Public Information Notice No. 10/08

Public Information Notice: IMF Executive Board Concludes 2009 Article IV Consultation with Portugal

January 20, 2010

On January 15, 2010, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Portugal.¹

Background

12B12The global economic crisis has severely affected the Portuguese economy. Output will likely contract by almost 3 percent in 2009, driven by sharp falls in exports and investment. Despite a substantial rise in unemployment to nearly 10 percent, wage growth remained brisk, and, with productivity falling, unit labor costs rose further. Encouragingly, some signs of adjustment are emerging, as prices have fallen faster than in the euro area (though coupled with strong real wage growth, this squeezed firms’ profit margins), households are saving more, and the large current account deficit is estimated to have narrowed somewhat to under 10 percent of GDP. Still, with the economy’s weak growth potential likely undermined by the global crisis and high debt levels, and given a likely eventual tightening in monetary conditions, growth seems set for a weak recovery of about ½ a percent in 2010.

Following impressive fiscal consolidation achieved between 2005 and 2007, the global financial crisis prompted stimulus measures of some 1¼ percent of GDP over 2008–09, broadly in line with other euro area countries. Combined with the impact of the recession, the fiscal deficit increased to around 8 percent of GDP in 2009, with debt close to 80 percent of GDP. The fiscal stance is not expected to adjust substantially in 2010 but the government aims to achieve a deficit target of 3 percent of GDP by 2013. This will require structural consolidation of around 1 percent of GDP a year on average.

The banking system weathered the global financial crisis relatively well, reflecting pre-existing strengths, such as limited exposure to toxic assets, the absence of a property bubble, retail-based business models, and a sound supervisory/regulatory framework. However, some vulnerabilities increased as investment portfolios suffered, credit quality declined, funding large wholesale borrowing requirements became more difficult, and the already high concentration of loans to large exposures rose. The authorities have taken decisive steps to address these vulnerabilities, including raising the coverage limit for deposit insurance, instituting facilities to recapitalize banks and guarantee their borrowing, and recommending that all banks bring their Tier I capital ratios to 8 percent. Further pro-active measures are on the authorities’ agenda—including introducing minimum liquidity ratios—which are expected to be implemented in the context of the evolving European and international financial architecture.

Executive Board Assessment

Executive Directors noted that as a consequence of the global economic crisis output in Portugal contracted significantly and unemployment rose substantially. Directors welcomed the authorities’ rapid policy response. Signs of adjustment are now emerging, with prices falling faster than in the euro area, households savings increasing, and the large current account deficit narrowing. However, addressing long-standing imbalances, including low productivity, weak competitiveness, and high debt, will be key to reducing vulnerabilities and raising the economy’s long-term growth potential. An ambitious policy response is needed with strong public support and determined leadership over many years.

Directors encouraged the authorities to prepare a credible fiscal consolidation plan that would prevent further deterioration in fiscal balances. They commended the authorities’ commitment to the deficit target of 3 percent by 2013. Directors agreed that a start towards consolidation should begin this year. Efforts should focus on reducing the public wage bill and social transfers along with some revenue enhancement, especially by broadening the tax base and streamlining the process of tax administration. Improving fiscal frameworks, for example by introducing a medium-term expenditure rule could help strengthen the fiscal position.

Directors noted that the financial sector faced the crisis from a position of strength and weathered the crisis relatively well. They welcomed the decisive policy actions taken by the authorities to address vulnerabilities, especially by raising capital standards. Directors recommended that the authorities review the existing legal toolkit for intervening in troubled financial institutions and to give consideration to a special resolution framework for financial institutions and to enhance inter-agency coordination also in the context of evolving European and international financial architecture. They observed that the implications of the envisaged switch to the “twin peaks” model of financial sector supervision should be carefully assessed and the model cautiously implemented.

Directors agreed that improving productivity and external competitiveness remained critical to improving the economy’s growth potential and restarting the income convergence process. They noted that the adoption and implementation of the European Union Services Directive would help foster competition and productivity. Directors commended the continued progress being made in cutting red tape and encouraged the authorities to further strengthen the Competition Act. They welcomed recent labor market reforms and encouraged the authorities to assess the effectiveness of the recent revision to the labor code. They recommended that the authorities review the unemployment benefit system, especially with a view to providing greater incentives to find work over time, and to ensure that adjustments to the minimum wage remain in line with economic fundamentals.