Is the crisis over for Portugal?

On January 23, the Portuguese Ministry of Finance successfully placed five-year bonds, something the institution had not done since 2011, when the country lost confidence in international debt markets. Following the success of this operation, politicians in the country and Eurocrats in Brussels began to praise the efforts made by Portugal to overcome the economic crisis, and once again statements like “The worst is behind us!” were made. Is that really true?

Judging by the success of the long-term public debt placement, Portugal really seems to have managed to restore market confidence. Demand for the €2.5 billion issue exceeded supply by almost five times, and foreign investors (mainly from the US and UK) accounted for 93% of all. As a result, the weighted average interest rate fell to 4.9%, extremely cheap financing for a country with a public debt of over 120% of GDP and no control over its monetary policy. Moreover, the auction was originally scheduled for September this year, when long-term bonds worth €5.8 billion matured and Portugal was supposed to test market confidence by refinancing these obligations with new long-term debt. Some experts and politicians made bold statements that with this issue, Portugal had already achieved its long-awaited return to the markets and the country had “jumped the trap”. However, looking at the real economy, things look radically different.

Portugal before the Great Recession

Portugal is often called “the poorest country in Western Europe”, and rightly so. In the years before the global economic crisis, the country recorded weak growth. Even after Portugal joined the EU (1986) and the eurozone (1999), the economy continued to grow at a lethargic pace. From 2001 to 2008, average GDP growth was 1%, which is a rather weak performance, considering the not-so-high base from which the country started at the beginning of the new millennium. At the same time, the banking system’s access to cheap monetary resources from the ECB has inflated lending and over the past decade or so, debt levels have ballooned enormously at all levels: households, businesses, the financial and public sectors. To date, the total amount of gross debt of the entire economy exceeds 800% of GDP (see Chart 1). The reasons for the weak growth before the crisis were structural: heavy regulations, low competitiveness and an ever-growing welfare state. Add to this the southern mentality, characterized by a reluctance to work, corruption and ever-growing claims to benefits from the nanny state, and you get an economy unable to deal with its imbalances without bankruptcy or financial assistance from outside.

Graphics 1

Structure of the Portuguese economy

Like many developed countries in Western Europe, the Portuguese economy is almost entirely concentrated in the service sector. The process of transition to such an economy has been particularly intensified since the country joined the EU. Low-competitive producers have gradually disappeared, and the country has replaced their production with more competitive imported products from other EU countries. This has led to a widening of the country's current account deficit, which is subsequently financed by foreign investment, but also by the accumulation of large levels of debt. This has created large external imbalances for the country, and after global financial markets froze in the second half of 2008, Portugal has started to compensate for the decline in external financing by further accumulating debt.

This additional debt accumulation led to a loss of confidence among foreign investors in the Portuguese economy's ability to repay these obligations, and the country was cut off from global debt markets in 2011. An agreement with the EU and the IMF followed to provide 78 billion euros over three years, accompanied by numerous commitments for structural reforms and a gradual reduction in the budget deficit. The latter amounted to 12.6% of GDP in 2008 and gradually began to decrease, reaching 4.6% of GDP in 2012, according to preliminary data, achieving the target of a deficit below 5% of GDP. However, these figures hide a number of accounting tricks. The budget deficit targets of the Troika (EC, ECB and IMF) in 2011 and 2012 were achieved only thanks to one-off operations, such as the nationalization of the pension funds of the banking system, reporting privatization revenues above the budget balance line, etc. The question is what will the government of the Iberian country do to meet the budget deficit target of 4.5% of GDP in 2013, given that there are no plans to implement such measures this year?

Current state of the economy

Състоянието на реалната икономика в Португалия в момента не може да се похвали с успеха на 5-годишната дългова емисия от 23 януари. Вътрешното търсене, основен двигател на растежа преди кризата, продължава да спада, поради спада в разполагаемия доход на местното население, високата задлъжнялост, ниските нива на доверие и песимистичните очаквания за бъдещето. Най-засегнат в случая бива строителният сектор, където дълги години изкуствено евтиният паричен ресурс е надувал балон. Процентът на безработица към края на 2012 година е 16.9% като очакванията са той да продължи да расте през 2013 година. Кредитната активност в страната продължава да стагнира, а нивата на необслужвани кредити, макар сравнително ниски към момента, растът стремглаво нагоре. Банковата система за момента е стабилна, но това е благодарение на рефинансиращите операции на ЕЦБ и спасяването на четири големи банки от правителството посредством фондът за предоставяне на ликвидност на банковата система в размер на 12 млрд. евро, част от спасителния пакет на стойност 78 млрд. евро.

However, it is also worth noting some positive developments in the country. Thanks to the improvement of the competitiveness of the export sector (mainly through wage reductions) and the decline in imports as a result of weak domestic demand, the external imbalance of the economy has significantly improved in recent years and the current account is even expected to register a surplus in 2013, after a small deficit of 1.5% of GDP in 2012. In accordance with the agreements with the Troika, Portugal managed to push through numerous reforms in the labor market, the real estate market, etc. Savings in the country are growing, which creates a resource for investment in better times for the economy. The country's budget deficit has been significantly reduced over the years, but expectations that Portugal will meet the Maastricht criteria of 3% of GDP in 2014 will most likely be postponed by 1 year due to the weak performance of the economy.

But even these achievements are being undermined in various ways. In terms of external imbalances, Portugal’s export growth has lost momentum since the beginning of 2012 due to the deepening crisis in the EU. And the EU accounts for over 70% of the country’s exports. In terms of savings, a large part of them is used by banks to buy up government debt. Sales of government debt by foreign investors are offset by purchases by local banks, which are currently financed solely by the ECB and resident deposits. That is, a large part of the population’s savings are directed towards unproductive investments, in the form of Portuguese public debt. As for Portugal’s budget deficit, fiscal consolidation in the country is focused on the revenue side of the budget. For example, the country’s ruling coalition adopted a 2013 budget with planned cuts of €5.3 billion. However, 80% of this fiscal consolidation is focused on the revenue side, i.e. by increasing taxes, rather than cutting spending in the already bloated welfare state.

Prospects for Portugal

The outlook for Portugal is not very rosy. The country's economy contracted by 3.2% in 2012 (according to preliminary data), while expectations for a 3% decline were high. The government predicts that the country's economy will contract by 2% in 2013, while some other institutions paint a darker picture. This automatically means that the budget gap of 4.5% of GDP will be larger, considering that this deficit was calculated on the basis of a projected decline of 1%. It is interesting how representatives of the Troika claim that Portugal is strictly implementing its economic restructuring program, when this same institution extended the deadline for the country to comply with the Maastricht criteria to 2014 and this deadline is expected to be extended by another year at the next Eurogroup meeting in March. And how do Portuguese politicians claim that the country is meeting these requirements and is on the path to recovery, after at the January Eurogroup meeting (a meeting of the finance ministers of the eurozone countries) the finance minister officially requested that the maturities of the loans provided by the EU be extended?

It is naive to think that Portugal will register any significant economic growth in the near future at these levels of debt. Even if the government starts spending less than it receives, in the process of paying off the mountain of debts, GDP is not expected to grow by more than 1-2% per year. Accordingly, I think that debt forgiveness will follow (as happened in Greece twice already), or additional financial assistance from the Troika. The second scenario was even officially supported by the rating agency Fitch at the end of January. Portugal's exit from the common currency union cannot be ruled out. If the Portuguese leaders want the economy to work again, government spending must be significantly reduced. This is a difficult and unpopular political decision, but at the moment the size of the state is stifling economic development. In addition, many more structural reforms should be made, mainly aimed at liberalizing sectors of the economy. Production in Portugal must be reoriented from services to competitive tradable goods and the EU's share must be gradually replaced by countries such as Brazil, China, Russia, etc.

Portugal’s successful “return” to the long-term debt markets on January 23 was not a consequence of economic progress in the country, but a result of the artificially positive sentiment in the markets in Europe, generated by the statement of the President of the ECB Mario Draghi that he would do everything possible to save the euro. This was followed by the announcement of a program for unlimited purchase of bonds on the secondary market by the ECB, as well as monetary easing policies by many key central banks around the world. Issuing five-year bonds will in no way improve the economic situation of Portugal. The sale of public debt will be truly successful when the economy starts working again and the markets soberly, without the intervention of institutions such as the ECB, assess the country’s achievements.

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