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Global Economic Outlook
Portugal: Q3 2010 Outlook
By Katharina Jungen
- In 2010, the Portuguese economy will see only a moderate expansion given the ongoing weakness in domestic demand and fading support from the external sector.
- The outlook for private consumption remains weak in light of rising inflation, fading stimulus measures, tight credit conditions and high unemployment.
- Portugal introduced additional austerity measures to calm financial markets, but if growth surprises on the downside, further tightening might be required.
Outlook Update: Moderate Growth in 2010, Renewed Economic Contraction in 2011
Following a contraction in Q4 2009, the Portuguese economy experienced a robust start to the year with a strong expansion in Q1 2010. RGE now expects the Portuguese economy to see moderate growth of 0.5% in 2010 as fragile domestic demand dampens the positive impetus from the external sector. In 2011, Portugal’s economy is expected to return to negative growth and contract by 0.5%. Not only will private consumption and investment slow as the government’s fiscal consolidation measures take full effect in 2011, but also the impetus from the external sector is expected to moderate in light of slowing global demand. Given the dismal economic outlook, pricing pressures will remain moderate at 0.7% in 2010 and 0.9% in 2011.
Growth Dynamics: Structural Weaknesses and Austerity Measures Limit Portugal’s Growth Potential
Due to stronger-than-expected export growth and firm private consumption, the Portuguese economy surprised with a strong 1.1% q/q GDP expansion in Q1 2010, significantly above the eurozone average growth rate of 0.2%.
Figure 1: Contributions to GDP Growth
Business surveys suggest that the momentum remains strong in Q2 2010, with the economic climate indicator in June reaching its highest level since September 2008. The economic upswing is largely driven by the recovery in global demand, with industrial orders from abroad clearly outperforming domestic orders. However, Portugal will only reap limited benefits from the recovery in global economic activity due to substantial competitiveness problems and an unfavorable geographical export composition. Portugal’s external sector lost global export share due to the economy’s declining price and cost competitiveness. At the same time, the economy failed to conquer new export markets and for a long time tried to hold on to traditional, labor-intensive export industries in which it faced harsh competition from emerging economies with abundant low-cost labor. The Portuguese export sector’s strong focus on intra-eurozone trade, in particular with Spain, reduces Portugal’s ability to benefit from brighter growth prospects in emerging markets as well as the weak euro exchange rate.
Even though global economic activity will start to slow in H2 2010 in light of expiring fiscal stimulus packages, pressing fiscal consolidation needs and fading inventory effects, net exports will contribute positively to economic growth in 2010 with weak domestic demand keeping a lid on import demand. Private consumption is expected to stagnate at best in 2010 in light of rising inflation, fading stimulus measures, tight credit conditions and high unemployment (10.6% in Q1 2010). In June 2010, consumer confidence registered its lowest value in 12 months.
Figure 2: Business Confidence vs. Consumer Confidence
Source: Statistics Portugal
Investment activity will see further declines in 2010 given large excess capacities and the uncertainty surrounding the economic recovery.
In 2011, the contraction in domestic demand will accelerate as external stimuli continue to fade and the impact of austerity reaches its peak. The effect of the government’s austerity package on economic activity will prove particularly harsh in the case of Portugal as private and public spending will be reduced simultaneously. The Portuguese private sector, which is among the most indebted in the eurozone, will find it difficult to maintain its spending level in light of the increasing constraints on external financing. Hence economic growth, long boosted by external financing, is bound to suffer. RGE expects the Portuguese economy to experience a renewed contraction of 0.5% in 2011.
Risks: Sustainable Public Finances Require Broad Structural Reforms
Portugal will find it increasingly difficult to service and/or stabilize its ever-growing debt burden in light of weak economic growth prospects. Hence, after fiscal consolidation, the main objective for the Portuguese government is to implement growth-boosting structural reforms. The main areas to consider are enhancing export competitiveness and rebalancing the economy away from consumption-led growth. Tapping into dynamic export markets and establishing a strong position in higher-value added export industries will prove to be key challenges. In order to do so, Portugal needs to raise its productivity through more investment in human and physical capital. In order to raise investment targets, external funds will need to be channeled away from consumption towards productive investments. Labor market reforms and a focus on wage moderation are crucial to increase the Portuguese economy’s competitiveness. A significant reduction in red tape and other competition-boosting measures will further raise the growth potential of the Portuguese economy.
Fiscal Policy: Will Additional Austerity Measures Reassure Financial Markets?
In March 2010, the Portuguese government’s Stability and Growth Program (SGP) committed to reduce the deficit from 9.4% in 2009 to 2.8% by 2013, largely through expenditure cuts. Initially the government had hoped to postpone fiscal consolidation to 2011 and beyond in order not to interfere with the still fragile economic recovery process. However, as anticipated in RGE’s Q2 outlook for the Portuguese economy, the government recently revised its originally back-loaded fiscal consolidation plan in favor of immediate spending cuts in an effort to calm financial markets. Moreover, in a move to offset contagion fears, the government drew up additional budget measures. While the 2013 fiscal target remains unchanged, the frontloading of already agreed-upon fiscal measures and the introduction of additional austerity measures reduced the initial fiscal targets for 2010 and 2011 by 1 percentage point and 2 percentage points, respectively. The austerity measures included in the revised fiscal consolidation plan are equally balanced between spending cuts and tax hikes. In the case of a negative growth surprise, RGE cautions, that an additional round of fiscal austerity measures might be required to reassure investors if Portugal will miss its fiscal targets.
In May 2010, the Harmonized Consumer Price Index (HICP) accelerated to 1.1% y/y, boosted by the rebound in energy-related prices. The tax hikes included in the government’s fiscal consolidation plan, in particular the increase in the value added tax (VAT), in the personal income tax as well as in the corporate income tax will put additional upward pressure on consumer prices.
Figure 3: Core inflation vs Headline Inflation
Core inflation, which remains slightly negative at -0.1% in May 2010, has started to strengthen, but in light of weak demand inflationary pressures will remain subdued. RGE expects consumer prices to rise 0.7% in 2010 and 0.9% in 2011.