Country Report Portugal
The outlook for Portugal has improved in recent months, in terms of both economic recovery and future market access. However, this and next year’s election cycle are expected to weigh on support for further structural reforms.
Strengths (+) and weaknesses (-)
(+) Reform appetite
Portugal will reap the fruits of the encouraging amount of structural reforms which have been implemented in recent years.
(+) Access to European rescue funds
European leaders have declared they stand ready to support Portugal until full market access is regained, albeit on the condition of strict program implementation.
(-) Structurally low economic growth
Portugal is characterized by a structural lack of robust economic growth which has negative implications for welfare, unemployment and debt sustainability.
(-) Worrying state of public finances
Amid the very high public debt level a robust budgetary effort will be necessary for many years to come, while a scenario of debt becoming unsustainable cannot be excluded.
1. Recovery stronger than expected
Portuguese GDP figures surprised on the upside since mid-2013, with steady growth in the last three consecutive quarters. Growth was mainly driven by net exports, but also domestic demand contributed positively to the growth figures. Sentiment indicators confirm our view of a gradual recovery going forward. Based on the GDP growth outlook by the EC (0.8% in 2014), Portugal should be able to achieve its budget target under the excessive deficit procedure (4%-GDP in 2014). Given this growth outlook we do not expect that the unemployment rate –which already dropped quickly from 17.6% in February 2013 to 15.3% in February 2014, mostly on the back of lower labour supply- will drop significantly further going forward. Despite this recent momentum and the improved short term outlook, please note that the current economic activity is still 6.5% below its pre-crisis peak of end 2007 (figure 1). The sizeable output gap (4.6% in 2013, according to the European Commission (EC)) is expected to be closed only gradually in the coming years, mainly as both private deleveraging and public retrenchment will remain a substantial drag on growth. Besides that, it remains uncertain to what extent the reform progress has boosted the country’s long term growth potential, which used to be one of Portugal’s main weaknesses.
2. Clean program exit most likely
The current bailout program runs until 17 May 2014 and given the fact that interest rates on 10-year government bonds have dropped significantly (currently 3.9%) compared to the levels in recent years (figure 2), we believe a full second bailout is unrealistic. Two options remain on the cards: 1) a credit line from the European Stability Mechanism or 2) a ‘clean’ exit without any further financial assistance. We believe a credit line is desirable, both to provide a cushion in case of a deterioration of investors’ appetite as well as to maintain the pressure on the government to continue with the austerity and reform agenda. Please note that a continuation of the general drop in government bond yields across the eurozone periphery –which can be partly attributed to a return of confidence after the ‘whatever it takes’ pledge by ECB-president Draghi- cannot be taken for granted as it also depends on political stability and liquidity in global financial markets. That said, an ‘Irish style’ clean exit is most realistic. Firstly, both the Portuguese coalition and the creditor countries have a clear incentive to sell ‘good news’, the latter given the upcoming European elections. Secondly, the conditionality demanded by the creditor countries for the establishment of a credit line –a constitutional reform, which would end the risk of further constitutional rejections- seems politically unattainable in Portugal. Thirdly, the Portuguese government is currently fully funded until 2014 and will try to stretch this until mid-2015 in the coming months. This both reduces the need for financial assistance and strengthens its bargaining position with its creditors.
3. Next year elections hamper reform appetite
Next to the risk of a deterioration of investors’ appetite, we stress there remain large political challenges ahead, which are expected to hamper the reform progress going forward. Since end-2012, there has been ongoing disagreement between the coalition partners, the Social Democratic Party (PSD) of Coelho and the People's Party (CDS-PP) of Portas. The weak coalition might be tested by future decisions by the Constitutional Court to reject measures from e.g. the budget 2014. Public support for the current coalition has dampened quickly since 2012. Polls show that especially the Social Democrats have lost much support to the main Socialist opposition party; the latter is leading the polls by around 10%-points. Please note that recent polls suggest that the loss of support for the coalition has more or less halted since the start of the economic recovery and the fall in government bond yields, which is claimed as the success of the current coalition. Nevertheless, the next parliamentary elections in autumn 2015 are likely to result in a change towards a less austerity-minded government, leaded by the Socialists. Although their rhetoric shows a strict anti-austerity policy, given the close watch of the European Commission and financial markets it is expected that also the Socialists will be forced to continue a moderate austerity and reform agenda. Against this background of a weak coalition and fierce political opposition, we do not expect any sweeping reforms before next year’s elections. Despite the encouraging implementation of structural reforms in recent years, key future reforms are 1) a medium term fiscal plan 2) an educational reform and 3) a reform to boost competition in the non-tradable sector. In general, we take comfort from the fact that, if Portugal perseveres with strict program implementation, euro area member states have declared they stand ready to support until full market access is regained. If there will be any future IMF involvement, we note that the IMF’s debt sustainability analysis will be important for the discussion on a possible debt restructuring. In the 10th review, the IMF stated the Portuguese debt is still sustainable in most scenarios. However, given the uncertain economic outlook and the expectation of only low future inflation, we stress there is little margin for fiscal slippage, significantly higher funding costs and other (external) shocks. As European leaders have stressed the uniqueness of the Greek private sector involvement (PSI), our base case remains that such a PSI will not be applied to Portugal.
Partly due to the period of structural low economic growth since the 1990’s, Portugal has the lowest GDP per capita of the larger eurozone countries. This period of low growth can be explained by several structural weaknesses in comparison to its European peers: a low level of domestic competition, an inflexible labour market, an inefficient government and a poor business climate. After the financial crisis Portugal entered several years of severe economic contraction, driven by a large austerity effort, private deleveraging and weak external demand. While the relatively closed Portuguese economy is far away from internal balance, the external balance has improved quickly since the crisis. It should be noted that this rebalancing is driven largely by an import contraction and only to a smaller extent by export growth. Structural low growth has increased worries about public debt sustainability: in November 2011, the Portuguese government received a rescue package from Europe and the IMF, worth €78bn. Considerable progress has been made under this bailout program, especially regarding the implementation of structural reforms and safeguarding financial stability. However, the self-defeating character of recession and austerity led to a rapid rise of Portugal’s unemployment rate (16%) and to increasing public dissatisfaction with the policies demanded by Portugal’s creditors. Since the large public protests in September 2012, there have been several disputes between the current coalition partners, fuelled by stiff pressure from the opposition and by the decision by the Constitutional Court to reject several austerity measures. Although the fragmentation of Portugal’s political landscape is limited –since the democratic reforms after the dictatorship ended in 1974 the landscape is dominated by two parties- the harsh economic situation makes it difficult to continue with necessary structural reforms.