The challenges for Portuguese public finances
Portugal has presented a budget for 2016 that indicates political commitment to further fiscal consolidation. A revised budget is targeting a fiscal deficit of 2.2% of GDP. As background, after a delay of more than three months, brought about by the formation of a new government at the end of last year, the Portuguese government submitted its Draft Budgetary Plan to the European Commission at the end of January. Under this plan, the headline deficit target for the year was set at 2.6% of GDP, lower than the 2.8% presented in the economic programme in December; and the structural deficit target was expected to fall to 1.1% of GDP. A real GDP growth rate of 2.1% in 2016 was also assumed, which may be optimistic. However, the improvement in the structural deficit was mainly the result of the classification of some measures as one-offs in 2015 and 2016, implying that there was in fact no improvement but instead a deterioration in the structural balance.
Following talks with the European Commission, the Portuguese government adopted additional fiscal consolidation measures at the beginning of February, and agreed on the classification of one-off measures. As a result, the Commission has estimated that the fiscal effort at between 0.1% and 0.2% of GDP. While still below the recommended 0.6% of GDP, the deviation was not considered significant and the Commission decided not to request a revised budget from the Portuguese government. However, the Commission still deems the budget to be at risk of non-compliance with the Stability and Growth Pact, and thus additional measures might be needed. A reassessment of compliance with the EU fiscal rules planned for May, after Portugal’s Stability Programme and the European Commission Spring Economic Forecast are presented, will be an important benchmark.
Under the 2016 budget currently under discussion in the Portuguese parliament, the government is targeting an ambitious fiscal deficit of 2.2% of GDP. This compares to an estimated 3.0% in 2015 (excluding one-offs operations) and 3.4% in 2014. The budget measures contain the reversal of the cuts in public sector wages and the surcharge on personal income tax, as well as a restraint on public intermediate consumption expenditure. Additional measures on the revenue side include taxes on car purchases, fuel and tobacco, and higher taxes on bank contributions to the Portuguese resolution fund. Additional measures on the expenditure side include restrictions on hiring civil servants and controls on social security. However, there are some risks to the implementation of these measures. First, the reduction in expenditure could be challenging, especially in the absence of binding and clear expenditure ceilings. Second, a further improvement in the performance of state-owned enterprises is also planned, but the results are uncertain. Third, there is a risk that the governing Socialist Party, the Left Bloc and the Communists could disagree over the measures. DBRS would be concerned if fiscal slippage became persistent.
Portugal has undergone a significant fiscal effort, and this is already reflected in DBRS’s ratings at BBB (low). Between 2010 and 2015, the reduction in the structural balance amounted to 6.2 percentage points of GDP, similar to that of Ireland. However, public debt remains high. After peaking at 130.2% of GDP in 2014, general government debt is estimated to have declined to 128.7% of GDP in 2015, the third highest ratio in the Euro area. The 2016 budget envisages the government debt ratio to fall further, to 127.7% of GDP in 2016. Over the medium term, DBRS expects a gradual reduction in government debt, reflecting moderate structural fiscal adjustment and modest growth prospects. The sale of Novo Banco should contribute to the reduction of debt, but the timing of the sale remains uncertain.
An improved debt repayment profile, with extended debt maturities, partly mitigates some of the risks stemming from high debt. However, the high level of public debt leaves Portugal exposed to several shocks. Debt dynamics are particularly susceptible to a negative growth shock and a primary deficit shock. A rise in borrowing costs could also have a negative impact on the trajectory of debt-to-GDP. Although the risk from contingent liabilities has moderated following the restructuring of most state-owned enterprises since 2013 and the strengthening in banks’ capital ratios, contingent liability risks persist. With the structural adjustment expected to be moderate and given the risks of slippage, stronger growth could play a more i mportant role in the reduction of debt. However, growth prospects look modest. DBRS would be concerned if durable growth fails to materialise.
Portugal’s economic recovery has been gradual and the prospects look modest. After growing by 0.9% in 2014, real GDP is estimated to have grown by 1.5% in 2015. These outcomes were broadly in line with the Euro area average, but below growth of 1.4% and 3.2% in Spain in 2014 and 2015, respectively. Under the 2016 budget, the government revised downwards its assumption for growth to 1.8% this year. While less optimistic than under the Draft Budgetary Plan, it is still above the European Commission’s latest forecast for the Portuguese economy of 1.6% and the IMF forecast of 1.4%, which were published at the beginning of February. Growth is expected to remain supported by private consumption, while investment remains subdued and net exports are set to detract from growth.
Downside risks to the outlook include renewed uncertainty over economic policies, the political situation and the banking sector. Potential uncertainty could affect economic sentiment and lead households to increase their savings, affecting private consumption. Weaker-thanexpected external demand from the Euro area, particularly from Spain, could also pose risks to the outlook.
Lifting Portugal’s growth potential remains a major challenge for the country. Although several structural reforms have been implemented over the past five years, Portugal’s potential growth remains low. This largely reflects low levels of investment, insufficient competition in the nontradable sector and rigidities in the labour market. As a result, the continued implementation of structural reforms remains important.
To conclude, Portugal has already undergone an important fiscal effort and seems committed to further adjustment. However, fiscal slippage remains a risk. More importantly, government debt remains high and is expected to decline only gradually, leaving the country exposed to shocks. In the longer term, modest fiscal structural adjustment and the absence of durable economic growth could pose a risk to the sustained improvement in public finances.