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Introductory statement given by Governor Vitor Constâncio - Economic Bulletin December 2000

Lisbon, 25 January 2001

Publication of projections and the Portuguese economic policy

1. As from December 2000 the ECB Monthly Bulletin started to publish staff economic projections for the euro area main economic variables, including inflation. These projections, which result from the involvement of all national central banks, will be released twice a year, in June and December, and will always cover a two-year horizon.

As it is known, the Banco de Portugal used to publish economic forecasts in March and September, for the same year, although it did not include inflation in the variables shown. The new stance adopted at the Eurosystem’s level implies, however, a change in this procedure. The Banco de Portugal has thus decided that the Economic Bulletin, to be published immediately after the ECB Monthly Bulletin containing the staff economic projections, will release the projections for the Portuguese economy produced by the Banco de Portugal within the framework of the preparation of euro area projections – now also including inflation. In the December issue of the Economic Bulletin of each year the projections for the following year will be presented and only in the June issue of the Economic Bulletin will the projections for the subsequent year be disclosed. The reason for this difference vis-à-vis the procedure adopted in the euro area is due to the fact that it is more difficult to make forecasts for a longer horizon, with an acceptable degree of reliability, for a small economy, which is more open and volatile than the euro area as a whole. In June there is a larger amount of information available and hence there is an increased possibility of making more reliable projections for the next year.

2. Our concern to ensure the credibility of the projections stems from the rationale behind the decision to publish, from now on, the economic projections that the Eurosystem has always produced internally. In fact, any modern monetary policy strategy must take into account the effect of economic agents’ expectations on the process of transmission of monetary impulses to the economy. The publication of economic projections, namely those for inflation, is an attempt to stabilise expectations around the values considered by the Eurosystem itself, when preparing monetary policy decisions. In this case, transparency helps to enhance the credibility of monetary policy. The increased credibility, in turn, renders the conduct of this policy more flexible, enabling for example a better response to recessive shocks, without jeopardising the confidence in the ability to control inflation, or making possible more abrupt changes in interest rates if the need arises, without introducing too much noise in the information provided to economic agents.

The projections released are an exercise of conditional forecasts, based on the assumption that monetary policy will remain unchanged, i.e. that during the whole period both interest rates and the exchange rate remain unchanged. This procedure aims to maintain the information content of the existing rates, which are necessarily considered by authorities as the most adequate to the economic situation of a particular moment. To make forecasts on the future trend of interest rates inter alia would render less flexible the future policy decisions determined by the actual conditions of a specific moment in time. Central banks that publish projections normally use this method, although a few complement it with projections based on future interest rates implied in money market and financial market rates. The conduct of this exercise tends to be more comprehensive in the countries which follow a monetary policy strategy of so-called «inflation targets», which is not the case of the Eurosystem. As it is well known, we adopt a more flexible hybrid strategy, which uses parts of different approaches to the design of monetary policy. This flexibility allowed monetary policy to properly adjust to the needs of the European economy. Following the cut in interest rates in early 1999, in response to the recessive risks existing at that time, the rise in the rates decided by the Governing Council in the course of last year kept in check the inflationary process, without jeopardising economic growth and the decrease in unemployment. Given that the creation of the euro allowed for the implementation of a single monetary policy, it provided European countries with a powerful instrument to largely decouple their own short-term economic situation from developments in other parts of the world. This autonomy, which can only be provided by a single monetary policy, is quite evident in recent developments, which particularly show the difference between the American and the European economic situations. Europe has now better conditions to withstand the consequences of the deceleration of the US economy.

3. The most recent developments mentioned above are a good example of the speed with which nowadays projections become outdated, at least partially. Indeed, the figures disclosed at end-December were computed from assumptions set out in early November. Since that date there was a recovery in the euro exchange rate, the oil price is now lower and growth prospects in the economy of the rest of the world are more pessimistic. The projections published assumed an unchanged euro-US dollar rate of 0.85 and recent values range around 0.94, while the oil price considered at the time was USD 29, compared with prospects of an average value of around USD 25 this year. In turn, growth prospects, which are now more consensual for the US economy, stand at around 1 percentage point below the forecasts made three months ago. According to many forecasters, all these developments are likely to influence euro area growth and to reduce it by approximately 0.25 percentage points vis-à-vis the projections of last December, which pointed to a range centred on 3.1%. The effects on inflation can also be quite significant, bringing its average value to below 2% in 2001, if assumptions currently made by forecasters for the euro exchange rate or the oil price turn out to be true.

As I mentioned above, the projections that the Banco de Portugal is releasing in this Economic Bulletin are the ones produced in the context of the preparation of those disclosed for the euro area in the December 2000 issue of the ECB Monthly Bulletin. No attempt was made to update data, which must be interpreted against the background in which they were prepared. The principles underlying the changes referred to for the euro area would lead to the conclusion that, with the new assumptions, inflation and growth forecast for Portugal would be slightly lower than those calculated in the December publication. The figures referred to above show that the differences would be rather small and that – given the uncertainty which necessarily surrounds the forecasts of variables, such as investment or wages – the forecast ranges presented in this Bulletin would certainly accommodate them.

4. The growth scenario shown reflects a slight deceleration which is in line with a smooth adjustment of the Portuguese economy towards a moderation of the growth of domestic expenditure, which has been financed by growing indebtedness. The economy cannot maintain indefinitely expenditure levels which are far above production levels. The indebtedness of economic agents associated with domestic demand above GDP gives rise to an external deficit. However, for a country with no national currency of its own, as is currently the case of Portugal, the limits of the external deficit result chiefly from the aggregation of the borrowing capacity of each agent, including banks. These have been acting as intermediaries between domestic agents and abroad, borrowing from euro area interbank markets in order to finance credit expansion. Financial markets and foreign banks have provided these resources because of their positive assessment of the soundness of Portuguese banks.

Such a process obviously has limits, and there will be a time in which, a natural process of moderation of expenditure growth will start. What is important for a country integrated into a monetary union is precisely the existence of self-correcting mechanisms of an excessive external imbalance, and the Portuguese reached almost 10% of GDP in 2000. Indeed, either agents start to moderate expenditure and increase their saving levels or banks must tighten their risk assessment criteria and consequently reduce credit supply. The later this deceleration process begins, the more abruptly the economy may come to an halt and the higher the risks of a true recession. Thus, the economy should continue to decelerate, a process which is in fact already visible in consumption and industrial production.

This in general implies a slight fall in the growth of the economy, also partially checked by our situation of full employment. As I mentioned last July: «The Portuguese economy is in a situation of full employment, whereas the euro area still has room to grow before it reaches potential output, given its higher unemployment. In order to grow at higher rates, Portugal would need a surge in productivity, which is difficult to achieve in the short run, or to resort to labour import on a larger scale.»

Thus, it is not surprising that other European countries such as Spain or Greece, the latter now being subject to the effect of a cut in interest rates, are growing more strongly than Portugal. We need productivity increases which imply structural transformations on the supply side with an improvement in the quality of inputs and in the efficiency of their use. This is a medium and long-term process which depends on some public policies which create new external economies in production, but which above all depends on entrepreneurial initiative.

The predominance of supply policies is one of the rules to be respected by an economy integrated into a monetary union. With no fundamental instruments to control overall demand and short term instability, economic policy must concentrate on other aspects. Factors such as the infrastructures, the quality of human capital, the incentives to labour supply, a favourable climate for productive investment and technological modernisation are the cornerstones of competitiveness and of the possibility to improve the standard of living. A monetary union is an area of globalisation of economic relationships, which inevitably requires increased competition.

As a consequence, a second rule should be followed by all member countries: the acceptance of the openness to foreign countries and to corporate internationalisation, in line with the basic principles of a single, highly competitive market, subject to the discipline of an integrated capital market. These and other operational rules have not yet been completely understood among us. There are still some signs of the old ways of thinking dependent on the environment prevailing when there was still a national currency and the control of capital movements.

5. The behaviour regarding inflation largely reflects the fact that the new operational framework of the Portuguese economy has not been fully interiorized. The projection made in the context of the Eurosystem can be now revised downwards due to the latest developments in the euro exchange rate and in the oil price. However, the fact that inflation was higher than forecasted in the last two months of 2000 and the uncertainty about the wage policy warrant caution in the revision of the value expected for 2001.

The fact that fuel prices were raised at the end of March 2000 leads inflation measured early this year to record a one-off acceleration, probably above 4%, since the comparison will be made with the first months of 2000, i.e. prior to fuel price rises. As mentioned in the text on the economic policy situation, the average inflation projected for this year is likely to range between 2.9% and 3.3%, albeit recording an intra-annual pattern of strong deceleration throughout the year. It is thus estimated that at end-2001 inflation is likely to stand slightly below 2.5%. The risk associated with the much higher inflation recorded at the beginning of the year results from the fact that it is usually in this period that the major wage negotiations occur, and these can be erroneously influenced by the most recent levels of recorded inflation.

In fact, and more importantly, the increase in average wages in Portugal cannot continue to ignore developments in the remaining euro area countries. This is another operating rule of a monetary union which we cannot ignore: with no national currency of its own and thus without the possibility of making devaluations, wage increases above the growth rates recorded in the rest of the monetary union in the long run will chiefly affect competitiveness and unemployment. This means that the decisions which influence costs and prices should take as a reference the average values of the euro area, so that there is, inter alia, an increase in unit labour costs (ULC) which does not steadily differ from that in the rest of the euro area. It should be noted that this variable is already taking into consideration the development of relative productivity. Indeed, a usual indicator of competitiveness vis-à-vis our trading partners is an index which results from the correction of the nominal exchange rate with the ratio of developments in ULC in Portugal and in its trading partners. The change in ULC is given by the difference between the growth rate of nominal wages and the growth rate of productivity measured in real terms. On the other hand, as regards the other euro area countries, the «exchange rate» now equals 1 (we share the same currency) and its change equals zero. Thus, in order for the real exchange rate to be kept unchanged (measured by relative ULC), it is necessary that the difference in the growth of nominal wages between Portugal and the euro area equals the difference in the growth of real productivity. Only in this way can ULC grow equally and competitiveness be maintained (see annex 1). However, this has not been the case in the past few years.

Table I - ULC growth

Portugal4,2 %4,0 %3,9 %
Euro area0,3 %1,1%0,8 %
Spain2,3 %2,3%2,4 %
Ireland3,4 %2,3 %2,4 %
Italy-2,3 %1,4 %1,0 %

In the past five years ULC in Portugal have always grown above those in the remaining euro area countries (therefore excluding Greece, which only joined the euro area this year). This trend cannot continue indefinitely. Price competitiveness can be maintained for a few years through the shrinkage in profit margins and/or the above-the-average growth in some producers of tradable goods, but both solutions have obvious limits. It is true that this indicator is usually assessed in relation to all our trading partners and competitors and not just the euro area, which nevertheless receives more than 80% of our exports and from which we import more than 70% of the total, and is therefore the most relevant group.

On the one hand, wage developments in Portugal, which have been increasing more than productivity in recent years, have been narrowing corporate profit margins. In the long run, wage growth eventually move close to the increase in productivity, although there can be limited periods when the functional distribution of income is changed. However, developments in recent years have been particularly marked.

Table II - Wages and Productivity

Growth of nominal wages (whole economy)5,8 %6,0 %5,3 %5,7 %
Productivity growth1,8 %1,9 %1,3 %1,7 %
<p>Euro area:</p>
Growth of nominal wages (whole economy)2,1 %1,4 %1,9 %2,4 %
Productivity growth1,5 %1,1 %0,7 %1,6 %

On the other hand, when making a comparative analysis of real wages and productivity, terms of trade cannot be ignored. Indeed, when there are gains in terms of trade (relative development in export and import prices) the maintenance of the functional distribution of income implies that real wages have to grow above productivity. Similarly, when there are losses in terms of trade, as in 1999 and 2000, real wages should increase below productivity, in order not to affect the profitability of other production factors. A decline in terms of trade (other things being equal) means a reduction in the real income of the economy in which all economic agents must participate (see annex 2).

6. All the basic principles that I have just recalled are valid for developments in total average wages. In practice, though, there is always a wage drift equal to the difference between actually paid wages and negotiated wages. The wage drift above wage settlements is justified by factors such as promotions, restructuring of careers, or simply because some corporations pay above wage settlements. The difference between negotiated wages and actually paid wages has therefore to be taken into account. In Portugal, this difference has been very significant.

Table III - Portugal - Actual and negotiated wages

Corporate Sector:    
Growth of actual wages5,3 %5,1 %4,8 %5,0 %
Growth of negotiated wages3,6 %3,1 %3,3 %3,5 %
Wage drift1,7 %2,0 %1,5 %1,5 %
Public Sector:    
Growth of actual wages6,6 %6,5 %6,7 %5,9 %
Growth of negotiated wages3,0 %2,8 %3,0 %2,5 %
Wage drift3,6 %3,7 %3,7 %3,4 %

The table above illustrates the importance of the wage drift phenomenon in Portugal. An analysis of a longer period evinces that the size of this drift changes significantly according to the economic cycle. In a full employment situation, as the one we are experiencing, it is expected to be at least as high as in recent years. This implies that particular caution should be observed in wage settlements. In the euro area total actual wages rose only by 2.4% in 2000 and in 2001 they are expected to rise by 2.75%. Taking this into account, as well as developments in recent years, it is straightforward that average wage settlements should clearly rise by less than 3% in 2001. Thus, the 3.71% increases in the wage settlements of government employees, which may turn out to be effective increases of more than 6% as in recent years, are a bad example, hardly reconcilable with the situation of public finances, and should not be followed by the remaining sectors of the economy.

In fact, with a significant wage drift, the increase in staff costs will hamper the execution of the budget, considering that Portugal, due to its development level, is already in an extraordinary position as the euro area country with the highest General Government staff costs as a percentage of GDP. On the other hand, in the past few years the increase in government employees' wages was higher than that in the remaining sectors of the economy, and average net wages of government employees are around one third higher than those in the corporate sector. This situation is only partly explained by the higher average education level in the Public Administration.

In Portugal the wage settlement procedures need a structural reform, so as to comply with the following principles:

  1. Cost increases in the euro area and real productivity differentials from which we may benefit should be a relevant benchmark.
  2. Negotiated wages for two years (instead of only one) should be introduced to provide stability and reduce uncertainty and the costs of economic conflict. This happens in several European countries and it will tend to become broadly based, since it is possible to rely on a system of stable inflation around 2% across the euro area.
  3. Overall wage benchmarks should not jeopardise the taking into account of specific sectoral, regional and corporate conditions, guaranteeing some room for negotiation at the microeconomic level.

These principles may seem the expression of an orthodox thinking, but they simply correspond to the recognition of a fundamental reality, which is currently the Portuguese one. The workers’ representatives, who have the illusion that recent years developments may continue indefinitely, must understand that such a situation would only add to future unemployment. From now on, unemployment is the variable that adjusts and, if the developments of recent years persist, the consequences on unemployment will also reflect the power of the social oligopoly of those who are currently employed.

The sustainable improvement of the living standards and the convergence to European average levels can only occur on the basis of a real productivity growth above that of our partners. We need a consensual national policy to reduce cost inflation to values close to those of the European average, with a view to contributing to the competitiveness of Portuguese companies, which are expected to make a greater effort of investment and technological modernisation.

7. The increase in wage costs in recent years has created difficult conditions to fiscal policy, contributing to a rise in government current expenditure. The increase in government consumption has fostered domestic demand and contributed to a pro-cyclical fiscal policy as from 1997. Only the budget for the current year, when adjusted for the effects of the economic cycle, shows a restrictive autonomous impulse. However, the excessive growth of expenditure in recent years reduced the flexibility of the fiscal policy to face a deceleration of the increase in tax revenue over the coming years, which implies, as recently stated by the Minister of Finance, the need of deeper reforms to curb the growth of expenditure. The provisions of the mandate given by the Minister of Finance to the Co-ordination Group for the Reform of Government Expenditure (Ecordep), which has recently taken office, are worthy of support. We expect the development in Public Finances to benefit – beyond current expectations – from those principles and from the measures proposed by the Ecordep.

This is essential for the compliance with another rule, the fourth I mention, which countries in a monetary union have to adopt. In fact, fiscal policy remains the only instrument at the countries’ disposal to fine-tune the economic situation. Thus, fiscal policy has to become more flexible and create room for manoeuvre in periods of prosperity, in order to have a significant anti-cyclical effect and to absorb adverse economic shocks. These are the principles underlying the Stability and Growth Pact which, although restrictive, have their ultimate rationale in the idea of achieving a balanced budget in the course of an economic cycle, allowing for higher deficits in periods of recession, provided that they are offset by surpluses in periods of strong economic growth.

8. The new operating rules that I have mentioned as imperative for countries participating in a monetary union may be summarised as follows:

  1. Predominance of supply policies. Those depending on public policies, such as infrastructures, training of human resources, incentives to labour supply or to a favourable investment climate, as well as those resulting from the behaviour of companies from which technological modernisation and increase in productivity is required.
  2. Acceptance of full openness to foreign countries and to corporate internationalisation, in line with the basic principles of a single market in which frontiers disappeared and where there is higher competition and the discipline of an integrated capital market.
  3. Higher relevance to the relationship between wages, competitiveness and unemployment. Without being possible to resort to the depreciation of the national currency, wages, more than domestic inflation, determine, in the long run, competitiveness and unemployment.
  4. Need to use the fiscal policy more in an anti-cyclical manner in order to absorb economic shocks and recessive periods, which implies the creation of room for manoeuvre, and even budget surpluses, in periods of prosperity.

The two latter rules mean that, in order to be successful, participation in a monetary union implies the interiorization of new operating rules regarding wage and budget policies. It means to operate according to a sound principle of reality and to withdraw all the consequences of participating in a monetary union from which there is no going back. We made an irreversible historical choice and we have to fully assume it. Otherwise we cannot ripe the fruits of our participation. Without it we would not have been benefiting from a low interest rate system for some years now. The fall in interest rates during the second half of the 1990s implied an increase in the wealth and in the borrowing capacity of private economic agents. Many households and corporations suddenly became solvent to borrow and, in view of the new inflation and low interest rate regime, rationally decided to use their borrowing capacity to increase their expenditure. Corporations seized the opportunity to expand and modernise their capacity utilisation, their indebtedness being estimated to have increased to 71.4% of GDP in 1999. In 1990 households had an estimated indebtedness of 18.5% in relation to disposable income and the interest payments accounted for 4.8%. In 1999, the debt ratio had increased to 76%, but the interest payments were only 3.5% of disposable income. This increase in indebtedness has as its counterpart the access to goods and services, which increased significantly the living standards. In other words, it was not only the increase in real income, but also the access to durable goods (housing, cars, etc…) which made of these years a unique period in Portuguese economic history.

This process had natural limits associated with the borrowing capacity of each economic agent. We are about entering a phase of adjustment and moderation of income growth. As the proverb runs "hood does not make the monk". It will not suffice to have the wealthy outfits of monetary union, it is also necessary to assume its demanding virtues and rules of life. However, as classical wisdom assures, «all excellent things are as difficult as rare».

23 January 2001

Vitor Constâncio 

Annex 1  

Unit labour costs, wages and competitiveness

The definition of labour costs per produced unit of output (Portuguese acronym: CTUP) is the following:

It is important to compare in international terms nominal unit labour costs in the same currency.

That is, in order to maintain competitiveness, the growth differential vis-à-vis abroad of nominal wages has to equal the growth differential of real productivity.

Annex 2

Eeffect of terms of trade on the functional distribution

Let us consider the following equations:

Let us analyse the conditions required for the maintenance of the functional income distribution. We start from the share of labour in GDP,

We can write the same equation but with real wages and real GDP, considering that when terms of trade can change, the overall consumer price index can change differently from a GDP deflator. We shall have: