Portugal’s crisis due to legacy of policy failures: IMF
IMF says 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 globalization. The rapid transition from decades of financial repression and monetary instability was proving difficult. Monetary union, instead of delivering on the promise of sustainable catch-up growth to EU living standards, facilitated the accumulation of economic and financial imbalances. The competitiveness of the tradable sector eroded. Abetted by a banking system prone to allocating too much credit to poor risks, leverage in the non-tradable sector increased marked- ly, notwithstanding weak productivity growth. 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 gradually reverse the accumulated imbalances and forestall crisis. A front-loaded fiscal adjustment program is aiming at restoring credibility in government bond markets, while jump-starting external adjustment. Financial sector measures seek to keep banks well capitalized and liquid, while facilitating orderly deleveraging. And structural reforms, ranging from reforming inefficient courts to phasing out rent controls, aim to revitalize 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 sizable 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.
Success of the program will also depends on whether European policymakers forge ahead with reforms to overcome euro area fissures. While implementation of the adjustment program remains the key for mending Portugal’s own deep-seated economic problems, these domestic efforts will need to be complemented by reforms of euro area arrangements to clear a path not only toward a durable return to market financing for Portugal but also to avoid a repeat of the build-up of unsustainable imbalances in the future. The public commitment by European leaders to provide adequate support to Portugal until market access is restored, provided the program is on track, provides a valuable safety net. To overcome credit market segmentation and restore an appropriate monetary policy transmission, it would also be important to further clarify the eligibility criteria for the ECB’s Outright Monetary Transactions as the country starts regaining bond market access.
Given the still significant fiscal adjustment ahead, public debate is needed on how to share the burden of remaining fiscal adjustment fairly and in a growthfriendly manner.