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Portugal: Completing the Job

(Version in Português)

Today the IMF released a report on Portugal’s progress under the country’s Economic Adjustment Program. What is the latest assessment?

A strong start

There is no doubt that Portugal has made remarkable progress over the past three years. When the sovereign lost access to international bond markets in 2011, the outlook was grim. The economy was facing large domestic and external imbalances and dismal growth prospects. Unprecedented official financing from Portugal’s European partners and the IMF provided a window of opportunity to address the weaknesses at the root of the crisis and regain market confidence. While constrained by formal and informal strictures, the authorities rose to the occasion.

The authorities have made substantial progress in fiscal adjustment, while needing to frontload it in view of the high debt burden and to establish fiscal policy credibility. However, it is important to recognize that fiscal targets were relaxed when it was possible to do so, to avoid more severe consequences on growth. All told, about two-thirds of the structural fiscal effort necessary to comply with the European Fiscal Compact’s medium-term objectives has now been completed.

Equally important, wide-ranging structural reforms were enacted in spite of difficult socio-economic circumstances and legal hurdles. The government took steps to improve the functioning of the labor and product markets and make the business environment more conducive to growth. External adjustment has exceeded expectations implying a lower need to borrow from overseas; and financial stability has been preserved. The economy now shows early signs that it may have turned the corner. In light of the progress on all of these fronts, foreign bond market investors seem reassured, and sovereign yields recently dipped to their lowest level since April-2010.

Risks persist; unemployment remains high

These significant achievements in a relatively short period of time, however, do not mean the job is complete. Unemployment remains high, and even more so for the youth and long-term job seekers. Both public and non-financial private sector debt—respectively close to 129 and 255 percent of GDP—remain uncomfortably high by any standard. Faced with such high debt, clearly, further fiscal consolidation and private sector deleveraging will be necessary. But perhaps more importantly, working these heavy burdens down will require sustained high growth.

One thing is certain: durable high growth cannot be achieved by going back to the old pre-crisis model. There is no room to borrow more for consumption or unproductive investment. Moreover, since Portugal’s negative investment position vis-à-vis the rest of the world is so large—currently above 110 percent of GDP—and tilted toward debt, borrowing externally is not an option for the foreseeable future. The economy needs to generate external surpluses to reduce this negative investment position; investment needs to be geared toward tradable sectors—sectors that generate their earnings by selling their goods and services abroad; growth and employment have to be driven by exports.

This means that sustaining efforts to raise the economy’s competitiveness is the only path forward.

Adjustment burden should not fall excessively on labor

Given the constraints imposed by the monetary union framework, and in the absence of exchange rate flexibility, boosting the economy’s competitive position requires lowering unit labor and other input costs, raising productivity, and enhancing firms’ ability to adjust to shocks.

We have seen some progress in lowering unit labor costs in the private sector, facilitated in part by the reforms implemented thus far to soften employment protection and encouraging more flexible work arrangements, allowing enterprises to better adjust to the demand shock they were facing. Reforms to collective bargaining have helped to better align wages and productivity.

While more could be done to improve labor market functioning and employment opportunities, reducing other production costs is perhaps even more important. For one, labor costs make up only about 30 percent of operational costs. In addition, it is important to ensure that the burden of adjustment does not fall excessively on labor and is balanced by adjustment elsewhere. Therefore, ambitious product market reforms aimed at increasing competition and reducing rents in the nontradable sector need to be a centerpiece of the growth agenda going forward. Progress has been made on this front. Nonetheless, a lot more can be done to take the process forward. One priority is to identify remaining impediments to price flexibility and steps to boost productivity. Another one is to ensure that the new laws and regulations translate into effective change and lower input prices for exporters.

Maintain the momentum

Policymakers need to persist with ambitious reforms—to bring ongoing fiscal adjustment to term, to facilitate private sector deleveraging, and to boost competitiveness. Portugal cannot go back to the pre-crisis economic model which proved unsustainable. What has been achieved thus far, and under difficult circumstances, deserves to be recognized and needs to be taken forward over coming years. This will take time, and continued efforts will be needed irrespective of who is in power. It will require as broad a consensus as possible.