Portugal: Staff Concluding Statement of the 2018 Article IV Mission

May 29, 2018

An International Monetary Fund (IMF) mission visited Frankfurt, Porto and Lisbon during May 15-29, 2018, for the annual Article IV consultation discussions with Portugal. At the end of the visit, the mission team issued the following statement:

Portugal’s near-term outlook remains favorable, although external risks have risen lately. Following the strong outcome in 2017, fiscal targets for 2018 appear feasible, while stability and confidence in the banking system have improved. Sustained and vigorous growth is needed for Portugal to converge to average EU living standards and to reduce the vulnerabilities from high public and private debt. Ensuring balanced growth requires higher and sustainably financed investment and continued efforts to address structural rigidities. Current favorable conditions create an opportunity for continuing structural fiscal consolidation and support for the supply side of the economy.

1. Job rich growth continued in the last year, supported by a pickup in investment and exports, and prospects remain largely favorable. Real GDP grew by 2.7 percent in 2017 on the strength of investment and exports of goods and services, notably tourism. Flash statistics for the first quarter of 2018 showed somewhat subdued growth largely on account of temporary factors affecting exports, and possibly also of moderation of demand in some export markets. The mission team forecasts real GDP growth to reach 2.3 percent this year, decelerating to 1.8 percent in 2019 and gradually towards a rate of about 1.4 percent in the medium term. Unemployment has fallen to 7.4 percent in March, below the euro area average, with reductions across all dimensions of labor under-utilization. In some sectors of the economy firms are beginning to find it difficult to fill vacancies, especially for high-skill jobs. Growth of real average wages continued in 2017, while the minimum wage coverage rose to 22 percent of all earners (from 20.6 percent in 2016) according to provisional social security data, reflecting in part the growth in low-skill positions.

2. Risks to the favorable baseline scenario are mostly external, but shocks would be amplified by lingering domestic vulnerabilities. Recent months have seen a rise in uncertainty around the world, with weaker readings in high-frequency indicators of activity or rising political and policy uncertainty in some partner countries, as well as heightened volatility in some currency and bond markets. This is a reminder that external conditions, while still broadly benign, can turn less favorable. A weakening of euro-area growth would significantly affect Portugal, an open economy whose exports have successfully increased their presence in foreign markets. Given still high leverage across the economy, market interest rate surprises could have an impact on cashflows and activity. The main domestic risk is that of yielding to pressures to erode past policy efforts, which have facilitated the successful recovery seen so far.

3. Portugal made significant progress on fiscal consolidation in 2017, helped by disciplined budget execution, and the deficit target for 2018 appears feasible. The overall fiscal deficit (excluding the recapitalization of CGD) closed well below the official target in 2017 thanks to the strong economy and a structural primary balance in surplus for a sixth straight year—in fact, 0.4 percent of GDP higher than in 2016. This allowed the government to absorb the CGD recapitalization cost while keeping the headline deficit, as measured by the Eurostat rules, within the Stability and Growth Pact benchmark of 3 percent of GDP. For 2018, continued focus on expenditure control and ongoing cyclical momentum in the economy make the attainment of the deficit target of 0.7 percent of GDP feasible. The strong fiscal performance has generated important spillovers in the economy, such as lower country risk spreads, which tend to benefit most borrowers.

4. The favorable environment provides an opportunity to make faster progress in the reduction of public indebtedness. While the Stability Program’s objectives for fiscal consolidation for the period 2018-2022 are ambitious, the bulk of the adjustment is proposed for 2020 and 2021. By that time, however, the mission expects that growth will be decelerating towards its medium-term potential. Moreover, the uncertainty around any economic projection (be it the mission’s or the authorities’) becomes wider with time. The mission would thus see merit in frontloading the adjustment envisaged in the Stability Program both to avoid the risk that policy may become procyclical, and to ensure that the adjustment envisaged is robust to potential adverse surprises down the road. Moreover, continuing structural consolidation, by reducing debt, will help lower the government’s interest bill, releasing resources for more desirable uses, and contribute to re-build fiscal buffers to face future adverse shocks. Containing the growth in the government wage bill and pension spending is key to keeping current expenditure growth moderate while safeguarding the quality of public services and public investment.

5. The past year saw significant improvements in financial stability. Capital ratios have increased, while the stock of non-performing loans (NPL) has fallen by over EUR 13 billion from its peak in mid-2016, bringing the NPL-to-loans ratio to 13.3 percent at end-2017, down from its 17.9 percent peak. This pace is consistent with meeting or exceeding the banks’ NPL reduction objectives. While these are encouraging results, additional progress is needed to strengthen banks’ profitability. This will help them absorb additional costs that might arise from MREL and to provide support to the economy. Moreover, supervisors should continue to encourage banks to strengthen further their corporate governance and risk management while persevering in their NPL-reduction and cost-cutting strategies to generate internal capital. Although the growth of credit aggregates was still negative, the flow of new credit has strengthened. The trend toward increasingly favorable terms in mortgages and consumer loans prompted the Banco de Portugal to take timely macroprudential measures. Rising house prices should continue to be monitored, given the importance of mortgages in the banks’ loan books.

6. Attaining faster growth in the medium term requires building on past reforms and generating soundly financed investment. Steadily improving skill and education levels should continue to support growth in coming years. Increasing investment on a sustainable basis can contribute to strengthen growth in productivity and output, helping offset the adverse effects of long-term demographic trends in the growth of the labor force. Investment can be fostered by enhancing business conditions, streamlining excess regulations, further improving corporate restructuring and liquidation processes, and preserving or increasing the flexibility of institutions and markets. The present favorable conditions are propitious for taking additional steps in these areas. Moreover, labor reforms undertaken in past years have facilitated the job-rich character of the recovery currently underway. But introducing new rigidities, or reintroducing old ones, would undermine competitiveness and productivity, and make it difficult for firms to manage fluctuations in demand. Encouraging the buildup of equity and stronger private savings would also help ensure that investment can increase without giving rise to external imbalances.

The mission would like to express its gratitude to the Portuguese and European authorities and other interlocutors.