Mission Concluding Statement 

Portugal: Staff Concluding Statement of the Seventh Post-Program Monitoring Mission

November 30, 2018

The Portuguese authorities announced on November 29, 2018 their intention to pay off their remaining debt to the IMF this year. Portugal’s early repayments, started since 2015, have already markedly reduced its outstanding debt to the Fund. Early repayments to the IMF reflect Portugal’s favorable market access conditions and send a positive signal to investors and markets. These operations are financially advantageous because they improve the public debt maturity profile and generate interest bill savings. Combined with the policy of maintaining strong cash reserves, this contributes to a further build-up of financial defenses against future adverse events. Once the announced repayment takes place, Portugal will exit Post-Program Monitoring status.

Economic activity remains cyclically strong, although moderating since GDP growth peaked in 2017. Third-quarter real GDP growth of 2.1 percent y-o-y suggests a deceleration after first- and second-quarter outturns, respectively, of 2.2 percent and 2.4 percent y-o-y. The deceleration reflects largely some loss of momentum in exports and investment. The job market has continued to improve, with unemployment falling from 7.9 percent in December 2017 to 6.6 percent in September 2018, driven by broad-based employment growth.

The economy is projected to continue to decelerate gradually towards its medium-term potential. Growth is projected at 2.2 percent in 2018, easing to 1.8 in 2019, and toward 1.4 percent in the medium term. Investment and exports should continue to be important drivers of growth, albeit at a slower pace.

The main downside risks looming over the economy relate to the external environment. Portugal would directly feel the negative consequences of lower euro area wide growth, Brexit-related turbulence, and weaker international trade following increased protectionism. On the domestic front, there is a risk that the government might adopt weaker policies that could undermine investor confidence and the business environment, and possibly result in increased budgetary rigidities and a reduction in the quality of government expenditures. In contrast, strong macroeconomic, macro-financial, and structural policies would not only bolster the outlook, but would also increase Portugal’s resilience to market volatility and other shocks, including in the event of spillovers from other euro area countries, as shown by the experience of recent months. On the upside, more robust cyclical developments than currently projected could materialize.

Robust economic growth, careful expenditure execution, and a falling interest bill mean that the 2018 fiscal deficit target will likely be achieved, and public debt will decline again this year. For 2019, while the budget targets a headline deficit of 0.2 percent of GDP, staff project a deficit of 0.4 percent of GDP, reflecting more moderate economic growth assumptions for next year (1.8 percent rather than 2.2 percent assumed in the budget). This forecast assumes that policies evolve in line with the 2019 budget, including in areas such as the unfreezing of career progressions. After removing ‘one-off’ effects, interest payments, and the cyclical components, this would imply a slight deterioration of the structural primary balance of 0.1 percent of GDP relative to 2018. Under staff’s assumptions, debt will continue its downward trajectory to 121 percent of GDP in 2018, 118 percent in 2019, and 103 percent of GDP by 2023.

Despite declining in the last few years, high public debt remains a major vulnerability, requiring continuing fiscal consolidation efforts. The currently favorable conditions provide an opportunity to frontload the multi-year fiscal consolidation envisaged in the government’s Stability Program, and thus speed up public debt reduction, contributing to favorable borrowing conditions throughout the economy. Moreover, a stronger primary surplus would also provide additional buffers against adverse changes in interest rates and economic growth and other contingencies. Such strengthening needs to be built on a durable containment of current expenditure, including through comprehensive reviews of the level and composition of public employment and of pensions, especially at the higher end, while preserving capital spending.

Important progress has been made in repairing the banks’ balance sheets, but continued effort is needed to reduce vulnerabilities. Asset quality improved further this year, with NPL ratios falling from 13.3 percent at end 2017 to 11.7 percent in June 2018, while the regulatory capital ratio has remained stable above 15 percent in the same period. Nevertheless, banks are constrained by still high NPL levels and low profitability, and will face additional cost pressures as MREL requirements are phased in. Other vulnerabilities include significant concentrations of exposures to real estate (38 percent of total assets at end-2017, with housing loans accounting for about 28 percent of total assets) and, to a lesser extent, public debt (about 15 percent of banks’ assets at end-2017, with the domestic sovereign accounting for 8 percent of total assets). Supervisors should ensure that banks follow through on their NPL reduction plans and strengthen their internal risk management and corporate governance. They should also encourage banks to step up efforts to improve operational efficiency and profitability. Finally, supervisors should continue to monitor the evolution of housing prices, which have been rising fast in Portugal in recent years, and ensure that banks have sufficient capital buffers to withstand adverse shocks to their balance sheets.

Sustained robust growth over the medium-term is key to the continuing deleveraging in the public and private sectors, helping reduce vulnerabilities. Despite seeing significant reductions in the last several years, household and nonfinancial corporate debt ratios in Portugal exceed the corresponding European averages. Just like with public debt, deleveraging benefits from sustained economic growth. Strengthening growth will require fostering investment—as well as domestic saving to avoid a weakening of the country’s external position. Raising productivity and investment demands maintaining the focus on improving the regulatory environment, supporting firms’ capacity to grow, strengthen their capital, and innovate, and building up skills levels in the population. Continuing ongoing efforts to strengthen the legal and institutional framework for debt enforcement and insolvency are necessary to support a more productive allocation of economic resources. Keeping labor markets flexible is important for Portugal’s ability to process adverse shocks, and maintaining competitiveness requires wage growth consistent with developments in productivity.