Carlos da Silva Costa: Portugal's situation in the post-Troika period
Address by Mr Carlos da Silva Costa, Governor of the Bank of Portugal, at the "Portugal
post-Troika" economists meeting, Lisbon, 5 July 2013.
* * *
Thank you, Mr. President.
In my speech, I would like to address Portugal's situation in the post-Troika period, starting
with an assessment of how we got there, i.e. "the day before". Indeed, the situation on the
day before the conclusion of the Economic and Financial Assistance Programme is as
important as the day after, given that it conditions subsequent developments.
I. The day before the conclusion of the Adjustment Programme
Taking into account the currently available economic projections, and using traffic lights as
reference, we reach the time of transition with our external account indicators exhibiting a
"green" light, economic activity indicators and a number of fiscal indicators a "yellow" one and
unemployment and public debt a "red" one (Table 1).
Table 1
Macroeconomic outlook at the conclusion of the Economic and
Financial Assistance Programme
Significant adjustment in external accounts (green)
The external rebalancing of the Portuguese economy is remarkable, having been quicker
and stronger than in the two previous programmes, when the foreign exchange rate was
used as an adjustment instrument. The current and capital account and the goods and
services account - which in 2012 recorded positive figures for the first time in decades -
should remain in surplus. This adjustment reflects both the impact of contracting domestic
demand on imports and the increase in the market share of Portuguese exports. In fact, in a
particularly adverse international environment, Portuguese firms made remarkable efforts to
enhance the penetration and diversification of export markets.
Muted recovery in economic activity and continuation of the process of fiscal deficit
reduction (yellow)
However, the dynamics of exports was not sufficient to sustain economic activity expansion.
In fact, economic activity contracted more than initially projected and the current outlook
points to a muted recovery in 2014.
Fiscal adjustment, albeit lower than initially projected, is very substantial. The primary fiscal
balance, which excludes interest expenditure, improved substantially. The adjustment is also
very significant if we look to developments in the structural balance of public finances.
However, the fiscal consolidation process was slower than expected and its sustainability
must be ensured through public expenditure-cutting measures.
Unemployment and public debt are very high and still growing (red)
The level of unemployment is clearly a cause for concern, namely given that it largely reflects
structural unemployment. This situation calls for the implementation of a safety network that
safeguards social cohesion, allows for the re-training of long-term unemployed and prevents
them from falling into inactivity.
Public debt reached very high levels and is still growing. It is imperative that its developments
ensure a sustainable path. This constitutes the main constraint on economic policy in the
future.
I would here like to draw attention to one point which is of fundamental importance to me and
deserves thorough consideration. As pointed out in Mr. Marco Buti's speech, our adjustment
programme was strictly implemented. This notwithstanding, a perception of failure arose
among the Portuguese population and social and political players, namely the perception that
we have failed to meet the programme targets. This perception is incorrect. Therefore, in my
opinion, it is not only necessary, but important to debunk this idea, stressing that:

first, international economic developments were much more adverse than previously
expected, which had very negative consequences for exports, investment, economic
activity and, consequently, fiscal revenues and expenditure and public debt. As
such, and by way of illustration, if external demand had evolved in line with what had
been initially projected in the Programme, the effort of budgetary adjustment made
to date would imply that the government debt ratio would already be on a downward
path (the dashed line in Figure 1 below).

second, the Programme's projections relied on fiscal multipliers that were ultimately
below those estimated ex post. Increased uncertainty among economic agents that
resulted from the continued weakness of the external environment of the
Portuguese economy and, in particular, the simultaneous fiscal consolidation
process under way in those external economies, led economic agents to predict a
higher fall in permanent income. As a consequence, the impact of fiscal
consolidation measures on GDP - the multipliers - was underestimated.
Public debt as a percentage of GDP
Source: Banco de Portugal.
The combination of these two adverse factors with the establishment of the Programme's
targets as a percentage of GDP has made it necessary to revise those targets, on pain of
triggering and feeding a vicious circle between fiscal consolidation and economic activity
developments. This warrants some rethinking of the adjustment programmes' target set-up
so as to prevent the return effect of GDP developments on compliance with the budgetary
targets - through tax revenues and social spending - and debt targets - through tax
revenues, social spending and the "denominator effect". My message, to Mr. Buti in
particular, is: the fiscal targets of future programmes should not be set as a percentage of
GDP, but in the form of limits to nominal public expenditure given that these targets can be
controlled by fiscal policymakers and, as such, allow for an actual assessment of the results
achieved and the consequent accountability for failures.
Still on the subject of the day before the post-Troika period, it is important to take into
account the degree of financial market access by the sovereign issuer. If market access is
not restored in a credible and sustained manner over time, upon the Programme's
conclusion, a very painful process will begin. For this reason, the issuance of five and
ten-year Portuguese Treasury bonds, in January and May respectively, are key milestones.
They were crucial so as to gauge the market's "temperature" and to set up the progressive
credibility enhancing of the Portuguese government debt. It should be recalled that, even
after we balance public accounts, we will continue to depend on financial markets, given the
substantial need to pay off existing public debt (Figures 2 and 3). This means that we will still
need financial markets to be willing to refinance our debt. To this end, investors must feel
comfortable with the public debt level, its development path and the consistency and
credibility of the fiscal process. To sum up, creditors must feel that: our debt is sustainable,
our fiscal policy accommodates the respective servicing, its reduction is consistent in the
medium run and political players ensure compliance with the resulting liabilities. Given the
state of our public finances, the leverage available to us is restricted to the pace of public
debt adjustment.
Public debt - maturity profile
Source: Banco de Portugal.
Figure 3
Medium and long-term debt annual repayment schedule
(after extension of the EFSF and EFSM loans)
Source: IGCP (Portuguese Treasury and Debt Management Agency).
By way of illustration, it should be noted that, assuming a long-term growth rate of nominal
GDP at around 3 per cent, compliance with budgetary targets set in the programme for
2013-2014 and the fiscal compact commitments thereafter (in particular, a structural
adjustment in the primary balance of at least 0.5 p.p. per year) would make it possible for us
to reach a government debt-to-GDP ratio of approximately 60 per cent around 2030
(Figure 4). This means that, in a scenario of return to economic growth, compliance with
medium-term commitments under the fiscal compact would imply a sustainability path in the
medium to long run for the Portuguese public debt.
Figure 4
Public debt as a percentage of GDP
Note: Assumptions of this scenario: (i) fulfilment of the Programme targets in 2013
and 2014; (ii) increase of the structural primary balance by 0.5% of GDP per year
until 2020, reaching the MTO; (iii) consolidation effort exclusively on the
expenditure side; (iv) increase in the implicit interest rate on public debt to 4.4% in
2020 (3.9% in 2012).
Source: Banco de Portugal.
This exercise corresponds to an aggressive adjustment profile in terms of public debt
reduction. My preference goes to a smoother debt adjustment path, compatible with a
parallel decline in the tax burden. Figure 5 shows a scenario of gradual reduction of the tax
burden over time resulting from a freeze on nominal expenditure, against a background of
strict compliance with fiscal commitments. This scenario would result in a slower reduction of
public debt, albeit on a sustainable path, which would have the advantage of allowing for a
tax burden reduction.
It is common knowledge that I have advocated that the "bonus" resulting from economic
growth should be divided between public debt cuts and tax cuts. Debt reduction is key to
enhance our credibility with financial markets and, accordingly, ensure refinancing. In turn, a
tax burden reduction is fundamental to unlock the growth potential and absorb structural
unemployment in Portugal. It would be useful if we could arrive at a broad political
consensus, in tandem with a broad consensus among social partners, whereby we would
accept that the future economic growth bonus be used to reduce public debt and taxes.
To this end, one option would be to reach a compromise to maintain nominal public
expenditure at a constant level from 2015 onwards, which corresponds to a decline in real
terms equivalent to the inflation rate at that time.
Figure 5
Public debt as a percentage of GDP
Note: Assumptions underlying this scenario: (i) fulfilment of the Programme targets in
2013 and 2014; (ii) stabilisation of nominal expenditure from 2015 onwards;
(iii) gradual decline in direct taxes throughout the horizon; (iv) increase in the structural
primary balance by 0.5% of GDP per year until 2020, reaching the MTO;
(v) consolidation effort exclusively on the expenditure side; (vi) increase in the implicit
interest rate on public debt to 4.4% in 2020 (3.9% in 2012).
Source: Banco de Portugal.
II. The post-Troika period
The challenges that lie ahead after the conclusion of the Economic and Financial Assistance
Programme are not smaller than those faced in the course of the Programme. More
specifically, we must be able to answer the following questions:
How can we ensure that the return to the financial markets is not reversed?
How can we ensure sustained and balanced economic growth of the Portuguese economy
within the euro area?
As mentioned by the President and Mr. Buti, to answer these questions certain conditions
must be fulfilled both at domestic and external level (Figure 6).
At domestic level, and in the short run, the adjustment process of the Portuguese economy
must go forward. This means, inter alia, to proceed with the consolidation of public accounts,
improve banking system profitability, push on with the household and corporate balance
sheet adjustment, create a social security network for long-term unemployed and to set up
conditions inducing potential output growth in Portugal.
Conditions for a successful exit of the Programme
Looking further ahead, a new institutional framework must be established, on the basis of a
broad consensus, fostering behaviours consistent with the maintenance of fundamental
macroeconomic balances and the economy's competitive capacity.
In this context, the first point to have in mind is social cohesion. The ongoing sectoral shift in
the Portuguese economy suggests that unemployment rates should remain high over a
protracted period of time. Safeguarding social cohesion is key so we can manage
unemployment in line with its structural nature. In fact, a mechanical exercise conducted in
Banco de Portugal shows that an 8 per cent annual growth of external demand up to 2020
would have a cumulative reducing impact of 7 p.p. on the unemployment rate (to around
11 per cent), which means that the solution to our unemployment problem does not lie on the
demand side. We must be able to free up and generate entrepreneurial skills, attract foreign
direct investment and boost our productive sector. At the same time, we must create support
schemes to re-train long-term unemployed with a view to increase their employability.
In addition to social cohesion, there are two other conditions which I find important. The first
is the creation of a political consensus on the Portuguese economic policy leeway. This
political consensus is not the same as "unanimity", it is, rather, the acknowledgment of
economic policy limits and the curtailment of the political discussion to those limits resulting
from our external financing constraints and public indebtedness.
The second condition is consensus among social partners. We must enhance the dialogue
between social partners, so as to ensure a realistic negotiation of the distribution of income,
i.e. taking into account productivity gains in the economy. We can draw inspiration from the
experience in countries like Belgium and Finland. These countries have in place systems
that, in case of risks to competitiveness, subordinate wage settlements to the imperative of
safeguarding competitiveness and employment.
At the same time, external conditions supportive of our adjustment must be put in place.
These external conditions depend on the solidarity of our European partners, which can only
be accomplished if we prove to have a sense of responsibility and the ability to comply with
our commitments. The keyword in this whole process is "trust".
Setting up the above-mentioned domestic conditions is important to strengthen our partners'
confidence in the fulfilment of our obligations over time and to win their solidarity.
As regards short-term external conditions for a successful exit of the adjustment programme,
I consider it crucial that European mechanisms be in place so as to address incidental
factors. To deal with any excess volatility in financial markets and, consequently, prevent
investors from moving away from Portuguese debt, European intervention mechanisms in
the primary and secondary Portuguese debt markets must be in place, which, in turn, entails
the adoption of a precautionary programme. The precautionary programme will help enhance
the credibility of the macroeconomic adjustment process in the period immediately after the
conclusion of the Programme. The associated conditionality is, on the one hand, the
counterpart to our European partners' solidarity and, on the other hand, a key element to
consolidate market confidence in the country's economic policies.
Turning to medium-term conditions, it is crucial that the European Union implements
mechanisms of economy policy coordination and establishes a process of cooperative
European growth. In this context, European countries with a favourable economic situation
should make use of the leverage available to them to expand their domestic demand,
contributing to a more balanced and sustainable adjustment of the whole economy. The
establishment of a Banking Union is a central pillar for fixing financial fragmentation in the
euro area and breaking the link between sovereign risk and bank risk. This is a very
important step towards enhanced competitiveness, given that it will make it possible for
identical firms in terms of profitability and risks to have similar financing conditions,
regardless of their geographical location. Moreover, structural reforms should be
implemented that induce potential output growth across Europe (e.g. output market
deregulation and tax system reforms).
In sum:

For a successful adjustment of the Portuguese economy and to ensure its prosperity
within the monetary union, certain domestic and external conditions must be
established. By proving that domestic conditions are in place, external conditions will
ensue and be strengthened.

In terms of domestic conditions, social cohesion must be ensured and consensus
among social partners, as well as a broad consensus between political players,
must be reached.

The necessary political consensus does not concern policies to be implemented but
only the limits and constraints to their definition and implementation (as I have said
on other occasions, although we may have different opinions on how to decorate the
living room, we must admit that the living room walls are our limit and our constraint;
in terms of economic policy, the walls in the exercise correspond to the external
constraints placed on any given country).
Thank you very much.