Portugal Staff Concluding Statement of the 2023 Article IV Mission

May 9, 2023

A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.

The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.

Washington, DC: An International Monetary Fund mission, led by Rupa Duttagupta, and comprising Kamil Dybczak, Antonio Pancorbo, Ippei Shibata, Laura Valderrama, and Hannah Winterberg, conducted discussions for the 2023 Article IV consultation with Portugal during April 26-May 5, 2023. At the conclusion of the visit, the mission issued the following statement:

Recent Developments and Outlook

Portugal sustained its dynamic economic recovery from the pandemic into 2022. Output surpassed its pre-pandemic level in early-2022, with growth (6.7 percent) markedly higher than the euro area (3.5 percent). Growth was led by rebounding tourism and private consumption, the latter reflecting policy support, labor market strength, and pent-up demand. The momentum continued through early 2023 with growth at 2.5 percent (year-on-year) in Q1.

However, high inflation and tighter financial conditions are weakening the economy. Inflationary pressures—initially driven by surging global energy and food prices, which amplified further due to spillovers from Russia’s war in Ukraine—have become broad-based amid limited slack. Headline inflation averaged 8.1 percent in 2022, receding slightly to 6.8 percent in April 2023. Monetary policy tightening has translated into significantly higher borrowing costs given a high share of variable interest rate loans, and strong house price growth has dampened housing affordability.

Real GDP growth is expected to slow in the rest of the year to average 2.6 percent in 2023 and inflation recede to 5.6 percent. Higher cost of living is expected to depress domestic demand growth and lower global and euro area growth weaken export growth.

Growth is projected to stabilize to around 2 percent over the medium term. As energy prices subside, inflation would continue easing. But core inflation is projected to be stickier given a tight labor market and elevated profit margins.

Risks to the outlook are broadly balanced. A greater-than-expected tightening of financial conditions, sharper global or regional slowdown or greater volatility in commodity prices would drag growth. With interest rates rising, banks could further tighten lending standards, weighing on debt servicing capacities of households and corporates, which combined with a potential sharp correction in housing prices, could raise systemic risk and crimp domestic demand.

Conversely, a faster tourism momentum and sustained labor market resilience would support growth. Over the medium term, global fragmentation, or slower use of Next Generation EU (NGEU) funds would hamper growth potential. For inflation, key upside risks rise from higher- for-longer energy prices and nominal wage pressures.

Policies Fiscal Policy

Despite sizeable cost-of-living fiscal support, the fiscal position improved significantly in 2022, reinforcing public debt reduction. Fiscal measures (2 percent of GDP) comprised support to households and energy-intensive firms and tax reduction on energy-related products. Despite this, the fiscal deficit sharply narrowed on the back of revenue overperformance. Public debt-to-GDP ratio declined at a faster pace than the euro area, falling below its pre-pandemic level.

In 2023, fiscal policy needs to remain non-expansionary to preserve fiscal space and support monetary policy, while being nimble if shocks materialize. Additional fiscal support for 2023 (around 2 percent of GDP) includes public wage and pension increases, temporary VAT exemption on essential items, and housing support measures. Receding energy prices provides an opportunity to phase out broad-based measures and target support to vulnerable households. If growth weakens appreciably, automatic stabilizers should be fully deployed; conversely fiscal overperformance must be saved. Further fiscal support should be reserved only for severe downside scenarios and designed to be temporary, non-price- distortionary, and well targeted.

Sustaining a strong fiscal effort over the medium term would rebuild fiscal space and mitigate public debt risks further. Recent successive adverse shocks emphasize the priority to build fiscal space in good times and raise fiscal resilience to contingency risks. Fiscal consolidation combined with strong medium-term growth is key to a steady reduction of public debt, while continuing public investment even after the end of NGEU funds.

The mission recommends measures to raise revenue performance on a sustained basis and improve the composition and efficiency of spending:

  • Tax reforms should aim to eliminate distortions, roll back reduced VAT rates, and rationalize tax expenditures. Modernizing the tax system, including digitalizing tax administration, would improve tax efficiency. Stronger property taxes would raise revenue and help alleviate house price pressures. Falling energy prices open a window for a timely increase in carbon taxes.
  • Expenditure measures need to increase the share of public investment—including by implementing the NGEU-financed Recovery and Resilience Plan—over current spending, reversing recent trends. Main priorities are improving pension sustainability, containing the upward creep in the public wage bill, strengthening the financial position and efficiency of the National Health Service (NHS), and further improving the targeting of social
  • Structural fiscal reforms to improve public sector efficiency, governance, and fiscal sustainability of state-owned enterprises (SOEs) must A full implementation of the 2015 Budgetary Framework Law will strengthen the medium-term budgetary framework.

Financial and Macroprudential Policies

Bank balance sheets have steadily improved, though this trend could come under pressure under adverse scenarios. Banks’ tier 1 capital ratios (CET1) are comfortably above minimum requirements, though below euro area average and edging down slightly in 2022 amid dividend distributions and some valuation losses. Banks’ liquidity buffers remain high, nonperforming loan ratios have declined, profitability has risen with strong interest income, and spillovers from recent global financial stress have been limited. The introduction and tightening of macroprudential measures by Banco de Portugal since 2018 have helped strengthen underwriting standards. However, rising cost of living are stretching household finances and could weigh on debt servicing capacity, warranting continued monitoring as asset quality deterioration could materialize with a lag.

Continued prudent risk management practices and close monitoring of banking vulnerabilities are crucial under current economic and financial uncertainties. Banks and supervisors should continue to maintain vigilance on credit quality, interest rate risk, and liquidity management. Continuously improving capital headroom would serve as an important safeguard, particularly given the current uncertainty. Prudential policies should ensure that banks continue strengthening their capital levels and contingency planning. Caution is advised in capital distribution, especially if buffers weaken under stressed conditions.

A further gradual macroprudential policy tightening would help contain systemic risks from vulnerabilities in the housing market. While credit build-up has been contained and mortgage credit growth has softened, the mission assesses the housing market to be overvalued following years of strong house price growth. Persisting imbalances in this market would push up systemic risks further. To strengthen banking sector resilience to macro- financial risks from real estate exposures, the Portuguese authorities could consider gradually phasing in a sectoral systemic risk capital buffer, provided procyclical effects are avoided.

Conversely, macroprudential policies should flexibly adjust if downside macro-financial risks begin to materialize. Over the medium term, a positive neutral counter-cyclical capital buffer (CCyB) could be considered to further support financial stability.

Policies to support housing supply would help ease housing affordability strains. Housing affordability has weakened, particularly for low-income households and renters. The anticipated termination of the Golden Visa program is not expected to significantly impact housing prices. Measures to increase the supply of residential and rental property— supplemented by public investment for social housing under the National Recovery and Resilience Plan—are key to reduce housing market imbalance and improve affordability.

The private debt resolution regime should continue to be strengthened. National Law already incorporates the EU Directive for insolvency and restructuring. Further streamlining judiciary processes and strengthening out-of-court procedures should continue. The duty to file for bankruptcy—which was suspended during the COVID pandemic—should be reinstated so that resources are better allocated for more productive use.

Structural Policies

A timely implementation of Portugal’s ambitious National Recovery and Resilience Plan would support the transition towards a more productive, resilient, and green economy. The NRRP is expected to boost productivity by increasing R&D and public spending to support and small and medium enterprises. It also includes reforms to catalyze digital transformations of private companies and the public sector, promote digital skills of the labor force, modernize the education system, support renewable energy, and revamp active labor market policies. Effective completion of the NRRP would also help spur private investment.

These reforms would be further reinforced by addressing long-standing issues in the labor market to boost labor productivity and external competitiveness. Reducing the duality in the labor market would increase labor market efficiency and enhance equality. The Decent Work Agenda aims to promote job stability by reducing the maximum number of renewals for temporary employment contract. At the same time, making permanent contracts more flexible would help reduce duality while preserving efficiency. A well-targeted stronger social safety net would help limit adverse distributional effects.

Reinstating and increasing the carbon tax—suspended during the energy crisis—would help meet carbon neutrality targets as currently planned. Portugal’s share of renewable energy is among the highest in the euro area. A gradual increase in the carbon tax, combined with a scaling up of green investment and targeted support for the vulnerable would help realize Portugal’s ambitious target of carbon neutrality by 2045.

The IMF team would like to thank the Portuguese authorities and all other private sector and civil society stakeholders in Lisbon and Porto, and the ECB, for their hospitality, engaging discussions, and productive collaboration.

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