The recent decision by the Portuguese constitutional court to unwind public sector salary cuts included by the government in its austerity measures has once more given rise to speculation the country may not meet its 4.5% deficit target for 2012. The court - which ruled the non-payment of the two traditional Christmas and Summer salary payments for the years 2012 through 2014 was unconstitutional - took the view that since the measure did not also apply to the private sector, it was discriminatory. Whatever view we may take on how the Portuguese Constitution defines "discrimination" the important detail to note is that the decision will not apply to 2012, and will hence only have the impact of forcing the government to find additional adjustments for 2013 and 2014, or at least a new formulation which allows them to constitutionally cut public sector pay.
Nonetheless, despite the fact it will not affect this year's fiscal effort, the coincidence of the timing of the court decision with the appearance of a report from the parliamentary commission responsible for monitoring the execution of this years budget only served to heighten nervousness about the possibility that, with unemployment rising more sharply than anticipated and the economic recession still accelerating, this year's deficit numbers may not add up as planned.
The country is facing a deep ongoing recession with a contraction of the order of 3.5% expected this year, and the outlook for the second half of the year is now shaping up as though it may well be tougher than the first half. In addition, with the European sovereign debt crisis threatening to cast its long shadow right across next year, it looks increasingly unlikely that the country will be able to go back to the bond markets in September 2013 as planned. So September may well be a good month to make some needed revisions to the existing IMF program.
All in all, Portugal may be in the invidious position of finding that while it complies with most of its immediate program objectives, the road to sustainable debt and growth levels is fraught - as the IMF itself notes in its April program review - with almost insurmountable difficulty. This post, which is a revised and expanded version of a presentation I recently gave in Brussels, will examine the challenges - both demographic and economic - the country faces in the longer term. You can find the original presentation on Slide Share.
(Click on any graphics below to enlarge)
So Here's The Problem
Over the past ten years, the Portuguese economy has been virtually stationary. Notably, the problem is not simply a euro one, since the decline started in the mid 1990s, and has never been reversed. Here's another way of looking at the same issue. Portuguese GDP rose rapidly in the 1990s, and then much more slowly in the first decade of the 21st century.
So now we know that the issue is not hard to define, the only difficulty facing policy makers is finding the way to do something about it. Under standard economic theory, once a country falls into recession, the "hidden hand" adjustment mechanisms will, one day sooner or one day later, serve to drag the country back out of it again (unless, naturally, the economy is caught in one of those darned liquidity traps). But for the countries inside the euro, the normal automatic adjustment mechanisms aren't operative, since one of the links in the chain - the devaluation one - has been (intentionally) broken. So as we can see, countries can get "stuck", and aspects of the situation can become self perpetuating; and this is the danger that Portugal faces.
Ageing Society With Growing Debt
Portugal's problem is as much about debt as it is about growth. During the euro years, the levels of both the public and the private sector debt grew substantially - which means it has the worst of all worlds.
In addition, the country had private sector debt (including securities as well as bank lending) to the tune of 249% of GDP at the end of 2011, according to Eurostat data. Add this to the 106% of gross government debt and you get a total debt to GDP ratio of around 355%. Without growth, this is clearly not sustainable. In fact, what is incredible is how the country was able to accumulate so much debt without the accompanying economic growth. The bang per buck was, frankly, terrible.
And it isn't just any old debt. A lot of it has been financed through the European interbank market, meaning a massive external debt has been run up and used to finance all those imports and current account deficits. Portugal's net international investment position showed a debt of over 100% of GDP at the end of 2011.
Now of course the moment of truth has come, and it is time to start paying it all back. Which means that living standards which were being maintained by borrowing to buy imports will fall since the borrowing stops, but they will also fall due to the need to now pay the borrowed sums steadily back.
So, far from euro membership being an unmitigated success for Portugal, the country has seen a serious lack of growth in living standards and even a loss of relative position in the "euro league". If we look at the graph below, which shows per capita GDP in both Portugal and Slovenia as a percentage of the EU average, we can see that while living standards in Slovenia rose steadily during the first decade of this century, in Portugal they were more or less stationary (in relative terms). Yet as we know, Portugal is a comparatively poor country in EU terms, and should have benefited much, much more. Now Portugal's relative position is even likely to fall.
The thing I often say about the monetary union is that it is a structure which offered every facility to a country which wants to get into trouble (cheap borrowing, enhanced credit rating, very low sovereign debt spreads) but which makes it much more difficult to correct the problems once they have built up. Portugal's tragedy is that it got into trouble just before it joined, and the euro only added to the country's problems rather than offering a framework which made it possible to sort them out. How ironic that the one country unable to advance unaided from the reform and growth program (that became know as the Lisbon Agenda) should be Portugal. The real "Lisbon" agenda was evidently something else entirely.
Some Unique Portuguese Features
The curious thing about Portugal is how its trajectory towards first full EU and later EMU membership shows more resemblance to the path which was later trod by a number of East European societies than it does to that of its South European peers.
In what was to be a harbinger of events elsewhere a decade or so later, the country systematically lost population during the EU "coupling" years, as workers left in droves in search of higher wages elsewhere. The phenomenon has left a lasting scar on both the economy and the society. Little surprise that the country, which was once a prototypical "emigration society" should so rapidly have become one again under the impact of the current crisis.
Naturally Portugal, like all European societies, is aging quite rapidly, a process which won't be helped any by the significant numbers of young people who are now leaving.
And the main reason for this societal aging process is, of course, long-term, very low fertility. I've said it before, and I'll say it again, it makes absolutely no economic sense for a society with long-term fertility levels well below replacement rates to become a net exporter of labor. In the long run, the economy of such a country cannot be sustainable, and I'm surprised the IMF hasn't noticed this yet.
Under The Tutelage of the Troika
Portugal was the third euro area country to succumb to the pressures of the financial markets, and bolt for safe harbour in the form of an EU/IMF rescue program. As a result, the country has now received an initial 78 billion euro ($95.6 billion) bailout in return for which it is implementing a strict deficit correction program. Even if one might want to quibble about some of the details, the country has implemented most of what was asked of it.
And as a result, the Troika has consistently given Portugal what can only be called "glowing reports" - which compared to the ones Greece receives they certainly are.
And along with the deficit, even the bond yields are coming down. Yields hit a spike back in February as markets worried about the second Greek bailout, with its debt restructuring component, and asked themselves the question - will Portugal be next?
So Where Are The Problems?
Well, so much for the good news. Despite the high level of program performance, the country still faces severe "challenges" since implementing reforms and austerity is one thing and achieving growth and reducing debt quite another. Not unsurprisingly, the economy is now in deep recession. The IMF expects the economy to contract by 3.3% in 2012, and return to timid growth in 2013 (0.3%). But as the IMF itself recognizes, there are strong downside risks to the 2013 forecast, and it is not improbable the economy will once more contract.
Equally worryingly, unemployment has now started rising sharply, raising questions about a "Greek turn" in events. Apart from the social distress caused, this surge in unemployment is having two consequences. The original deficit targets will not now be met, even with this year's public sector pay cut, and the young and educated are leaving the national ship in increasing numbers.
As the IMF says in its April program review the country is conducting a large macro economic adjustment with only a "constrained toolbox" available (a euphemism I presume for the inability to devalue).
The IMF report was, incidentally, quite frank and realistic about the problems the country faces, unusually so, and far more explicit about the issues than the Romanian one I reviewed last week.
On the one hand the IMF states:
Competitive indicators are showing some signs of improvement, with wages declining in some sectors and a sizable improvement in the current account deficit in 2011
Despite this progress,formidable challenges remain…the simultaneous pursuit of fiscal austerity, structural reforms, and the deleveraging of the economy-objectives that can work at cross purposes-increases the risk that the program's objective of rapidly reducing macroeconomic imbalances remains out of reach in the near-term.
What macroeconomic model are we talking about here? Well, in the first place, despite the above-mentioned improvements, the country still runs a goods trade deficit.
And while the current account deficit has been substantially reduced, the IMF is still forecasting a 4% of GDP deficit for 2012. More tellingly, the IMF sees the country as being unable to reduce the deficit below 3% of GDP before 2018. To really start to get sustainable export-driven growth and ongoing debt reduction (what the IMF call "external stability") we will need to see the current account move into surplus, and stay there. So are we facing a case of the low hanging fruit now having been picked? In any event, and taking the IMF warnings to heart, it doesn't seem unrealistic to suppose that Portugal will need some sort of support for its correction throughout the rest of this decade. That is what having a "constrained toolbox" means.
Portugal's post 2009 export recovery has been strong.
But as with most other economies on the periphery, the slowdown in European and Emerging Market growth is making this improvement in export performance hard to sustain. Indeed the rate of export growth has been slowing, and has now fallen into negative territory on an inter-annual basis.
Obviously Portuguese exports will pick up again once global growth starts to recover, but by just how much can they pick-up without a much larger change in relative prices? As part of its third program review, the IMF carried out a competitiveness study as a result of which the Fund estimated the competitiveness gap at some "13%-14% as of 2010″, noting in passing that "the gap has to date only narrowed marginally (by about 1 percentage points)".
Using an external stability approach, one which focuses on reducing the net International Investment Position - IIP) the IMF also found that "to halve Portugal's highly negative IIP (to about -52% of GDP), a real exchange rate depreciation of about 13% would be needed".
Both ways of looking at the issue seem to give a similar result - that around a 13% improvement in competitiveness is needed - and given that the IMF also found that "since peaking in 2009, the adjustment in unit labor costs has been fairly limited. In particular, as of Q3 2011, ULC-based real effective exchange rates are only 2%-3% below their 2009 peaks" it is clear there is still a very, very long way to go.
Banking and Financial Sector
Portugal's banks continue to be dependent on the ECB for liquidity. Borrowing hit a new record of 60.5 billion euros ($74.11 billion) in June, up 3% from May.
At the same time, the flow of credit to the private sector remains constrained. Bank lending to the private sector was down about 4.5% from a year earlier in May, according to Bank of Portugal data.
Also, bad loans are rising, especially in the construction sector. Bad debt owed by Portuguese households and companies rose a further 8% in April to reach almost €14 billion, according to Bank of Portugal data. This was an increase of €2 billion since the start of the year.
The majority of this, around €9 billion, is corporate debt, but there has surely been a good deal of "evergreening" going on, and the total exposure of Portuguese banks to souring loans - in particular builder and developer ones - is undoubtedly much larger.
Construction Slump Threatens Bank Balance Sheets and Employment
Portugal did not have a housing boom like Spain or Ireland. Nonetheless, with a strong tourist industry, construction has played an important role in the economy in recent years, a constitution of something like 18% of total GDP in turnover terms. According to Manuel Reis Campos, head of the Portuguese Construction and Real Estate Confederation, the sector, which is the country's largest employer, faces rampant unemployment and bankruptcies that threaten the repayment of 38 billion euros ($46.5 billion) in debt to the banking sector as the credit crunch and austerity bite.
"The (construction) sector owes 38 billion euros to the banks, bad loans have gone up sharply, much more than expected, along with bankruptcies. We expect 13,000 companies to go bust this year and the sector to lose 140,000 jobs," Reis told foreign correspondents at a briefing. "The sector has no work, the banks don't finance us and the state does not pay. It is a disaster," Reis said.
Reis predicts the country will follow Greece and Spain into the 20% plus unemployment bracket by the end of this year if things don't change. Government forecasts have unemployment rising to 15.5% this year from last year's 14% and to 16% in 2013. Unemployment was at a seasonally adjusted 15.2% in May, according to the latest Eurostat data. Construction and real estate employed 670,000 workers in Portugal in 2011, compared with 830,000 in 2008.
According to the Royal Institute of Chartered Surveyors' European Housing Review 2012, Portugal has seen a drop of 71% in annual housing starts since the initiation of the crisis.
As they say, this puts the country just behind Spain, Ireland and Greece in the construction slump league.
House price increases were modest, as have been the more recent declines:
But the slump in construction activity has been dramatic.
Conclusions - What Happens Next?
The First Consequence - A Second Bailout Looks Very Likely
Portugal is scheduled to return to the bond markets next year. Given the outlook for the sovereign debt crisis, this seems unlikely to be possible. In addition, January's Standard and Poor's decision to downgrade the country (from BBB- to BB), means that its debt is now rated sub-investment grade (aka "junk" status) by all three main credit rating agencies. In practical terms, the downgrade led to a reduction in the country's potential investor base, since many investment and money market funds are now unable to hold Portuguese debt, while resident financial institutions can't possibly assume responsibility alone.
On the other hand, markets have pulled back from their aggressive stance of earlier this year and bond yields have fallen substantially. One conclusion which could reasonably be drawn here is that they are now not pricing in Private Sector Involvement (PSI) in any kind of debt restructuring in any forthcoming program revision, during the foreseeable future. And this seems perfectly realistic since Portuguese PSI is most unlikely at this point. What is more probable is a restructuring of the size and term (and possibly interest cost) of the current official sector loans, together with some relaxation in deficit targets, in tune with the EU's new "modified austerity" stance.
Estimates of the size of the second bailout vary. More than likely we are talking about something in the region of 50 billion euros ($61.25 billion): 24.2 billion euros for financing in 2013/14, plus another 26.9 billion euros for 2015. And then something to allow for the worsening economic scenario and the relaxed deficit conditions.
But whatever happens in September, in the longer run, the future of Portuguese debt looks very precarious. It is delicately balanced on a knife edge, and could easily veer sharply upwards under an unfavourable scenario. So PSI in the longer term is far from ruled out.
As the IMF says in its third program review,
if growth disappoints, interest rates are higher, or the fiscal effort less than envisaged under the program, the debt dynamics would be less forgiving-leading to a debt-GDP ratio that would remain well above 100% for the foreseeable future. And the adverse combination of low growth, higher interest rate and a lower primary balance would place debt on an unsustainable trajectory.
They also stress the danger that private sector debt may need - Spanish style - to be bailed out:
The scenarios also show that there would be little scope to accommodate the migration of private sector liabilities to the public sector balance sheet.
Think of Mr Campos mentioned above, of Portuguese builders and developers, and of what may be happening to bank balance sheets even as I write.
Or think of the significant number of effectively state-owned enterprises (SOE's) that are still officially classified as private sector. According to IMF estimates, explicit guarantees to SOEs (including those outside general government accounts) represented between 10% and 15% of GDP in mid-2011.
According to the Troika's central case scenario, Portuguese debt will increase from 107.2% of GDP in 2011 to 116.3 % of GDP in 2012 and peak at 118.1% in 2013. Debt sustainability is expected to be confirmed from 2014, when the debt-to GDP ratio is expected to decline to 115.8%. The Troika assumes that Portuguese GDP falls by 3.0% in 2012 followed by a mild recovery (0.7%) in 2013 and a pick-up in growth to 2.4% in 2014. Thereafter, the Troika assumes real GDP growth of 2.0% per year and nominal GDP growth of 4%. As the Troika expects that Portugal will return to market funding in 2013, it estimates the average interest rate for new debt of around 4.8% for the period up to and including 2015.
Back in February, a team of Citi researchers lead by Jürgen Michels examined a number of scenarios for GDP growth spanning the 2012-16 period around the Troika's baseline (see chart above). To give an idea of just how sensitive the Portuguese debt path is to the economic growth parameter. They found that in the event of GDP growth undershooting the baseline forecast by between 1 percentage point and 3 percentage points, the debt-to-GDP ratio would be on an unsustainable path, rising to 134% and 202% of GDP, respectively,by 2020.
Naturally, having higher than expected interest costs, or significant debt transfer from the private sector would have similar negative effects.
In Addition, Young Educated People Are Increasingly Leaving
According to Peter Wise, writing in the Financial Times, "Portugal's prime minister has been free with his advice to the legions of young and unemployed in his country. They should "show more effort" and "leave their comfort zone" by looking for work abroad. Teachers unable to find a job at home should think about emigrating to Angola or Brazil".
The background to this controversy is, as Peter points out, the sudden emergence of Portugal as an origin country for emigration.
In the decade after Portugal met the criteria to join the euro in 1999, emigration, which had served as an economic "escape valve" for 200 years, virtually came to a standstill. For the first time in its history, Portugal was a net importer of migrants. But with an estimated 120,000-150,000 people leaving a country of 10m last year, emigration has now surged back to the peak levels of the 1960s and 1970s, when waves of impoverished workers departed for northern Europe and the Americas.
And as he emphasizes, the difference between this and earlier population outflows is that, unlike the largely uneducated workforce that left in previous hemorrhages, many of today's migrants are young graduates with university degrees.
The net loss of human capital is evident. The impact on population aging is less so, but soon becomes clear when you think about what happens to the population pyramid. But what about economic growth, what does this do to the long-term growth rate? Isn't a country with long-term below replacement fertility effectively committing suicide if it exports its working age population?
Economic growth attracts migrants as the labor market expands, this increases the working age population and with it the long-term growth rate. On the other hand, a country which has a lasting economic contraction can lose population as unemployment rises (this is what is happening now along Europe's periphery), with the loss of population, the potential growth rate falls, and with it future employment. If you aren't careful, this encourages more people to leave, and the situation becomes circular (arguably this has already happened in Latvia) with low growth/recession feeding on itself. If the median age of the people leaving is lower than the median age of the workforce, or if the educational level of those leaving is above the average of the workforce, then the quality of your labor force, and with it potential productivity, falls. At the same time, the debt problem becomes greater, since there are less people left to share the debt.
It gets worse, because less young people means less household formation (think of those builders with their empty houses), less new families, less children, and more health and pension unsustainability in the long-term. All of this is so obvious that the only thing which surprises me is that I have found NO EVALUATION WHATEVER of this phenomenon in any of the Troika literature.
Some will say that these movements are good, since what Europe needs is more labor market flexibility. To which I would say yep, you are right, the only difficulty is we still have nation states who are expected to be self sustaining, so pension contributions are paid in one place, while the old people waiting to receive are in another. Naturally, if Europe was like the United States, none of this would be a problem - but it isn't!