Portugal's crisis is due to a legacy of policy failures in the face of a rapidly changing environment. Economic institutions and policies proved ill-adapted to the demands and opportunities of monetary union and globalisation.
The rapid transition from decades of financial repression and monetary instability was proving difficult. The public sector in turn financed rapidly growing spending, particularly on social protection, through higher taxes and accumulating debts. And in the face of all this, the policy response was, at best, muted. Consequently, in the first half of 2011, Portugal’s government and banks were shut out from financial markets.
In response, the Portuguese authorities have mounted an impressive policy effort to reverse gradually the accumulated imbalances and forestall crisis. A front-loaded fiscal adjustment programme is aiming at restoring credibility in government bond markets, while jump-starting external adjustment. Financial sector measures seek to keep banks well capitalised and liquid, while facilitating orderly deleveraging. And structural reforms, ranging from reforming inefficient courts to phasing out rent controls, aim to revitalise the economy’s supply side. Considerable progress has already been made. In spite of setbacks, underlying fiscal adjustment has advanced markedly; external account adjustment has also made significant strides.
Yet the near-term outlook is uncertain, and sizeable medium-term economic challenges remain. With trading partner growth slowing, the economy will likely be in recession in 2013, while unemployment will rise further from already record high levels. Beyond the short term, maintaining and anchoring fiscal discipline and deleveraging private-sector balance sheets will remain imperatives, but also generate headwinds for growth. In particular, fiscal adjustment needs to continue, although unexpectedly large revenue shortfalls are delaying the achievement of the original nominal deficit path. Fostering more competitive tradable sectors while reducing excessive mark-ups in the non-tradable sectors requires politically difficult structural reforms. Overcoming these challenges will continue to test Portugal’s so far remarkably sturdy social and political consensus.
Despite setbacks, fiscal adjustment remains broadly on track. The authorities have made good progress implementing a range of strong revenues and expenditure measures. The objectives remain to contain and gradually reduce public debt, while restoring the credibility of fiscal policy, both in terms of achieving announced targets and in terms of strengthening the budgetary framework, in line with Portugal’s EU obligations. The programme’s fiscal adjustment path remains ambitious, although with the economy’s external and internal adjustment proceeding faster than expected, the associated revenue shortfalls have necessitated a somewhat slower adjustment path than originally envisaged.
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