## _cr15126 — EXECUTIVE SUMMARY ## Source details **Canonical URL:** [_cr15126 — EXECUTIVE SUMMARY](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2015/_cr15126.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2015/_cr15126.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2015/_cr15126.pdf.json) --- ### CONTEXT — Post-Crisis Stabilization - Past large current account deficits were corrected over the 2011–14 EFF, but at the cost of large internal slack. - Before the adjustment, easy access to external financing financed non-tradable consumption and investment, eroding competitiveness and reducing productivity growth. - Sudden stop in 2011 forced an adjustment that corrected the flow imbalance and stabilized the external position, but domestic demand collapse produced a large internal imbalance. - Labor and output metrics: - Unemployment rate peaked at 17.5 percent in 2013. - Labor market slack (broader measure of labor under-utilization) is still around 20 percent. - Real GDP "barely grew" between the early 2000s and the report date. - Recovery pattern: - Economy expanded at close to 1 percent per year on average since early 2013, with growth driven largely by consumption. - 2014 fiscal deficit narrowed to 3.5 percent of GDP (excluding one-off operations), yielding a second successive year of 1 percent structural primary adjustment. - Better fiscal outturn partly reflected cyclical factors (rising consumption and employment) and savings on unemployment benefits, and under-execution of investment spending offsetting Constitutional Court rulings on public sector wages and survivor pensions. ### Banking System and Financial Vulnerabilities - Banking system recovery is gradual; return to profitability remains elusive. - Key banking indicators: - Average CT1 ratio fell by 0.5 percentage point to 11.4 percent in 2014. - Loan-to-deposit ratio has been declining steadily, reducing reliance on Eurosystem refinancing. - Stock of non-performing loans continued to rise, reflecting slow corporate balance sheet repair. - Income from financial operations and trading has not been sufficient to offset losses from provisions, impairments, and high operating costs. - Structural developments: - Sale of Novo Banco is proceeding as scheduled; other mergers and acquisitions of large banks are under consideration. - Non-performing loans trends and central bank funding dynamics indicate improved liquidity but persistent asset-quality and profitability challenges. ### NEAR-TERM OUTLOOK AND RECENT POLICY MOVES - Inflation and monetary environment: - Disinflation trend (boosted by falling energy prices) appears arrested; core inflation stabilized but remains low at 0.3 percent due to a sizeable output gap. - Fund credit early repurchases: - Repurchased €6.6 billion in March (almost one quarter of total owed to the Fund). - Early repurchases expected to result in interest cost savings exceeding €500 million, partly offset by valuation losses from the euro’s depreciation against the SDR basket. - ECB and market tailwinds: - ECB expanded asset purchase program (QE) pushed sovereign yields to record lows and effectively eliminated remaining financing concerns. - QE envelope described as up to €1 billion a month for Portugal; sovereign bond purchases could amount to the equivalent of about 60 percent of planned debt issuance in 2015. - A sharply weaker euro and lower oil prices have improved the short-term outlook. - Staff projections: - Staff revised up growth projections for 2015 and 2016 and sees an improved outlook for inflation over the forecast horizon. ### MEDIUM-TERM OUTLOOK AND STRUCTURAL CHALLENGES - With short-term factors fading, growth is projected to moderate over the medium term. - Rebalancing to absorb labor slack and raise potential growth hinges on: - Higher investment. - Enhanced external competitiveness to avoid re-emergence of external imbalances. - Sustained and deeper structural reforms; many reforms since 2011 still need full implementation or strengthening, especially in public and financial sector areas. - Staff growth projections: - During the program, sustained structural reform implementation was expected to deliver medium-term growth of 1¾ percent. - With more limited progress on structural reforms, staff now projects medium-term growth of around 1¼ percent, ¼ percentage points below the euro-area average. - External position: - External position remains slightly weaker than implied by medium-term fundamentals and desirable policy settings. - EBA REER gap estimates range from -5 to 9 percent, reflecting achievement of short-term external balance. - Large negative NIIP and the need to reduce labor slack imply the need for sustained current account surpluses at or above the projected 2015 level over the medium term. ### KEY RISKS - Risks skewed mostly to the upside given favorable global liquidity and low risk aversion, but these could unwind rapidly if disruptive tail events occur (notably euro-area volatility). - Public and private balance sheets are highly exposed to such risks. - Additional downside risk: Portugal’s trade with and investment in Angola (fourth-largest goods export market) could be adversely affected by Angola’s growth deterioration from low oil prices. - Region-wide compression in bond spreads may not reflect country-specific fundamentals and could reverse. ### POLICY RECOMMENDATIONS — Resilience and Growth (Staff views) - Use favorable cyclical conditions and benign financing to strengthen resilience and raise growth potential through decisive policy action: - Continue fiscal adjustment with emphasis on expenditure rationalization. - Undertake a comprehensive reform of public sector wages and pensions. - Adopt a more proactive, bank-led approach to deleveraging to maintain financial stability and ensure efficient resource allocation. - Implement additional structural reforms (in the context of rigid labor markets and limited domestic competition) to absorb large labor slack and spur economic growth. - Priorities emphasized: - Strengthen competitiveness through further implementation and potential stepping-up of structural reforms. - Address excessive leverage in public and corporate sectors and high external debt. - Raise investment and reduce policy uncertainty to improve medium-term growth prospects. *Source: EXECUTIVE SUMMARY (April 15, 2015) — _cr15126* --- ### Authorities’ views on recent market reaction and medium-term outlook (Box 2) - Market reaction to the QE announcement has been rapid and strong; growth and inflation "may very well surprise on the upside in the short term." - Authorities emphasized largely permanent factors in spread compression: - A comprehensive European crisis backstop has been put in place and is viewed as credible. - Most market participants expect a slightly larger spread differentiation than before the crisis. - This favorable environment will raise growth in 2015 and 2016 above what had been expected only a few months ago. - Authorities expressed concern that low yields and compressed spreads could lead to the accumulation of external imbalances in the future. - Medium-term outlook (authorities’ view): - Portugal’s external competitiveness has improved. - Re-balancing between tradable and nontradable sectors is underway (signified by stronger employment and credit growth in the tradable sector and robust export growth). - The economy will grow faster in the medium term, fueled by investment, the rising stock of human capital, and continued strength of external demand. - Banking system still faces important challenges; economic recovery and supportive monetary policy should create conditions for corporate and bank balance sheet repair. --- ### Fiscal path, arrears, and cash management ### 2014 fiscal outturns and debt - Fiscal deficit narrowed to 4.5 percent of GDP in 2014 (below the authorities’ target of 4.8 percent), primarily due to under-execution of investment spending. - Excluding several large one-off transactions related to SOE and banking support operations, the deficit fell to 3.5 percent of GDP, amounting to a structural fiscal adjustment of 1 percent of GDP. - Debt-to-GDP ratio stood at 130.2 percent, slightly higher than originally projected due to adverse valuation effects of euro depreciation, additional debt issuance to maintain the government’s cash buffer, and a downward revision to nominal GDP. ### Arrears and cash management developments - In 2014, arrears were reduced by €367 million (20 percent), mainly through the government clearance strategy. - Additional funding to public hospitals (€151 million) led to the settlement of €59 million of arrears in the health sector. - Arrears initially accumulated in early 2014, were cleared at the end of the year, but began rising again in early 2015 (an increase of €47 million in January). - January parliamentary amendment of the commitment law requires line ministries to create contingency reserves to forestall accumulation of new arrears. ### Staff views and recommended fiscal anchor - Fiscal sustainability priority: - Portugal remains vulnerable due to high public debt (the third-highest in the euro area following Greece and Italy), large refinancing needs, small economy size, and weak growth prospects. - Debt-to-GDP ratio projected to decline modestly, reaching 121 percent in 2020 under baseline projections. - Debt dynamics remain highly vulnerable to adverse yet plausible macro-fiscal and contingent liabilities shocks. - A more pronounced decline in the debt ratio would require greater fiscal adjustment than under the baseline and structural reforms to boost growth. - 2015 fiscal stance: - Staff projects a fiscal deficit of 3.2 percent of GDP for 2015—marginally above the excessive deficit procedure target of 3 percent of GDP—and higher than the budgeted 2.7 percent of GDP. - Difference versus budget primarily reflects more pessimistic revenue assumptions; the budget incorporates large revenue gains from measures to improve tax compliance and recover outstanding tax debt. - Structural primary balance projected to deteriorate in 2015. - Recommended anchor: - Fiscal policy should be anchored around an annual structural primary adjustment of 0.5 percent of GDP. - Rationale: limited space for counter-cyclical policy given debt and borrowing needs; ensure windfall savings from low sovereign yields are used to reduce public debt and restore fiscal buffers. - Adjustment should be achieved mainly through expenditure rationalization and introduction of expenditure targets for each level of government. - Under this adjustment scenario, debt would decline to around 110 percent of GDP by 2020. ### Specific fiscal measures recommended - Introduce multi-year expenditure targets covering all general government expenditure; make them sufficiently binding and include local governments and social security funds. - Use intergovernmental coordination council to monitor outturns and identify in-year corrective measures. - Contain spending with focus on public sector wages and pensions (together account for nearly 25 percent of GDP and more than half of non-interest government spending): - Public wages: - Past wage-bill measures yielded smaller savings than expected due to successive Constitutional Court (CC) rulings and design weaknesses. - Public employment was reduced by almost 10 percent, but wage cuts failed to reduce the public-private compensation gap. - Priority: further reduce number of employees via higher natural attrition and targeted cuts in overstaffed areas; enhance departure mechanisms. - Structural measures should aim to limit automatic wage increases and career progression to generate permanent savings of about 0.1 percent of GDP per year. - Footnote: Savings from a reduction of the workforce by additional 10 percent are estimated at around 0.5 percent of GDP. - Pensions: - Recent CC rulings cancelling targeted pension measures call for a more comprehensive approach. - Authorities should adopt a new indexation rule based on economic factors to automatically adjust benefits and ensure sustainability. - Suspension of early retirements introduced in 2012 and lifted in 2015 should be reinstated to contain retiree numbers. - In short and medium term, public sector employees’ contribution to CGA could increase to improve its financial sustainability. - Other reforms: - SOEs and hospitals: proceed resolutely with restructuring to address structural challenges and high debt. - PPPs: annual gross payments related to PPPs expected to be reduced by about 20-25 percent after renegotiations but will stabilize at about €1.5 billion (0.8 percent of 2015 GDP) until 2022, before slowly declining to about €0.6 billion in 2030; renegotiations should be pursued forcefully. - Budgeting and public administration: finalize and adopt a new Budget Framework Law, consolidate all government revenues in the Treasury single account, move gradually to accrual accounting, devolve more responsibility to line ministries with stronger financial accountability, and reduce public administration fragmentation at central government level. - Within sustainability constraints, fiscal policy should promote growth and alleviate employment bottlenecks via targeted tax measures (e.g., deduction for corporate equity) and increase labor force participation through social security cuts to address localized labor market malfunctions. - Scaling up public investment may not be needed given high level and quality of public capital stock compared to other euro area countries. --- ### Deleveraging — background and staff recommendations - Background: - Deleveraging framework largely in place (institutional and legal changes to corporate debt restructuring, lowered creditor approval thresholds, tax code changes favoring equity, monitoring). - No systemic solution introduced (no accelerated SME restructuring or large-scale bank write-offs). - Corporate debt declined slowly in 2013 and stands at 119 percent of GDP, close to level at beginning of the EFF program and still one of highest in the EU. - Staff’s views: - Eliminating the corporate debt overhang is essential for recovery. - With banks facing high operating costs, overcapacity, and weakening asset quality, waiting for growth to improve bank profitability is likely to be disappointing. - Credit misallocation would persist if banks retain nonperforming, less-productive assets. - Successful deleveraging would allow banks to reallocate resources to viable firms, increase investment, and support growth. - Banks should use the supportive environment to: - Raise more capital, - Increase provisioning, - Accelerate write-offs. - Corporations should be encouraged to reform corporate governance, retain more earnings, and inject new equity. - To reduce tax debt bias, authorities could complement efforts to reduce deductibility of debt interest by introducing a deduction of equity for corporate income tax. - Authorities’ view on deleveraging pace: - The deleveraging strategy appears to be working; recent corporate debt decline has been facilitated by equity injections from foreign investors and equity-favoring tax incentives. - Authorities favored a gradual pace of deleveraging to better safeguard financial stability and doubted banks’ ability to raise sufficient capital if the process were accelerated. --- ### Structural reforms, firm survey findings, and institutional transition ### Notable reform developments - Number of new collective bargaining contracts in 2014 approached levels last seen in 2011, and more contracts were reached at the firm level. - GPEARI—the planning unit of the Ministry of Finance—has been given a formal mandate by the Council of Ministers to coordinate the process of evaluating structural reforms. - Proposal to impose a one-time levy on GALP; if effective, would be applied to reduce gas prices by 3 to 5 percent for end users for each of the next three years. - Renegotiation of one port concession contract completed, with remaining four expected to follow soon. - New bylaws for 18 services and regulated professions were approved by the Council of Ministers and are currently under discussion in Parliament. - Simplified centralized electronic garnishments system enabled seizure and recovery of €0.3 billion in enforced claims in a little over a year. ### Staff assessment and reform needs - Baseline recovery judged "too mild to return the economy to full employment over the medium term." - Portugal faces adverse capital and labor trends: negative net investment in the short term, and a falling working-age population in the short- and medium term. - Baseline growth insufficient to absorb labor market slack; job prospects for the lower-skilled would remain dire. - Priority reform objectives: - Alleviate impediments to external competitiveness and potential growth. - Revisit reforms that have not delivered, fully implement initiated reforms, and address remaining bottlenecks through fresh reforms. - Public administration and courts: - Upgrade effectiveness of central and local public administrations. - Review functioning of the courts. - Increase payment discipline of public sector entities. - Product market functioning: - Fully implement measures to reduce the cost of energy, use of transport infrastructure, and costs of professional and other services and evaluate outcomes. - Empower the competition authority with resources and political support to tackle anti-competitive practices in sheltered sectors. - Promote greater market integration at the European level. - Labor market and social policy: - Fresh reform ideas needed while avoiding policies that undermine job creation. - Review effectiveness and scope of programs to promote managerial skills. - Make unemployment support more inclusive (e.g., reduce minimum contribution period for eligibility, reduce inactivity traps, especially for older workers). - Caution against premature increases in the minimum wage given increasing share of workers paid at the minimum wage. - Recognize alternative tools to fight poverty may be more effective than minimum wage increases. - Political economy: - Current post-crisis recovery and benign financing conditions create a conducive environment to pursue further institutional change. - Encourage a more inclusive and transparent social partner dialogue to promote competitiveness and job creation. ### Firm-level survey findings (Box 1 summary) - Survey covered 35 structural reform areas; responses from large firms and SMEs, broken down by exporters and non-exporters. - Perceived impact of reforms: - Most reforms had some positive impact; exporting firms generally perceived more positive impacts than non-exporters. - Labor market reforms were seen as having the highest positive impact; product market reforms were seen as having the least impact. - Very few reforms were perceived as having had significant impacts; exporters saw significant positive impacts in "increasing work time flexibility" and "reducing the cost of paying taxes". - Perceived urgency of additional reforms: - Strong consensus that many public and financial sector reforms need to be revisited or stepped up. - Exporters especially see urgent needs to: - Increase effectiveness of public administration (central and local). - Upgrade effectiveness of courts. - Improve payment discipline of public sector entities, particularly SOEs. - Improve insolvency and corporate debt restructuring frameworks. - Perceived urgency was generally lower for labor and product market reforms, though exporters flagged near-urgent needs in energy, road pricing, rail costs, enforcement of competition, and hiring and firing costs. - Methodological note: - Perceptions may differ from actual outcomes; nevertheless, perceptions influence firm decisions on job creation and investment. - Recommendation: repeat the firm survey at regular intervals (e.g., in about a year) to track perception changes. ### Institutional transition and rent-seeking (Box 7) - Growth challenge: - Earlier boom episodes driven largely by factor accumulation; productivity growth declining over past half-century. - Working-age population projected to fall; capital stock contracting because of underinvestment. - Institutional transition and rent-seeking: - Minimizing rent-seeking is key for raising productivity, attracting investment, and jump-starting growth. - Nontradable sector less productive and offers opportunities for rent-seeking, leading to higher mark-ups and misallocation. - Cross-country evidence implies Portugal should: - Minimize rent-seeking to channel resources to productive activities and strengthen pro-reform tradable sector companies. - Develop the tradable sector to raise overall productivity and attract more productive investment. - Further invest in education, with emphasis on vocational training. --- ### Debt dynamics, DSA, and Risk Assessment ### Recent debt developments and baseline projections - Public debt rose from 129.7 to 130.2 percent of GDP in 2014, reflecting several large one-off transactions related to SOE support, adverse valuation effects of euro depreciation, and a downward revision to nominal GDP. - Debt is projected to decline steadily beginning in 2015 as the headline fiscal deficit continues to fall, with Portugal benefitting from a sizable reduction in interest costs as yields have declined. - Under the baseline (absent further consolidation efforts), debt would still remain at nearly 121 percent of GDP at the end of 2020. - Portugal’s debt net of government deposits amounted to 120 percent of GDP at end–2014. - Footnote: The majority of Portugal’s foreign-currency denominated debt is hedged through currency swaps; unhedged foreign-currency denominated debt is around 3 percent of GDP. ### Risk assessment and stress test scenarios - Debt ratio already exceeds the debt burden benchmark for advanced economies of 85 percent of GDP under the baseline. - Public financing needs are above the relevant benchmark of 20 percent of GDP under the baseline. - Baseline realism and alternatives: - Staff estimate of potential growth lowered; staff updated projection assumes achieving growth of 1¼ percent over the medium term. - Primary balance expected to reach nearly 2 percent of GDP over the medium term under staff’s baseline. - Stress tests: - Growth shock scenario: - Lowers output by nearly 4.5 percentage points in 2016–17 and inflation by a cumulative 1 percentage point. - Debt would peak at about 134 percent of GDP in 2017, over 10 percentage points higher compared with the 2016 baseline. - Deflation scenario: - Lowers output by 5½ percentage points in 2016–17 and is associated with deflationary pressures with inflation lower by cumulative 4 percentage points. - Under this scenario, debt would rise to 142 percent of GDP by 2017 and remain at this level over the medium-term. - Interest rate shock: - A sustained interest rate shock of 200 bps throughout the projection period would slow down the rate of debt decline so that by 2020 the debt-to-GDP ratio is about 3 points higher compared with the baseline. - Contingent liabilities shock: - Severe scenario could materialize for about 5 percent of GDP due to SOEs, PPPs, and State guarantees; such a shock would push the 2015 debt ratio to about 131 percent of GDP. - Severe combined shock: - Incorporating the macro-fiscal and contingent liabilities adverse scenarios would push debt to 135 percent of GDP in 2017 and then continue to rise gradually over the medium term. ### External stability assessment highlights (Annex III) - REER trends: - REER continued trend depreciation after short interruption. - Euro depreciation after ECB actions, lower oil prices, persistent labor market slack, and low capacity utilization expected to put downward pressure on ULC-based and CPI-based REER this year. - Offsetting factors: increases in minimum wage and non-subsidized electricity tariffs. - External position and valuation: - EBA estimates through 2014 broadly reflect external balance, but staff assesses external position as slightly weaker than implied by medium-term fundamentals and desirable policy settings. - Portugal’s net foreign liabilities: 110 percent of GDP in 2014. - CA and ES approaches produce differing signals; REER approaches indicate an overvaluation between 2.9 and 8.5 percent. - External financing flows: - Portfolio inflows resumed and accelerated in 2014, increasing from close to zero in 2013 to 7 percent of GDP in 2014. - FDI inflows picked up slightly to 4.8 percent of GDP in 2014 (down from 11 percent of GDP peak in 2012). - Export performance: - Exports held up during crisis aided by diversification toward Angola, Brazil, China, but export growth slowed in 2014 and Portugal lost market share in 2014. ### Risk Assessment Matrix — Major risks (Annex II) (relative likelihood and impact) - I. A surge in financial volatility: Relative Likelihood: H; Impact: H. Policy response: Shore up liquidity and capital buffers; encourage private savings. - II. Protracted slower growth in advanced economies ("new mediocre"): Relative Likelihood: H; Impact: H. Policy response: Step up structural reforms. - III. Political and legal setbacks that delay policy implementation: Relative Likelihood: H; Impact: M. Policy response: Step up structural reforms. - IV. Political fragmentation in global hotspots: Relative Likelihood: M; Impact: M. Policy response: Step up structural reforms. - V. Excessively low inflation: Relative Likelihood: M; Impact: M. Policy response: Shore up liquidity and capital buffers; step up structural reforms. - VI. Bond market stress from reassessment of sovereign risk: Relative Likelihood: M; Impact: H. Policy response: High-quality fiscal adjustment and fiscal structural reforms; continue pre-financing efforts. --- ### Selected macroeconomic projections and indicators (staff and authorities material) - Staff and authorities projections and selected indicators (2014–17): - Real GDP: 0.9 (2014), 1.6 (2015), 1.5 (2016), 1.4 (2017) - Private consumption: 2.1 (2014), 1.7 (2015), 1.6 (2016), 1.5 (2017) - General government balance (percent of GDP): -4.5 (2014), -3.2 (2015), -2.8 (2016), -2.5 (2017) - Primary government balance: 0.4 (2014), 1.6 (2015), 1.7 (2016), 1.8 (2017) - General government debt: 130.2 (2014), 126.3 (2015), 124.3 (2016), 122.7 (2017) - Unemployment rate (percent): 13.9 (2014), 13.1 (2015), 12.6 (2016), 12.1 (2017) - Nominal GDP (billions of euros): 173.1 (2014), 177.6 (2015), 182.7 (2016), 187.6 (2017) - Authorities’ Stability Program projections (selected): - Government projects GDP growth: 2015: 1.6 percent; 2016: 2.0 percent; 2017: 2.4 percent; 2018: 2.4 percent; 2019: 2.4 percent. - Unemployment rate projections: 2013: 16.2 percent; 2014: 13.9 percent; 2015: 13.2 percent; 2019: 11.1 percent. - Net lending position expected to reach 2.7 percent of GDP in 2019; current account projected to improve from 0.5 percent of GDP in 2015 to 1.4 percent of GDP in 2019. - Government 2015 deficit target: 2.7 percent of GDP. *Source: IMF staff report excerpts and Portuguese authorities’ submissions as provided in the chapter text.* ### EXECUTIVE SUMMARY ### _cr15126 - EXECUTIVE SUMMARY ### CONTEXT — Post-Crisis Stabilization - Past large current account deficits were corrected over the 2011–14 EFF, but at the cost of large internal slack. - Before the adjustment, easy access to external financing financed non-tradable consumption and investment, eroding competitiveness and reducing productivity growth. - Sudden stop in 2011 forced an adjustment that corrected the flow imbalance and stabilized the external position, but domestic demand collapse produced a large internal imbalance. - Key labor and output metrics: - Unemployment rate peaked at 17.5 percent in 2013. - Labor market slack (broader measure of labor under-utilization) is still around 20 percent. - Real GDP "barely grew" between the early 2000s and the report date. - Recovery pattern: - Economy expanded at close to 1 percent per year on average since early 2013, with growth driven largely by consumption. - 2014 fiscal deficit narrowed to 3.5 percent of GDP (excluding one-off operations), yielding a second successive year of 1 percent structural primary adjustment. - Better fiscal outturn partly reflected cyclical factors (rising consumption and employment) and savings on unemployment benefits, and under-execution of investment spending offsetting Constitutional Court rulings on public sector wages and survivor pensions. ### Banking System and Financial Vulnerabilities - Banking system recovery is gradual; return to profitability remains elusive. - Key banking indicators: - Average CT1 ratio fell by 0.5 percentage point to 11.4 percent in 2014. - Loan-to-deposit ratio has been declining steadily, reducing reliance on Eurosystem refinancing. - Stock of non-performing loans continued to rise, reflecting slow corporate balance sheet repair. - Income from financial operations and trading has not been sufficient to offset losses from provisions, impairments, and high operating costs. - Structural developments: - Sale of Novo Banco is proceeding as scheduled; other mergers and acquisitions of large banks are under consideration. - Non-performing loans trends and central bank funding dynamics indicate improved liquidity but persistent asset-quality and profitability challenges. ### Near-Term Outlook and Recent Policy Moves - Disinflation trend (boosted by falling energy prices) appears arrested; core inflation stabilized but remains low at 0.3 percent due to a sizeable output gap. - Authorities began early repurchases of outstanding Fund credit: - Repurchased €6.6 billion in March (almost one quarter of total owed to the Fund). - Early repurchases expected to result in interest cost savings exceeding €500 million, partly offset by valuation losses from the euro’s depreciation against the SDR basket. - Near-term cyclical tailwinds: - ECB expanded asset purchase program (QE) pushed sovereign yields to record lows and effectively eliminated remaining financing concerns. - QE envelope described as up to €1 billion a month for Portugal; sovereign bond purchases could amount to the equivalent of about 60 percent of planned debt issuance in 2015. - A sharply weaker euro and lower oil prices have improved the short-term outlook. - Staff revised up growth projections for 2015 and 2016 and sees an improved outlook for inflation over the forecast horizon. ### Medium-Term Outlook and Structural Challenges - As short-term factors fade, growth is projected to moderate over the medium term. - Required rebalancing to absorb labor slack and raise potential growth hinges on: - Higher investment. - Enhanced external competitiveness to avoid re-emergence of external imbalances. - Sustained and deeper structural reforms; many reforms since 2011 still need full implementation or strengthening, especially in public and financial sector areas. - Staff growth projections: - During the program, sustained structural reform implementation was expected to deliver medium-term growth of 1¾ percent. - With more limited progress on structural reforms, staff now projects medium-term growth of around 1¼ percent, ¼ percentage points below the euro-area average. - External position: - External position remains slightly weaker than implied by medium-term fundamentals and desirable policy settings. - EBA REER gap estimates range from -5 to 9 percent, reflecting achievement of short-term external balance. - Large negative NIIP and the need to reduce labor slack imply the need for sustained current account surpluses at or above the projected 2015 level over the medium term. ### Key Risks - Risks skewed mostly to the upside given favorable global liquidity and low risk aversion, but these could unwind rapidly if disruptive tail events occur (notably euro-area volatility). - Public and private balance sheets are highly exposed to such risks. - Additional downside risk: Portugal’s trade with and investment in Angola (fourth-largest goods export market) could be adversely affected by Angola’s growth deterioration from low oil prices. - Region-wide compression in bond spreads may not reflect country-specific fundamentals and could reverse. ### Policy Recommendations — Resilience and Growth (Staff views) - Use favorable cyclical conditions and benign financing to strengthen resilience and raise growth potential through decisive policy action: - Continue fiscal adjustment with emphasis on expenditure rationalization. - Undertake a comprehensive reform of public sector wages and pensions. - Adopt a more proactive, bank-led approach to deleveraging to maintain financial stability and ensure efficient resource allocation. - Implement additional structural reforms (in the context of rigid labor markets and limited domestic competition) to absorb large labor slack and spur economic growth. - Priorities emphasized: - Strengthen competitiveness through further implementation and potential stepping-up of structural reforms. - Address excessive leverage in public and corporate sectors and high external debt. - Raise investment and reduce policy uncertainty to improve medium-term growth prospects. *Source: EXECUTIVE SUMMARY (April 15, 2015) — _cr15126* ### Box 2). Notwithstanding these concerns, given ### _cr15126 - Box 2). Notwithstanding these concerns, given ### Authorities’ views on recent market reaction and medium-term outlook - Market reaction to the QE announcement has been rapid and strong; growth and inflation "may very well surprise on the upside in the short term." - Authorities emphasized largely permanent factors in spread compression: - A comprehensive European crisis backstop has been put in place and is viewed as credible. - Most market participants expect a slightly larger spread differentiation than before the crisis. - This favorable environment will raise growth in 2015 and 2016 above what had been expected only a few months ago. - Authorities expressed concern that low yields and compressed spreads could lead to the accumulation of external imbalances in the future. - Medium-term outlook (authorities’ view): - Portugal’s external competitiveness has improved. - Re-balancing between tradable and nontradable sectors is underway (signified by stronger employment and credit growth in the tradable sector and robust export growth). - The economy will grow faster in the medium term, fueled by investment, the rising stock of human capital, and continued strength of external demand. - Banking system still faces important challenges; economic recovery and supportive monetary policy should create conditions for corporate and bank balance sheet repair. ### Fiscal path — background and recent developments - 2014 fiscal outturns: - Fiscal deficit narrowed to 4.5 percent of GDP in 2014 (below the authorities’ target of 4.8 percent), primarily due to under-execution of investment spending. - Excluding several large one-off transactions related to SOE and banking support operations, the deficit fell to 3.5 percent of GDP, amounting to a structural fiscal adjustment of 1 percent of GDP. - Debt-to-GDP ratio stood at 130.2 percent, slightly higher than originally projected due to adverse valuation effects of euro depreciation, additional debt issuance to maintain the government’s cash buffer, and a downward revision to nominal GDP. - Policy framework and timing: - Authorities have not defined a structural primary adjustment path beyond 2015. - The 2014 Fiscal Strategy Document envisages a minimum structural adjustment effort of ½ percent of GDP per year, in line with the European Treaty on Stability, Coordination, and Governance framework. - A new Stability Program was expected to be issued at the end of April (reference in original text). ### Arrears and cash management - Arrears developments: - In 2014, arrears were reduced by €367 million (20 percent), mainly through the government clearance strategy. - Additional funding to public hospitals (€151 million) led to the settlement of €59 million of arrears in the health sector. - Arrears initially accumulated in early 2014, were cleared at the end of the year, but began rising again in early 2015 (an increase of €47 million in January). - January parliamentary amendment of the commitment law requires line ministries to create contingency reserves to forestall accumulation of new arrears. ### Staff’s views and recommendations on fiscal policy - Fiscal sustainability priority: - Portugal remains vulnerable due to high public debt (the third-highest in the euro area following Greece and Italy), large refinancing needs, small economy size, and weak growth prospects. - Debt-to-GDP ratio projected to decline modestly, reaching 121 percent in 2020 under baseline projections. - Debt dynamics remain highly vulnerable to adverse yet plausible macro-fiscal and contingent liabilities shocks. - A more pronounced decline in the debt ratio would require greater fiscal adjustment than under the baseline and structural reforms to boost growth. - 2015 fiscal stance: - Staff projects a fiscal deficit of 3.2 percent of GDP for 2015—marginally above the excessive deficit procedure target of 3 percent of GDP—and higher than the budgeted 2.7 percent of GDP. - Difference versus budget primarily reflects more pessimistic revenue assumptions; the budget incorporates large revenue gains from measures to improve tax compliance and recover outstanding tax debt. - Structural primary balance projected to deteriorate in 2015. - Recommended anchor: - Fiscal policy should be anchored around an annual structural primary adjustment of 0.5 percent of GDP. - Rationale: limited space for counter-cyclical policy given debt and borrowing needs; ensure windfall savings from low sovereign yields are used to reduce public debt and restore fiscal buffers. - Adjustment should be achieved mainly through expenditure rationalization and introduction of expenditure targets for each level of government. - Under this adjustment scenario, debt would decline to around 110 percent of GDP by 2020. ### Specific fiscal policy measures recommended - Introduce multi-year expenditure targets covering all general government expenditure; make them sufficiently binding and include local governments and social security funds. - Use intergovernmental coordination council to monitor outturns and identify in-year corrective measures. - Contain spending with focus on public sector wages and pensions (together account for nearly 25 percent of GDP and more than half of non-interest government spending): - Public wages: - Past wage-bill measures yielded smaller savings than expected due to successive Constitutional Court (CC) rulings and design weaknesses. - Public employment was reduced by almost 10 percent, but wage cuts failed to reduce the public-private compensation gap. - Requalification pool and voluntary separations underperformed. - CC has ruled out additional nominal cuts; reforms should be structural rather than across-the-board. - Priority: further reduce number of employees via higher natural attrition and targeted cuts in overstaffed areas; enhance departure mechanisms. - Structural measures should aim to limit automatic wage increases and career progression to generate permanent savings of about 0.1 percent of GDP per year. - Footnote: Savings from a reduction of the workforce by additional 10 percent are estimated at around 0.5 percent of GDP. - Pensions: - Recent CC rulings cancelling targeted pension measures call for a more comprehensive approach. - Authorities should adopt a new indexation rule based on economic factors to automatically adjust benefits and ensure sustainability. - Suspension of early retirements introduced in 2012 and lifted in 2015 should be reinstated to contain retiree numbers. - In short and medium term, public sector employees’ contribution to CGA could increase to improve its financial sustainability. - Other structural fiscal reforms to reduce fiscal risks and support growth: - SOEs and hospitals: proceed resolutely with restructuring to address structural challenges and high debt. - PPPs: annual gross payments related to PPPs expected to be reduced by about 20-25 percent after renegotiations but will stabilize at about €1.5 billion (0.8 percent of 2015 GDP) until 2022, before slowly declining to about €0.6 billion in 2030; renegotiations should be pursued forcefully. - Budgeting and public administration: finalize and adopt a new Budget Framework Law, consolidate all government revenues in the Treasury single account, move gradually to accrual accounting, devolve more responsibility to line ministries with stronger financial accountability, and reduce public administration fragmentation at central government level. - Within sustainability constraints, fiscal policy should promote growth and alleviate employment bottlenecks via targeted tax measures (e.g., deduction for corporate equity) and increase labor force participation through social security cuts to address localized labor market malfunctions. - Scaling up public investment may not be needed given high level and quality of public capital stock compared to other euro area countries. ### Authorities’ views on fiscal targets and measurement - Authorities’ 2015 deficit target of 2.7 percent of GDP viewed as well within reach; encouraged by initial results from improved tax compliance efforts: - Measures include reducing fraudulent VAT refund claims, curbing tax evasion related to rental income, and recovering outstanding tax debt. - Cash revenue outturn for January-February was in line with authorities’ projections. - Authorities agreed further fiscal adjustment is needed but noted complications in defining adjustment in structural terms due to uncertainty about potential output calculations and differentiating structural versus cyclical developments. ### Deleveraging — background and staff recommendations - Background: - Deleveraging framework largely in place (institutional and legal changes to corporate debt restructuring, lowered creditor approval thresholds, tax code changes favoring equity, monitoring). - No systemic solution introduced (no accelerated SME restructuring or large-scale bank write-offs). - Corporate debt declined slowly in 2013 and stands at 119 percent of GDP, close to level at beginning of the EFF program and still one of highest in the EU. - Staff’s views: - Eliminating the corporate debt overhang is essential for recovery. - With banks facing high operating costs, overcapacity, and weakening asset quality, waiting for growth to improve bank profitability is likely to be disappointing. - Credit misallocation would persist if banks retain nonperforming, less-productive assets. - Successful deleveraging would allow banks to reallocate resources to viable firms, increase investment, and support growth. - Banks should use the supportive environment to: - Raise more capital, - Increase provisioning, - Accelerate write-offs. - Corporations should be encouraged to reform corporate governance, retain more earnings, and inject new equity. - To reduce tax debt bias, authorities could complement efforts to reduce deductibility of debt interest by introducing a deduction of equity for corporate income tax. - Authorities’ view on deleveraging pace: - The deleveraging strategy appears to be working; recent corporate debt decline has been facilitated by equity injections from foreign investors and equity-favoring tax incentives. - Authorities favored a gradual pace of deleveraging to better safeguard financial stability and doubted banks’ ability to raise sufficient capital if the process were accelerated. _italic: Source — Portuguese authorities and IMF staff estimates (extracted from the provided IMF chapter/section)._ ### 29. Even though the number of newly implemented structural measures has fallen with ### _cr15126 - 29. Even though the number of newly implemented structural measures has fallen with ### Notable developments (paragraph 29) - The number of new collective bargaining contracts in 2014 approached levels last seen in 2011, and more contracts were reached at the firm level. - GPEARI—the planning unit of the Ministry of Finance—has been given a formal mandate by the Council of Ministers to coordinate the process of evaluating structural reforms. - There is a proposal to impose a one-time levy on GALP, the largest natural gas provider. If the levy becomes effective, it would be applied to reduce gas prices by 3 to 5 percent for end users for each of the next three years. - Renegotiation of one port concession contract has been completed, with the remaining four expected to follow soon. - New bylaws for 18 services and regulated professions were approved by the Council of Ministers and are currently under discussion in Parliament. - The simplified, centralized, and electronic system of garnishments of bank accounts under the new Code of Civil Procedure enabled the seizure and recovery of €0.3 billion in enforced claims in a little over a year. ### Staff’s assessment of the outlook and reform needs (paragraphs 30–36) - The baseline recovery is judged "too mild to return the economy to full employment over the medium term." - Portugal faces adverse capital and labor trends: negative net investment in the short term, and a falling working-age population in the short- and medium term. - The baseline rate of growth is insufficient to absorb labor market slack; job prospects for the lower-skilled would remain dire. - Priority reform objectives: - Alleviate impediments to external competitiveness and potential growth. - Revisit reforms that have not delivered, fully implement initiated reforms, and address remaining bottlenecks through fresh reforms. - Public service quality and public administration: - Upgrade effectiveness of central and local public administrations. - Review functioning of the courts. - Increase payment discipline of public sector entities. - Product market functioning: - Fully implement measures to reduce the cost of energy, use of transport infrastructure, and costs of professional and other services and evaluate outcomes. - Empower the competition authority with resources and political support to tackle anti-competitive practices in sheltered sectors. - Promote greater market integration at the European level. - Labor market reforms and social policy: - Fresh reform ideas needed while avoiding policies that undermine job creation. - Review effectiveness and scope of programs to promote managerial skills. - Make unemployment support more inclusive (e.g., reduce minimum contribution period for eligibility, reduce inactivity traps, especially for older workers). - Caution against premature increases in the minimum wage given increasing share of workers paid at the minimum wage. - Recognize alternative tools to fight poverty may be more effective than minimum wage increases. - Political economy: - Current post-crisis recovery and benign financing conditions create a conducive environment to pursue further institutional change. - Encourage a more inclusive and transparent social partner dialogue to promote competitiveness and job creation. ### Authorities’ views (paragraph 36) - Authorities contend: - The wide range of structural reforms implemented under the program is already paying off. - Yet-unseen benefits of many reforms (e.g., corporate deleveraging strategy) will become more visible soon. - Observed improvements, such as gains in external competitiveness, can be sustained in the medium term. - Product market reform implementation remains on track (citing steps in energy and transport infrastructure). - On labor market, they emphasize challenges in further reducing employment protection and argue that lowering duration of unemployment benefits for older workers while widening coverage would go against their contributive nature. ### Point–Counterpoint (paragraphs 37–40) - Claim: Further fiscal adjustment is unnecessary. - Counterpoint: High public debt is projected to decline only gradually; reversal of favorable financing conditions or a stalled recovery could re-open debt sustainability risks, making debt reduction and rebuilding fiscal buffers imperative. - Claim: Structural reforms are substantially complete; more reforms would increase uncertainty. - Counterpoint: Despite progress, Portugal still lags peers on key structural indicators; modest growth and persistent slack warrant pushing the reform agenda further. - Claim: Focus on corporate deleveraging is misplaced; growth will resolve debt overhang. - Counterpoint: Gradual approach has been less successful; banks have incentives to keep unviable firms afloat, non-performing loans have continued to rise, and delaying deleveraging perpetuates resource misallocation. - Claim: Burden of adjustment was unfairly distributed. - Counterpoint: Labor market flexibility and financial sector stabilization were necessary to restore exports and credit to viable firms; while new collective bargaining contracts declined during the crisis, they increased as the recovery took hold in 2014. ### Staff appraisal and policy recommendations (paragraphs 41–46) - Macro assessment: - Portugal achieved a balanced current account position at the cost of large internal slack, weak domestic demand, output contraction, and high unemployment. - Recovery is driven largely by consumption; medium-term growth prospects remain challenged by lagging structural reforms. - Near-term tailwinds include the ECB’s expanded asset purchase program (historically low sovereign yields), a weak euro, and a dramatic fall in oil prices. - Key recommendations: - Rationalize public expenditure and encourage corporate deleveraging to reduce vulnerability from large stocks of public, private, and external debt. - Implement an annual structural primary adjustment of 0.5 percent of GDP based on expenditure rationalization. - Given a high tax burden, introduce multi-year expenditure targets to ensure focus on expenditure reform. - Pay particular attention to comprehensive reform of wages and pensions, which together account for more than a half of all non-interest government spending. - Seek a systemic solution for excessive leverage: - With authorities’ involvement and encouragement, banks should raise more capital and accelerate debt write-offs. - Corporates must reduce excessive reliance on debt in favor of equity. - Implement further structural reforms to improve growth prospects and reduce labor market slack: - Enhance local competition (notably in the energy sector). - Increase labor market flexibility. - Address the plight of low-skilled workers via vocational training, improving managerial skills, reducing work disincentives, and making social dialogue more inclusive. - Institutional recommendation: - Staff recommends the next Article IV consultation be held on the standard 12-month cycle. ### Firm-level survey findings (Box 1 summary) - Survey covered 35 structural reform areas; responses from large firms and SMEs, broken down by exporters and non-exporters. - Perceived impact of reforms: - Most reforms had some positive impact; exporting firms generally perceived more positive impacts than non-exporters. - Labor market reforms were seen as having the highest positive impact; product market reforms were seen as having the least impact. - Very few reforms were perceived as having had significant impacts; exporters saw significant positive impacts in "increasing work time flexibility" and "reducing the cost of paying taxes". - Perceived urgency of additional reforms: - Strong consensus that many public and financial sector reforms need to be revisited or stepped up. - Exporters especially see urgent needs to: - Increase effectiveness of public administration (central and local). - Upgrade effectiveness of courts. - Improve payment discipline of public sector entities, particularly SOEs. - Improve insolvency and corporate debt restructuring frameworks. - Perceived urgency was generally lower for labor and product market reforms, though exporters flagged near-urgent needs in energy, road pricing, rail costs, enforcement of competition, and hiring and firing costs. - Methodological notes: - Respondents could choose "no answer" when lacking information. - Perceptions may differ from actual outcomes; nevertheless, perceptions influence firm decisions on job creation and investment. - Recommendation: repeat the firm survey at regular intervals (e.g., in about a year) to track perception changes. *Source: _cr15126 - 29. Even though the number of newly implemented structural measures has fallen with* ### Box 2. Portugal's Regained Market Access: Opportunities and Risks ### Box 2. Portugal's Regained Market Access: Opportunities and Risks ### Decline in Portuguese bond spreads: timeline and context - Portuguese bond spreads "peaked at over 1,400 basis points" in the winter of 2012. - Spreads across stressed European economies were under similar pressure through the summer of 2012 and then "declined rapidly" thereafter. - The turn-around is "widely credited to Mario Draghi’s 'whatever it takes' statement on July 26." - The correlation in spreads suggests perceptions of the establishment of a European backstop and rising global risk appetite were common forces behind the decline. ### Fundamentals versus global factors - While "many of the high-spread countries have also seen significant economic turnarounds," the analysis asks: "Which factors dominate in the case of Portugal?" - Despite "improved fundamentals," other factors appear to have been principally responsible for the decline in spreads: - Plotting average ratings of the three major agencies against "10 year bond spreads indicates a dramatic shift downward in spreads across the board." - "Average country ratings have improved modestly" over the period, but "Portugal would have required a significantly higher rating to have earned its current spread in the summer of 2012." - Other indicators of economic fundamentals for Portugal—"the unemployment rate, GDP growth, public debt, and the current account balance"—support the same conclusion that fundamentals alone do not explain the full extent of spread compression. ### Global drivers and market mechanics - "Global factors have been the main drivers of spread compression." - Both the VIX and "the first principal component of periphery country spreads are positively associated with spreads," indicating strong reaction to measures of global turbulence and risk aversion. - "Other global factors such as the ECB policy rate also help explain the low spreads." - The investor base for Portuguese debt has shifted: - It "has diversified towards more risk-averse borrower types and residencies," including "insurers and pension funds" that "hunt for yield in an environment of extremely low interest rates." - Note on instrument referenced: analysis centers on "10 year bond spreads" (spread over Bunds). ### Risks and sensitivity to market sentiment - "Portugal’s spreads are sensitive to changes in market sentiment." - As global factors normalize, expected dynamics include: - Yields will "likely exhibit an upward trend." - Pricing "will become more sensitive to fundamentals." - "Debt service burdens will rise." *Source: _cr15126 - Box 2. Portugal's Regained Market Access: Opportunities and Risks* ### Box 7. Further Structural Reforms and Institutional Transition ### Box 7. Further Structural Reforms and Institutional Transition ### Portugal’s growth challenge - Earlier boom episodes have largely been due to factor accumulation, while the productivity growth has been declining over the past half-century. - Looking forward, Portugal’s working-age population is projected to fall, and the country’s capital stock is contracting because of underinvestment. ### Institutional transition and rent-seeking - An institutional transition that minimizes rent-seeking is key for raising productivity, attracting investment, and jump-starting growth. - The nontradable sector is less productive than the tradable sector, but it offers opportunities for rent-seeking. - Rent-seeking in the nontradable sector results in higher mark-ups, which makes the nontradable sector an attractive investment destination and leads to misallocation of resources. ### Cross-country evidence and implications for Portugal - A cross-country study finds that institutional transitions are associated with trade openness, press freedom, “good” neighbors, and higher levels of education; aid, in contrast, makes institutional transitions less likely (IMF, “Building institutions.” World Economic Outlook, September 2005, 125–160). - In the Portuguese context—with abundant press freedom, “good” EU neighbors, and little emphasis on aid—the focus should be on minimizing rent-seeking, developing the tradable sector, and further investment in education. ### Policy priorities and recommendations - Minimize rent-seeking to ensure scarce resources are channeled to productive activities and to strengthen the clout of the pro-reform tradable sector companies. - Develop the tradable sector to raise overall productivity and attract more productive investment. - Further investment in education, with particular emphasis on vocational training, to allow tradable sector companies to compete more successfully in the global economy. *Sources: Banco de Portugal; Eurostat; INE; OECD; and IMF staff calculations.* ### Annex I. Main Recommendations of the 2012 Article IV Consultation ### Annex I. Main Recommendations of the 2012 Article IV Consultation and Authorities’ Response ### 1. Address accumulated financial imbalances — Fiscal (public sector imbalance) - Policy recommendation: Rebalance the mix of revenue and expenditure adjustments toward one third revenue and two thirds expenditure. - Implementation and outcomes: - Consolidation continued to rely heavily on revenue measures, accounting for half of the adjustment effort from 2011–2014, as Constitutional Court rulings cancelled spending cuts and required offsetting revenue measures. - (a.1) Spending reforms core focus: social transfers and public wages (about two thirds of total spending). - Adjustment efforts were geared toward the wage bill and pension spending. Some measures were later reversed, especially nominal cuts in wages and pension benefits. - (a.2) Implement spending cuts while increasing efficiency and equity given relatively high public employment, high wage premium versus private sector, and more generous pensions alongside limited old-age poverty alleviation. - Public employment was reduced by about 10 percent from 2011–2014. - Public wage premium proved difficult to reduce; wage cuts adopted in 2011 were to be fully reversed by 2016. - Public pensions were aligned with private pension in 2014, and the suspension of pensions’ indexation excluded minimum pensions. - (a.3) Implement growth-oriented tax reform to reduce distortions via streamlining and targeting tax expenditures. - Comprehensive corporate income tax (CIT) reform adopted in 2013 to gradually reduce statutory CIT rate and improve tax provisions to retain multinational companies. - 2014 PIT reform improved incentives to work; a green tax reform was introduced. - Cost of tax expenditures sharply reduced, particularly under the CIT. - (a.4) Strengthen tax compliance, including greater use of the anti-money laundering framework. - Authorities implemented an ambitious tax compliance and anti-fraud strategy and adopted a new strategy for 2015–2017. - Key measures included an automatic VAT invoice system. - Progress on improving compliance uneven for high wealth individuals and self-employed professionals. - (b) Anchor fiscal discipline over the medium and long term. - The medium-term budget framework has been partially improved, with formulation of a no-policy change baseline. - A draft Budget Framework Law (BFL) is being finalized to expand MTBF coverage to all central government spending. - (b.1) Reduce budget fragmentation. - Draft BFL expected to reduce number of budget appropriations and reintegrate some autonomous entities into line ministries. - (b.2) Improve the medium-term fiscal framework, including consistency with the EU fiscal compact. - BFL expected to revise MTBF and include all EU fiscal compact provisions in Portuguese legal framework. - (b.3) Move towards accrual accounting. - Full accrual-based financial statements, including general government balance sheet, would be produced by 2019-2020, in line with FAD recommendations. - (b.4) Continue to build stronger implementation capacity at the Ministry of Finance. - Key reforms improved fiscal reporting, but capacity constraints in the Ministry of Finance continue to impede management and implementation of fiscal reforms. ### 1.2 Corporate deleveraging (private sector imbalance) - (c) Mitigate risks associated with corporate deleveraging. - Authorities strengthened supervision, regulation, legal and institutional frameworks. - (c.1) Regular supervisory inspections and stress test exercises to ensure adequate bank capital. - Quarterly stress-testing during the EFF allowed supervisors to assess resilience on a forward-looking basis. - Three systemic banks took part in the ECB Comprehensive Assessment concluded in October 2014. - (c.2) Implement new corporate and household debt restructuring frameworks. - Institutional and legal frameworks for debt restructuring were strengthened under the EFF. - Regimes for in-court (PER) and out-of-court (SIREVE) workouts introduced and refined; PER had limited effect. - TA mission in January 2014 recommended systemic approach to debt restructuring (especially for SMEs) which has not been implemented. - (c.3) Use supervision and regulatory frameworks to limit ever-greening and ensure credit flows to dynamic enterprises. - Bank of Portugal strengthened regulatory framework for non-performing loans and restructured credits. - Recurrent impairment reviews bolstered loss recognition; however, NPLs are high and still rising, indicating need for bank balance sheet repair. - (d) Counteract renewed buildup of excessive leverage of bank balance sheets. - Macro-prudential policy tools were largely deferred until 2014 given prior credit crunch. - (d.1) Use macro-prudential tools (net stable funding, leverage ratios consistent with Basel III). - In December 2014, Bank of Portugal issued first description of objectives and instruments for macro-prudential toolkit (in line with ESRB recommendations). - Two instruments (systemic risk buffer and sectoral capital requirements) are already available but not yet applied. - Two other instruments (countercyclical policy buffer and buffer for systemically important institutions) will be available from January 1, 2016 onwards. ### 2. Restore competitiveness and growth - (e) Increase incentives toward tradable sectors by reducing excessive rent of nontradable sectors. - Wide range of structural reform measures introduced or continued under the EFF to: (i) reduce labor market rigidity; (ii) cut excessive rent of nontradable sectors; (iii) strengthen market competition; and (iv) enhance external competitiveness. - Notable measures: - Severance pay reduced to 12 days per year of service, now closer to the EU average. - Survival period of collective agreements shortened from 5 to 3 years; possibility of temporary suspension of collective agreements in face of economic crises or natural disasters introduced. - A 3rd package of energy reform measures adopted; a new special levy to tackle windfall profits of natural gas providers under consideration. - Note: A key component of the 3rd package, renegotiation of the long-term natural gas sale and purchase agreements, is not implemented. - Formal renegotiations of existing port concession contracts launched and expected to be completed soon. - Competition Authority’s resources improved by a newly established funding model. - Several national regulatory authorities adopted, or are in process of adopting, new bylaws. - 18 services and regulated professions in final legislation stages of adopting new bylaws. - (f) Close human capital and structural policy gaps between tradable and nontradable sectors. - (See Selected Issues Paper for overall assessment on impact of structural reform measures.) ### Annex II. Risk Assessment Matrix — Major risks, likelihood, impact, and policy responses - I. A surge in financial volatility, with investors re-assessing underlying risk and moving to safe-haven assets. - Relative Likelihood: H - Impact: H - Key concern: High corporate and private debt levels make Portugal highly susceptible to financial contagion; heightened financial stress in banking system given balance sheet fragilities. - Policy response: Shore up liquidity and capital buffers; encourage private savings. - II. Protracted period of slower growth in advanced economies, especially euro area ("new mediocre"). - Relative Likelihood: H - Impact: H - Key concern: Euro area accounts for 60 percent of total exports; trade balance deterioration could push current account back into deficit and derail downward path for sizable net foreign liabilities; lower growth weakens debt dynamics. - Policy response: Step up structural reforms to improve competitiveness and reduce debt overhang. ECB policy actions expected to support exports to trade partners outside the euro area. - III. Political and legal setbacks that delay policy implementation (acute around QE and elections). - Relative Likelihood: H - Impact: M - Key concern: QE temporarily removes sovereign financing concerns, reducing urgency for reforms. - Policy response: Step up structural reforms to improve competitiveness. - IV. Political fragmentation involving Russia/Ukraine, Middle East, and Africa. - Relative Likelihood: M - Impact: M - Key concern: Conflicts depress business confidence, heighten risk aversion, disturb global markets; oil price spike problematic for net oil importer (oil trade deficit of about 3½ percent of GDP). - Effects: Inflation pickup, higher real debt burden, depressed domestic and external demand; overall impact expected to be subdued given current low base. - Policy response: Step up structural reforms to improve competitiveness. - V. Excessively low inflation. - Relative Likelihood: M - Impact: M - Key concern: High debt levels and tepid growth; compression of interest margins reduces interest income and weakens profitability; higher real debt burden; lower domestic demand. - Policy response: Shore up liquidity and capital buffers. Step up structural reforms to improve competitiveness and reduce debt overhang. - VI. Bond market stress from reassessment of sovereign risk in the euro area. - Relative Likelihood: M - Impact: H - Key concern: High public debt makes Portugal susceptible to sovereign stress despite recent ECB action; although a cash buffer covers a large share of 2015 financing needs, medium-term debt dynamics remain fragile and dependent on market access on favorable terms. - Policy response: High-quality fiscal adjustment and fiscal structural reforms to rein in financing needs. Continue pre-financing efforts to build cash buffers on favorable terms. ### Annex III. External Stability Assessment — Key findings and metrics - 1. Real effective exchange rate (REER) trends: - After short interruption, REER continued trend depreciation. - Depreciation of the euro after ECB policy actions, lower oil prices, persistent labor market slack, and low capacity utilization expected to put downward pressure on ULC-based and CPI-based REER this year. - Offsetting factors: increases in minimum wage and non-subsidized electricity tariffs. - Without additional actions to improve cost competitiveness, factors driving up costs expected to reverse trend depreciation over medium term. - 2. External position assessment and valuation: - EBA estimates (through 2014) broadly reflect external balance, but large debt overhang and structural challenges lead staff to assess external position as slightly weaker than implied by medium-term fundamentals and desirable policy settings. - Current account (CA) and external sustainability (ES) approaches suggest exchange rate is undervalued; REER approaches suggest overvalued by as much as 8.5 percent. - Portugal’s net foreign liabilities: 110 percent of GDP in 2014. - CA approach details: - CA surplus was 0.6 percent of GDP in 2014, corresponding to estimated cyclically adjusted surplus of around -0.1 percent of GDP. - Model-based norm of -2.0 percent of GDP would suggest a 5 percent undervaluation; large regression residual exists. - Staff assesses norm about -0.5 percent of GDP, implying the cyclically adjusted CA would be around 0.4 percent of GDP stronger than implied by fundamentals and desirable policies. - ES approach: - Current account surplus needed to stabilize NFA at just above -60 percent of GDP estimated at 0.2 percent of GDP. - Staff projects medium-term current account surplus of 0.1 percent (compared with 1.7 used in EBA calculations), implying broad exchange rate alignment by this metric. - Reaching target NFA at debt-stabilizing surplus would take many years; a current account surplus of 1 percent would bring NIIP down to 80 percent of GDP by 2020. - REER approaches: - Indicate an overvaluation between 2.9 and 8.5 percent. - Recent euro depreciation caused a real effective depreciation of 3 percent since end-2014, likely delaying short-term effects of overvaluation. - Policy implication: Policy action to improve fundamentals needed to ensure competitiveness when Euro-area-wide depreciation forces unwind and to reduce risks from high debt burden. - 3. External financing flows and vulnerabilities: - Portfolio inflows (primarily public, some private) resumed and accelerated in 2014, increasing from close to zero in 2013 to 7 percent of GDP in 2014. - Public external debt benefits from a more diversified investor base and issuance at maturities up to 30 years, which mitigates sudden reversal risk. - Recovery of portfolio inflows mirrored a reduction in other investment inflows, partly reflecting end of program financing. - FDI inflows picked up slightly from 2013 to 4.8 percent of GDP in 2014 (down from 11 percent of GDP peak in 2012). - Despite restored market access and reduction in external financing needs, small external surplus and sizeable external debt render Portugal vulnerable to shocks (confirmed by external DSA). - 4. Export performance and market share: - Exports held up during crisis aided by diversification toward Angola, Brazil, China, but export growth slowed in 2014. - Goods exports declined partly due to production stoppages at an oil refinery in early 2014; services exports maintained growth. - Portugal lost market share in 2014 as external demand growth outpaced export growth. - Temporary boost to exports likely from euro depreciation and lower oil prices, but exports expected to remain subdued absent further reforms to alleviate growth and competitiveness bottlenecks. ### Annex IV. Public Debt Sustainability Analysis (DSA) — Overview - Staff assessment using Public DSA framework for Market-Access Countries: - Portugal’s gross debt trajectory is subject to significant risks given sizable debt burden and gross financing needs. - Debt dynamics hinge on additional growth-supporting structural effort over the medium term and remain highly vulnerable to adverse yet plausible macro-fiscal and contingent liability shocks. - Baseline projections reflect authorities’ current fiscal policies, but additional fiscal consolidation in 2015 and outer years remains critical to anchor debt on a downward-sloping path, boost policy credibility, and strengthen resilience to market reversals. - A. Baseline Scenario (DSA continues beyond excerpt). *Source: Annex I–IV, “Main Recommendations of the 2012 Article IV Consultation and Authorities’ Response,” Portugal country material.* ### 1. Public debt continued to increase in 2014 despite further progress on fiscal ### Public debt continued to increase in 2014 despite further progress on fiscal adjustment ### Recent debt developments and baseline projections - Public debt rose from 129.7 to 130.2 percent of GDP in 2014, reflecting several large one-off transactions related to SOE support, adverse valuation effects of euro depreciation, and a downward revision to nominal GDP. - Debt is projected to decline steadily beginning in 2015 as the headline fiscal deficit continues to fall, with Portugal benefitting from a sizable reduction in interest costs as yields have declined. - Under the baseline (absent further consolidation efforts), debt would still remain at nearly 121 percent of GDP at the end of 2020. - Portugal’s debt net of government deposits amounted to 120 percent of GDP at end–2014, reflecting the accumulation of sizable cash reserves in recent years. - Footnote detail: The majority of Portugal’s foreign-currency denominated debt is hedged through currency swaps; unhedged foreign-currency denominated debt is around 3 percent of GDP. The chart in Figure 4 shows total foreign-currency debt, not accounting for hedging operations. ### Risk assessment - Portugal’s debt ratio already exceeds the debt burden benchmark for advanced economies of 85 percent of GDP under the baseline scenario. - Public financing needs are above the relevant benchmark of 20 percent of GDP under the baseline. - The debt profile is subject to medium to low risks in terms of market perception, projected change in short-term debt, and the share of public debt held by nonresidents. - Bank vulnerabilities are below the relevant thresholds identified by the MAC DSA template; therefore the standardized contingent liabilities shock does not apply and is replaced by a customized shock addressing contingent liabilities from SOEs and PPPs. - The total (public and private) external financing requirements exceed significantly the relevant benchmark under the baseline; in the case of Portugal, the figure includes, among others, non-residents bank deposits, accounting for about 45 percent of GDP. ### Realism of baseline assumptions and alternative scenarios - Staff estimate of potential growth has been lowered relative to earlier projections; growth is expected to slow as cyclical momentum fades after 2016. - Staff’s updated projection assumes achieving a growth rate of 1¼ percent over the medium term, consistent with moderate growth convergence but subject to sustained structural effort and successful rebalancing from nontradable to tradable sectors. - Portugal’s growth forecast track record shows a relatively large median error compared with other countries with Fund-supported programs, especially during the pre-crisis period. - The primary balance is expected to exceed its debt-stabilizing threshold over the projection period. Under staff’s baseline scenario, the fiscal primary balance is expected to reach nearly 2 percent of GDP over the medium term. - The 3-year change in the cyclically-adjusted primary balance identified for Portugal is in the top third of fiscal adjustments observed in other countries with debt greater than 60 percent of GDP; however, this largely reflects fiscal efforts already achieved over 2011–14 due to the 3-year rolling nature of the estimate. - Authorities’ medium-term fiscal strategy is expected to target a more ambitious adjustment path than staff’s current-policies baseline, consistent with the European Treaty on Stability, Coordination, and Governance framework which establishes a minimum structural adjustment effort of ½ percent of GDP per year, until the medium term objective is achieved. ### Stress tests and scenario outcomes - Baseline sensitivity: The baseline remains highly sensitive to macro-fiscal and contingent liabilities shocks. - Growth shock scenario: - Lowers output by nearly 4.5 percentage points in 2016–17 and inflation by a cumulative 1 percentage point. - Debt would peak at about 134 percent of GDP in 2017, over 10 percentage points higher compared with the 2016 baseline. - Deflation scenario: - A sharper growth shock that lowers output by 5½ percentage points in 2016–17 and is associated with deflationary pressures with inflation lower by cumulative 4 percentage points. - Under this scenario, debt would rise to 142 percent of GDP by 2017 and remain at this level over the medium-term. - Interest rate shock: - A sustained interest rate shock of 200 bps throughout the projection period would slow down the rate of debt decline so that by 2020 the debt-to-GDP ratio is about 3 points higher compared with the baseline. - Contingent liabilities shock: - Staff’s assessment suggests that, under a severe scenario, further contingent liabilities could potentially materialize for about 5 percent of GDP, due to SOEs, PPPs, and State guarantees. - A contingent liabilities shock of this magnitude would push the 2015 debt ratio to about 131 percent of GDP. - Severe combined shock: - Incorporating the macro-fiscal and contingent liabilities adverse scenarios would push debt to 135 percent of GDP in 2017 and then continue to rise gradually over the medium term. *PORTUGAL — INTERNATIONAL MONETARY FUND* ### 6. The authorities took note of the risks highlighted by staff, but also stressed their ### _cr15126 - 6. The authorities took note of the risks highlighted by staff, but also stressed their ### Authorities’ assessment of risks and divergence from staff baseline - Authorities acknowledged the risks highlighted by staff but stated a divergence from staff’s baseline scenario. - Authorities were more optimistic about the growth outlook and foresee a larger improvement in medium-term debt dynamics than projected by staff. - Authorities expressed confidence that the 2015 fiscal deficit target will be achieved, resulting in a larger reduction of the debt-to-GDP ratio by the end of the year, and putting debt dynamics on a trajectory to improve at a faster pace than envisaged under staff’s baseline scenario. - As foreseen in the EU framework, the authorities will present revised macroeconomic and fiscal projections for the medium-term in their Stability Program by end-April. ### Fiscal adjustment, investor confidence, and Fund prepayment - Authorities emphasized significant progress on fiscal adjustment in recent years and the resulting improvement in investor confidence. - Improved investor confidence has allowed a return to market borrowing on favorable terms and facilitated the prepayment of nearly one-fourth of their outstanding borrowing from the Fund in March 2015. ### Recent increases in gross debt and cash balances - Authorities noted that recent increases in gross debt have been largely due to the sustained build-up of central government cash balances. ### SOE debt management operation (2014) - The SOE debt management operation in 2014 aimed at restoring the financial viability of these companies, thus significantly reducing fiscal risks and future borrowing needs. ### Key macroeconomic projections and indicators (from the same report) - Output is expected to increase by 1.6 percent in 2015 and by 1.5 percent in 2016. - The economy has expanded at close to 1 percent per year on average since early 2013, with growth driven largely by consumption. - The 2014 fiscal deficit objective of 4.0 percent of GDP (excluding one-off operations) has been achieved, implying a structural primary adjustment of 1 percent. - Selected projections and indicators (2014–17): - Real GDP: 0.9 (2014), 1.6 (2015), 1.5 (2016), 1.4 (2017) - Private consumption: 2.1 (2014), 1.7 (2015), 1.6 (2016), 1.5 (2017) - General government balance (percent of GDP): -4.5 (2014), -3.2 (2015), -2.8 (2016), -2.5 (2017) - Primary government balance: 0.4 (2014), 1.6 (2015), 1.7 (2016), 1.8 (2017) - General government debt: 130.2 (2014), 126.3 (2015), 124.3 (2016), 122.7 (2017) - Unemployment rate (percent): 13.9 (2014), 13.1 (2015), 12.6 (2016), 12.1 (2017) - Nominal GDP (billions of euros): 173.1 (2014), 177.6 (2015), 182.7 (2016), 187.6 (2017) ### Policy timing and deliverables - Authorities to present revised macroeconomic and fiscal projections in the Stability Program by end-April. *Source: IMF staff report excerpts and figures as provided in the chapter text.* ### 16.6 percent in 2012). This led to an acceleration of import growth (+6.4 percent), which ### _cr15126 - 16.6 percent in 2012). This led to an acceleration of import growth (+6.4 percent), which ### Macroeconomic outlook and labor market - Import growth accelerated by +6.4 percent, surpassing exports growth of +3.4 percent. - Government projects GDP growth: - 2015: 1.6 percent - 2016: 2.0 percent - 2017: 2.4 percent - 2018: 2.4 percent (maintaining a similar pace) - 2019: 2.4 percent (maintaining a similar pace) - Unemployment rate projections: - 2013: 16.2 percent (historical) - 2014: 13.9 percent (historical) - 2015: 13.2 percent (expected) - 2019: 11.1 percent (forecast) - External adjustment and current account: - Net lending position of the Portuguese economy expected to reach 2.7 percent of GDP in 2019. - Current account balance forecast to improve from 0.5 percent of GDP in 2015 to 1.4 percent of GDP in 2019. - Narrative: The Stability Program views the 2014 shift toward private consumption and imports as temporary and driven by an improvement in confidence after the adjustment process; staff and Government scenarios are broadly aligned for 2015, with Government more optimistic from 2016 onward. ### Fiscal policy - Fiscal targets and outcomes: - Government reaffirms commitment to exit the EU Excessive Deficit Procedure (EDP) by 2015. - 2015 deficit target: 2.7 percent of GDP. - 2014 General Government deficit and related figures (as released April 17): - 2014 General Government deficit: 4.5 percent of GDP (EUR 7.717 billion). - 2013 General Government deficit: 4.8 percent of GDP (EUR 8.181 billion). - 2014 deficit net of one-off items: 3.3 percent of GDP. - 2013 deficit net of one-off items: 5.1 percent of GDP. - 2014 primary surplus: 0.5 percent of GDP (second consecutive year). - Total correction in the primary balance between 2010 and 2014: 8.7 percentage points of GDP. - Medium-term fiscal strategy and trajectories: - Medium-term objective: structural deficit of 0.5 percent (set for Portugal). - Structural deficit expected to be achieved in 2016 (one year earlier than in the 2014 Fiscal Strategy Document). - General Government balance targeted to improve from a deficit of 2.7 percent of GDP in 2015 to a surplus of 0.2 percent of GDP in 2019. - Public debt projections: - General Government Gross Debt expected to decline by 6 percentage points in 2015, reaching 124.2 percent of GDP by end-December 2015. - Gross Debt projected to fall to 107.6 percent of GDP in 2019. - Excluding Central Administration deposits, public debt expected to decrease from 116.5 percent of GDP in 2015 to 103.8 percent of GDP in 2019. - Assessment: Improvements in fiscal accounts contributed to recovery of market access and decline in spreads; Government notes staff report underplays role of fiscal and current account improvements. ### Financial sector policies and banking sector developments - Liquidity and deleveraging: - Loan-to-deposit ratio fell to 107 per cent in December 2014 from 117 percent at end 2013. - Central Banks’ financing decreased, reaching minimum levels since the beginning of the Program at end 2014. - Credit dynamics: - Credit decreased in residential mortgage segment and sectors dependent on domestic demand (notably construction and real estate). - Exporting firms experienced increasing positive (net) flows of credit. - Evidence of stronger competition across banks for firms with good risk profiles; differentiation in credit conditions in 2014 by firm risk. - Growth rate of loans to lowest-risk firms increased during 2014; growth rate of loans to riskiest firms remained significantly negative. - Deposits and loans levels were not affected by the resolution measure applied to BES. - Solvency and profitability: - Common Equity Tier 1 reached 11.3 percent at end 2014 for the banking system as a whole. - The decrease in CET1 in Q4 2014 reflected low profitability and revisions of actuarial assumptions for pension funds due to lower interest rates. - Profitability remains low for most banks despite improvements in return on asset and return on equity ratios. - Positive drivers in 2014: favorable dynamics in net interest income, increase in profits from financial operations, decline in operational costs. - High level of impairments, largely linked to exposure to non-financial firms, continues to weigh on profits. - Non-performing loans and impairments: - Stock of impairments as a percentage of gross loans: 7.7 percent (one of the highest in Europe). - At end 2014, about 50 percent of non-performing loans granted to firms on banks’ balance sheet were under litigation. - Banco de Portugal inspections and the ECB Comprehensive Assessment led banks to recognize significant NPLs and reinforce impairments. - Policy considerations and challenges: - Priority to regain bank profitability without excessive risk-taking or excessive concentration in certain activities/markets. - Need for banks to adjust business models to a macroeconomic context of relatively moderate potential growth and low interest rates. - Reconciling controlled deleveraging with promoting economic growth is challenging. - Further measures to accelerate deleveraging and clean up bank balance sheets must be assessed for impacts on (i) debt; (ii) banks’ profitability and capital ratios; and (iii) financial stability and economic growth, considering credit demand constraints. - The swiftness of the judicial system is key to accelerate cleaning up banks’ balance sheets given litigation levels. ### Structural reforms - Role and progress: - Structural reforms considered crucial to increase external competitiveness and potential growth. - Commitment to reforms was visible during the Program and continued after Program completion; milestones regularly achieved. - The National Reform Program documents the updated state of play and future plans. - Product markets and sector-specific reforms: - Energy sector: only two measures from the Third Energy Package remain to be fully completed. - Transport infrastructure: concessions for urban transportation progressing; Porto concession awarded to an international company; Lisbon international tender should be completed by July. - Privatizations: CP Carga and EMEF privatizations approved; process for TAP relaunched. - Institutional change: merger of Estradas de Portugal and REFER formalized, naming the new company Infraestruturas de Portugal. - Public administration and labor market: - Ongoing reforms in administrative reorganization, courts’ efficiency, and payment discipline. - Government remains committed to labor market reforms to promote job creation and skills upgrading while reinforcing social cohesion. - Implementation timeline and expectations: - Some reforms already show evident payoffs; others take longer to materialize due to expected time lags in full effectiveness. *Source: IMF staff summary from the Stability Program submission and related program documentation.* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2015/_cr15126.pdf_