IMF Executive Board Concludes Second Post-Program Monitoring with Portugal

On July 31, 2015, the Executive Board of the International Monetary Fund (IMF) concluded the Second Post-Program Monitoring with Portugal,¹ and endorsed the staff appraisal without a meeting on a lapse-of-time basis.²

Portugal’s economic recovery remains on track in 2015, boosted by rising exports and consumption, together with a recent upturn in investment. Real GDP expanded by 1.5 percent (year-on-year) in the first quarter, and is projected to increase 1.6 percent for the full year. Fiscal adjustment has slowed, meanwhile, with a structural loosening likely this year. Employment has declined in recent quarters, after increasing sharply from early-2013 through mid-2014, and the unemployment rate was at 13.7 percent at the end of March.

The banking system as a whole remains adequately capitalized, with decreasing reliance on Eurosystem financing, but loan performance has continued to deteriorate. Non-performing loans increased to 12.3 percent at the end of March, putting further pressure on already weak profitability as banks absorb large impairment expenses and high operating costs.

Recent market volatility related to Greece has had limited impact on Portugal, reflecting the country’s improving fundamentals in addition to the overall supportive external environment. Portugal has benefitted from favorable commodity prices, low interest rates and a weaker euro. Growth is projected to moderate over the medium term, however, as these supportive cyclical factors weaken and still high public and private debt constrain the pace of recovery.

Executive Board Assessment

In concluding the Second Post-Program Monitoring Discussions with Portugal, Executive Directors endorsed the staff’s appraisal, as follows:

The economic recovery remains on track, but the public and private debt overhang is likely to constrain medium-term growth prospects as favorable cyclical factors weaken. The pickup in investment in the first quarter is encouraging, but this will be difficult to sustain without greater efforts to reduce the corporate debt overhang and alleviate structural impediments to reallocating resources away from nonviable and low-productivity firms. Exports have benefitted from the strong recovery underway in Spain, but will need to be supported by faster progress on structural reforms to underpin external competitiveness and expand market share over the medium-term.

Maintaining policy credibility will be essential to ensure favorable financing conditions. With increased financial market volatility in the context of developments in Greece, it is crucial to ensure that investors retain confidence in the direction of economic policies. The authorities have made progress in improving the profile of public debt, but medium-term financing needs remain large, and rising bond market volatility implies significant risks around the baseline financing plan. The authorities should continue to retain a large cash buffer in order to maintain flexibility in implementing their borrowing program.

Further fiscal adjustment is needed to further reduce vulnerabilities from high public debt, particularly given the increased risk of financial market turbulence. The authorities’ Stability Program sets appropriately ambitious targets for medium-term debt reduction, but this needs to be accompanied by credible measures to achieve the required fiscal adjustment.

More decisive steps to improve banks’ balance sheets are desirable. Weak profitability provides little cushion for banks to absorb further losses, in the context of still-rising non-performing loans. More concerted efforts are needed to reduce operating costs in order to improve financial performance and accelerate the process of balance sheet repair; banks should not rely on economic growth alone to mend their balance sheets.

A more forceful approach to corporate debt work-outs is needed to accelerate the structural transformation of the economy. Corporate debt leaves economic resources excessively tied up in unviable and low-productivity firms, constraining lending to productive firms and weighing on new investment and medium-term growth prospects. The authorities should be proactive in putting in place a coordinated approach to debt work-outs to restructure the debts of viable firms, and move forward with liquidation of those that are no longer viable.

It will be essential to regain momentum on structural reforms when a newly elected government is formed. The current economic recovery and beginning of a new political cycle presents a favorable opportunity to press ahead with reforms, particularly in the areas of labor market and public sector reform. Moving forward, it is critical to ensure that product market reforms introduced in recent years are fully implemented as intended, to achieve tangible results on the ground. It will also be important to ensure that the difficult reforms that have been undertaken, such as to contain the rise in energy costs, are not reversed.

¹ The central objective of PPM is to provide for closer monitoring of the policies of members that have substantial Fund credit outstanding following the expiration of their arrangements. Under PPM, members undertake more frequent formal consultation with the Fund than is the case under surveillance, with a particular focus on macroeconomic and structural policies that have a bearing on external viability.

² The Executive Board takes decisions under its lapse-of-time procedure when the Board agrees that a proposal can be considered without convening formal discussions.