Mission Concluding Statement 

Portugal -- 2005 Article IV Consultation, Preliminary Conclusions of the IMF Mission

July 11, 2005

1. Portugal has yet to emerge from the slump that followed the EMU-related boom. The sharp drop in interest rates that accompanied the move toward monetary union stimulated large increases in consumption and investment, but also substantial rises in private indebtedness and external imbalances. Lower interest rates also allowed a steady growth of government spending that further fanned the flames of the expansion. Meanwhile, lagging productivity growth, strong wage increases, and rising competition from emerging market countries eroded external competitiveness. Domestic demand growth slowed in 2001 and turned negative in 2002-03, as firms and households sought to work off imbalances and fiscal policy turned contractionary to fulfill the requirements of the Stability and Growth Pact. Although growth resumed in 2004, it remained below potential. Income convergence has come to a halt, and per capita GDP relative to the euro area average is barely above its ratio a decade earlier. The fiscal deficit remains very high, and the public debt has grown steadily.

2. Portugal confronts an extremely difficult environment, and recovery is likely to be only gradual. While private consumption—financed by further increases in bank borrowing—has proven surprisingly resilient, consumption growth looks set to slow in the period ahead as households begin again to reduce accumulated imbalances. Over time, increasing productivity and moderate wage growth—resulting in part from somewhat higher unemployment—can be expected to improve competitiveness, but achieving a substantial turnaround in the external sector will take time. In addition, the measures introduced to reduce the budget deficit could restrain domestic demand in the short-run. Thus, GDP growth is unlikely to exceed about ½ percent this year and 1¼ percent in 2006, with downside risks in both years. These relate primarily to external factors, such as higher international oil prices and slower growth in partner countries.

3. In this unfavorable context, the challenge for the authorities is to create the conditions to restart per capita income convergence as soon as possible. The mission agrees with the authorities that achieving this objective will require significant fiscal consolidation to reduce the budget gap without recourse to one-off measures, as well as reforms to improve the functioning of product and labor markets, enhance the business environment, and strengthen human capital development.

Fiscal Policy

4. The deficit-reduction strategy appropriately puts the emphasis of the medium-term adjustment effort on expenditure containment, although additional measures may be needed to bring the deficit to 3 percent of GDP by 2008. Steady rises in the public wage bill and in pension spending in recent years are at the heart of current fiscal difficulties, and the authorities' intention to focus on these items is well-founded. More generally, the decision to concentrate efforts on expenditure is welcome, both because experience in other countries has shown that expenditure-based adjustments tend to be more lasting and less damaging to growth than revenue-based ones, and because public spending—at more than 49 percent of GDP this year—is high given Portugal's per capita income level. Prompt action to implement the reforms underlying the planned expenditure adjustment would maximize the credibility of the deficit-reduction program, particularly as some of these reforms will take time to produce substantial savings. The mission also strongly supports the authorities' decision to abandon the use of one-off measures. Not only have these measures served as a substitute for more fundamental reforms over the last few years, obscuring the true state of the public finances, they have also added to future fiscal pressures by reducing revenues or raising spending in subsequent years. However, the growth forecasts for 2007-2009 contained in the SGP update appear to be optimistic. Based on the mission's projections, which show growth rising to about 2 percent by 2008, additional measures on the order of ¾ percent of GDP would be required to reduce the deficit to 3 percent of GDP that year. If such measures prove necessary, they should continue to come predominantly from the expenditure side, to preserve the focus of the fiscal strategy.

5. The balance of measures in 2005, however, tilts to the revenue side, and greater spending restraint would be desirable to reinforce the adjustment effort. The relatively-greater weight of tax increases in 2005 than in later years reflects in part the fact that, as noted above, pension and civil service reforms will take time to yield dividends. However, even after the adoption of planned measures, the underlying fiscal position (that is, the cyclically-adjusted primary balance net of one-off measures) will still weaken in 2005, by about ¾ percentage point of GDP. In addition, the revised budget assumes that measures to combat evasion and fraud and to encourage the repatriation of capital will increase revenues by about 0.3 percent of GDP this year. Improved administration has boosted tax revenues recently, but the yield from the new enforcement measures is still uncertain. Moreover, we expect slower output growth this year than assumed in the budget, which could add 0.1 percent of GDP to the deficit. To offset the structural deterioration in this year's budget and to provide some cushion should revenues fall short of their forecasted level, the authorities should seek to keep current expenditure below its level in the revised budget, for example through tighter ceilings on intermediate consumption or through a moratorium on public sector hiring. Such measures could also provide additional confirmation of the authorities' determination to contain the growth of current spending.

6. The authorities should move quickly to clarify the outstanding details of the adjustment package for 2006 and the medium term and implement the associated reforms, thus maximizing the credibility of the adjustment effort. Parameters of the reforms of public administration and of the pension scheme for private sector workers, which are at the core of the adjustment effort, have not been finalized. A report on private sector pension reform options is expected to be available by September. In addition, a public administration review is under way that should form the basis for a rationalization of government services, although the Ministry of Finance intends to initiate ministry-specific reforms prior to the review's completion, expected by end-2006. There is considerable evidence that the efficiency of public spending in Portugal is low—for example, in education and health care, where spending exceeds that in other euro-area countries without producing better results. The potential returns from these reforms are therefore sizable, and the authorities' estimate that they could yield savings of 0.4 percent of GDP in intermediate consumption over the next four years could prove conservative. Progress in the ministry-specific reviews and in the pension study sufficient to allow them to be reflected in the 2006 budget will be critical to document the authorities' resolve to control spending growth.

7. Fiscal performance could be enhanced by reforms to budgetary processes to help ensure the achievement of deficit targets:

• The establishment of a three-year rolling expenditure framework envisioned in the SGP update would be an important step to develop a more focused fiscal strategy. The afore-mentioned ministry-specific reforms, which are expected to include spending goals for the remainder of the legislature, could be a first move in this direction. Such frameworks should be based on conservative estimates of future output growth.

• Increased use of competitive bidding for goods and services could help reduce costs.

• Reforms to financing arrangements for local governments—as already anticipated by the authorities—could reduce the incentives for higher local government spending inherent in the current system.

8. Efforts to promote private sector involvement in infrastructure investment are welcome, but risks should be carefully monitored. Public-Private Partnerships (PPPs) could in some cases prove to be an effective way of enhancing investment while containing fiscal pressures. It is essential, however, that any contingent commitments entered into through PPPs be recorded with the utmost clarity in the documentation accompanying annual budgets, to allow a full assessment of the associated risks. Moreover, to the extent that PPPs commit the public sector to make future payments to private partners they are akin to debt, and care should be taken to ensure that these transactions do not—like one-off measures in the past—compromise future budget flexibility. The expected stream of any future payments should also be recorded in budget documents. In allocating public funds for investment, projects offering the highest possible economic or social returns should receive priority.

9. The fiscal adjustment planned for the next four years should be seen as only the first—albeit critical—stage of a longer process of deficit reduction. Ensuring fiscal sustainability will require moving to overall budget balance in the medium term. As in other industrial countries, population aging will put increasing pressure on spending in the near future. To the extent that planned reforms slow the long-term growth of pension spending, not all of the necessary further adjustment need come from other current spending. Nevertheless, the expected rise in aging-related spending in the coming years underscores the need to find durable measures to improve the quality and efficiency of public expenditure.

Enhancing Growth and Competitiveness

10. The authorities' plans to promote investment in research and development and in information technologies can improve productivity and competitiveness, but these efforts should be accompanied by other structural reforms. Measures are needed to strengthen human capital, enhance the business environment, and liberalize product and labor markets. Such measures could in themselves encourage investment in R&D and ICT by increasing the returns firms earn from these types of investment.

• Coverage of the education system has improved dramatically, but international test scores suggest problems with the quality of schooling remain. In addition, a still-large percentage of workers have not completed secondary education, and investment in worker training is low. Recently-adopted and planned initiatives to enhance the efficiency and quality of education and to promote training are welcome, therefore, in order to ensure that Portugal will have the skilled workers and managers needed to adapt to new technologies.

• A number of international studies point to problems in Portugal's business environment, and recent initiatives to reduce the bureaucratic burden on firms—notably the new streamlined requirements for starting a business, and the reduction in administrative costs imposed by the tax system—are important improvements. Additional measures that help reduce administrative burdens—for example, by simplifying and accelerating the processes involved in the granting of permits to open or expand plants and facilities—are still needed, however. Measures to improve the efficiency of the legal system and reduce lengthy delays in resolving disputes are also called for.

• Productivity would benefit from enhancing competition in a number of sectors, notably telecommunications, energy, and transportation. The planned consolidated electricity market with Spain (the Mibel) has the potential to help reduce energy costs, although the passing on to Portuguese consumers of the stranded costs associated with cancelled long-term supply contracts will reduce the reform's initial impact on prices.

11. Additional steps to raise labor market flexibility are needed. The December 2003 Labor Law increased the flexibility of working arrangements and allowed expanded use of fixed-term contracts. However, little progress has been made in reducing relatively tight dismissal restrictions. In particular, those on individual dismissals remain cumbersome and lengthy. Although these restrictions may be less binding in practice than on paper, the resulting extensive use of temporary contracts and self-employment creates a segmented labor market, with one class of workers enjoying strong employment protection and a second subject to considerable job instability. Not only do such conditions raise equity concerns, they also hamper productivity growth by slowing the movement of protected workers from low-growth sectors to higher-growth ones. They may also contribute to Portugal's low level of worker training.

The Financial Sector

12. The financial sector has proven resilient to the slowdown. Despite a difficult macroeconomic environment, banks have remained adequately capitalized and liquid. Profitability has been solid, and the quality of banks' loan portfolios has remained broadly stable. In addition, banks have prudently taken advantage of favorable market conditions to improve the structure of their financing, issuing directly in capital markets and reducing reliance on the interbank market. As recognized by the authorities, potential vulnerabilities arise mainly from the high levels of corporate and household debt and the concentration of loans across sectors and enterprises. Of particular concern is the high share of mortgages in lending, with most loans at floating rates. The supervisory authorities are well-aware of these risks, and continue to monitor developments carefully. A Financial Sector Assessment Program mission scheduled for later this year will conduct a more detailed review of the financial sector.

13. Our discussions with representatives from the public and private sectors and from civil society have been marked by a broad consensus on the challenges confronting Portugal. There has also been in evidence a strong resolve to overcome these challenges, despite the sacrifices required in the short run. This widespread commitment to undertake the tasks needed to create a stronger and more vibrant economy bodes well for the future.

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The mission would like to thank its counterparts for their time, for the high quality of the discussions, and for the gracious hospitality they extended to us. We also thank the authorities for their skillful handling of the administrative aspects of the mission.

Lisbon, July 11, 2005