Good progress so far in adjusting economic imbalances in Portugal

In the June 2011 early parliamentary elections, the centre-right parties PSD [liberals] and CDS-PP [conservatives] achieved an absolute parliamentary majority. The elections were precipitated as former Prime Minister from the Socialist party resigned in March 2011, after proposed further austerity measures were voted down in parliament. As the coalition holds a solid majority it is expected to remain in power for most of the legislative period until 2015. Violent mass protests against austerity measures, of the kind seen in Greece, are not expected in Portugal and so far any demonstrations have been peaceful.

According to Statistics Portugal [INE], real GDP decreased 1.6% year-on-year in 2011. However, this was 0.6% better than envisaged in May 2011 when the EU/IMF bailout package was agreed. This package contains financial assistance worth EUR 78 billion, guaranteeing the countrys financing needs provided that Portugal abides by its conditions.

Although GDP growth stood at 0.9% in the first half of 2011, the second half of the year saw a steep decrease, intensifying in Q4 when all components recorded an acute decline. This was due mainly to restrictive fiscal policies, austerity measures, tighter credit conditions and weaker foreign demand. Real consumer spending decreased 3.9% year-on-year in 2011 - in Q4 by as much as 6.5% - because of higher unemployment [14% in Q4], limited access to consumer credit and a special 50% tax on Christmas bonus payments. Government consumption also fell steeply in the last quarter of 2011 [down 5.7%], registering an overall 3.9% decline for the year. Investments fell by a massive 11.4% in the same period.

While imports decreased 5.5% on the back of lower domestic demand, exports rose by 7.4% in 2011, contributing positively to GDP. The current account deficit is shrinking at a healthy pace, expected to have reached 8.4% at end of 2011, slightly better than the originally projected 8.6%.

Inflation is currently higher than the EU average, reaching 3.7% in 2011 as a result of a VAT increase and higher commodity prices. These effects have continued into 2012 [with 3.0-3.2% inflation forecast], but will fade during the course of the year, with the result that inflation will decrease to 1.6% or even lower in 2013.

Fiscal deficit pressures remain

After a fiscal deficit representing 9.8% of GDP in 2010, the target of 5.9% for 2011 turned out to be ambitious and could be met only by the partial transfer of banks pension funds, valued at 1.6% of GDP, to the state social security system. The 2011 deficit target was under pressure as the 2010 deficit was revised upward by 0.7% of GDP, while domestic arrears [i.e. outstanding amounts payable to the government] have continued to increase - to 3.2% of GDP despite hopes that they would stabilise.

However, progress was made with fiscal structural reforms of revenue administration and public finance management. For 2012, the target is a deficit of 4.5% of GDP, which the IMF expects to be met provided that the Eurozone crisis does not escalate further. The current forecast is that the debt to GDP ratio will peak in 2013 at 118%, after which  it will gradually diminish.

Although the terms of the Portuguese bailout agreement were negotiated by the previous government, the centre-right coalition is keeping to its terms. Both parties endorse the programme, which aims to control Portugals public finances and reach a sustainable public deficit reduction. The government is also putting measures in place designed to promote the countrys productivity and tackle its structural inefficiencies.

Several of the austerity measures demanded in the EU/IMF bailout plan were swiftly put in place, as the government understood that prompt action was needed if the programme was to be effective and reach the targets agreed with the EU and the IMF. Among these initial measures were the raise of VAT on some products and services, the cutting of 2012 and 2013 Christmas and vacation bonuses for the public sector, suspension of four public holidays, and several cuts in welfare and fiscal benefits. Government spending and investment were also put under tight control through cuts and suspended works that will probably persist for the duration of the programme: until mid 2013.

Along with these austerity measures, the following structural reforms have been, or will be, implemented:

Labour market reforms: workers redundancy payments currently among the highest in the Organisation for Economic Cooperation and Development countries [OECD] - have been reduced: especially for workers with service beyond five years. In addition, collective bargaining agreements have not been automatically extended to whole sectors. Moreover, no increase in the minimum wage is planned for 2012 for the minimum wages, implying real wage decreases.

Competitive framework strengthened: a new competition law has come into force, aimed at promoting efficiency, innovation and lower mark-ups, particularly in non-tradable sectors. In addition, the telecoms sector is undergoing many ambitious reforms, such as encouraging new entrants and increasing market transparency, while the regulatory legislation goes beyond the minimum EU requirements.

Enforced privatisation process: EDP and REN - two large companies operating in the energy market - have already been privatised, with the states shares sold to the Chinese companies China Three Gorges and State Grid respectively. In these cases, the sales were considered successful and transparent, allowing the government to obtain more than two thirds of the expected income from the privatisation. Also set to be privatised in the near future are TAP [Portugals flight operator], ANA [airport administration], Águas de Portugal [water utilities], RTP [public television services] and parts of CGD [national bank].

Reform of the judicial system: designed to increase the efficiency, speed and reliability of court administration.

Bond spreads remain high

As the Eurozone crisis intensified in the autumn of 2011, Portuguese bond spreads were badly affected, with the market pushing yields above the 10% benchmark to peak at more than 15% in early 2012. Following the European Central Banks [ECB] intervention market sentiment had calmed down. However, current spreads remain above 10%, as markets still fear a potentially Greece-like bail-out for Portugal. Portugal still lags far behind an Irish-style recovery of bond spreads, and access to the financial markets is unlikely in the foreseeable future.

Prospects: still a long and rocky road ahead

The Portuguese government is demonstrating a firm commitment to the austerity measures and reforms demanded by the EU and IMF and is so far on track: as confirmed by the IMF, following its third Review Mission on February 28. Various public official statements issued by senior representatives of the IMF, ECB and EU have praised Portugals efforts and show confidence in the positive medium-term effects of the measures being applied.

However, as in the second half of 2011, these austerity measures will continue to take their toll in 2012: after last years 1.6% decrease, the economy is set to decline further in 2012 - by 3.25% -according to the latest IMF forecast. The severe fiscal consolidation needed to achieve a reduction in the government deficit to 4.5% of GDP, coupled with weak domestic demand, will eat into all domestic GDP components. Government consumption will decline 2.8% year-on-year, while private consumption is expected to decrease by between 6% [Bank of Portugal forecast] and 7% [IHS Global Insight forecast]. Unemployment will remain worryingly high in 2012, after its increase to 14% in the last quarter of 2011: a rise that had not been anticipated. Youth unemployment stands at 30% and long-term unemployment at 44%: both matters of concern.

After the steep decrease in investments in 2011, tighter constraints on investment credits remain one of the main concerns of the Portuguese government and the EU/IMF, since the bailout programmes success will be determined largely by the economys capacity to achieve sustainable growth and competitiveness. But persistent uncertainty about the economic outlook, reflected in deteriorating business confidence, will continue to affect investment decisions in 2012. Therefore, real fixed investments will reduce further [13.8% year-on-year].

The current account deficit will decrease even more

Exports alone will provide a boost to the economy. Falling exports in Q4 of 2011 triggered fears of an end to their growth potential. However, those fears were allayed by recent INE data showing that in January 2012 exports returned to a robust year-on-year growth of 13.1% and 9.4% on the previous month. Still, the decelerating growth and negative outlook of many of Portugals main trade partners is bound to take its toll on Portuguese exports, leading to an expected lower growth rate in this component of GDP in 2012. The current account deficit will decrease further in 2012 - to 6.4% of GDP - with further improvements in subsequent years.

Banking system needs bolstering

As the ECB still provides a liquidity lifeline to Portuguese banks, capital ratios will have to improve more than originally envisaged and liquidity provision will have to be increased. Meanwhile, loan provision will remain tightened. To bolster bank recapitalisation, EUR 12 billion has been made available under the EU/IMF programme.

Insolvencies to increase further in 2012

As a result of the continuing decrease in consumption, investment, and employment conditions for many businesses will remain tight and access to bank loans will remain problematic. Those sectors particularly exposed to the downturn are construction, timber and furniture, fixtures and fittings and iron and steel. Petrol stations and transport companies are currently suffering from higher oil prices. After their 17.1% year-on-year increase in 2011, we expect business insolvencies to rise again this year: by 5%, to about 6,300 cases.

The expected default frequency [EDF] for listed companies in Portugal is currently among the highest in the Eurozone, and has shown a sharply increasing trend since mid-2011. The EDF stands at very high levels compared to the previous five years, meaning that listed companies in Portugal are facing a significantly high default risk.