Portugal: 2018 Article IV Consultation—Press Release; Staff Report; and Statement by the Executive Director for Portugal
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International Monetary Fund. European Dept.
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Publication Date:
12 Sep 2018
eISBN:
9781484375921
Language:
English
Keywords:
ISCR; CR; firm; core inflation; recovery code; SME; holding; debt ratio; private sector; nominal interest rate; headline inflation; accounts payable; Nonperforming loans; Fiscal stance; Credit; Global
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2018 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Portugal

Abstract

2018 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Portugal

Recent Developments

1. After growing strongly in 2017, the economy slowed somewhat in 2018:Q1. Real GDP growth reached 2.7 percent in 2017 reflecting reenergized investment, robust exports, and stable consumption. In addition to construction, investment in equipment and machinery grew vigorously in 2017 and 2018:Q1; tourism growth remained strong, but is beginning to face capacity constraints (for example, in Lisbon Airport). In 2018:Q1 growth decelerated to 2.1 y-o-y (0.4 percent q-o-q), owing to weaker exports reflecting slower activity in Europe and some temporary factors.1 Unemployment fell from 10.1 percent in December 2016 to 7. 1 percent in April 2018, even as labor force participation was rising, thanks to broad-based employment growth. The output gap is estimated to have narrowed in 2017 and to turn positive this year.

uA01fig01

Contribution to Real GDP Growth

(Percentage points, year-on-year)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Source: Haver Analytics.
uA01fig02

Labor Underutilization

(Percent)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Sources: Eurostat; and IMF staff calculations.

2. Consumer prices have been rising, though price competitiveness has stabilized recently. Headline inflation rose to 2 percent y-o-y in June 2018 driven in part by increases in energy prices, while core inflation was 1.5 percent. Unit labor costs (ULCs) continued to increase, both in nominal and real terms, reflecting wage growth outpacing gains in labor productivity (compensation per worker grew on average, while labor productivity declined in the past two years).2 Price competitiveness, as measured both by the CPI- and ULC-based real effective exchange rate (REER), had been deteriorating since mid-2015, although it appears to have stabilized in the last year. Imports of goods have increased strongly, resulting in a reduction of more than one-percentage point of GDP in the goods trade balance in 2017. Growth in exports of services has, however, been strong too since late 2016, led by booming tourism. As a result, the decline in the goods and services balance is a much smaller 0.3 percentage points. The current account balance was essentially unchanged in 2017.

uA01fig03

Real Effective Exchange Rate

(2010= 100)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Sources: International Financial Statistics.
uA01fig04

Portugal: Unit Labor Cost and Labor Share

(2005:Q1=100)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Sources: Haver Analytics; and IMF staff calculations.
uA01fig05

Portugal: Labor Productivity and Compensation Growth

(Year-on-year percentage change, 4-quarter moving average)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Sources: Haver Analytics; and IMF staff calculations.

3. The underlying fiscal balance improved in 2017. The fiscal performance in 2017 was robust, reflecting strong economic growth, prudent budget execution, and falling interest costs. Nevertheless, the headline fiscal deficit widened to 3.0 percent of GDP owing to one-off payments (2.0 percent of GDP), mainly associated with bank recapitalization costs. In primary structural terms, the fiscal stance tightened by 0.4 percent of GDP.

uA01fig06

Fiscal Balance

(percent of GDP)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Source: IMF staff calculations.

4. The sovereign’s improved access to market financing has contributed to more favorable borrowing terms throughout the economy. 10-year sovereign spreads in late July were around 130 basis points vis-à-vis the German bund, having exceeded 300 bps in early 2017. S&P and FITCH both upgraded Portugal to investment grade in 2017. ECB purchases have also supported the bond markets (and thus aggregate demand), but their importance has waned.3 Rates on new corporate and household loans are at multi-year lows. However, the sovereign spread experienced increased volatility in May and June owing to spillovers from political uncertainty in Italy.

uA01fig07

New Loans to Households and NFC

(Billion of euros, 12-month rolling sum)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Source: Haver Analytics.

5. Credit continues to lag the recovery, although new lending is increasing. The contraction in bank credit has essentially halted, with rising new loans, especially to households, driven by both demand (responding to lower interest rates and improved confidence) and supply (improved bank capitalization) factors. In the nonfinancial corporate (NFC) sector, new loans to firms in dynamic tradable sectors with better risk profiles have accelerated.

6. Banks’ balance sheets strengthened in 2017 with capital augmentations and improved macroeconomic conditions. The average CET1 ratio rose 2.5 percentage points since end-2016 to 13.9 percent at end-2017. During the same period, non-performing loans (NPLs) fell by EUR 9.4 billion from EUR 46.4 billion at end-2016, largely driven by write-offs and sales of business loans, and debt recovery (cures) for household loans, bringing the NPL ratio to 13.3 percent of gross loans from 17.2 percent. Most banks posted profits.4 Meanwhile, the impairment coverage ratio increased to 49.4 percent in end-2017 from 45.3 percent at end-2016. The liquidity coverage ratio reached 173.4 percent at end-2017 (a minimum of 100 percent is required since January 2018).5

Authorities’ Views

7. The authorities noted in their Stability Program 2018–2022 that output growth has been generally strong, and that the deceleration in 2018:Q1 was temporary. Growth has been accompanied by strong employment creation, boosting social security contributions and reducing unemployment claims. The deceleration registered in the first quarter was in their view largely due to temporary factors, and did not warrant a revision of growth forecasts for the year. Data for April and May 2018, they stressed, already indicated an acceleration of exports.

Outlook and Risks

8. Growth is expected to ease in 2018 from its recent cyclical peak and gradually moderate over the medium term. Real GDP growth is projected to decelerate to 2.3 percent in 2018, 1.8 percent in 2019, and to moderate over the medium term under a baseline with no new significant reforms. Investment and exports should remain important drivers of growth, albeit at a slower pace, while private consumption eases somewhat. Employment growth is expected to decelerate, and the labor market should continue tightening in 2018, with average unemployment declining below 7.5 percent, supporting moderate real wage growth. Staff is projecting consumer inflation of 1.7 percent for 2018 and 2.1 percent over the medium term. In 2018 the external current account balance is expected to deteriorate somewhat owing to strong import demand.

9. The fiscal deficit should fall in 2018, helping reduce public debt ratios, although the trajectory of public debt remains subject to significant risks. Staff is projecting a headline fiscal deficit of 0.7 percent of GDP in 2018, and public debt of 121 percent of GDP at end-2018, down from 126 percent in 2017. It should decline further to 103 percent by 2023 assuming a largely unchanged structural primary balance after 2018 and no major one-off expenditures. The trajectory of Portugal’s public debt remains subject to risks which could delay debt reduction (Annex I).

10. Risks to the outlook, especially external, appear to be tilting downward (Annex II). Portugal would be negatively affected by a significant weakening of growth in the euro zone. Renewed market instability related to policy uncertainty in key euro area countries could increase Portuguese bond yields and raise borrowing costs for most agents. Similarly, additional tightening of global financial conditions would affect highly leveraged firms and households as short-term and variable-rate loans are repriced, and could weaken banks’ balance sheets through higher NPLs and a reduction in the value of government bonds. A turn in the global economy toward protectionism would impact Portugal because of its increasingly strong linkages to European export-oriented value chains. Additional increases in real labor costs might hurt corporate sector profits (see Selected Issues paper) and competitiveness. As the expansion continues, there is a risk that excess confidence will build among policy makers and other stakeholders, leading to policy slippages or the erosion of past reforms. On the upside, exports could continue to surprise, including tourism if bottlenecks can be eased soon, and reforms might yet provide additional strength to the economy.

Authorities’ Views

11. The authorities in their Stability Program 2018–2022 saw the economy maintaining growth above two percent in coming years, and pointed to downside developments in the EU as the main source of risk, while emphasizing their commitment to further reduce domestic vulnerabilities. They agreed that a slowdown in the EU would be a significant challenge, as would renewed uncertainty in European markets, but Portugal’s ability to manage shocks has improved. They stressed that spreads are lower owing to strong policies, government cash buffers amount to at least 40 percent of prospective 12- month needs, and the public debt ratio, while still high, is on a declining trend. Similarly, they argued that the level of NPLs is high, but has been on a consistently declining trend, and continued policies to strengthen balance sheets would further mitigate risks. They also explained that recent non-price competitiveness gains, reflected in rising export market shares, make Portugal less vulnerable to fluctuations in price competitiveness. A global economic slowdown and tighter global financial conditions, especially in Europe, could affect Portugal, for example through their impact on foreign demand for Portuguese exports. Nevertheless, the authorities see market conditions remaining supportive through the ongoing monetary policy normalization, given muted wage and inflation pressures in the euro area. They also reiterated that Portuguese policies would continue to be strong and robust to risks, and that past reforms were not at stake.

Policy Discussions

A. Macro-Financial Issues and Policies

12. The pace of deleveraging is slowing amid benign financial conditions. In 2017, the net flow of loans to households turned positive for the first time since 2011, driven by consumer loans and mortgages. In the case of NFCs, the positive net flow of financial debt was due to intra-group lending by non-residents, while NFCs continued to reduce their borrowing from the domestic banking system. Household saving rates were low at 5.4 percent of disposable income in 2017. These developments translated into a slowdown in the deleveraging process. Private indebtedness, however, remains high: at end-2017, total household and NFC debts were 73.4 and 139.1 percent of GDP, respectively,6 while the euro area medians of the household and NFC debt-to-GDP ratios were 56.2 and 124.9 percent. High leverage makes Portuguese households and firms vulnerable to negative shocks to income and spikes in interest rates. This is compounded, in the case of households, by the preponderance of floating rate loans, and long maturities for mortgages (33 years on average), which extend into the retirement years.

uA01fig08

Non-financial Corporates: Cumulative Change in the Debt Stock to GDP Ratio

(Percent)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Sources: ECB; and IMF staff calculations.
uA01fig09

Households: Cumulative Change in the Debt Stock to GDP Ratio

(Percent)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Sources: ECB; and IMF staff calculations.

13. The Banco de Portugal deployed macroprudential measures to prevent the financial sector from taking excessive risk in a context of low interest rates and heightened competition. Against the background of gradually rising loan maturities, loan-to-value (LTV) and loan-to-income ratios in mortgage and consumer credit, the measures aim at preventing overexposures to residential mortgage and consumer loans by financial institutions and minimizing the risk of default by households. The measures (Box 1) include limits on maturities and LTV and debt-service-to-income (DSTI) ratios, and their design considers the risk that debt service burdens may rise as interest rates normalize. Early in July, banks started to implement the limits under this measure. Staff welcomes the activation of these macroprudential tools at this juncture, when credit standards were starting to ease. The introduction of tighter LTV, DSTI, and loan maturities will contain such easing, bolstering the resilience of financial institutions and households to variations in real estate prices, interest rates, and incomes. While supporting the measured approach taken, staff calls on the authorities to closely monitor the effectiveness of these measures and to supplement them if warranted.

14. Although declining, the stock of NPLs remains a concern. At end-2017, the stock of NPLs stood at EUR 37 billion (13.3 percent of total loans), with about half of the NPLs covered by provisions. The majority of NPLs correspond to loans to NFCs (SMEs), with the bulk concentrated in three banks. The elevated stock of NPLs is tying up resources in the economy, and holding back bank profitability. The authorities have been pursuing an NPL resolution strategy based on three pillars: (i) supervisory actions (under the SSM), which includes requesting regular updates of banks’ NPL reduction strategies, setting targets for NPL reduction, and monitoring and enforcing implementation; (ii) legal, judicial and fiscal reforms to remove impediments to NPL resolution; and (iii) measures to improve management of NPLs and develop secondary markets for troubled loans. Staff welcomes the progress made so far in the implementation of the NPL resolution strategy, reflected in the significant reduction of the NPL stock, and encourages the authorities to maintain this momentum, and to press banks to strengthen their risk management and corporate governance.

Macroprudential Measures on New Mortgage and Consumer Loans

The Banco de Portugal announced in February 2018 macroprudential measures focused on new mortgage and consumer loans, which went into effect on July 1, 2018, under the principle of ‘comply or explain’. The main provisions are:

  • LTV ratio for new mortgages for primary residence cannot exceed 90 percent (80 percent for purposes other than primary residence).

  • The DSTI ratio should not exceed 50 percent, with some limited exceptions. In the case of variable or mixed rate loans, banks are required to calculate DSTI ratios assuming interest rate increases of 100 basis points for loans with maturity below five years, 200 basis points for maturities between five and 10 years, and 300 basis points for maturities over 10 years. For these calculations, income is net of taxes and social security contributions.

  • The maturity of mortgage and related loans is capped at 40 years, and the average maturity of new credit agreements should gradually converge to 30 years by 2022. For consumer credit agreements, the maturity of new loans should not exceed 10 years.

  • New loans should be granted with regular payments of interest and capital.

15. Despite the improved economic outlook, generating strong and sustained bank profitability will be challenging. Net interest income, the main source of Portuguese banks’ profits, remains moderate, and may come under renewed pressure as deposit rates bottom out, funding costs increase due to MREL issuances, and competition from Fintech and nonbank financial institutions intensifies. High nonperforming assets are still a drag on profitability, and the updating of business models can involve upfront costs, as when closing brick-and-mortar branches.

uA01fig10

Net Interest Income

(Percent of total assets)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Sources: Haver Analytics.

16. Housing prices continue to increase, but there is no significant overvaluation yet. Following a decline of 18 percent in real terms over 2010–13, housing prices have since increased by about 20 percent in real terms (7.9 percent in 2017), especially in Lisbon, Porto and the Algarve region.7 While the increases have been driven largely by transactions on existing dwellings by non-residents, the share of housing transactions financed by Portuguese mortgages has been growing since 2015 (reaching 41 percent in the last quarter of 2017). Estimates in the ECB’s May 2018 Financial Stability Review suggest that there are incipient signs of overvaluation in the residential real estate market. The authorities should continue to improve the quality of real estate data and related analytical tools, and to monitor mortgage markets and the evolution of risks to banks from developments in real estate markets.

uA01fig11

Price-to-Rent Ratio

(Percent deviation from historical mean; 1995Q1–2017Q4)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Sources: OECD; and IMF staff calculations.

Authorities’ Views

17. While acknowledging remaining challenges in the financial sector, the European and Portuguese authorities pointed to progress achieved so far and reforms underway to address them:

  • Deleveraging in the non-financial private sector. The Portuguese authorities noted that the nonfinancial private sector’s debt-to-GDP had fallen by 47 percentage points since 2012, but recognized that continuing the deleveraging process is key to making the economy more resilient to future shocks. They observed that the positive net flow of loans to households in 2017 was driven by consumer loans, with newcomers to the credit market accounting for the largest contribution. The non-resident sector was the main contributor to the positive net flow of total credit (loans plus securities) to corporations with access to international securities markets. This financing was partially channeled to their domestic affiliates via intra-group loans.

  • Addressing NPLs. The European and Portuguese authorities highlighted the NPL reduction over the last two years as an indication that all stakeholders, including at the EU level, are determined to address this issue. They pointed to several measures that have been recently finalized or are underway. At the EU level, the implementation of the Action Plan to Tackle Non-Performing Loans in Europe is underway.8 At the national level, the measures include: (i) the continuous improvement of the legal, judicial and tax framework, including the recent establishment of a common decision body between the tax authority and the social security administration to participate in restructuring negotiations; (ii) the enhancement of in-court restructuring and insolvency frameworks (including through digitalization of processes); (iii) the introduction of several measures to speed up out-of-court settlement procedures; and (iv) ongoing actions to put in place an early warning mechanism and the development of a simplified regime to facilitate the transfer of NPL portfolios. In addition, at the bank level, they noted the strong execution of the NPL reduction plans submitted by banks to the supervisor and the operationalization of the platform for integrated management of NPL cross-exposures. The authorities also indicated that strong economic growth would contribute to the reduction of NPLs.

  • Ensuring strong and sustained bank profitability. Acknowledging the challenges ahead, the European and Portuguese authorities indicated that banks’ determined implementation of their strategies to cut costs and diversify income sources, alongside the improved economic outlook, would help ease pressure on profitability from low interest rates and increased competition. They highlighted progress achieved over the last years in improving the cost-efficiency of the Portuguese banking system as evidence of such resolve.

  • Mispricing of risk and excessive-risk taking. While noting that there are no signs of a systematic mispricing of risk and excessive risk-taking by banks at this juncture, the Portuguese authorities pointed to the macroprudential measures taken in February 2018 on new mortgage and consumer loans as an indication of their determination to prevent them from happening.

B. External Balance and Policies

18. Portugal’s external position remained weaker than consistent with medium-term fundamentals and desirable policy settings in 2017 (Annex III). There has been a strong improvement in the current account since the crisis, reflecting in large part rising goods exports and tourism. Nevertheless, the Net International Investment Position (NIIP) is still in deeply negative territory, and substantially improving the position would require sustained current account surpluses over the medium term. EBA model-based estimates suggest there was no current account gap in 2017. However, staff projects the current account balance to turn into a moderate deficit over the next several years as domestic demand increases and the growth in tourism subsides. Staff thus see a current account shortfall of about 2–4 percent of GDP in the medium term. This is also consistent with EBA results on the REER suggesting an overvaluation of about 5–10 percent. Continued and sustained quality upgrades and innovation, supported by appropriate structural, fiscal, and financial policies, would contribute to stronger external balances, as would the maintenance or improvement in price competitiveness.

Authorities’ Views

19. The authorities agreed that a stronger NIIP would be desirable and would require sustained current account surpluses. Accordingly, they anticipate the current account to remain in surplus, fostering a steady and significant improvement in the country’s external position over the medium-term. They pointed to non-cost competitiveness gains as the driving factor behind the strong export growth and the rise in market shares in recent years. They expect Portugal’s external position to continue strengthening based on increased innovation, continued movement up the quality ladder, a well-educated labor force, and other factors improving non-cost competitiveness.

C. Fiscal Issues and Policies

20. The authorities have adopted a more ambitious 2018 fiscal deficit target than was contained in the state budget. Controlling for the capitalization of CGD, the budget closed 2017 with an overall deficit (0.9 percent of GDP) that was already lower than the original 2018 budget deficit target approved in late 2017 (1.1 percent of GDP). Accordingly, a more ambitious 2018 target of – 0.7 percent of GDP was included in the Stability Program 2018–2022 launched in April 2018. Staff expect that the authorities will meet this target, with the improvement relative to 2017 driven by smaller expected one-offs9, the favorable effect of the cycle, and a declining interest bill. Staff projects the public debt to GDP ratio to decline to 103 percent of GDP by 2023 on the assumption of unchanged policies.10

Fiscal Balance

(Percent of GDP)

article image
Source: Staff calculations.

21. When temporary factors are removed, however, the structural primary balance would deteriorate by about 0.3 percent of GDP in 2018. Spending pressure will be acute for wages, where the authorities have committed to the unfreezing of career progression (estimated net cost of EUR 200 million in 2018, or 0.1 percent of GDP, but subject to upward risk) and to continue with the gradual transition to a 35-hour week in the public sector. Meanwhile, public investment, although rising, remains low by cross-country and historical standards.

22. The authorities should take advantage of the favorable economic environment and front-load their announced fiscal consolidation plans. The Stability Program envisages a significant 1.5 percent of GDP adjustment in the primary balance (minus one-offs) over the period 2018–22. However, with the structural primary balance loosening by a cumulative 0.5 percent of GDP in 2018–19, almost all the proposed adjustment would occur in 2020 and 2021, when staff expects that growth will be weaker. To avoid such a pro-cyclical fiscal stance, adjustment should be front loaded. Specifically, the authorities could consider a one percent of GDP tightening of the structural primary balance cumulatively over 2018–2019, including aiming for over-performing on their official overall balance target for 2018.

23. Frontloading would provide valuable policy space now and in the future. Rising uncertainty, including over external conditions, provides a further motive to adjust now when conditions are favorable, building policy space to deal with potential shocks. Near term, front-loading could allow contingent liabilities, such as Novo Banco support (Box A2), to be accommodated without disturbing the firm downward trajectory of debt. More fundamentally, a faster pace of consolidation now would shorten the time required to reduce public indebtedness to levels which are both safer and closer to regional averages. Portugal’s debt to GDP ratio is 40 percentage points above the euro area average of 86.7 percent of GDP in 201711 (roughly the same as the 85 percent threshold viewed as high-risk by the IMF—see Annex I). Such high indebtedness limits the space Portugal would have to handle significant economic shocks. Depending on growth and interest rate assumptions, the proposed strengthening in the structural primary balance, starting now and sustained over time, could shorten the time required to reach the 85 percent of GDP mark by three or more years.

Years to reach public debt of 85 percent of GDP

article image

baseline assumption

uA01fig12

Public Debt

(Percent of GDP)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Sources: IMF and staff calculations.

24. Continued structural fiscal consolidation should be based on durable expenditure reform. To preserve public capital, the consolidation should concentrate on the current balance. The ongoing expenditure review is a valuable tool, but it should be complemented with structural reforms to public employment and pensions to achieve lasting consolidation.

  • The move to a 35-hour week that started in 2016, the difficulties in meeting small employment reduction goals in the past two years, and the ongoing unfreezing of career progressions (the extent of which is still under debate) suggest the need for a well-designed reform of the civil service, aimed at improving the level and composition of public employment. Previous staff analysis suggested that demographic trends should guide public employment reform, as they influence the demand for public services.12 (For example, the pupil-teacher ratio in primary schools is below those of most European peers, and has declined in recent years, indicating room for consolidation.)

  • On the pension system, measures are under consideration to reduce penalties for early retirement of employees with more than 40 years of contributions. While justifiable, they would risk increasing cash-flow needs in the social security system in the near term, albeit moderately, if qualifying individuals were to retire early, and should be accompanied with measures generating savings. In the medium-term, it is recommended that the ‘grandfathering’ of existing pensioners from the recent reforms be revisited, focusing on the highest pensions.

Figure 1.
Figure 1.

Portugal: Pension Indicators

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Sources: OECD and Eurostat.

25. Budget monitoring and control need to be improved. In the health sector, injecting public funds (about €1.4 billion in 2017–18) to clear arrears is unlikely to provide durable results without addressing the root causes of arrears, such as under-budgeting, as well as weaknesses in monitoring and enforcement practices. Recent initiatives to improve cost-effectiveness, such as the creation of a joint unit by the health and finance ministries, are important steps in the right direction; their effectiveness should be monitored, and if necessary, additional interventions should be directed at preventing the accumulation of new payment arrears. Finally, local governments should not delay the transition to an integrated accrual-based public accounting system.

Authorities’ Views

26. The authorities believe that the targets set out in the Stability Program 2018–2022 are realistic and appropriately paced. Their deficit reduction strategy is focused on: (i) continued restraint on public sector wages and employment, even as some necessary changes are phased in; (ii) efficiency savings from the ongoing spending review; and (iii) falling interest payments, which they expect to lead to a sustained decline of current expenditure of 2.4 percent of GDP by 2022. They view the pace of consolidation as appropriate, given their assessment that the economy is currently still in the recovery phase of the cycle and that growth will remain strong over the medium term. They project the fiscal deficit to decline to 0.7 percent of GDP in 2018 and turn to a surplus in 2020; they also expect that their fiscal strategy will reduce public debt to 102 percent of GDP by 2022, a downward trajectory that they consider robust to macroeconomic and financial shocks.

27. The authorities emphasized their commitment to advancing expenditure reforms with a view to enhance efficiency and improve inclusion of the most vulnerable groups. The authorities explained that they have bolstered the financing of pensions by phasing in the earmarking of a fraction of corporate income tax (reaching two percentage points by 2021) and improved the transparency of the system by launching an online pension benefit calculator. To improve the fairness of the system, the authorities are raising the value of the lowest pensions and analyzing the possibility of further reducing excessive penalties for early retirement, while keeping the legal retirement age indexed to life expectancy. In the health sector, the authorities explained that they are stepping up efforts to contain arrears accumulation by transferring additional resources to hospitals (about €500 million by end-2018) and strengthening budget planning and controls, which they expect to result in better services. They stressed that, in the context of the ongoing spending review, they are centralizing the procurement of drugs and medical devices, and renegotiating contracts with suppliers while tackling fraud. In March 2018, a task force of health experts was formed to collaborate with the Ministries of Health and Finance in identifying additional measures to improve the sustainability and efficiency of the health sector.

D. Structural Issues: Investment and Growth

28. Improving medium term growth prospects is necessary for Portugal to converge to euro area standards of living and reduce vulnerabilities. During the euro crisis, Portugal’s average income fell further behind the euro area core, and in staff’s projections convergence is not expected in the next five years, as growth of GDP per capita would be just above that in the euro area. And the still large stocks of public and private debt remain sources of vulnerability. Faster output growth would facilitate both income convergence and further deleveraging.

uA01fig13

Real GDP per capita of EA Countries

(Thousands; constant 2010 USD)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Sources: WDI, WEO and IMF staff calculations.

29. Potential growth in the medium term will remain moderate. The reforms implemented since the program era have improved labor market flexibility, product market competition, and the effectiveness of the judicial system, while the investment composition has shifted toward tradable sectors, reflecting the structural transformation of the economy. This laid the basis for a resumption of growth and employment. However, staff estimates potential growth at around 1.4 percent over the medium-term13, considering remaining structural bottlenecks and unchanged policies. Near term, a decline in working age population (about 1 percent over five years) is expected to be offset by recovering labor force participation and moderating structural unemployment, but over the medium term a contracting labor force will weigh on growth (Annex IV). These estimates are subject to a large degree of uncertainty.

uA01fig14

Contributions to Potential Growth

(Percentage points)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Sources: Haver Analytics and IMF staff calculations.

30. Increasing growth over the medium-term will require stronger domestic saving to finance additional private investment. Despite its ongoing recovery, investment remains relatively low as a ratio to GDP. Given Portugal’s need to reduce its fiscal deficits further, public gross fixed capital formation is likely to remain constrained, although public investment efficiency can continue to improve from its strong level (see Selected Issues Paper). Private investment should thus be the driving force behind higher investment growth over the medium term, and will require larger saving to finance it—especially private.

  • Gross corporate saving rose significantly during the adjustment period, but has remained broadly unchanged at 10 percent of GDP since 2015, and going forward there is even a risk of erosion if there were significant additional increases in labor costs. The authorities could build on recent tax changes to support firms that retain and reinvest earnings and owners who inject new equity into their companies.

  • The household saving rate averaged 3.8 percent of GDP over the last three years, one of the lowest among advanced countries. The authorities should develop a medium-term strategy to strengthen saving, including by enacting regulations needed for the complementary professional pension regime as mandated in the pension law.

uA01fig15

Corporate Financing and Investing

(Percent of GDP)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Source: INE.

31. Portugal needs to overcome significant structural challenges to boost investment and raise productivity, building on past reforms. In particular:

  • Uncertainty and regulation. Ensuring a stable regulatory and tax environment would contribute to limit uncertainty, an important deterrent to investment14

  • Energy prices. Network industries such as energy and transport continue to be characterized by relatively high prices, affecting the competitiveness of firms in tradable sectors. Despite a decline in energy prices in recent years, they remain above the EU average. Ongoing work by the regulator to review existing tariff frameworks is thus welcome.

  • Wage growth and productivity. Wage growth has continued to exceed productivity growth, reflecting a tightening labor market, especially in some segments, and significant minimum-wage increases. The minimum wage increased to €580 per month in 2018 from €557 in 2017 and €530 in 2016, and the minimum wage coverage of employees increased to 22 percent in 2017 (from 20.6 percent in 2016). Maintaining a similar trajectory in the future could increase rigidities and reduce competitiveness.

  • Human capital development. Despite improvements in indicators of educational attainment, skill-shortages remain an obstacle to Portuguese firms, and the share of low-skilled workers (47 percent in 2017) is still much higher than the EU average (18 percent). Within its budget constraints, the government should continue to support on- and off-the job training, and linkages between public education institutions and industry.

  • Legal and institutional framework for debt enforcement and insolvency. Official data indicate that reforms of the legal and institutional framework for debt enforcement and insolvency/debt restructuring have yielded positive results on resolution efficiency, debt recovery, and more recently in NPL resolution. Among other reforms, the authorities have introduced a new purely out-of-court collateral enforcement procedure, a debt-to-equity procedure that may override shareholder opposition by court approval, and further simplification and efficiency measures. The authorities have also established tax incentives for debt restructuring and debt-to-equity swaps. Staff welcomes these reforms and the continued refinement of the legal and institutional framework, and recommends further actions in two areas: (i) enable public creditors to participate more fully in debt restructuring, preferably on the same footing as other creditors, subject to clear and transparent guidelines; and (ii) prioritize addressing conditions allowing non-viable insolvent businesses to delay liquidation.

uA01fig16

Energy Prices for Industrial Consumers, 2017H2

(Euro per kilowatt-hour including taxes and levies)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Source: Eurostat 500 MWh < Consumption < 2 000 MWh. Prices are invoiced prices paid by end-users.
uA01fig17

Minimum to Median Wages, 2016

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Source: Eurostat.
uA01fig18

Low-skilled Employment Rate

(Percent)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Sources: Eurostat; and IMF staff calculations.
uA01fig19

Employment by Type

(Percent of labor force)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Sources: INE and IMF staff calculations.

32. Preserving labor market flexibility is important for the economy to adapt to future shocks and to support productivity growth. Most jobs created in 2017 were permanent; however, temporary jobs in Portugal still represent a large fraction of employment by European standards. Against this background, the government coordinated tri-partite negotiations on labor regulations, aimed inter alia at increasing job security and reducing segmentation. The agreed reforms include measures that reduce firms’ ability to flexibly manage their labor, such as new constraints in the use of “banks of hours” and a reduction in the maximum duration of temporary contracts; but they also permit an increase in the duration of probation periods in permanent contracts, and take into account industry-specific practices in the design of some regulations. Thus, the agreement’s net effects on economic flexibility are hard to predict, as it both constrains temporary contracts and makes permanent contracts more flexible in some dimensions. These agreements are now in parliament. However, there are competing initiatives that would increase more markedly the restrictiveness of labor regulations. Such initiatives would be counterproductive, as flexible labor market institutions are key for Portugal, a member of a common currency area, to process adverse shocks.

uA01fig20

Temporary Contracts

(Percent of total employment, 2018:Q1)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Sources: Eurostat and IMF staff calculations.

Authorities’ Views

33. The authorities in their Stability Program 2018–2022 see stronger potential growth of around two percent over the medium-term, grounded in structural improvements in skills, investment allocation, and export-orientation. The ongoing improvement in education, both in attainment levels and quality, and the revitalization of the financial system are expected to support long-term potential growth and productivity, and are more relevant factors than the evolution of indicators such as labor cost indices, which can be misleading.15 The authorities agreed with the need to boost investment and savings and to continue to improve the business environment, and noted that recent tax changes aimed to encourage firms to build equity. They also emphasized the need for better management skills and to foster innovation in small businesses, which rely on the ongoing education strategy and could be boosted through the return home of skilled Portuguese migrants. They explained that the proposed changes in labor market regulations are intended to address long-standing labor market segmentation issues, which have undesirable social effects but could not be addressed earlier owing to labor market weakness. Moreover, they stressed that the tripartite process used to draft the reform package, building on an extensive in-depth discussion between employers, unions, and government, ensured that the agreed set of measures was balanced. The authorities believe that tackling remaining structural challenges and building social capital will require both supply- and demand-side support as well as patience by all stakeholders, as reforms take time to materialize.

34. The authorities stressed the importance of their multi-faceted strategy to boost investment and innovation. Besides the continuing improvement of the legal, judicial, and tax framework, other measures are being implemented to improve funding and capital levels of SMEs and Mid-Caps. These include a new public post-restructuring financing instrument, co-investment initiatives with venture capital funds and business angels, renewed credit facilities with mutual guarantee, and the creation of a new type of listed companies (SIMFE16) holding shares in unlisted Portuguese firms.

Staff Appraisal

35. The Portuguese economy performed well in 2017. Investment and exports were the key drivers of growth. The underlying fiscal balance posted a strong outturn allowing for ‘one-off’ payments. The improvement can be attributed to buoyant economic growth, disciplined budget execution, and falling interest costs, and has contributed to more favorable borrowing terms throughout the economy. Importantly, stability and confidence in the banking system increased following successful efforts to raise capital by banks and the sale of Novo Banco in 2017.

36. Prospects remain positive, but downside risks have increased. Portugal should continue to post strong, albeit moderating growth in the next few years. Continued fiscal restraint, together with the favorable economic context, bode well for the attainment of the 2018 fiscal target and for continued public debt reduction over the medium term. Nevertheless, policies need to remain strong in the face of heightened external risks and of pressures to erode past reforms. Weakening them may seem manageable in the present favorable circumstances, but it would impair the economy’s ability to handle shocks down the road.

37. Staff sees a good case for frontloading the fiscal adjustment envisaged in the Stability Program 2018–2022. The stability program appropriately aims at a continued reduction in public indebtedness, which remains very high. Frontloading fiscal consolidation would take advantage of current favorable cyclical conditions and avoid postponing the fiscal effort till a time when activity is likely to be moderating and create space to absorb contingent spending pressures that could materialize in the next few years. Moreover, frontloading would also help further differentiate Portugal at a time of potential bond market volatility.

38. While systemic risks appear to be contained, the still-elevated stock of NPLs and low bank profitability remain concerns. Addressing these lingering vulnerabilities will require perseverance in implementing the NPL-resolution strategy. To avoid future NPL build-up, supervisors should continue to press banks to strengthen their risk management and corporate governance. The authorities should also continue to pay close attention to credit standards, as the low-interest rate environment could lead to excessive risk-taking and be ready to adjust the macroprudential measures if needed to bolster the resilience of the financial system and households.

39. Portugal’s external position remains weaker than that consistent with medium-term fundamentals and desirable policy settings. The strengthening in the current account since the crisis helped change the trajectory of the country’s net international investor position. Significantly improving the country’s external position in the future requires larger-than-forecast current account surpluses over the medium term, which calls for policies geared at boosting domestic saving.

40. Stronger growth in the medium term will be essential to continue to reduce vulnerabilities and converge towards the average levels of productivity and income of the EU. Strengthening growth will require fostering soundly financed investment and continuing improvements in productivity and skills. Investment can be spurred by enhancing business conditions, streamlining regulations, and increasing the flexibility and responsiveness of institutions and markets. Sustainable financing of investment requires continuing efforts to strengthen domestic saving and the financial intermediation system.

41. Staff recommends that the next Article IV consultation be held on the standard 12- month cycle.

Figure 2.
Figure 2.

Portugal: Real Sector Indicators

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Sources: INE; Haver Analytics; and IMF staff calculations.
Figure 3.
Figure 3.

Portugal: Fiscal Sector Indicators

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Sources: Haver Analytics; IGCP; ECB; and IMF staff calculations.
Figure 4.
Figure 4.

Portugal: External Sector Indicators

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Sources: IFS; Haver Analytics; and IMF staff calculations.
Figure 5.
Figure 5.

Portugal: Financial Stability Indicators

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Sources: Banco de Portugal; Haver Analytics; and IMF staff calculations.
Table 1.

Portugal: Selected Economic Indicators

(Year-on-year percent change, unless otherwise indicated)

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Sources: Bank of Portugal; Ministry of Finance; National Statistics Office (INE); Eurostat; and IMF staff projections.
Table 2a.

Portugal: General Government Accounts 1/

(Billions of euros)

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Sources: INE; Bank of Portugal; and IMF staff projections.

GFSM 2001 presentation.

Table 2b.

Portugal: General Government Accounts 1/

(Percent of GDP, unless otherwise noted)

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Sources: INE; Bank of Portugal; and IMF staff projections.

GFSM 2001 presentation.

Table 3.

Portugal: Monetary Survey, 2014–2023

(Millions of euros, unless otherwise indicated; end of period)

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Sources: Haver Analytics; Bank of Portugal; and IMF staff projections.

Excludes Bank of Portugal.

Including emigrants.

Includes foreign interbank borrowing and securities issued.

Table 4.

Portugal: Balance of Payments, 2014–2023

(Billions of euros)

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Sources: Bank of Portugal; and IMF staff projections.

End-of-period data.

Table 5.

Portugal: Selected Financial Indicators of the Banking System, 2013:Q1–2017:Q4 1/

(Percent)

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Source: Bank of Portugal.

The banking system data present a break in time series in 2014:Q3 due to the resolution measure applied to Banco Espírito Santo (BES). The break in time series stems, in particular, from the fact that the assets/liabilities not transferred to the balance sheet of Novo Banco (NB) are not considered in the aggregate of the banking system from August 2014 onwards. In the absence of accounting information for BES on a consolidated basis for the period from June 30, 2014 to the day of implementation of the resolution measure (closing balance sheet and statement of profit or loss), the reporting of BES on an individual basis, with reference to July 31 2014, was considered when determining the aggregate results of the banking system for 2014:Q3. However, the adjustments stemming from the resolution measure applied to BES were also not considered.

On accounting basis; consolidated.

National concept of asset quality.

Data reflects the information from Instruction No 13/2009 of Banco de Portugal until 2015:Q3, which was adapted to be comparable with the latter data from ITS reporting framework (from 2015:Q4 onwards). This fact implied a slight change in the reporting universe of institutions.

Data reflects the information from Instruction No 23/2004 of Banco de Portugal (until 2015:Q3). From 2015:Q4, data is based on the ITS reporting framework. The reported data follows EBA’s proposal on the mapping from IT S on Supervisory Reporting to FSI.

Includes foreign currency deposits and deposit-like instruments of resident nonmonetary sector and claims of nonresident vis-à-vis resident monetary financial institutions (excluding Bank of Portugal).

Table 6.

Portugal: External Debt Sustainability Framework, 2015–2023

(Percent of GDP, unless indicated)

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Source: Fund staff estimates.

Derived as [r – g – r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency--not used here), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock. r increases with an appreciating domestic currency (e > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

Table 7.

Portugal: Indicators of Fund Credit, 2014–2023 1/

(Millions of SDR, unless otherwise indicated)

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Source: IMF staff estimates.

Exchange rates reflect actual exchage rates where available, otherwise historical and projected WEO annual averages for flows and end-of-period values for stocks.

Quota Increase in 2016.

Table 8.

Portugal: General Government Financing Requirements and Sources 1/

(Billions of euros)

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Source: Portuguese authorities and IMF staff estimates.

For projection years, all t-bills issuance is assumed to be short term (i.e. at maturities of 12 months or below).

For EFSF loans, outstanding loans are assumed to be rolled over for an additional seven years, as agreed with the EU.

Includes net financing from retail government securities programs, as well as adjustments for cash-accrual differences and consistency between annual projections and preliminary quarterly accounts.

Table 9.

Portugal: External Financing Requirements and Sources

(Billions of euros, unless otherwise indicated)

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Sources: Bank of Portugal and IMF staff estimates.

For EFSF loans, outstanding loans are assumed to be rolled over for an additional seven years, as agreed with the EU.

Annex I. Public Debt Sustainability Analysis (DSA)

Portugal’s debt remains high and vulnerable to a range of macroeconomic and financial shocks. Nevertheless, a return to growth, an improvement in the structural balance and a reduction in risks from the banking sector have led to an improvement in market sentiment. The marginal cost of borrowing has fallen significantly in recent years and S&P and Fitch have upgraded Portugal to investment status. In the baseline scenario, public debt is projected to decline from 126 percent of GDP in 2017 to 103 percent in 2023. However, while debt appears to be on a downward trajectory, risks will remain high over the medium term until levels normalize. In this regard, further effort to gradually raise the structural primary balance is required to build resilience and create policy space if adverse shocks materialize.

A. Baseline Scenario

1. Debt in 2017 remains elevated at 126 percent of GDP, but has continued its downward trajectory and is now below its 2012 level. Debt fell by 4.2 percentage points of GDP in 2017. The primary driver of this fall was real GDP growth, which reached its highest level since 2000, at 2.7 percent. The primary balance, at 0.9 percent of GDP, was smaller than the previous year, reflecting the impact of the recapitalization of CGD, which masked an underlying improvement. A decline in the interest rate bill and the use of cash deposits also contributed to the fall in debt. Despite these positive dynamics, the stock of debt remains very high, and well above the 85 percent of GDP high-risk threshold for the market access (MAC) DSA and the 60 percent of GDP target mandated in the Stability and Growth Pact.

uA01fig21

Public Debt

(Percent of GDP)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Sources: IMF and staff calculations.

2. Debt is expected to decline by 22 percent of GDP over the next six years, reaching 103 percent by 2023. The primary driver of this reduction is expected to be from the primary balance — reducing debt by a cumulative 19 percentage points of GDP, under the assumption that the structural primary balance will remain broadly constant at its 2018 level over the forecast horizon. Real GDP growth is expected to reduce debt ratios by a cumulative 11 percentage points of GDP. The interest bill will put upward pressure on debt, but the size of this effect is expected to decline from 3.9 percent of GDP in 2017 to 2.9 percent in 2023. While the ‘risk-free’ rate is expected to rise as monetary conditions normalize, the fall in Portugal’s spread and its declining debt stock will dominate, leading to an overall decline in interest payments (Box A1).

uA01fig22

Interest Bill

(Percent of GDP)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Source: Ministry of Finance, Dealogjc. and staff ejaculations.

Projecting the Structural and Cyclical Component of the Interest Bill

At the peak of the crisis, the yield on 10-year debt reached over 17 percent. Since then, borrowing costs have fallen dramatically. This decline can be attributed to strong policy action, including fiscal consolidation and pro-growth structural reforms, as well as support from the official sector. However, despite this spike in the marginal cost of borrowing, the effective interest rate on the stock of medium-to-long term (MLT) bonds remained relatively stable, largely due to the program support provided by the official sector. More recently, there has also been a steady decline in borrowing costs across Europe, with 10-year German Bunds around zero since 2015. This combination of a lower ‘risk-free’ rate and a declining spread, has led to a steady reduction in Portugal’s effective interest rate since the 2015.

uA01fig23

Interest Rate on MLT Bonds

(Percent)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Sources: Bloomberg, Dealogic and staff caclulations.

Using bond-level data, the effective interest rate can be separated into the ‘risk-free’ component and the spread. The former can be viewed as being largely driven by cyclical factors, in particular monetary policy; while the latter can be viewed as the structural component, driven primarily by credit risk. This shows that the cyclical component has fallen significantly over the last 10-years and is the primary driver of the recent decline of the effective interest rate. Improvements in the marginal cost of borrowing arising from declines in spreads will take some time to influence the effective interest rate.

uA01fig24

Effective Interest Rate on MLT Bonds

(Percent)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Sources: Dealogic and staff caclulations.

Looking ahead, the marginal cost of borrowing is likely to increase as monetary conditions normalize, with both the ‘risk-free’ rate and the spread increasing. Nevertheless, a falling debt stock, the early repayment of IMF credit and the steady amortization of previously accumulated high-yield debt will put downward pressure on the interest rate bill. The net effect will be a sustained decline in interest payments, from 3.9 percent of GDP in 2017 to 2.9 percent in 2023. This decline can be attributed to the dominance of structural drivers – the pass-through of lower spreads in new debt issuances and the steady decline in the debt stock.

uA01fig25

Change in the Interest Bill

(Percent of GDP)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Sources: Ministry of Finance, Dealogic, and staff calculations.

B. Risk Assessment

3. Portugal’s elevated debt burden leaves it highly vulnerable to a range of macroeconomic and financial sector shocks. Debt will exceed the high-risk threshold for market access countries (85 percent of GDP) throughout the forecast horizon (Figure 1). Government gross financing needs (GFN) are expected to remain below the equivalent high-risk threshold of 20 percent of GDP; although in 2021, the current amortization profile implies a spike to 17 percent. Market perception of debt vulnerabilities is favorable, and the risks from short-term debt and the stock of debt held by non-residents is assessed to be low. Nevertheless, a total economy external financing requirement of 50 percent of GDP leaves Portugal vulnerable to external conditions.

Figure 1.
Figure 1.

Portugal Public DSA Risk Assessment, 2016–2023

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Source: IMF staff.1/ The cell is highlighted in green if debt burden benchmark of 85 percent is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not baseline, red if benchmark is exceeded under baseline, and white if stress test is not relevant.2/ The cell is highlighted in green if gross financing needs benchmark of 20 percent is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not baseline, red if benchmark is exceeded under baseline, and white if stress test is not relevant.3/ The cell is highlighted in green if country value is less than the lower risk-assessment benchmark, red if country value exceeds the upper risk-assessment benchmark, yellow if country value is between the lower and upper risk-assessment benchmarks. If data are unavailable or indicator is not relevant, cell is white. Lower and upper risk-assessment benchmarks are: 400 and 600 basis points for bond spreads; 17 and 25 percent of GDP for external financing requirement 1 and 1.5 percent for change in the share of short-term debt; 30 and 45 percent for the public debt held by non-residents.4/ Long-term bond spread over German bonds, an average over the last three months, January 11, 2018 through April 11, 2018.5/ External financing requirement is defined as the sum of current account deficit, amortization of medium and long-term total external debt, and short-term total external debt at the end of previous period.

4. Risks are skewed to higher debt. At such high debt levels, relatively minor negative shocks to the main drivers of debt, or a deterioration in global risk sentiment, can lead to a loss of confidence and adverse equilibria. This can be seen from the asymmetric fan-chart in Figure 1. This suggests that further effort to gradually raise the structural primary balance would build resilience and create policy space, if adverse shocks materialize.

C. Realism of Baseline Assumptions and Alternative Scenarios

5. The baseline assumes a largely unchanged fiscal stance after 2018. Following a minor expected loosening in 2018, the structural primary balance is expected to remain essentially constant at around three percent of GDP for the rest of the forecast, significantly above the level needed to stabilize debt (-0.2 percent). While maintaining this fiscal stance is achievable when compared against historical experience (Figure 2), the authorities should resist pressure to rollback past efforts, now that the crisis period has ended. Continued growth, converging to potential (1.4 percent), is an important driver of the declining debt trajectory. If growth were to disappoint, perhaps due to a reversal of structural reforms or weaker external conditions, then this could stall the debt reduction process (Figures 4 and 5).

Figure 2.
Figure 2.

Portugal Public DSA – Realism of Baseline Assumptions

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Source: IMF Staff.1/ Plotted distribution includes surveillance countries, percentile rank refers to all countries.2/ Projections made in the spring WEO vintage of the preceding year.3/ Not applicable for Portugal, as it meets neither the positive output gap criterion nor the private credit growth criterion.4/ Data cover annual obervations from 1990 to 2011 for advanced and emerging economies with debt greater than 60 percent of GDP. Percent of sample on vertical axis.
Figure 3.
Figure 3.

Portugal Public Sector Debt Sustainability Analysis (DSA) – Baseline Scenario, 2007–2023

(in percent of GDP unless otherwise indicated)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Source: IMF staff.1/ Public sector is defined as general government2/ Based on available data.3/ Long-term bond spread over German bonds.4/ Defined as interest payments divided by debt stock (excluding guarantees) attheend of previous year.5/ Derived as [(r -π(1 +g) – g + ae(1 +r)]/(1 +g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).6/ The real interest rate contribution is derived from the numerator in footnote 5 as r – π (1 +g) and the real growth contribution as -g.7/ The exchange rate contribution is derived from the numerator in footnote 5 as ae(1 +r).8/ Includes asset changes and interest revenues (if any). In 2017, includes the recapitalization of CGD. For projections, includes exchange rate changes during the projection period.9/ Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.
Figure 4.
Figure 4.

Portugal Public DSA – Composition of Public Debt and Alternative Scenarios, 2012–2023

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Source: IMF staff.
Figure 5.
Figure 5.

Portugal Public DSA – Stress Tests, 2018–2023

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Source: IMF staff.

6. The authorities’ medium-term fiscal strategy under the Stability Program 2018– 2022 envisages a reduction in public debt to 102 percent of GDP by 2022. This compares to 107 percent of GDP in the staff baseline. However, the authorities’ projection is based on an ambitious fiscal adjustment, which has yet to be linked to specific policy measures. The Stability Program assumes average real GDP growth of 2.2 percent in 2018–22, as opposed to staff’s baseline projection of 1.6 percent over the same period.

D. Stress Test

7. The baseline remains highly sensitive to macro-fiscal and contingent liabilities shocks (Figure 5):

  • i. A growth shock of -2.3 percent (one-standard deviation of historical growth) applied in 2019 and 2020, would increase debt to 124 percent of GDP, 11 percent of GDP above the baseline.

  • ii. A primary balance shock of -1.7 percent of GDP (1/2 standard deviation of historical changes) applied in 2019 and 2020, would increase debt to 117 percent of GDP in 2020, 4 percent of GDP above the baseline.

  • iii. An interest rate shock of 350bps over 2018–23 would lead to a gradual deterioration of the debt position, leaving it 3 percent of GDP higher than the baseline by 2023.

  • iv. A standard contingent liability shock, equal to 10 percent of GDP, would raise debt by an equivalent amount across the forecast period. Such a shock also has the potential destabilize interest rates, which could have second round effects on growth and debt, although these factors are not modelled here.

  • v. A severe combined shock that incorporates the macro-fiscal and contingent liabilities adverse scenarios mentioned above would significantly affect the country’s debt dynamics, raising debt above 130 percent of GDP, where it would remain largely unchanged.

  • vi. An upside shock, where the authorities achieve the overall balance envisaged under the Stability Program (but with all other assumptions unchanged), would lead to debt of 99 percent of GDP by 2023, 4 percent of GDP below the baseline.

Contingent Liabilities Associated with the Novo Banco Sale

While the sale of Novo Banco to Lone Star in October 2017 prevented its resolution, the terms of the sale included a Contingent Capital Agreement that is expected to impact the public finances.

After the completion of the sale, the Portuguese Resolution Fund retained control of 25 percent of Novo Banco’s shares, but remained exposed to a large portfolio of specific troubled assets in the bank’s balance sheet. Under the terms of sale, the Resolution Fund would have to compensate Novo Banco for recognized losses in this portfolio of assets, to the extent that such losses may cause Novo Banco’s capital ratios to decline below predefined thresholds. The cumulative limit to such compensation payments was set at €3.89 billion (2 percent of 2017 GDP), over a period of eight years. Separately, the government agreed to give the Resolution Fund access to loans from the Portuguese Treasury to help finance such payments (the Resolution Fund was expected to finance at least a fraction of the payments with resources of its own). The payments themselves (not the loans) are classified as government spending, given the sectorization of the Resolution Fund.

The results for 2017 presented by Novo Banco in March shows a loss of nearly €1.4 billion, driven by impairments of €2 billion, most of which are related to the assets covered by the contingent capital agreement. In view of the effect on capital of those losses, the Resolution Fund made a payment to Novo Banco for €792 million (0.4 percent of GDP) to restore the bank’s capital ratio to the predefined level. The Resolution Fund borrowed about €430 million from the government to finance part of this payment.

The fact that Novo Banco moved aggressively with this first wave of impairments already in the last quarter of 2017 has convinced analysts that further payments arising from qualifying capital losses related to additional impairments should be expected in the future.

Annex II. Risk Assessment Matrix 1/

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Annex III. External Sector Assessment

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Annex IV. Labor Market Developments and Productivity

1. Labor factor growth is expected to support potential growth in the short term. In the near term adverse demographic trends are temporarily offset by declining structural unemployment and recovering labor force participation. In the longer term, when ageing and decreasing population will weigh more notably on labor factor growth, potential growth is estimated to be around 1¼ percent, or 1.5 percent in per capita terms.

uA01fig26

Contributions to Potential Growth

(Percentage points)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Sources: Haver Analytics and IMF staff calculations.

2. Continuing improvements in educational attainment and a reduction of self-employment underpin the medium-term projections for labor productivity and total factor productivity. Labor productivity outperformed the EU average in late 2000s-early 2010s, benefiting from rapid improvement of labor skills, as well as from labor shedding during the crisis. Average skills are expected to continue improving going forward, including as lower-skilled self-employed decline as a share of labor.

uA01fig27

Labor Productivity

(2000=100; per worker)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Sources: WEO, Eurostat, and IMF staff calculations.

3. Labor force participation started to recover in 2017, increasing by 0.8 percent. The activity rate stands at 66.2 percent, above the EU and EA averages of 64.7 and 64.2, respectively. It is projected to recover further towards pre-crisis levels, increasing on average by about 0.2 percent per year. An increasing share of full-time employment, including a reduction of involuntary part-time work, would also positively affect labor’s contribution to growth.

uA01fig28

Labor Force Participation Rate

(Percent)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Source: Eurostat.

4. Although the share of low-skilled workers in Portugal (47 percent in 2017) remains significantly higher than the EU average (18 percent), it has declined markedly since the mid-2000’s. The decline is broad-based and is more pronounced for employees and for the unemployed. There was a cyclical uptick during the crisis, especially for the unemployed, but not strong enough to offset the overall negative trend.

uA01fig29

Low-Skilled Share

(Percent)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Source: Eurostat.

5. Another notable development is the continuous reduction of self-employment. It declined from 24 percent in the late 1990s to 14.3 percent in 2017, approaching the EU average of 13.4. The reduction of self-employment in Portugal appears to be strongly connected to improvements in educational attainment and demographic cohort replacement. So as elder cohorts age and general educational attainment continues to rise, self-employment will continue to fall.

uA01fig30

Self-Employed Workers

(Percent of labor force)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Source: Eurostat.
uA01fig31

Self-Employed Workers by Age and Education, 2016

(Percent of labor force)

Citation: IMF Staff Country Reports 2018, 273; 10.5089/9781484375921.002.A001

Source: Eurostat.

6. Labor market reforms and human capital development would help to address demographic pressures going forward. The declining ratio of workers to the population will intensify pressures on social programs, pensions, and health care. Addressing labor market segmentation and fostering skill formation will promote more inclusive growth.

Annex V. Past Recommendations

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1

AutoEuropa and Galp had unscheduled production stoppages, and an unusually rainy March affected construction.

2

These trends appear to be broad based, being visible both in goods and services sectors.

3

As noted in the Sixth Post-Program Monitoring Report, despite a halving of average monthly purchases of Portuguese bonds under the ECB’s Public Sector Purchase Program in 2017, spreads over 10-year German bunds narrowed by about 200 bps through the year. The gradual phase-out of the Asset Purchase Program so far in 2018 does not seem to have affected spreads.

4

In 2017, Novo Banco recorded a loss of nearly €1.4 billion, driven by impairments of €2 billion, most of which are related to the assets covered by the contingent capital agreement (see Box A2).

5

Some contingent risks receded recently, as the authorities prevailed in litigation in the U.K involving a claim of about $835 million against Novo Banco pursuant to a facility agreement with Banco Espirito Santo under English law. The UK Supreme Court confirmed that the English courts had no jurisdiction as the legal dispute in connection with a bank reorganization action by Banco de Portugal is to be decided by the Portuguese courts.

6

Non-consolidated data for the NFCs.

7

For example, in 2017:Q4, the median value of residential real estate transactions per square meter increased by 18 percent y-o-y in Lisbon and Porto, compared to a national median value increase of eight percent.

8

This Action Plan includes, inter alia, the following initiatives: guidelines on management of nonperforming exposures and forborne exposures (building up on existing SSM guidelines); a blueprint for asset management companies; measures to strengthen NPL data infrastructure; measures to develop secondary markets for NPLs and enhance the protection of secured creditors; guidelines for the monitoring of loan tapes; measures to enhance disclosure requirements on asset quality; and measures to address potential under-provision of newly originated loans.

9

The Resolution Fund is expected to make a payment worth 0.4 percent of GDP to Novo Banco in compensation for some qualifying losses in 2017, as part of a contingent capital scheme (see Box A2 in the DSA), which is expected to be partially offset by other ‘one-offs’.

10

The authorities envisage a somewhat faster reduction in public indebtedness, as they project stronger GDP growth in the forecast period.

11

IMF Country Report 18/223. The figure is a weighted average.

12

IMF Country Report 17/279 (Portugal: Selected Issues).

13

The authorities in their Stability Program 2018–2022 estimate potential growth at around two percent, assuming a higher impact of skill-improvements on total factor productivity, and their Stability Program includes forecasts of real GDP growth slightly above two percent in the next four years.

14

Uncertainty, high regulatory burdens and complex licensing procedures feature prominently in various surveys of businesses, such as the EIB’s, and were issues raised during meetings between staff and private sector representatives.

15

The projected reduction of low-skilled employment from 53 to 42 percent of the labor force is expected to improve the level of potential GDP by seven percent in 10 years (Gouveia and Coelho, 2018).

16

Sociedades de Investimento Mobiliário para Fomento da Economia.

1/

The Risk Assessment Matrix shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of the staff). The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability of 30 percent or more).

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Cover IMF Staff Country Reports
Portugal: 2018 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Portugal
Author:
International Monetary Fund. European Dept.
Volume/Issue:
Volume 2018: Issue 273
Publisher:
International Monetary Fund
ISBN:
9781484375921
ISSN:
1934-7685
Pages:
65
DOI:
https://doi.org/10.5089/9781484375921.002

Contribution to Real GDP Growth

(Percentage points, year-on-year)

Labor Underutilization

(Percent)

Real Effective Exchange Rate

(2010= 100)

Portugal: Unit Labor Cost and Labor Share

(2005:Q1=100)

Portugal: Labor Productivity and Compensation Growth

(Year-on-year percentage change, 4-quarter moving average)

Fiscal Balance

(percent of GDP)

New Loans to Households and NFC

(Billion of euros, 12-month rolling sum)

Non-financial Corporates: Cumulative Change in the Debt Stock to GDP Ratio

(Percent)

Households: Cumulative Change in the Debt Stock to GDP Ratio

(Percent)

Net Interest Income

(Percent of total assets)

Price-to-Rent Ratio

(Percent deviation from historical mean; 1995Q1–2017Q4)

Public Debt

(Percent of GDP)
Figure 1.

Portugal: Pension Indicators

Real GDP per capita of EA Countries

(Thousands; constant 2010 USD)

Contributions to Potential Growth

(Percentage points)

Corporate Financing and Investing

(Percent of GDP)

Energy Prices for Industrial Consumers, 2017H2

(Euro per kilowatt-hour including taxes and levies)

Minimum to Median Wages, 2016

Low-skilled Employment Rate

(Percent)

Employment by Type

(Percent of labor force)

Temporary Contracts

(Percent of total employment, 2018:Q1)
Figure 2.

Portugal: Real Sector Indicators
Figure 3.

Portugal: Fiscal Sector Indicators
Figure 4.

Portugal: External Sector Indicators
Figure 5.

Portugal: Financial Stability Indicators

Public Debt

(Percent of GDP)

Interest Bill

(Percent of GDP)

Interest Rate on MLT Bonds

(Percent)

Effective Interest Rate on MLT Bonds

(Percent)

Change in the Interest Bill

(Percent of GDP)
Figure 1.

Portugal Public DSA Risk Assessment, 2016–2023
Figure 2.

Portugal Public DSA – Realism of Baseline Assumptions
Figure 3.

Portugal Public Sector Debt Sustainability Analysis (DSA) – Baseline Scenario, 2007–2023

(in percent of GDP unless otherwise indicated)
Figure 4.

Portugal Public DSA – Composition of Public Debt and Alternative Scenarios, 2012–2023
Figure 5.

Portugal Public DSA – Stress Tests, 2018–2023

Contributions to Potential Growth

(Percentage points)

Labor Productivity

(2000=100; per worker)

Labor Force Participation Rate

(Percent)

Low-Skilled Share

(Percent)

Self-Employed Workers

(Percent of labor force)

Self-Employed Workers by Age and Education, 2016

(Percent of labor force)