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Foreword by the Governor Vitor Constâncio - Economic Bulletin March 2002

30 April 2002

Economic adjustment and budget consolidation

The publication of this Economic Bulletin is an opportunity to do a first assessment of the behaviour of Portuguese economy over the past year. The recent evolution of the economy indicates the existence of three groups of problems:

  1. a deceleration of economic activity, that we share with the rest of Europe, but which has its own endogenous factors;
  2. a difficult budgetary position that requires a significant reduction of the deficit at a very short notice;
  3. a structural deficit of competitiveness, that we must face with new solutions intended to change the supply side of the economy, in order to meet the challenges posed by European Union enlargement.

2001 was marked by a significant decrease in the growth rate of output from 3.6% in 2000 to 1.8%, a value nonetheless still higher than the European average. This behaviour evolved in line with the world economy, that also characterised by a strong reduction in growth and by a deterioration of international trade that implied, in our case, a deceleration of demand in our external markets from 11.8 % in 2000 to only 1.2% in 2001. In addition to this, however, the slowdown of growth in Portugal was also due to the behaviour of domestic demand that went up by only 0.9%, after an increase of 3.0% in 2000. This deceleration of both consumption and investment, already initiated in 2000, reflects the adjustment of the economy, following a period of strong growth that implied a higher indebtedness of the economic agents. Therefore, since the second half of 2000, households have increased their savings rate and contained consumption, that grew by only 0.8% in 2001 compared with 2.8% in 2000. This behaviour, despite the continued increase in Disposable Income (1.9%) and the maintenance of the full employment situation, is a normal reaction to the indebtedness level attained and to the negative expectations generated in the meantime regarding the future of the economy. Likewise, firms also reduced investment that registered a global negative rate of 0.8%, in spite of the increase in public investment.

The deceleration of domestic demand, in turn, was offset by an increase in the contribution of exports net of imports to the growth of the economy. Indeed, exports grew more than international demand, meaning that our exports had a gain in market share. As a result, the deficit of the balance of goods and services declined significantly by 2 percentage points. In turn, the combined balance of the current and capital accounts (equivalent to the former balance of current transactions) declined to 8.1%. The deceleration in domestic demand was behind this improvement of the external balance and is expected to continue this year. In effect, the factors behind the recent trend of domestic demand continue to be present, and are possibly more pronounced due to the inevitable budget consolidation measures. Therefore, it is only natural that this year the Portuguese economy will grow below the European average.

Over the coming years, the deficit of the balance of goods and services will have to decrease further. The limits on the deficit and on indebtedness are introduced by the private agents themselves or by the markets, thereby ensuring the operation of deficit autocorrection mechanisms, which are naturally of a restrictive nature. The later this deceleration process is started, the more abrupt could be the slowdown and the higher would be the recessive risks. For this reason, the deceleration in domestic demand may be considered positive, since that corresponds o a path towards a smooth adjustment of the Portuguese economy. Since the second half of 2000, domestic expenditure decelerated in spite of a full employment situation, an improvement in real wages and an increase in the disposable income of households. This income increased more than the growth in consumption, which means that there was an increase in the household savings rate, which indicates that households have started on their own initiative to correct excessive expenditure growth.

This has therefore implied a fall in economic growth. However, the deceleration of domestic expenditure does not linearly translate into a reduction in output growth, since firms may always channel more production to exports. This seems to have happened last year, since, as I mentioned above, there was a gain in market share, including in traditional exports. It is necessary to maintain this development over the coming years. This should be taken into account in managing the expectations of economic agents, in order to avoid an excessive and unjustified pessimism about the future of the economy.

On balance, this means that we need a different growth pattern, less centred on domestic demand and more based on productivity increases, that improve our external competitiveness.

This leads me to address the third problem mentioned at the beginning. A profound structural shock is necessary on the supply side, dependent on some public policies, but which will chiefly be the result of more business initiative. Unfortunately, neither most private agents nor the State seem to have adequately realised the new operating rules of the economy for a country that is member of a monetary union. These rules require a change in behaviour, some structural reforms and a new macroeconomic regulatory system.

The most serious and immediate issue is the situation of public finance. Last year, I recalled the need to comply with the Stability Pact and I said then: “This requirement means that the country faces a budget crisis, rather than an economic crisis”. The issues at stake are the commitments assumed on the medium-term development of the budget deficit. As it is known, there is no technical problem of sustainability of Portuguese public finances. Our debt to GDP ratio is 55%, below the European average and the deficit-related regulations laid down in the Stability Pact ensure that it will have to decrease further. Compliance with the major guidelines contained in the Stability Programme is essential for the international credibility of our economic policy. The deterioration of the budget deficit in 2001 makes the task more difficult. A high level of national consensus is required as regards the objectives to be attained, without any drama, but in line with a sense of responsibility usually shared by everyone regarding the interests of the country. In particular, this external credibility requires the maintenance of the objective of a budgetary position close to balance by 2004, given the need to show serious efforts of budget consolidation. In order to reduce the deficit, some tough decisions will have to be taken, including containing expenditure and avoiding any measures that may reduce tax receipts. The situation may even justify an increase in some indirect taxes with more immediate effects on the recovery of current revenues.

In the short run, all these measures have restrictive consequences that must be offset by a higher buoyancy of exports, boosted by an international economic recovery and by a rechannelling of production to external markets. In order to make this development possible, it is necessary to reverse the trend observed in recent years of wage increases above output growth. This would not necessarily correspond to a freezing of wages, but to more moderation in wage increases. We must all realise that, under the present situation, this is an essential condition to maintain high employment levels and thus avoid the deterioration of exclusion factors and more inequalities in Portuguese society.

A last word to the recent creation of the Commission led by the Banco de Portugal, with the participation of the Ministry of Finance and the Instituto Nacional de Estatística, with a view to analysing and updating the accounts utilised in the notification of the Excessive Deficit Procedure reported in late February. It should be stressed that part of the problems related to the assessment of the final value of the deficit are associated with issues known for quite a long time, but that require final clarification with the Eurostat. These issues are related, firstly, to the treatment of equity increases in some public companies. This is particularly controversial, since they can be considered as financial asset operations or as capital transfers with an influence on the deficit. Secondly, they are related to the problem of the values of taxes and social contributions considered in National Accounts when compared with those registered in Public Accounts. On the other hand, there are still some issues related to the application of the specialisation principle of the fiscal year in the translation from Public Accounts concepts, which are mainly on a cash basis, to National Accounts standards. In addition, many Autonomous Funds and Services only have to present their final accounts by 15 May. It should be stressed, however, that the work of the Commission do not cover an audit to public accounts, in the technical sense of the term, since there are neither the time nor the means required to carry out such audit, nor should we interfere with the competences of the Court of Auditors. The Commission will present its conclusions up to August, in time for the preparation by the Instituto Nacional de Estatística of the forthcoming notification of the Excessive Deficits Procedure, to be reported in early September.