The Bank of Portugal releases today the Annual Report - The Portuguese Economy.

The first part of the Report focuses on the recent evolution of the Portuguese economy from a structural perspective. The second part addresses the different dimensions of the ongoing adjustment process within the framework of the Economic and Financial Assistance Programme (EFAP).

The analysis of the evolution of the Portuguese economy in 2013 was presented in the Economic Bulletin of April 2014.

1. In the first decade of the 2000s, the Portuguese economy was characterized by low GDP growth and the accumulation of various macroeconomic imbalances, with the solution to the structural problems being successively postponed (see text "Recent developments in the Portuguese economy"). Even before the recession starting in 2011, the performance of the Portuguese economy had diverged vis-à-vis the European Union (EU) average.

2. Several related factors contribute to explain the evolution of the Portuguese economy:

• The participation rate in the labor market had a negative contribution to growth, reflecting the decline in fertility rates and, more recently, the reversal of net migration flows. By contrast, the accumulation of human capital contributed positively to growth, with a considerable improvement in the average qualification of the workforce;
• The total factor productivity slowed down over this period. Although this is not a directly observable variable, total productivity is strongly related to the technological and institutional aspects, which allows inferring that the institutional framework did not enhance growth either;
• The accumulation of capital stock, although moderate, was positive until the early 2010s. Nevertheless, the stock of capital per worker in Portugal remains very low when compared to most advanced economies and that is reflected in a negative differential of productivity with respect to those economies. Induced by low interest rates and an erroneous risk assessment, leverage resulted in an inefficient allocation of investment decisions, with an excessive concentration of resources in firms of non-tradable sectors.

3. Most sectors in the economy reached high indebtedness levels, which were mainly intermediated by the financial sector. For households, this indebtedness was intended mainly for housing purchases; therefore, considering also their non-financial assets households net wealth was not significantly affected. In the case of government, the adoption of expansionary fiscal policy during almost the entire period of participation in the euro area, led to the accumulation of budget deficits and, consequently, to the increase of the stock of debt. The reduction in domestic savings was reflected in a significant increase in the net borrowing requirements in relation to non-residents and a sharp deterioration in the international investment position.

4. In 2010, with the sovereign debt crisis in the euro area and the sudden stop of the external financing, the adjustment became unavoidable. Initially, the external private financing was replaced by funding from the Eurosystem. In March 2011, the inexistence of sustainable financing alternatives, in the context of high refinancing needs of public and private debt in the short term, made the request for financial assistance, which took place in April 2011, inescapable. In these circumstances, the adjustment could be done in two ways: either abruptly facing a forced default scenario, with extremely high economic and social costs, or gradually and orderly, with the financing needs ensured by the international lenders, subject to conditionality.

5. The EFAP, signed in May 2011, was designed to correct gradually, over three years, the major imbalances of the Portuguese economy. The Programme had three main objectives: the structural correction of the imbalances in public finances and external accounts, the deleveraging of the economy within a framework of financial stability and the implementation of the necessary reforms to address the main structural blockages to economic growth.

6. During the adjustment process, economic agents reacted rapidly to changing incentives and took decisions consistent with an expectation of a strong and persistent income drop in the Portuguese economy. On the one hand, firms increasingly channeled the production of goods and services to foreign markets, with a productivity increase in the tradable sectors. On the other hand, households have significantly reduced consumption and increased the savings rate.

7. In the labor market, it was already a visible, since 2000, an increasing trend in the unemployment rate, in particular in long-term unemployment, with the highest incidence in the less skilled and the youngest (see text "The labour market in Portugal"). The fall in net job creation became deeper during the period of adjustment, particularly in the sectors most exposed to domestic activity. In a market with a significant incidence of fixed-term contracts, in recent years, there has been a sharp drop in the rate of hiring. Within the structural transformation underway it is difficult to estimate the impact of the reallocation of resources in structural unemployment.

8. The financing of the economy cannot be disconnected from the deleveraging process. Initially, following the global financial crisis, the banking system cost of funding was penalized. In a second stage, triggered by the sovereign debt crisis and the fragmentation in the euro area, there was a simultaneous contraction in the supply of credit from the banking system and in the credit demand by the private sector. The impact on the financing of the economy was heterogeneous, depending on the institutional sector, activity sector and size of firms. The credit contraction was more concentrated in smaller firms and in specific sectors such as construction, real estate and trade (see text "The deleveraging process of the Portuguese economy: facts and challenges").

9. The evolution of the Portuguese economy is strongly constrained by the context and the framework of economic and financial policies in the EU, especially within the Economic and Monetary Union. Recent changes in the European institutional framework, embodied in the "Fiscal Compact" and the creation of the Banking Union and the European Stability Mechanism, aimed at strengthening the sustainability of public finances and creating mechanisms of risk sharing. In the post-Programme phase, the new rules on fiscal and macroeconomic governance of the EU are fully applicable to Portugal. If properly appropriated, this will contribute to pursue the ongoing fiscal consolidation and structural reforms process, in order to ensure the sustainability of public finances and economic growth (see text "Recent institutional reforms in the European Union").

10. The EFAP goals were globally met (see article "The adjustment process underway in the Portuguese economy"). Over the past three years, and in terms of flows, the major macroeconomic imbalances of the Portuguese economy recorded a remarkable correction. In 2012 a net lending vis-à-vis non-residents was achieved and in 2013 a structural budgetary primary surplus was recorded. The adoption of a set of measures of a structural nature was also pursued. Macroeconomic developments were, however, substantially more adverse than initially projected, which aggravated the already high level of unemployment.

11. Notwithstanding the gradual recovery of the economy and the return of the sovereign to international debt markets, the process of structural rebalancing of the economy is still incomplete. The return of the Portuguese economy to market financing under regular conditions must be supported by sustained output growth. This is also a necessary condition to reduce the high level of unemployment prevailing in the economy - which is one of the most severe aspects of the adjustment process - and the indebtedness levels.

12. The sustained growth of the economy will depend largely on the ability of economic agents to:

• Ensure expenditure levels consistent with those of income and of wealth, promoting saving;
• Correctly use both capital and labor, through a careful selection of investments by firms and lenders, the qualification of the labor force and increased innovation and competitiveness, fostering the growth of more productive firms, especially in the tradable sector;
• Diversifying financing sources, reinforcing companies’ equity and finding alternatives to bank loans, including by attracting foreign direct investment.

This should be the way forward of the Portuguese economy, with the private sector playing the main role within a stable regulatory and macroeconomic context.

Lisbon, 28 May 2014