OECD Offers Some Hope But Portugal’s Finances Look Terrifying

In the eyes of many investors, the mathematics of Portugal’s public finances are little short of terrifying.


Portugal is in danger of failing to meet the exacting fiscal targets that support institutional investors’ fragile faith in its bond market, according to a report on the country published Thursday by the Organisation for Economic Co-operation and Development.

The Iberian republic faces a “significant” risk that the fiscal deadlines agreed in last year’s international bailout will not be achieved, because of the possibility that “growth undershoots expectations” due to poor international conditions and a continuing domestic credit crunch.

But the rich-country think-tank’s latest Economic Survey of Portugal also offers some hope for the future, saying: “On the upside, exports have performed well recently and could continue to grow above expectations.”

In the eyes of many investors, the mathematics of Portugal’s public finances are little short of terrifying. In return for a three-year bailout by the EU and International Monetary Fund (IMF) that began last year, Portugal has pledged to reduce its budget deficit from close to 10 percent of gross domestic product (GDP) in 2010 to 3 percent in 2013. OECD calculations which look at the underlying deficit suggest this requires a degree of fiscal hawkishness this year which makes even last year’s severe cuts look small by comparison. A fiscal consolidation of about 3.5 percent of GDP will be needed – with about two-thirds of this to come from spending reductions under present plans, including job losses and wage cuts in the public sector, and about one-third from increasing revenue.

Consequently, just at the time when -- in normal recessions unaccompanied by debt crises -- the government would be loosening fiscal policy to prop up the economy, Portuguese ministers will be doing the opposite. They will, at least, be trying to do so despite fears that while they pull the policy levers to turn spending off, other people will be tugging at largely unconnected policy levers that will turn spending on. Budget enforcement has been “impeded by fragmented, infrequent and limited financial reporting with financially autonomous units of the government not being held sufficiently accountable for over-spending”, says the OECD.

Spain provides a grisly parallel: this week’s fresh upsurge of panic about its bond market was caused by fears of the same lack of control by ministers over the country’s total debt mountain -- in Spain’s case because of overspending by regional government.

What hope is there to palliate the depressive economic effect of all this on the Portuguese economy and hence of its ability to collect much-needed tax revenue?

Large parts of the state superstructure which underpins the economy is in need of reform. Much of it can be done at little or no cost, though vested interests may still prove an obstacle. The OECD outlines a slew of possibilities, including making the justice system more efficient. There are 1.5 million pending civil and commercial cases, which compares with a population of only 10.6 million.

Such reforms are likely to be considered sympathetically by the Portuguese government. The finance minister Vitor Gaspar is a former head of research at the European Central Bank and exactly the sort of man whom the free-market apostles in Frankfurt and Washington, D.C., -- headquarters of the ECB and IMF respectively -- would have wished for the country. Its long-term economic growth has been held back by a tangled web of market distortions and bureaucratic obstacles.

Gaspar is also striving to boost Portugal’s underdeveloped international trade. Exports as a share of GDP are only 35.5 percent, which is low for a country of Portugal’s small size and little more than a third of the proportion for Ireland.

Portuguese exports surged by 11.6 percent year on year in the first quarter of 2012, encouraging hopes that the country, whose export specialties range from cars to designer shoes, can rely for growth on other, stronger economies.

There are, however, at least two problems with this hope. One is that many of the countries on which Portugal is relying look in similarly poor shape: most notably Spain, destination for about one-quarter of its exports. Another is that businesses’ ability to expand capacity to meet new demand – both abroad and at home – will be constrained by Portugal’s continuing lack of credit, as the banks go further down the long road of deleveraging.

The OECD concludes: “Tight credit conditions and a worsening external environment are deepening the recession in 2012.” Moreover, “the plan to meet fiscal targets in 2012 is very ambitious and will depress demand further.”

Should this “very ambitious” plan prove excessively so, what is the feasibility of Plan B -- slowing the pace of fiscal tightening? The report concedes that should “downside risks” to the economy materialize, leading to a deeper recession and causing output to “fall substantially more than projected” in the EU-IMF program, some leeway should perhaps be allowed. The OECD predicts a 3.2 percent decline in GDP this year, slightly worse than the 3 percent envisaged in the bailout agreement. The “automatic stabilisers” -- those output-boosting increases in government spending on benefits and reductions in tax, which naturally occur in a declining economy unless they are deliberately checked -- “could be allowed to play, at least partially.”

A very partial easing of fiscal tightening is all that Draghi, the fiscally conservative head of the ECB, would allow. Draghi put an end to this week’s surge in Portuguese bond yields on Thursday after saying that dealing with surging debt yields for member states was “part of the mandate” of the central bank. The yield on the Portuguese 10-year was 13 basis points lower on the day at 11.29 percent, after climbing from 10.47 percent at the end of last week. Draghi has repeatedly made clear, in both word and deed, that he will only step in to help governments if he feels they are doing their very hardest to bring their deficits under control. To put it succinctly, he expects national governments to do most of the heavy lifting.