price markup (Portugal) = 1.25 (i.e., 25 percent) - Comparative table (as presented): - Wage / Tradable goods / Nontradable goods - Portugal 1.25 1.10 1.25 - Spain 1.28 1.10 1.20 - Euro area 1.15 1.10 1.15 - Reform experiment: reduce nontradable goods and wage markups in Portugal by 5 percentage points; fiscal adjustment introduced to achieve a balanced budget in 7 years based on a reduction in public spending. - Assessment: impacts measured relative to an unchanged policies baseline. ### Simulation scenarios and key quantitative results - Reform variants simulated (percent deviation from baseline). Time horizons: 5 Years, 10 Years, Long Run. - Fiscal adjustment - GDP -1.9 -1.1 2.0 - Consumption -2.5 -0.9 6.4 - Capital stock (utilized) -2.2 -1.5 1.6 - Hours worked -0.3 0.5 2.0 - Real wages (firms) -3.6 -1.5 -1.0 - Labor market reform - GDP 0.6 1.1 1.3 - Consumption -1.4 -0.2 1.2 - Capital stock -0.3 0.4 0.7 - Hours worked 1.3 1.5 1.3 - Real wages (firms) -2.1 -0.8 -1.0 - Product market reform (nontradable goods) - GDP 1.1 1.9 2.7 - Consumption -2.3 -0.8 1.7 - Capital stock 0.7 2.4 3.6 - Hours worked 1.8 1.5 1.6 - Real wages (firms) 0.1 1.9 2.0 - Fiscal adjustment and labor market reform - GDP -1.2 -0.1 3.2 - Consumption -3.9 -1.1 7.6 - Capital stock -2.4 -1.0 2.3 - Hours worked 1.1 1.9 3.3 - Real wages (firms) -5.8 -2.2 -2.0 - Fiscal adjustment and product market reform - GDP -0.7 0.7 4.6 - Consumption -4.9 -1.8 8.2 - Capital stock -1.4 1.0 5.1 - Hours worked 1.5 2.0 3.6 - Real wages (firms) -3.6 0.6 0.9 - Simultaneous reforms - GDP 0.0 1.8 5.8 - Consumption -6.2 -2.2 9.2 - Capital stock -1.6 1.6 5.8 - Hours worked 2.9 3.2 5.0 - Real wages (firms) -5.9 -0.3 0.2 ### Interpretation of results and mechanisms - Fiscal adjustment alone: short-run contraction in GDP and consumption; long-run output about 2 percent higher than baseline due to higher employment and capital stock. - Labor market reform alone: permanent reduction in wage markup yields long-run GDP about 3 percent higher than baseline in narrative (table shows 1.3 long-run under labor market reform alone; combined with fiscal adjustment the long-run GDP rises 3.2 percent), higher employment and capital stock; firms adopt more labor-intensive technologies; real wages paid by firms fall permanently because goods and services prices do not decline proportionally. - Product market reform alone: lowers prices of final nontradable goods, induces real exchange depreciation, raises demand and output, and encourages firms to increase capital and labor; long-run key contribution to output increase comes from capital (capital stock 4.6 percent higher than baseline in narrative; table shows 3.6 percent under product market reform alone). - Short-run dynamics in a monetary union: greater competition in product and labor markets implies Portugal experiences sustained inflation below the baseline and the euro area; euro-area policy rate unchanged given Portugal’s small size; real interest rates in Portugal rise, which dampens consumption initially given large household debt; as competitiveness and external demand improve, consumption rises above baseline in later phases. - Sequencing and credibility: - Simultaneous implementation of labor and product market reforms facilitates labor market reform, especially politically when unemployment is high. - If reforms are fully credible, product and labor market reforms can be introduced sequentially and still yield the same long-term benefits due to forward-looking private agents. - If agents only update expectations when reforms are implemented, delaying reforms prolongs adjustment, increases real interest rates, and lowers consumption. ### Policy implications and recommendations - Combine fiscal consolidation with structural reforms in product and labor markets to restore competitiveness and fiscal sustainability. - Pursue reforms that reduce markups in nontradable goods and labor markets by about 5 percentage points (as modeled) to unlock significant long-run gains in GDP, employment, consumption, and capital accumulation. - Ensure strong credibility and clear communication of reform plans; announcing details of future reforms can induce private agents to adjust behavior earlier and reduce transitional costs. - Consider synchronized reforms at the euro-area level to lower transition interest rate costs and generate larger permanent increases in real wages and employment. ### Caveats and complementarities - Results depend critically on reform design, implementation, and initial conditions. - Analysis abstracts from productivity growth, which is a central driver of economic progress; more competitive markets are associated with faster productivity growth. - Complementarity between product and labor market reforms may amplify benefits: product market competition may also reduce wage markups, boosting employment more than simulated here. - Simulations do not model all potential channels; short-run adjustment costs and distributional impacts warrant careful policy sequencing and social mitigation measures. *Source: _cr1018 - 1. Securing fiscal sustainability and introducing comprehensive structural reforms (IMF staff note, prepared by Keiko Honjo) — extracted content.* ### APPENDIX I. PORTUGAL: FUND RELATIONS ### APPENDIX I. PORTUGAL: FUND RELATIONS ### Staff team and mission - Staff team: J. Daniel (head), K. Honjo, P. Kunzel, P. Sodsriwiboon (all EUR) visited Lisbon November 19–30, 2009. - Meetings: Met with the Minister of Finance, the Governor of the Bank of Portugal, senior staff of several government ministries and agencies, representatives of regulatory agencies, and banks. - Participation: Mr. Cardoso (OED) attended most meetings. - Outcome: The authorities released the mission’s concluding statement. ### I. Membership status and Fund accounts - Membership: Joined March 29, 1961; accepted the obligations of Article VIII, Sections 2, 3, and 4 of the Fund’s Articles of Agreement effective September 12, 1988. - General Resources Account (SDR Million / Percent of Quota): - Quota 867.40 100.00 - Fund holdings of currency 682.35 78.67 - Reserve position in Fund 185.07 21.34 - SDR Department (SDR Million / Percent of Allocation): - Net cumulative allocation 806.48 100.00 - Holdings 833.18 103.31 ### IV–VI. Lending, arrangements, and projected payments - Outstanding Purchases and Loans: None - Latest Financial Arrangements: - Type: Stand-by - Approval Date: Oct. 7, 1983 - Expiration Date: Feb. 28, 1985 - Amt Approved (SDR Million): 445.00 - Amt Drawn (SDR Million): 259.30 - Projected Payments to Fund: None ### VII–VIII. Exchange arrangements and restrictions - 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 to the Fund pursuant to Executive Board Decision No. 144-(52/51). ### IX–XII. Surveillance, technical assistance, and ROSCs - Article IV Consultation cycle: Portugal is on a standard 12-month consultation cycle. Last Article IV consultation discussions were concluded on October 1, 2008. - Technical Assistance (Year / Dept. / Purpose / Date): - 1998 STA Finalize Metadata for DSBB 9/98 - 1998 STA Revision of Monetary Statistics 11/98 - ROSCs: - Fiscal Transparency — Date of Issuance: December 1, 2003 — Country Report No. 03/373 - Resident Representative: None ### Statistical issues and data provision - Overall: Data provision to the Fund is adequate for surveillance purposes. Portugal subscribes to the Special Data Dissemination Standard (SDDS). - Real sector: - Since 2000 INE publishes a full set of national accounts based on ESA95 methodology, including quarterly GDP estimates. - Unemployment data suffer from statistical problems caused, inter alia, by frequent revisions to the measurement of unemployment and sampling rotations. - Fiscal sector: - Data underwent revisions during transition to ESA95, sizably altering revenue and expenditure and hampering comparisons across years. - From 2001 onward, budgets are presented consistent with recent national and fiscal accounting methodology. - Quarterly general government statistics on an accrual basis are available as derived from national accounts. - Trade and balance of payments: - Data provided according to IMF’s fifth edition of the Balance of Payments Manual. - External trade data meet timeliness standards, although revisions are frequent and sizeable. - Portfolio investment collection system has a simplified threshold of €500 million. - Authorities estimate about 1.5 percent of transactions are 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. ### Table of Common Indicators Required for Surveillance (As of December 8, 2009) — selected entries and reporting frequencies - Exchange Rates: Date of Latest Observation 12/07/09; Date Received 12/07/09; Frequency of Data D; Frequency of Reporting D; Frequency of Publication D - International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Date of Latest Observation 11/09; Date Received 12/09; Frequency M; Reporting M; Publication M - Reserve/Base Money: Date of Latest Observation 10/09; Date Received 11/09; Frequency M; Reporting M; Publication M - Broad Money: Date of Latest Observation 10/09; Date Received 11/09; Frequency M; Reporting M; Publication M - Central Bank Balance Sheet: Date of Latest Observation 11/09; Date Received 12/09; Frequency M; Reporting M; Publication M - Consolidated Balance Sheet of the Banking System: Date of Latest Observation 10/09; Date Received 11/09; Frequency M; Reporting M; Publication M - Interest Rates: Date of Latest Observation 10/09; Date Received 11/09; Frequency M; Reporting M; Publication M - Consumer Price Index: Date of Latest Observation 10/09; Date Received 11/09; Frequency M; Reporting M; Publication M - Revenue, Expenditure, Balance and Composition of Financing — General Government: Date of Latest Observation 10/09; Date Received 11/09; Frequency M; Reporting M; Publication M - GDP/GNP: Date of Latest Observation 2009:Q3; Date Received 12/09; Frequency Q; Reporting Q; Publication Q - Gross External Debt: Date of Latest Observation 2009:Q2; Date Received 09/09; Frequency Q; Reporting Q; Publication Q - International Investment Position: Date of Latest Observation 2009:Q2; Date Received 09/09; Frequency Q; Reporting Q; Publication Q ### Public Information Notice (PIN) — Executive Board conclusion of 2009 Article IV Consultation with Portugal (January 15, 2010) Background and economic outlook: - Output: - Output likely to contract by almost 3 percent in 2009. - Growth seems set for a weak recovery of about ½ a percent in 2010. - Unemployment and labor costs: - Unemployment rose to nearly 10 percent. - Wage growth remained brisk; with productivity falling, unit labor costs rose further. - Prices and current account: - Prices have fallen faster than in the euro area. - Large current account deficit estimated to have narrowed somewhat to under 10 percent of GDP. - Fiscal: - Stimulus measures of some 1¼ percent of GDP over 2008–09. - Fiscal deficit increased to around 8 percent of GDP in 2009, with debt close to 80 percent of GDP. - Government aims to achieve a deficit target of 3 percent of GDP by 2013, requiring structural consolidation of around 1 percent of GDP a year on average. - Banking sector: - System weathered the global financial crisis relatively well. - Authorities raised coverage limit for deposit insurance, instituted facilities to recapitalize banks and guarantee borrowing, and recommended all banks bring Tier I capital ratios to 8 percent. - Further measures planned, including introducing minimum liquidity ratios. Executive Board Assessment — key recommendations and observations: - Need for ambitious policy response to address long-standing imbalances: low productivity, weak competitiveness, and high debt. - Fiscal policy: - Prepare a credible fiscal consolidation plan to prevent further deterioration. - Start consolidation in the current year. - Focus on reducing the public wage bill and social transfers and some revenue enhancement (broadening the tax base and streamlining tax administration). - Consider improving fiscal frameworks, e.g., introducing a medium-term expenditure rule. - Financial sector: - Review legal toolkit for intervening in troubled institutions; consider a special resolution framework. - Enhance inter-agency coordination in the evolving European/international financial architecture. - Carefully assess and cautiously implement the envisaged switch to the “twin peaks” model of supervision. - Structural reforms: - Improve productivity and external competitiveness. - Adopt and implement the European Union Services Directive to foster competition and productivity. - Further cut red tape and strengthen the Competition Act. - Assess effectiveness of recent labor market reforms. - Review the unemployment benefit system to provide greater incentives to find work over time and ensure minimum wage adjustments align with economic fundamentals. ### Portugal: Selected Economic Indicators, 2004–10 (key figures) - Real economy (change in percent): - Real GDP: 2004 1.5; 2005 0.9; 2006 1.4; 2007 1.9; 2008 0.0; 2009 -2.7; 2010 0.5 - Domestic demand: 2004 2.7; 2005 1.6; 2006 0.7; 2007 1.7; 2008 1.3; 2009 -2.9; 2010 0.3 - CPI (year average, harmonized index): 2004 2.5; 2005 2.1; 2006 3.0; 2007 2.4; 2008 2.7; 2009 -0.9; 2010 0.8 - Unemployment rate (percent): 2004 6.7; 2005 7.6; 2006 7.7; 2007 8.0; 2008 7.6; 2009 9.6; 2010 11.0 - Gross national saving (percent of GDP): 2004 15.5; 2005 13.1; 2006 12.2; 2007 12.8; 2008 10.2; 2009 8.9; 2010 8.5 - Gross domestic investment (percent of GDP): 2004 23.1; 2005 22.6; 2006 22.2; 2007 22.2; 2008 22.3; 2009 18.8; 2010 18.7 - Public Finance (percent of GDP): - General government balance: 2004 -3.4; 2005 -6.1; 2006 -3.9; 2007 -2.6; 2008 -2.7; 2009 -8.0; 2010 -8.6 - General government balance 2/ (excludes one-off measures): 2004 -5.5; 2005 -6.1; 2006 -3.9; 2007 -2.7; 2008 -3.4; 2009 -8.1; 2010 -8.6 - Primary balance 2/: 2004 -2.8; 2005 -3.5; 2006 -1.2; 2007 0.1; 2008 -0.5; 2009 -5.0; 2010 -5.2 - Public debt: 2004 58.3; 2005 63.6; 2006 64.7; 2007 63.6; 2008 66.3; 2009 75.8; 2010 83.3 - Money and credit (end-of-period, percent change): - Credit to the nonfinancial private sector 3/: 2004 6.1; 2005 7.7; 2006 8.7; 2007 9.9; 2008 7.1 - National contribution to euro area M3 4/: 2004 5.5; 2005 6.1; 2006 3.1; 2007 8.1; 2008 12.9 - Interest rates (end-period): - Deposit rate, up to two years: 2004 2.0; 2005 2.1; 2006 2.7; 2007 3.6; 2008 4.0 - 10-year government bond yield: 2004 3.6; 2005 3.5; 2006 4.0; 2007 4.5; 2008 4.0 - Balance of payment (percent of GDP): - Trade balance: 2004 -10.3; 2005 -11.0; 2006 -10.8; 2007 -10.8; 2008 -12.8; 2009 -10.2; 2010 -10.1 - Current account (including capital transfers): 2004 -6.1; 2005 -8.3; 2006 -9.2; 2007 -8.1; 2008 -10.5; 2009 -8.6; 2010 -8.9 - Net official reserves (billions of U.S. dollars, end of period): 2004 10.7; 2005 10.9; 2006 9.4; 2007 10.8; 2008 12.6 - Exchange rate: - Exchange rate regime: -- euro-area member - Present rate (December 7, 2009): U.S.$1.48 per euro - Nominal effective rate (2000=100): 2004 100.2; 2005 100.0; 2006 100.2; 2007 101.5; 2008 103.4 - Real effective rate (2000=100): 2004 100.1; 2005 100.0; 2006 100.7; 2007 102.4; 2008 103.6 ### Statement by Arrigo Sadun, Executive Director for Portugal and José Cardoso, Advisor (January 15, 2010) — selected points - General endorsement: Broad agreement with staff appraisal and recommendations; highlighted additional points. - Gradual adjustment argument: Emphasized five issues supporting a likely gradual adjustment: - (i) overall robustness of the financial sector in the European context; - (ii) relatively long maturities of external debt (issued without currency risk); - (iii) sizeable external assets held by residents, amounting to around 150 percent of GDP; - (iv) non-existence of overvaluation in asset markets, notably in housing prices; - (v) Portuguese fiscal accounts stand at a relatively median position in the European context when assessing medium to long-run sustainability. - Macroeconomic developments: - Real GDP growth: 2008 0.0 percent; 2009 -2.7 percent. - Noted positive growth differential in 2009 of 1.3 percent between Portugal and the euro area. - Inflation (HICP): dropped from 2.7 percent in 2008 to -0.9 percent in 2009; widening negative inflation differential with the euro area to -1.5 p.p. at end-2009. - Households’ savings rate increased in 2008 and significantly in 2009. - Labor market: unemployment rose to record peaks; employment contraction noted. *Source: APPENDIX I. PORTUGAL: FUND RELATIONS (As of December 11, 2009).* ### 2007. However, the unprecedented external shocks that hit the Portuguese economy in late 2008 and ### _cr1018 - 2007. However, the unprecedented external shocks that hit the Portuguese economy in late 2008 and ### External shocks, activity, and labor market - The unprecedented external shocks in late 2008 and early 2009 "put a heavy toll on the activity of many firms." - Unemployment stood close to double digits in Q3 2009: 9.8 percent, and "this rate is expected to increase in 2010." ### Net external borrowing requirements and international investment position - 2009 recorded a fall in the net external borrowing requirements (as measured by the combined current and capital account deficit as a percentage of GDP). - Reasons for the 2009 reduction in net external borrowing requirements: - "the significant drop in oil prices, which led to an important improvement in the terms of trade, and consequently a reduction in the deficit of energy balance;" - "the reduction of interest rates, which led to a temporary inflexion in the upward trend of the income account deficit through its effects on debt service." - Sectoral composition in 2009: - "An increase of the borrowing requirements of the general government sector was observed in contrast to a significant decrease in the borrowing requirements of the private sector, both by corporations and by households." - The increase for general government "reflects — in the current context of a steep decline in economic activity — the growth of expenditure above nominal GDP growth, and the sharp reduction of tax revenues." - Net international investment position: - "the high net external borrowing requirements recorded over the last decade have had the effect of a progressive deterioration of the international investment position of the Portuguese economy." - The income account deficit evolution: "This deficit, which represented about 2 percent of GDP in 2000, reached a figure close to 4.0 percent of GDP in 2009, and is expected to increase in the near future." - External assets buffer and solvency caveat: - "resident sectors maintain a significant amount of external assets" allowing short-run discrepancy between domestic savings and investment. - "the possibility of a prolonged adjustment allowed by this significant amount of external assets does not eliminate inevitable inter-temporal solvency restrictions that will become active in a more or less distant future." ### Export diversification and external linkages - Pre-crisis trends: - "the degree of openness of the Portuguese economy (measured from the joint weight of exports and imports on GDP), rose again significantly;" - "the structure of goods exports by geographical area, in nominal terms, continued to reflect the growing weight of non-EU markets, in particular the Angolan market;" - "buoyant exports of services are particularly noteworthy (with nominal growth exceeding growth in the euro area)." - On the role of Spain for Portugal's growth outlook: - Staff's Box 1 stated "one of the key risks for Portugal’s growth outlook" relates to Spain; the report considers this "somewhat overdone." - GIMF 3-country model simulations: "baseline results ... suggest a very minor general equilibrium effect on the Portuguese economy stemming from a 1 percent GDP decline in the Spanish GDP." - Only when confidence effects are added is the impact magnified, but "the calibration of these confidence effects is naturally ad-hoc and would depend on the underlying shock driving the GDP decline in Spain." - "from a medium-run perspective — and given the high degree of financial and economic integration of the Portuguese economy — a further diversification of Portuguese economic links toward other destinations (something that actually was already taking place before the crisis) is expected." ### Fiscal policy, stimulus measures, and exit strategy - Fiscal consolidation 2005–2007: - General government deficit declined from 6.1 percent of GDP in 2005 to 3.9 percent of GDP in 2006, and to 2.6 percent of GDP in 2007. - Only one marginal one-off operation in 2007: "worth 0.1 percent of GDP." - Structural balance improvements: "improved by some 2 p.p. of GDP in 2006, followed by a further improvement by about 1 p.p. of GDP in 2007." - These improvements exceeded Council of the EU recommended fiscal efforts ("defined as 1.5 percent of GDP in 2006 and of, at least, 0.75 percent of GDP in 2007"). - As a result, "the decision of the Council of the EU that Portugal was in excessive deficit was abrogated in June 2008." - 2008 fiscal outcome: - Growth dropped from "almost 2 percent in 2007 to 0.0 percent" in 2008, and "the fiscal deficit stood at 2.7 percent of GDP, although with recourse to temporary measures (around 1 percent of GDP)." - Long-term fiscal sustainability and pensions: - Portugal had been among Member States with "the highest expected increase in population ageing-related expenditure in the 2005-2050 period." - "As a result of the reforms in public pension systems in 2006, Portugal was reclassified in October 2007 from a high-risk country to a medium-risk country concerning the sustainability of public finances." - Fiscal stimulus in 2008–2009 (EERP and other measures): - Stimulus characteristics: "timely, targeted, and temporary." - Measures included: - Social protection and employability measures, including targeted lowering of social contributions in 2009; - "an increase in public investment mainly based on the modernization of schools;" - "the incentive to investment by means of a tax credit in 2009;" - Support to competitiveness and exports via backing "some specific credit and insurance market mechanisms." - VAT cut announced March 2008: "reduction of the standard VAT rate by one p.p. from 21 percent to 20 percent from July 2008 onwards." - Cost and deficit effects in 2009: - "the total cost of these stimulus measures represented 1.2 percent of GDP in 2009." - Combined with the recession, "the general government deficit is expected to have reached around 8.0 percent of GDP in 2009." - Revenue impacts to November (public accounts basis): State VAT receipts "dropped by 19.4 percent until November;" State corporate income tax receipts "declined by 24.9 percent until November." - EU excessive deficit decision and required adjustment 2010–2013: - In November 2009 the Council of the EU decided Portugal was in excessive deficit and set the deadline for correction as 2013. - Portugal "have to ensure an average annual fiscal effort of 1.25 percent of GDP over the period 2010-2013." - "The adjustment should start gradually in 2010 and should be enhanced in the subsequent years." - 2010 State Budget was being finalized and to be presented to parliament; an update to the Stability and Growth Programme to be submitted to the European Commission. - Public debt outlook: - Public debt in 2007: 63.6 percent of GDP, which "finally reversed the past growing trend" before the crisis. - "Under the recent adverse circumstances, and also as a consequence of the expansionary fiscal policy, a significant growth of public debt is expected and unavoidable." - "Careful monitoring of debt levels is of the utmost importance." ### Financial sector measures, performance, and stress resilience - Public support and EU-coordinated measures in late 2008: - Measures implemented to: - "strengthen the financial institution’s information disclosure and transparency obligations;" - "strengthen the guarantee of bank deposits (from EUR 25,000 to EUR 100,000 per depositor and per bank);" - "make available an amount of up to EUR 20 billion for the granting of State guarantees and to strengthen credit institutions’ capital (not exceeding EUR 4 billion in this latter case)." - Banks used this support "in limited amounts and essentially during the peak of the crisis." - "These measures had no negative impact in the fiscal accounts." - Bank intermediation and capital adequacy in 2009: - Bank lending to the non-financial private sector in 2009 "was globally in line with the usual determinants governing demand for credit — interest rate and aggregate demand components." - Banks reinforced their own funds, particularly in the first half of 2009. - Tier 1 capital adequacy ratio recorded "a significant concentration at around 8 percent, which corresponded to the minimum value among the main banking groups in June 2009." - Most institutions "have, therefore, brought forward Banco de Portugal’s recommendation to raise Tier 1 capital adequacy ratio to a value equal to or exceeding 8 percent by September 30, 2009." - Mitigating factors supporting financial stability: - Listed structural mitigating factors include: - reinforcement of banks’ own funds in the first half of 2009; - banks’ financing "fundamentally denominated in euro and for medium to long-term maturities;" - "the non-overvaluation in the real estate market;" - "the absence of a subprime segment in mortgage credit in Portugal;" - "the exposure of Portuguese banks’ asset portfolios to the complex assets that were at the core of the financial crisis is insignificant;" - "the small weight in total credit of the most vulnerable households in terms of credit risk;" - "the relatively moderate debt service ratio of households — despite their high indebtedness levels — due to the relatively long maturities of mortgage loans, which are predominant in total credit to households;" - "the recent globally favorable evolution of liquidity indicators of Portuguese banks." - Liquidity developments in 2009: - Banks began issuing in wholesale debt markets "in progressively less unfavorable conditions — namely at longer maturities (3 and 5 years) — and, in a large measure, without government guarantees." - Debt issuance "was again the main source of financing of Portuguese banks in 2009." - Customer deposits remained important, with "a notable acceleration of household deposits for maturities over 2 years being recorded in 2009." - The declining trend in the credit-deposit ratio, started in H2 2007, "continued in 2009." - Liquidity gaps up to 3 months improved in H1 2009; the gap up to one month improved sizably with "the main banking groups recording positive gaps." - "In the horizon up to one year, the gap turned more negative, albeit comparing favorably with the situation before the financial crisis." This is expected to be temporary if access to international wholesale debt markets continues to improve. - Profitability, liquidity, solvency, and stress tests: - Conclusion: "profitability, liquidity, and solvency of the Portuguese banking system currently stand in a relatively favorable position in the European context." - Banco de Portugal stress test scenario: activity contracts 5.4 percentage points between 2008 and 2011; equity prices fall 30 percent in late 2009; housing prices fall 10 percent throughout the projection horizon. - Even under this scenario "all banks would observe the overall regulatory requirements throughout the projection horizon." - The resilience reflects concentration of credit in household mortgages and in large firms "both of which display relatively low probabilities of default." - The staff’s report "alludes to, but [does] not duly emphasize" these stress test conclusions; the summary sentence highlighted staff focus on vulnerabilities: "Financial stability has been maintained, though vulnerabilities — symptomatic of the macroeconomic imbalances — remain." The counterpoint: "even under an extreme configuration of shocks stressing the banks’ underlying vulnerabilities, the banking system in Portugal would continue to display a high degree of resilience." *Document content provided from the specified PDF chapter/section.* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr1018.pdf_