Public Information Notice No. 13/07

Portugal: IMF Executive Board Concludes 2012 Article IV Consultation

January 18, 2013

On January 16, 2013, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Portugal.¹

Background

Since the last Article IV consultation in early 2010, Portugal’s government has faced mounting funding pressures which resulted in an acute economic crisis and, ultimately, a request for financial support from the European Union and the IMF in May 2011. The impact of the crisis has been severe, with real GDP contracting by close to 5 percent during 2011–12 and unemployment edging up to about 16¼ percent in recent months.

The roots of the current crisis can be traced to the failure to adapt to the rigors of monetary union, in the face of a rapidly changing and more competitive international environment. Instead of delivering on the promise of sustainable catch-up growth to EU living standards, monetary union facilitated the accumulation of economic and financial imbalances. The competitiveness of the tradable sector eroded, while policy responses were, at best, muted. Counter-cyclical fiscal policy during the 2008–09 crisis led to ballooning government deficits and debt. Banks lost access to the wholesale funding market in mid-2010; and in the first half of 2011, Portugal’s government was shut out from financial markets.

Portugal has launched a comprehensive economic and financial program to reverse the imbalances and regain market confidence. A front-loaded fiscal adjustment program aims to restore fiscal credibility, while jump-starting external adjustment. Financial sector measures seek to keep banks well capitalized and liquid, while facilitating orderly deleveraging. A number of important structural reforms have also been implemented.

Despite some setbacks, underlying fiscal adjustment has advanced markedly—by an estimated 6 percent of GDP in primary structural terms over 2011–12. External account adjustment has also made significant strides. The 12-month rolling deficit reached 2½ percent of GDP in September—representing an adjustment of 10 percentage points from the low point in late 2008. There was also a significant decline in sovereign spreads from the heights of early 2012.

While the near-term outlook remains negative—with the economy likely to be in recession in 2013 and growth in trading partners slowing—growth is expected to gradually pick up over time. With fiscal adjustment proceeding as per the authorities’ program, this would allow debt to peak at about 122 percent of GDP in 2013–14.

Executive Board Assessment

Executive Directors welcomed the authorities’ impressive policy effort to gradually reverse the accumulated imbalances and prevent future crises. They noted the considerable progress already made in advancing fiscal and external adjustment, and implementing the structural reform agenda. They also welcomed the significant narrowing in sovereign spreads, which also reflect ongoing efforts to strengthen crisis management at the euro area level, and bodes well for the authorities’ strategy of regaining market access. Nonetheless, Directors highlighted that the near-term outlook was uncertain and sizable medium-term economic challenges remained. In light of this, they stressed the need to sustain efforts to make the tradable sector more competitive, boost long-term growth, and further advance fiscal consolidation.

Directors considered the authorities’ fiscal objectives as appropriate, provided that economic developments remain as expected, but emphasized the importance of striking the right balance between fiscal consolidation and measures supportive of economic growth. Given the sizable adjustment effort that still lies ahead, they saw a need for a public debate on how to best share the burden of the remaining adjustment. Directors noted that given the current high level of taxation, there was a strong case for focusing on expenditure savings going forward. They welcomed the ongoing public expenditure review, which should help rebalance the adjustment mix. Directors stressed that since spending is concentrated on sensitive outlays such as social transfers and public wages, it will be essential to build a broad consensus behind the required reforms.

While Directors agreed that it would likely be difficult to reduce the overall tax burden in the coming years, they concurred that a broader tax base and strengthened compliance could generate space for lower income tax rates. In this regard, they welcomed the planned corporate income tax reform as a way to foster investment and competitiveness. Directors also encouraged the authorities to follow through on measures taken to fight tax evasion. While acknowledging the significant progress achieved thus far in addressing weaknesses in public financial management, they stressed that continued strong implementation of the fiscal structural reform agenda was paramount in order to underpin a durable fiscal consolidation.

Directors welcomed the authorities’ strong track record in preserving financial stability, but stressed that the authorities needed to continue to monitor risks vigilantly. They were encouraged by the progress made in keeping the banks well capitalized and adequately financed. Directors emphasized the importance of improved credit conditions to facilitate economic recovery and ensure an orderly deleveraging by highly indebted firms.

Directors were encouraged by the progress on labor and product market reforms, as well as in the judiciary. They stressed that a more competitive tradable sector was key to sustaining growth and reducing high unemployment over the medium term and encouraged the authorities to vigorously pursue structural reforms that target growth bottlenecks, reduce production costs, and compress excessive profit mark-ups in the non-tradable sector.

Directors noted that, in addition to the domestic efforts, success would also depend critically on continued external support and successful crisis policies at the euro area level. They noted that support from the Eurosystem is important to contain credit market segmentation and restore appropriate monetary policy transmission.