Unlike its most vulnerable Euro area counterparts, Portugal saw its boom that followed the adoption of the euro fade quickly. In the run up to the launch of the euro, its GDP had grown at an average annual rate of almost 4 percent—one of the highest rates in the Euro area and more than 1 percentage point above the Euro area average. However, the demand boom, which was triggered by a sharp decline in interest rates and fuelled by expansionary fiscal policy, was not followed by a parallel increase in potential supply and, much like its boom, Portugal's rapid loss of competitiveness happened early relative to the other GIIPS.1 By 2001–2005, Portugal’s growth rate had decelerated sharply to just one percent.
While Portugal is doing better than Greece in terms of controlling its budget deficit and public debt, its poor long-term growth prospects, drastic loss of competitiveness, and high public and private indebtedness all make the country highly vulnerable to the Aegean flu. Moreover, Portugal’s reliance on Spain—itself vulnerable—as a market for 25 percent of its exports, adds to the contagion risk.
An Early End to the Euro Boom
As in the other GIIPS, the euro’s adoption led interest rates to fall sharply in Portugal—from an average of 12.3 percent in 1991–1995 to about 6 percent in 1996–2000—setting the stage for a consumption boom. Overly rosy expectations that Portugal’s GDP per capita—less than 60 percent of Germany’s from 1985 to 1995 in PPP terms, compared to 76 percent in Spain and 70 percent in Greece—would converge to Euro area levels likely further catalyzed the boom.
Between 1995 and 2000, private savings dropped by about 7 percentage points of GDP, while average gross fixed capital formation had accelerated. Household and non-financial sector debt more than doubled in percent of GDP terms between the mid-1990s and 2002. Reflecting external borrowing’s role in financing consumption and investment, the current account deficit soared to 9.0 percent in 2000, up from near-zero in 1995.
Though tax revenues surged, fiscal policy was pro-cyclical, adding to the expansionary conditions. The primary balance deteriorated by about 3.5 percentage points of GDP between 1995 and 2001.
After formal adoption of the euro, monetary policy in the Euro area, while clearly too loose for Greece, Spain, and Ireland, who saw housing booms, was too tight for Portugal, where housing investment as a percentage of GDP had declined over time and inflation had dropped. As household spending stalled amid high levels of debt and prospects seemed to deteriorate—with little actual GDP per capita convergence—the investment and consumption boom came to an end. Household consumption grew by an average of 1.5 percent per year from 2001 to 2007, compared to 3-5 percent in Spain, Greece, and Ireland. GDP growth averaged just 0.8 percent between 2001 and 2008.
Though the Great Recession did not hit Portugal as hard as the other vulnerable economies, it did lead GDP to contract by 2.7 percent in 2009. GDP is projected to grow by 0.5 percent in 2010 and 0.7 percent in 2011, driven by external trade as domestic demand is set to essentially stagnate. The downturn is also having a significant impact on unemployment, which reached 10.7 percent last month, up three percentage points from two years ago–a relatively modest increase by the standards of Spain and Ireland. In addition, the crisis severely affected public finances, with the debt level reaching 86 percent, up from 66 percent two years ago.
What Explains the Stagnation?
Portugal’s export structure at the launch of the euro was too weighted towards traditional slow-growing sectors where comparative advantage was shifting towards the emerging economies in Asia. The share of production in low-tech manufacturing sectors, for example, was 80 percent in 1995 and 73 percent in 2001. There is much evidence that Portugal’s business climate was especially weak and labor markets inflexible.
These facts, together with the rapid deterioration of competitiveness clearly played a role in the early end of its Euro boom. Significant labor market tightening and rapid wage increases had characterized the boom, with wages per capita rising by about 6 percent annually from 1995 to 2002, twice as fast as the EU average. Moreover, while Portugal’s wage bill increased by about two percentage points of GDP from 1995 to 2002, Spain’s and Ireland’s each fell by more than one percent. Portugal’s government wage bill reached 15 percent of GDP in 2002, compared with an average of around 10 percent in the Euro area.
The consequence is an appreciation in the real effective exchange rate (REER) (based on unit labor cost) –about 12 percent from 1994 to 2000, while it remained more or less unchanged in Spain and Ireland. This appreciation, which favored domestic demand over exports and led to a build-up of macroeconomic imbalance, was reflected in the current account deficit’s steady deterioration and the decrease in FDI inflows. FDI inflows fell below the Euro area’s average in the second half of 1990s as the country became less attractive for investment. The country also saw a 10 percent loss in export market share from 1995 to 2000.
At the same time, labor productivity slowed, with average annual growth falling from 3.1 percent in 1995–2000 to less than 1 percent in the beginning of this millennium. Labor productivity was also well below EU average–32 percent in agriculture for example – in all sectors of the economy. The country’s relatively low human capital formation and limited use of information technology partly explain this disappointing productivity performance. At 9 percent, Portugal’s labor force participation in tertiary education is the lowest in the Euro area, compared to 18 to 22 percent in Spain, Ireland, and Greece. Similarly, Portugal’s spending on R&D as a percentage of GDP is half of the average in the Euro area. Furthermore, its governance and business climate indicators are today among the lowest in the euro area.
Policy
Portugal could have taken the opportunity presented by the boom to move into higher value-added and faster growth sectors and towards a more outward-oriented production structure. Instead, its export structure was weighted too heavily towards traditional sectors. In addition, the government missed the opportunity to build a budgetary surplus—which would not only have balanced the budget, but would have also moderated the domestic demand boom and the excessive concentration in non-tradable activities. In hindsight, a tax structure weighted towards discouraging consumption and investments in non-tradables (e.g. housing) could also have been imposed.
Against the currently bleak outlook, the government has now devised a strategy to reduce its deficit from 9.4 percent in 2010 to below 3 percent of GDP by 2013. This would help stabilize the debt/GDP ratio at around 90 percent compared to nearly 150 percent for Greece and 75 percent for Spain according to their government plans.
The plan involves privatization, raising taxes on high earners and capital gains, and cutting civil servant wages and public investment spending. The recent announcement of tough austerity measures, including a 5 percent pay cut for top government officials and a 1 percent increase in the value added tax, is encouraging. However, the growth assumptions underlying the deficit reduction projections are, however, overly optimistic. They are based on stronger growth than has been observed historically and do not take the fiscal policy’s potential deflationary effects adequately into account. In addition, Portugal’s effort to increase taxes may face difficulties, as the country has one of the highest brain drain rates in Europe.
Furthermore, while this strategy may buy some time and should help dampen wage growth and reorient the economy toward exports, it is unlikely to address the country’s low productivity and slow growth on its own. Policy needs to concentrate on boosting competitiveness, especially through increased flexibility in labor markets, and increased competition in relatively sheltered backbone services. In the longer term, improving the country’s human capital base is of paramount importance to improve productivity and would also help it regain attractiveness with foreign investors. In addition, Doing Business indicators where Portugal performs poorly– especially in starting a business, paying taxes, and getting credit–suggest that a systematic approach to correct deficiencies in its business climate is needed.
Shimelse Ali is an economist in Carnegie’s International Economics Program.
