Mission Concluding Statement 

Portugal: Staff Concluding Statement of the 2024 Article IV Mission

July 1, 2024

Washington, DC

Portugal achieved a remarkable recovery from the successive shocks that hit the global economy since the pandemic. Growth in 2023 continued to exceed the euro area average while inflation decelerated faster. A large fiscal surplus was achieved in 2023, and public debt was reduced by an impressive 36 percentage points of GDP since 2020. The external position strengthened, supported by tourism, EU funds, and improved terms of trade. Financial stability indicators improved, reflecting a reduction in systemic risks. At this juncture, a soft landing is within reach. However, low productivity growth, population aging, and subdued investment remain key constraints to higher growth while poverty and inequality need to be addressed.

In this context, fiscal policy should still achieve a surplus in 2024 and be broadly neutral thereafter to balance growth and a return of inflation to target. This would also help reduce still-elevated debt, thus rebuilding space to address future shocks and lowering vulnerability to markets volatility. Meanwhile, the fiscal composition should be reoriented toward more growth-enhancing public investment, supported by a comprehensive tax reform and improved efficiency of public spending. Vigilance to financial sector risks, notably from the real estate market, remains warranted. Structural reforms, including to foster the digital and green transitions, remain critical to raise productivity, potential growth, and living standards.

A Benign Outlook under Balanced Risks

IMF’s staff project a soft landing, with moderate growth and declining inflation. Robust exports, strong private consumption backed by a resilient labor market, and public investment under the recovery and resilience plan (RRP) have been driving activity. IMF staff expects growth at around 2 percent in 2024, rebounding slightly to 2¼ percent in 2025 as financial conditions gradually ease. Over the medium term, an aging population, low investment, and low productivity growth are expected to keep growth below 2 percent. Headline inflation is projected to decline to 2 percent in 2025, notwithstanding a temporary edging up in 2024; core inflation, although stickier, should also decline. Continued buoyant tourism inflows would support a current account surplus throughout the medium term.

Risks to this outlook are broadly balanced. Downside risks to growth could stem from an escalation of geopolitical tensions leading to further economic fragmentation, lower external demand, and commodity price and market volatility. On the domestic front, core inflation may prove stickier, notably if wage growth continues to outpace productivity growth. Conversely, labor market resilience and stronger tourism momentum may provide an additional boost to growth.

Fiscal Policy to Support a Soft Landing, Rebuild Buffers, and Promote Growth

To balance growth and inflation objectives and further reduce debt, fiscal policy should aim at achieving a surplus in 2024 and stay broadly neutral thereafter. The large fiscal surplus in 2023 supported a fast deceleration in inflation and a further reduction in public debt. In 2024, a somewhat expansionary policy, consistent with a surplus of 0.2-0.3 percent of GDP—as intended by the government, would be appropriate, as it would support growth while the still-tight monetary policy would help lower inflation toward target. For 2025, a broadly neutral fiscal stance, combined with the expected gradual loosening of the ECB’s monetary policy, will help achieve a soft landing of the economy. Any further relaxation of the fiscal stance would risk rekindling inflation. Planned new tax cuts and spending increases should therefore be carefully designed to ensure that they remain consistent with achieving the targeted surplus or offset by other measures. Over the medium term, the fiscal position should stay broadly balanced. This will ensure that still-elevated debt continues declining, thus reducing vulnerability to changes in market sentiment and rebuilding buffers for future shocks.

Fiscal reforms can boost growth by making room for higher investment. Higher public investment in infrastructure and human capital is needed to enhance growth prospects, including in the areas of green and digital transitions, notably through the full utilization of RRP funds. Fiscal reforms are also needed to make room for additional investment and continue reducing debt:

• A comprehensive tax reform would reduce distortions and increase revenue. Simplifying the system and reducing exemptions (tax expenditure)—informed, as planned by the authorities, by a thorough assessment of their costs and benefits—could lead to significant revenue gains that would help offset losses from the intended personal and corporate income tax reductions. Age-based preferential personal income tax (PIT) rates will lead to sizeable revenue loss and raise threshold issues, while their effectiveness in limiting the emigration of the young is uncertain. Reducing progressive surcharges of the corporate income tax (CIT) can help align the average CIT rate with the euro area average while encouraging firm growth. Carbon tax adjustments, which were paused, should resume as intended. Over the medium term, property tax increases should be considered as housing affordability concerns subside.
• Fiscal pressures from an aging population need to be addressed. While past reforms improved the sustainability of the pension system, further adjustments would help mitigate spending pressures. There is also room to improve the efficiency of spending by the National Health System (NHS).
• Greater public sector efficiency should support these efforts. The integration of spending reviews into the regular budgetary process and the recent enhancements of the information system are welcome and should continue. To improve spending efficiency, the 2015 Budgetary Framework Law should be implemented fully in a timely manner. Areas where further reforms may be needed include the public employment and compensation structure and state-owned enterprises. The fiscal council could take a greater role in supervising efficiency improvements and assessing fiscal risks and fiscal sustainability.

Financial Sector Policies to Mitigate Risks and Build Resilience

Financial stability indicators have improved. Banks’ balance sheets strengthened as capitalization improved owing to strong profits from net interest margins, while the stock of nonperforming loans declined further, and their provisioning increased. Risks from the bank-sovereign nexus fell as the sovereign deleveraged. Although tight financial conditions strained households and corporates’ repayment capacity, they contributed to their further deleveraging. Furthermore, some structural features of Portugal’s banking sector, such as its reliance on a traditional, deposit-based business model, and the relatively low interconnectedness of banks help mitigate risks. Still, capital adequacy and asset quality indicators remain below most euro area peers, indicating further room for improvement.

Continued monitoring of financial stability risks from the real estate market is warranted. Residential real estate prices have continued to grow above fundamentals. With a large share of mortgage loans at variable interest, higher interest rates have sharply increased mortgage service costs as a share of household incomes. While the expected monetary loosening will gradually alleviate the pressures on households, the impact on bank balance sheets through a deterioration of asset quality may still materialize with a lag. Also, while interest subsidies and easier loan restructurings provided some relief, the postponement of principal amortization may have delayed the emergence of vulnerabilities. In addition, low housing affordability presents a serious social concern, and the government’s focus on increasing housing supply is appropriate.

The introduction of a sectoral systemic risk capital buffer (sSyRB) is welcome. The sSyRB for household loans secured by housing properties, which will become effective in October 2024, will help strengthen banks’ resilience to macro-financial risks from real estate exposures. Depending on the evolution of risks in the residential real estate sector, as well as broader macro-financial risks, Banco de Portugal may need to recalibrate the sSyRB and adjust other macroprudential measures. It could also consider implementing a positive neutral countercyclical capital buffer to lock in banks’ temporarily-high profits into releasable capital that could help further support financial stability in downturns.

Efforts to contain transnational money laundering risks are welcome and should continue. The AML/CFT framework should be further upgraded by continuously assessing risks, including those stemming from the revised golden visa program, and by ensuring timely access to adequate, accurate and up-to-date beneficial ownership information, in line with the revised international standards.

Structural Policies to Increase Productivity and Potential Growth

To foster higher living standards and faster income convergence with the euro area average, reforms are needed to boost productivity. Efforts to streamline red tape and, where needed, regulations should be accelerated to improve the business environment. A more competitive product market environment can stimulate investment, encourage firm growth, and channel resources where they are the most productive. Further reforms to make open-ended contracts more flexible would help continue reducing the usage of temporary contracts and promote growth. Upskilling the labor force, digitalization, and AI preparedness should also be areas of focus. Minimum wage hikes should be paced with productivity increases to minimize any negative effects on competitiveness. At the same time, means-tested social transfers can help reduce inequality and poverty.

The authorities’ ambitious decarbonization targets are commendable. They will be supported by the reactivation of the carbon tax adjusting mechanism, the further reduction of fuel subsidies, and sectoral policies, together with the planned broadening of the EU emission trading system coverage. Protecting the most vulnerable from spillovers of the green transition will be important.

The IMF team thanks the Portuguese authorities and other stakeholders for their hospitality, candid discussions, and collaboration.