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Global Economic Outlook
Portugal: September 2010 Outlook Update
By Katharina Jungen
- Despite strong momentum in H1 2010, economic growth will decelerate significantly in the coming months due to slowing export growth and further declines in domestic demand.
- The outlook for private consumption remains weak in light of rising inflation, fading stimulus measures, tight credit conditions and high unemployment.
- Boosting economic growth through broad structural reforms remains the key to guaranteeing the sustainability of Portugal’s public finances.
Outlook Update: Moderate Growth in 2010, Renewed Economic Contraction in 2011
Following a strong start to the year, the economic recovery decelerated significantly in Q2 2010. RGE now expects the Portuguese economy to expand by 1.1% in 2010, largely driven by a robust contribution from net exports. In the coming months, however, economic growth will slow to a notable degree as weakening impetus from the external sector starts to weigh on the already depressed domestic economy.
Figure 1: Real GDP Levels (€ millions, right axis) vs. GDP Growth Rate q/q (left axis)
In 2011, the slowdown in economic activity will sharpen further, pushing the Portuguese economy back into recession. RGE expects GDP to fall by 0.5% in 2011 as fading impetus from the external sector coincides with marked contractions in private consumption and investment once the government’s fiscal consolidation measures take full effect.
Growth Dynamics: Domestic Demand to Weaken Further on Slowing Export Growth and Fiscal Austerity Measures
Following a robust economic expansion of 1.1% q/q in Q1 2010, growth slowed to 0.3% q/q in light of weakening impetus from the external sector. Domestic demand, on the other hand, held up relatively well. Stabilizing business sentiment surveys and weakening forward-looking indicators such as industrial order growth suggest that the recovery peaked in Q2 and economic growth is set to moderate significantly in H2 2010 and beyond.
Figure 2: Portuguese Industrial Orders (indexes, base 2005 = 100)
Source: Portugal Statistics
In line with cooling global economic activity, the demand for Portuguese exports, which is already limited given the economy’s severe structural weaknesses, will start to slow in the coming months. The deceleration in Portuguese export growth is likely to prove more pronounced than in other eurozone countries due to the external sector’s strong focus on intra-eurozone trade—in particular with the battered Spanish economy—which means Portugal will not benefit much from brighter growth prospects in emerging markets. However, we still expect net exports to make a positive growth contribution in 2010 with weak domestic demand keeping a lid on demand for imports.
Domestic demand will see an even stronger slowdown in activity over the next few months. Following a strong start in H1 2010, we expect private consumption to stagnate at best this year as indicated by depressed consumer confidence levels. RGE envisages household spending remaining severely constrained for a prolonged period of time as a result of rising inflation, falling real wages, tight credit conditions and new tax hikes. Furthermore, unemployment stood at a record high of 10.6% in Q2 2010. RGE expects the labor market to deteriorate further in 2010/11 given the renewed decline in economic activity.
Investment activity will continue its downward trend in 2010 given large excess capacities, restricted access to credit and weakening economic growth prospects. In addition, the cuts to public investment programs, given pressing fiscal consolidation needs, will weigh on construction investment. As a result of the combined slowdown in the domestic economy and the external sector, RGE expects quarterly growth rates to slip back into negative territory at the turn of 2010/11.
In 2011, the contraction of domestic demand will intensify as external stimuli continue to fade and the impact of austerity reaches its peak. The effects 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 the Implementation of Broad Structural Reforms
Portugal will find it increasingly difficult to service and/or stabilize its ever-growing debt burden in light of its weak economic growth prospects. Hence, after fiscal consolidation, the most important 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. To do so, Portugal needs to raise its productivity through more investment in human and physical capital. The reform of the educational system together with the liberalization of product and labor markets will be key to improving the economy’s competitiveness. A significant reduction in red tape and the implementation of other competition-boosting measures will further raise the growth potential—and thereby help reduce the external imbalances—of the Portuguese economy.
Policy Implications: Portugal Remains Highly Vulnerable to Market Sentiment
Markets applauded the Portuguese government’s announcement of additional austerity measures in June 2010 aimed at speeding up the deficit reduction. However, while fiscal consolidation efforts remain on track in Portugal, with 2010 GDP growth very likely to exceed initial government estimates, sovereign debt fears returned in early September, driven by worries about the health of eurozone banks. The spread between Portuguese 10-year bonds and the German bund rose to an all-time high on reports that Portugal’s commercial banks borrowed more than €49 billion from the ECB in August due to difficulties in accessing private markets. Given that the Portuguese banking sector is relatively sound, particularly compared with banks in Ireland and Spain for example, the sharp increase in borrowing costs shows how vulnerable Portugal continues to be to market sentiment, even if it concerns developments in other periphery economies.
The Harmonized Consumer Price Index (HICP) accelerated to 1.9% y/y in July from 1.1% in May. For the first time since August 2007, the Portuguese HICP registered about the eurozone average. Core inflation rose to 0.7% in July, up by 0.7 percentage points from its value in May.
Figure 3: Annual Change in HICP vs. Core HICP
The tax hikes included in the government’s fiscal consolidation plan, in particular the 1 percentage point increase in the value-added tax in July 2010, will put additional upward pressure on consumer prices, which will be partially mitigated by the ongoing slack in the economy. RGE expects inflation to reach 1.4% in 2010 before rising to 1.8% in 2011.