New Delhi :An International Monetary Fund mission, led by Rupa Duttagupta, conducted discussions on the 2022 Article IV consultation with Portugal during October 21-November 4, 2021 (virtual) and May 9-13, 2022 (in-person).
The Portuguese economy gained ground in 2021 after a deep pandemic-induced recession . Reflecting the relevance of tourism, the economy was harder hit than the euro area (EA), but a decisive and comprehensive policy response, bolstered by the response at the EU level and by the ECB, helped moderate the effects of the pandemic on households and firms. A strong vaccination drive allowed for early lifting of activity restrictions and has supported the recovery through early 2022. Despite lower increases in domestic energy and electricity prices relative to the EA―reflecting policies to limit passthrough to retail prices―inflation pressures have broadened. However, wage inflation remains contained thus far and below the rest of the EA.
But the economy is now facing new risks posed by the war in Ukraine. Although direct linkages with Russia and Ukraine are limited, spillovers from the war through higher commodity prices, greater supply bottlenecks, weaker confidence, softer external demand, and tighter financial conditions will weigh on the recovery and raise prices.
Economic outlook and risks
Growth is expected to ease to about 4.5 percent in 2022 and 2 percent in 2023. This represents a cumulative downgrade of about one percentage point relative to pre-war. Growth is expected to be led by private consumption—supported by a faster normalization of household savings rate to pre-pandemic averages—NGEU-backed public investment, and exports, with tourism reaching its pre-pandemic level in 2023. Over the medium term, growth is projected to moderate to below 2 percent with output still remaining some 2 percent below its pre-pandemic trend by 2027. Inflation is projected to rise to 6 percent in 2022 and start receding in 2023 on the back of declining energy and food prices.
However, risks are tilted to the downside. The key risks stem from the exceptional uncertainty surrounding the war and potentially new virus waves. Tighter financial conditions could hurt growth and the fiscal position. The effects of the end of loan moratoria have not yet fully materialized, and could eventually expose higher insolvencies, lowering investment and bank capital. Slower use of NGEU funds pose additional risks. Moreover, despite its projected decline, public debt will remain uncomfortably high and rising real estate prices constitute an added vulnerability. On the upside, a continuation of the strong tourism recovery, further bounce-back from pent-up demand supported by the high vaccination rates, and higher payoffs from NGEU investments would brighten the outlook.
Policies will need to balance short-term urgencies and dealing with high energy prices and other impacts from the war in Ukraine with a smooth transition to private-led growth, rebuilding fiscal space and advancing reforms for a more resilient economy. In the medium term, structural reforms—including in the context of the Recovery and Resilience Plan (RRP)—sustained public investment, and fiscal consolidation within a medium-term plan will build a more dynamic and resilient economy. These efforts are critical to accomplish the long-standing priority to raise Portugal’s growth potential and accelerate income convergence to the rest of the EA.
After the much-needed fiscal support in 2020-21, the unwinding of the COVID-19 measures, while maintaining a broadly supportive fiscal policy in 2022 is appropriate. The robust recovery in employment and consumption, along with the full reopening of the economy, justify the further unwinding of the exceptional COVID-19 economic support measures in 2022. Excluding these measures―which are expected to be replaced by higher private demand—a projected fiscal deficit of 2.4 percent of GDP is appropriately accommodative. The government has recently taken measures to mitigate the impact of high energy prices. NGEU grant-financed spending provides additional support to the economy. Nonetheless, some 2 percent of GDP of the 2020–21 fiscal measures are expected to be permanent. It is important to ensure that further support is sufficiently targeted and temporary in nature. In this context, the broad-based price measures, and tax cuts in response to the energy shock should preferably be replaced with more targeted and temporary support for vulnerable households and viable firms, while preserving price signals for most users. Fiscal policy will also need to be nimble to identify further targeted contingency measures under severe downside risks while being ready to achieve more ambitious fiscal savings should the economy surprise to the upside.
Starting from 2023, a gradual fiscal adjustment will be needed to rebuild fiscal space, address ageing-related spending pressures, raise public investment, and reduce debt-related risks. Early announcements of specific fiscal reforms, supported with the effective implementation of the Budgetary Framework Law (BFL), to enhance overall medium-term focus and upgrade the budgetary process, expenditure control, and cost efficiency would bolster the credibility of these efforts. In this regard, recent amendments to the BFL to strengthen the budgetary process and improve the integration of the annual budget with the medium-term budgetary framework are welcome. The mission recommends a growth-friendly fiscal adjustment focused on:
Tax reforms aiming for greater efficiency, elimination of distortions, and broadening the tax base. There is scope for strengthening tax policy and tax expenditure analysis, streamlining and constraining proliferation of tax incentives, revisiting reduced VAT rates, and strengthening less distortionary instruments, such as property and environmental taxes.
Rationalizing current spending , through bolstering pension sustainability, strengthening financial management in the national health service, improving financial sustainability and governance in state-owned enterprises, and better targeting of social benefits. Containing the public wage bill over the medium term will require a comprehensive review of the public employment and compensation structures.
Maintaining strong growth-enhancing public investment . Over the last decade, public investment has fallen below EU peers. The NGEU funds can help reverse this trend, with scaled up investment in R&D spending, digital and climate transitions. Efficient and transparent planning and budgeting, implementation, and oversight will be key. Stronger fiscal efforts during 2023–26 will enable maintaining public investment beyond the RRP.
Corporate and financial policies
Despite strong policy support, solvency needs of the non-financial corporate (NFC) sector increased compared to pre-pandemic levels. Support measures are estimated to have saved some one-third of jobs and 20 percent of NFC output. These measures along with the indefinite suspension of the duty to file for insolvency have kept a lid on bankruptcies and closures so far. Nonetheless, pandemic-induced solvency needs are estimated to have risen by some 2¼ percent of GDP, with firms in the accommodation and food services and transport sectors most impacted. Additional vulnerabilities from the war in Ukraine, cost-push pressures, supply chain disruptions and higher interest rates could also increase insolvency risk.
An effective resolution of corporate sector challenges would enable a smooth reallocation of resources and strengthen the economy. The Resilience and Capitalization Fund, managed by the state-owned Banco Português de Fomento (BPF), is expected to support debt reduction and recapitalization of viable corporates. Prompt implementation of targeted viability-based solvency support—leveraging on banking sector technical expertise for NFC viability assessments―would offer targeted support to viable firms. The role of the BPF should be clearly defined for accountability purposes and its activities should not create market distortions. The insolvency and restructuring system need to normalize to allow market processes to work—to prepare for this, the authorities should establish and announce a short-term deadline for the suspension of the duty to file for insolvency. Non-viable enterprises should be swiftly liquidated, complemented with targeted support for the vulnerable and active labor market policies for displaced workers, so that resources are reallocated to productive uses and financial support is directed to firms that have prospects of recovery.
Additional steps to improve Portugal’s legal framework would further bolster corporate sector financial health and governance and improve efficiency and productivity . Measures that could be considered include simplifying and strengthening the effectiveness of Portuguese restructuring and insolvency law, establishing clear guidelines for the participation of public creditors (tax, social security, and other public administrations) in all procedures; and streamlining liquidation procedures by addressing the remaining bottlenecks in the verification of claims and the sale of assets. The recent implementation of the EU Restructuring Directive is welcome. A broader reform that rationalizes the insolvency regime should also be considered. Continuing to build on recent efforts to strengthen insolvency statistics would enable better analysis of the effectiveness and efficiency of current insolvency systems.
Close monitoring of banks’ credit quality remains essential. The impact of the end of moratoria and new risks, including from the housing market, on credit quality are likely to remain sources of uncertainty for some time. Prudential authorities are actively monitoring banks’ credit quality and confirm that the materialization of credit risk, until now, was not as significant as expected in the beginning of the pandemic. Strategies to reduce NPLs are bearing fruit, yet a few banks have not yet completed their adjustment processes. Ongoing efforts for timely identification and reporting of credit risk and adequate loan classification and provisioning to preserve financial stability need to continue. Risks from rising real estate prices, while still well-contained, should also be closely monitored. Once the recovery is well established, the Banco de Portugal could consider introducing a positive rated countercyclical capital buffer or a sectoral systemic risk buffer against potential macro-financial risks from banks’ real-estate exposures. Rebuilding of capital buffers need to proceed gradually and dividend distributions and share buybacks should be cautious until the uncertainties on capital needs, also in light of new economic shocks, are better assessed.
Portugal’s Recovery and Resilience Plan provides a unique opportunity to transform the economy and make it more resilient, dynamic, and green. In this context, advancing structural reforms to raise skill levels and increase competitiveness, along with sustained fiscal consolidation and resolution of corporate sector strains would be key to maintaining stronger saving and investment rates over the medium term, without generating external imbalances.
Addressing the skill gap and reducing labor market duality would unlock long-standing obstacles to stronger growth . The RRP includes targets and reforms to improve the quality of education and training, provide opportunities for lifelong learning for low-skilled adults, reduce digital skill gaps and raise employability. In addition, there is a need for addressing labor duality due to differences in job security and conditions of workers under permanent and temporary contracts. Active labor market policies, also planned in the RRP and the 2022 Budget, combined with higher flexibility of permanent contracts and improved protection of workers under temporary contracts would help reduce the differences between contracts.
Building on recent successes, more policy effort will be needed to meet Portugal’s ambitious climate targets. With a carbon tax introduced in 2015 and the last coal-fired power plant phased out in 2021, Portugal’s share of electricity from renewables is among the highest in the EU. The authorities also plan to invest 3 percent of GDP by 2030 to support climate-related research and innovation. Nonetheless, achieving the RRP milestones for sustainable mobility, energy efficiency, renewables, decarbonization and the bioeconomy will require accelerated implementation of the Roadmap for Carbon Neutrality 2050 and the National Energy and Climate Plan. Specifically, swift implementation of measures aimed at promoting the use of biofuels and hydrogen in the transport sector, accelerated renovation of buildings are critical. In addition, the authorities may need to consider further adjustment of the carbon price, combined with measures to offset the impact on the most vulnerable households. Also, given the country’s exposure to extreme weather events, raising investment in risk prevention and preparedness and climate adaptation will likely be needed.
The mission would like to thank its interlocutors in Portugal—the government agencies, Banco de Portugal, the private sector, and civil society–and the European Central Bank for generously sharing their time and knowledge.