The Eurozone resembles a vast dyke which is full of holes and liable to disintegrate at any moment. This note concentrates on Portugal, where the recent resignation of the very able finance minister, Vitor Gaspar, was a huge disappointment. (It must be said that the Eurozone’s holes in Greece, Spain, Italy and France also remain large and conspicuous, despite international officialdom’s attempts to patch them.)
Portugal’s problems arise partly because the economy’s trend rate of growth is now very low, perhaps even zero or negative. Gross domestic product per head is lower than ten years ago. With inflation almost zero, nominal GDP is at best flat. As a result, any deficit leads to an increase in the ratio of public debt to GDP. A May 2011 bailout negotiation with the ‘troika’ extended €78b. of loan and other financing, to help the Portuguese government and banking system. It must be acknowledged that Portugal has tried hard, with Gaspar at the finance ministry, to meet the conditions attached to the bailout plan. The cyclically-adjusted budget deficit fell from 9.0% in 2010 to 4.0% in 2012. Nevertheless, the debt-to-GDP ratio has kept on rising and is now over 120%, the kind of figure that was associated with the Greek dégringolade in 2012. (A fair verdict is that a debt-to-GDP ratio of 120% is sustainable when the nominal interest rate on the debt is 5% or less, but – once the interest rate goes into double digits – the debt interest burden runs amok like a Frankenstein monster.) The Portuguese people are apparently weary with austerity, and it has to be said that – without a resumption of growth and particularly of asset price appreciation, which would help banking solvency – the danger has to be that further deficit-reduction measures would not restore fiscal sustainability or national solvency. Holders of Portuguese banks’ bond liabilities and depositors with Portugal’s banks, you have been warned! PEXIT (Portuguese exit from the Eurozone) is – almost certainly – a better option than staying in.
Portugal’s austerity drive ends in a cul-de-sac
Portugal’s governing coalition has narrowly managed to survive the crisis triggered by the resignation on 1st July of Vitor Gaspar, the country’s finance minister. However, Portugal’s public finances and banking system remain in deep trouble. In 2011 the ‘troika’ provided a €78b. bailout package to the Portuguese government. (The troika is the group of international bodies [the International Monetary Fund, the European Commission and the European Central Bank] acting more or less in unison to ensure that financially-distressed Eurozone countries can honour their international debts.) Immediate money was made available in loan form, on condition that sharp tax rises and public spending cuts were implemented to eliminate the budget deficit. Gaspar, who was responsible for drawing up the details of the austerity programme, is widely admired as an able and well-informed financial technician. However, as will emerge in the next few paragraphs, Gaspar’s sincere and strenuous efforts have not returned Portugal to fiscal solvency.
Portugal’s decision to apply for a bailout in 2011 was no surprise. Its public sector finances had been worsening for several years. The ratio of gross government debt to gross domestic product stood at 48% of GDP in 2000. Since then it has climbed remorselessly. The increases were gradual and quite moderate until 2008, when the debt-to-GDP ratio had reached 72%. But the onset of the Great Recession caused the public finances to deteriorate sharply. At the end of last year the debt-to-GDP ratio had reached 123% of GDP.
The austerity programme was imposed from 2011 onwards and had a clear effect in reducing the budget deficit. The reduction in the budget deficit was particularly impressive given the depressed state of the economy, since weak demand and employment did hit tax revenues. The IMF calculates that the so-called ‘structural budget deficit’ (i.e., the deficit on an underlying basis, with the effects of the business cycle removed) dropped from 9.0% of GDP in 2010 to 4.0% in 2012.
Unfortunately, the trend rate of economic growth in Portugal is now very low. In combination with the adverse effect of the European recession on the economy, national output has fallen during Gaspar’s period at the finance ministry. Although the deficit has been reduced and the growth of debt has been much lower than it would have been without official corrective action, the debt-to-GDP ratio is still over 120%.
The deficit has been reduced, but not enough
On 15th July troika officials are due to arrive in Lisbon to review Portugal’s economic progress and to check that it would be in order to proceed with the latest instalment of the loan facility As has been explained, Portugal has tried to comply with the terms imposed by its creditors and has been commended by the international financial community for its efforts. But significant resistance from powerful interest groups within Portugal has emerged. The country’s constitutional court ruled against planned cuts to pay and seasonal bonuses for public sector workers, on the grounds that the private sector did not have accept similar cuts and the measures were therefore discriminatory.
Nonetheless, other changes were pushed through, including a hike in the VAT rate (to 23%), an increase in the top rate of taxation and pay cuts for senior public sector officials. (The tax burden in Portugal is not high by international standards. According to the Portuguese Ministry of Finance’s own studies, only 29% of businesses paid taxes on their 2010 earnings, for instance.)
As the chart below shows, the austerity drive did succeed in reducing the deficit from its pre-bailout 2010 level. Both 2011 and 2012 had much lower deficits than 2010. (But note that the apparent improvement at the end of 2011, which reduced the budget deficit to 4.5% of GDP, was because of an accounting trick. This was the one-off transfer of pension assets from the country’s banks.) How is the budget deficit developing in 2013? Data for the first four months of the year are now available. The deficit stands at just over €3b., broadly similar to the first four months of 2012 and somewhat higher than in the first four months of 2011. If the monthly profile in the balance of 2013 mirrored that in the previous years, the deficit would end up at approaching €10b. This would be about 5% – 6% of GDP, which would breach the agreement with the troika, but would hardly be a great disaster in itself. By comparison with the Greek budget deficits, well into the double digits as a % of GDP, Portugal’s public finances are almost saintly. The trouble is that Portugal is suffering from a severe cyclical downturn in the context of long-term economic stagnation. National output dropped by over 3% in 2012 and is expected to fall a further 2% – 3% in 2013. So it is not sufficient for policy-makers to reduce the rate at which the debt grows. Even with a reduced rate of debt growth, the debt-to-GDP ratio will rise.
A supplementary budget was presented to Portugal’s parliament in May 2013, with another round of retrenchment to trim the deficit by €1b. – €2b. This was a gesture to persuade the troika and the other external creditors that the Portuguese government remained serious in the deficit-reduction task. However, the budget proposals have struggled to gain acceptance in Portugal’s public debate. Gaspar resigned rather than try to bluff his way through the imminent meeting with the troika representatives. His action may also have galvanized his fomer colleagues into the acceptance of tougher measures.
A faster trend rate of economic growth would help ease the increasing strain in the public finances. With a zero deficit, 6%-a-year growth of nominal GDP would lower the debt-to-GDP ratio from over 120% to 90% in five years and to under 70% in a decade. But there is little evidence that Portugal can grow its way out of recession. Portugal was losing its competitiveness before it joined the euro, with low productivity and an inflexible labour market. Eurozone entry saw interest rates fall and wages rise, which led to an increase in consumption and an expansion in the country’s already bloated public sector. Unemployment, which stood at 4% at the beginning of 2002, had doubled by 2006 and is now much higher at almost 18%. (At the end of May youth unemployment was over 42% and up by 10% in a year.) Per capita GDP growth was negative in three of the ten years to 2010 and was above 1½% only twice.
The only glimmer of light has been the growth in exports. Portugal managed to grow its exports by 22% in the three years to 2012. Unfortunately, Portugal’s opportunities to export its way back to growth are limited by its Eurozone membership, which precludes any currency devaluation.
The monetary situation
The broad money figures only confirm the gloomy outlook for the country, as illustrated by the chart below. Annual M3 growth remained in positive territory until September 2009, but after that date, broad money has contracted every month, apart from a short period from May to October 2011, in the aftermath of the bailout. In the second half of 2012, M3 contraction was running at an annual rate 5-7%. By April 2013, this had eased to 3.4%, although the annualised quarterly M3 contraction was over 6.1%. Major concerns have been expressed about the profitability of Portugal’s banks. In spite of boosting their capital since 2011, solvency remains an issue. Two of the biggest banks, Banco Espirito Santo and Banco Comercial Portugues, reported losses in the first quarter of 2013. The banks estimate that 10% of all loans are at risk of default, with the bulk of these relating to consumer credit or construction projects.
Portugal’s heavily-indebted private sector is showing little appetite for new loans. House prices have been falling since 2010, and demand remains very weak, with mortgage lending down by 3.7% in the year to April 2013. Consumer credit fell by 5.6% in the same period, while business loans fell by 1.4% and loans to “non- monetary financial institutions” fell by 11.9%.
Anyone for PEXIT?: avoiding the fate of Greece and Cyprus
What are the options for this unfortunate country? Portugal needs to find €13b. this year and €15b. in 2014 to repay maturing debt. With revenue falling and social spending rising, the money to cover increasing debt liabilities does not exist. The political crisis in the first week of July saw yields on Portuguese 10-year bonds briefly touch 8%, and they have only fallen to around 6.7% a week later. Because Portugal’s economy is not growing, interest rates at these levels imply that the burden of debt interest payments will rise rapidly relative to GDP. Indeed, the recent tumble in bond prices makes it implausible that the Portuguese governments can regain full access to the capital markets later this year, which was the troika’s aspiration in the 2011 bailout package.
What is the larger message? A second bailout is surely inevitable. However, this would require the consent of governments and legislatures across the European Union, including that of the German Bundestag. So-called ‘bailout fatigue’ could result in the imposition of extremely harsh terms, as in the recent case of Cyprus. Will bondholders be required to take a ‘haircut’ (i.e., a reduction in the value of the amount that will be repaid, as part of a wider debt arrangement)? If so, that would replicate the outcome with Greece’s successive bailouts, as it became clear in 2011 and 2012 that Greece could not – simply could not – honour its debts in full. But debt haircuts, or even worse a write-down of the banks’ uninsured deposit liabilities, would create a serious credibility problem for the Eurozone and in fact the EU as a whole. The European Commission and the ECB insisted that the Greek debt repudiation was exceptional, a one-off, and would not recur. (They did this because they wanted banks across the Eurozone to be able to fund their assets by means of bond issuance in the private capital markets. If those markets were closed, the banks would have to continue to borrow from the ECB.)
What about leaving the Eurozone? None of the main Portuguese political parties support his option, but a book called Porque Debemos Sair do Euro (Why we should leave the euro) by the economist Professor João Ferreira do Amaral became a bestseller within days of its publication in April. The most recent opinion polls suggest that, at the present time, only one in five of the Portuguese electorate favour a return to the escudo.
Well, of course, most Portuguese people oppose a return to the national currency. Of course they do. Like the Cypriots in the opening months of 2013, they want unlimited access to their euro deposits and the ability to make payments wherever they wish. But holes in a nation’s public finances and banking system balance sheets are holes in a nation’s public finances and banking system balance sheets, and those holes cannot be made to disappear merely by official declaration. Professor Amaral’s book argues that Portugal’s departure from the Eurozone (anyone for PEXIT?) and currency devaluation are the only ways for his country to regain its competitiveness. The recession has been bad, but not as bad as in Greece. It would be tragic, foolish and unnecessary for Portugal to go through the same trauma as Greece and Cyprus have suffered since 2011. Portugal may decide to stay inside the Eurozone. Two or three years from now it might then be as far from a solution as Greece and Cyprus still are, but with national output 10% to 20% lower, and hundreds of thousands more jobs destroyed.