The macroeconomic outlook: growth prospects weaken and inflation picks up
2. Growth will likely slow in 2008 to about 1¼ percent, and to about 1 percent in 2009, driven by weaker partner country growth, the international financial turbulence, and higher commodity prices. The current account deficit will likely widen somewhat and, as elsewhere, inflation is projected to pick up in 2008 (though should remain below the euro area average, in part due to the VAT rate reduction), before declining in 2009.
3. The growth risks to this outlook seem tilted to the downside. In particular, the slowdown in credit growth, prompted by the international financial turbulence, could be more pronounced, dampening consumption and investment. On the upside, exports could strengthen, driven by the ongoing restructuring process. As elsewhere, inflation risks are tilted to the upside.
Continuing fiscal consolidation and reform
4. Decisive action has reduced fiscal imbalances and enhanced credibility, putting the fiscal accounts on a stronger footing to face the current more difficult economic circumstances. Since 2005, the deficit has fallen by 3½ percentage points of GDP to 2.6 percent of GDP in 2007—the lowest level for some 30 years, allowing Portugal to exit the Excessive Deficit Procedure a year earlier than envisaged and the debt-to-GDP ratio to fall. The consolidation has also, appropriately, been driven by containing primary current spending. Revenue overperformance has also contributed, due in significant part to enhanced revenue administration.
5. Despite recent impressive gains, Portugal's fiscal position remains weak and the risks significant: merely keeping the deficit below 3 percent of GDP is not enough. Public debt remains above 60 percent of GDP, the Medium-Term Objective (MTO) of a structural deficit of ½ a percent of GDP remains a long way off (and may need to be improved upon to address longer-term pressures such as population aging), Portugal's external imbalances continue, and there are considerable risks. The recent revenue buoyancy, especially of corporate income tax, may not be sustained, and the benefits of the public administration reform still need to be fully realized. Fiscal policy should thus remain anchored to a credible path for achieving the MTO, although automatic stabilizers could be allowed to operate around this.
6. Fiscal consolidation is set to continue in 2008, though at a slower pace. Following substantial overperformance in 2007, the government appropriately tightened the deficit target to 2.2 percent of GDP. However, the cut in the VAT rate by a percentage point and some specific measures to support those most affected by higher commodity prices and interest rates, will reduce the structural consolidation to somewhat below ½ a percent of GDP.
7. Fiscal consolidation needs to continue in 2009, and there is no scope for any further discretionary loosening. The government's plan envisaged structural consolidation of some 0.8 percent of GDP in 2009, but with the weaker economic outlook, there are grounds for reducing the pace of consolidation. To ensure the credibility of achieving the MTO, even by 2011, and to avoid jeopardizing the gains achieved so far, structural consolidation should be at least a ½ percent of GDP. Indeed, as the heightened spreads on Portugal's government debt indicate, there is little room for maneuver and the costs of slippage are high. Such an adjustment in 2009 should (just) be achievable on the basis of current policies, but there are risks. Particular care should be taken to keep public wage growth under control, not only to foster competitiveness and consolidation, but also to prevent "second-round" effects feeding into inflation. Any further measures to mitigate recent commodity price and interest rate increases should be targeted, temporary, offset by other measures, and designed to maximize the supply response, avoiding distorting price signals.
8. Efforts to enhance the quality, transparency, and durability of fiscal consolidation need to continue. In particular, progress should continue to be made on performance-based budgeting and a binding medium-term framework. Continued progress needs also to be made on divesting and reforming public enterprises, including greater use of performance evaluation, centralizing the ownership function in the Ministry of Finance, and enhancing transparency in public accounts. Especially in the current economic context, the program to make public agencies pay on time needs to be strictly enforced and possibly made more ambitious.
Keeping the financial sector sound
9. The financial system remains sound and well supervised. While global financial tensions and the macreconomic outlook have heightened some existing vulnerabilities, these should remain manageable and the system resilient. Portuguese banks' reliance on wholesale funding raises liquidity risks and banks are exposed to market risk through employees' pension funds and banks' own investment portfolios. High household and corporate debt increases credit risk given rising interest rates and the weak macroeconomic outlook, and loan concentration in some banks to certain sectors and large exposures appears significant. As funding from longer-term securities declined, banks switched to deposits to sustain strong credit growth, though both deposit and credit growth rates will likely slow in coming months.
10. The Bank of Portugal (BdP) is well aware of these vulnerabilities, which are not new, and has been proactive in addressing them. Banks with weaker capital ratios have increased equity and some banks have also started issuing securities to retain on their own portfolio to use as collateral as a precautionary liquidity measure. The BdP, which requires banks to maintain liquidity buffers, has enhanced monitoring of banks' liquidity positions and banks' plans to address potential liquidity shortfalls.
11. These measures are welcome, and some further enhancements to the financial stability framework could be considered. Many of these are already under consideration, including in the context of ongoing changes in the international financial architecture. To further strengthen liquidity supervision, a zero maturity gap could be required at the 15-day or 1-month horizon and, in line with recommendations from the Basel Committee, haircuts for structured products might warrant reconsideration. The BdP should ensure that banks have appropriate internal limits on sectoral credit concentrations and large exposures, in compliance with the internal controls instructions. Stress tests could be more proactively used to assess the adequacy of capital buffers. If Tier I capital ratios were to fall significantly below 7 percent, banks should be encouraged to raise capital. In the context of Basel II implementation, banks' own risk-management models should be validated. The transition to full economic provisioning might also usefully be completed.
12. Given Portugal's external imbalances, household savings need to rise over time. Recent reforms of the social security system and the benefits of enhancing banks' domestic retail funding also call for more proactive promotion of household savings. A key channel for such savings are occupational pension schemes, but these are relatively undeveloped—consideration should be given to conducting a public financial literacy campaign and to introducing "soft compulsion" schemes that require opting out of, rather than into, occupational pension schemes.
Raising the economy's supply capacity and improving its competitiveness
13. At the root of Portugal's economic problems lies anemic productivity growth. This in turn reflects a rigid economy, as well as other structural factors relating to human capital and the judicial system. The duality of the labor market has increased, and, unlike for other EU countries, so has unemployment (especially long-term). While unit labor costs are now growing in line with the euro area, the competitiveness gap, at some 10-20 percent, remains substantial. Important steps are being taken to address these challenges. These need to be followed through and assessed, and further reform should focus on making the economy more flexible and competitive.
14. The recent agreement on reforming labor relations is a welcome step forward. In particular, the agreement can be expected to facilitate internal flexibility for companies, rationalize collective bargaining, encourage firm-level agreements, and streamline procedures for dismissal. The envisaged increase in the rate of social security contributions on fixed-term contracts by three percentage points, however, should be reconsidered: experience from Portugal, and other EU countries, show that such contracts are an important path to traditional, open-ended employment for many and have proven critical to boosting employment. The test of the new agreement will be in its implementation and whether it improves the working of the labor market. This will need to be carefully monitored and further actions, such as eliminating the automatic extension of collectively-agreed contracts and broadening the scope for individual dismissal, could be considered.
15. The ambitious and broad-ranging SIMPLEX program continues to improve the business climate and its priority on licensing in 2008 is well placed. It will be important to: broaden the participation of local governments, building on recent efforts; ensure that small and medium-sized businesses are included in the benefits; and, to follow through with plans to assess effectiveness. In this context, advantage should be taken of the need to implement the EU Services Directive to make a clean sweep of regulations at all levels of government. The recent public administration reforms should also be built upon to continue to enhance public sector productivity.
16. Competition in domestic markets needs to be further enhanced. The Competition Authority should build on its encouraging first five years to continue to advocate and enforce competition. Enhancing judicial system efficiency would support the Authority's effectiveness, and consideration could also be given to permitting courts the option of increasing penalties in the event of appeals and allowing the Authority jurisdiction to issue binding decisions on government procurement actions. For electricity, integration with the Spanish market is continuing, but it will be important that regulated tariffs are set to ensure full cost recovery, that the roadmap for the end of regulated prices be developed, and that opportunities be grasped to increase competition in domestic generation.
17. The reform momentum needs to be maintained. Policies should avoid jeopardizing recent achievements and long-term goals for short-term gain, preserving the continuity of adjustment and reforms and avoiding policy drift that Portugal can ill-afford. In this context, consideration could be given to developing mechanisms to formulate a "catch-up" growth agenda, which could broaden social support and could be rapidly acted upon by the next legislature.
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The mission would like to thank its counterparts for their time and the high quality of the discussions. We also thank the authorities for their skillful handling of the administrative aspects of the mission.
