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Monday, January 12, 2009

Portugal Sustains

by Edward Hugh: Barcelona

"Art has a function of teaching about the human condition. We live in hope, hope is fundamental" - Manoel de Oliveira

Manoel de Oliveira (photo and quote above) is a living example for the Potuguese people of how to force their way out of the low growth/low per capita income trap into which they have steadily stuck their neck. Oliveira celebrated his 100th birthday last December - and how did he celebrate it: by starting work on a new film. Traditional productivity theory suggests most people slow down with age, but Oliveira seems to have done just the opposite - and since 1990, he has made at least one film a year. His secret for longevity, work much and rest little (oh yes, and also remember that living in hope is fundamental, it's funny, but my father who lived to be 84 and worked to 80 gave me the same sort of message). Indeed far from implementing a 35 hour week he seems to only stop on Saturdays - "This is the only day of the week that I rest," he told journalists back in December when he interrupted shooting on his latest film to give them a rare press conference. So in a country where the average age of leaving the labour force is currently 63, and where raising employment participation rates is a national priority, what better example of a "local hero" than Manoel. What follows will be an attempt to reveal just what it was he was so meticulously trying to capture with his camera in the photo above. Just call me an inveterate "peeping tom", lookout Portugal all is now going to be revealed!

But Some Reasons Why We Are A Little Short On Hope Right Now

Portugal, it seems lives in perpetual hope, hope for that sustained and substantial recovery which always, somehow and disappointingly, lies waiting for it just around that next corner but never actually appears. Equally Portugal is not in recession, at least not yet it isn't, although if we look at the most recent movements in the EU economic sentiment indicator, the Portuguese economy could hardly be said to be passing through one of its best moments. The thing is, since the turn of the century it has been hard for anyone to identify one of those "better moments" in the Portuguese case, or to offer some empirical justification for that evident existential need we all have to eternally live in hope.

Having said this, Portugal could also hardly be said to be riding the wave of a boom-bust trajectory (like its Iberian counterpart and neighbour), since if you never got the boom in the first place, well you obviously aren't going to get the bust part either. So it should not surprise us to find that after contracting slightly during the first quarter of 2008, the Portuguese economy has continued to move forward, and was even continuing to "sustain" a 0.7% year on year growth in Q3 2008. Hardly spectacular, but then (as we shall see) Portuguese growth has hardly been spectacular in recent years, but equally far from being a "worst case scenario".

But then, as we know, everything that lives was born to die, and so it will be even with Portugal's current (lacklustre) expansion, with the Portuguese economy seemingly set to contract this year for the first time since 2003 as its main export markets weaken and Portuguese consumers rein in their spending. Portugal's central bank now expect the economy to shrink by 0.8 percent in 2009 - a downward revision from its July forecast for a 1.3 percent expansion. Also according to the bank, the country’s economy probably grew 0.3 percent last year, a prognosis which seems reasonably realistic following Prime Minister Jose Socrates recent admission that the economy shrank 0.1 percent in the third quarter. So even while Portugal sustains, resistance, this year at least, would seem to be futile.

The Short Terms Dials All Move Over To Red

All the main short term indicators (industrial output, retail sales, employment etc) showed significant weakening in the second half of 2008 (industrial output, in particular, really went west in the second half - and together with manufacturing industry, construction activity was down, although it is important to note that in Portugal's case construction was never really "up" - or at least in recent years it wasn't as we will see below). Industrial output was down 2.9% in October over October 2007, and contracted on a year on year basis in each of the five previous months (see chart below). Retail sales were down 1.6 % year on year in November and by 1.4% from October (seasonally adjusted).

As just one indicator of the way demand for some Portuguese products is waning at this point, the three European countries most affected by the heavy-truck sales plunge are Spain, Portugal and Germany, with respective declines of 58 percent, 40 percent and 34 percent registered in November. As in other countries the automotive sector is being particularly hard hit, and the government announced a 200 million euro credit line for auto and car parts exporters back in December. The package, agreed between the government and companies including Volkswagen and Peugeot Citroen includes 70 million euros for training courses for some 10,000 employees - the Portuguese association of auto industry producers has estimated that the downturn in car sales will lead to 12,000 job losses during the first half of 2009. Economy Minister Manuel Pinho has stated that, including trade credit insurance of 300 million euros and the potential investments that the incentives should generate, the total value of the government plan is likely to be in the region of 900 million euros - not a lot of money in terms of the sort of programmes being seen in countries like the United States, but for a small, comparatively poor country like Portugal, with a government debt problem to think about, hardly insignificant.

Ever Weakening Trend Growth?

As the big wheel of global events follows its charted course, Portugal can at least be thankful for small mercies, since the country is not suffering under the added burden of a housing crash (it is not an Ireland, or a Spain, or the UK, or even, dare I say it, Denmark), for the very simple and straightforward reason that it never had a housing boom in the first place (or better but, since the late 1990s it hasn't had one, and one of the purposes of this article will be to examine just why that is). Portugal's problems are, unfortunately, more long term and more endemic, strikingly similar in many ways to those of Italy. So we should beware of making a simplistic generalisation and talking about a North-South divide in the eurozone. The economic profile of Portugal (or Italy) is really rather different from that of Spain (or Greece), in much the same way that France's economy is essentially very different from Germany's (of course, Sir Roy Harrod will probably be turning over in his grave at this point, with the thought of what this might imply for the theory of "convergence", but for now we might perhaps leave him in his tomb to timelessly struggle with this rather thankless labour and move on, since before jumping to too many overhasty generalisations it may be worth first examining in detail the actual dynamics of a number of the individual eurozone economies).

The nice thing about empirically grounded sciences is the freedom they give their practitions to follow (or chase after) the "facts", without the pressure of being compelled a-priori to reach premature conclusions, regardless of whether or not it is considered to be politically - or incorrect - so to do (hence Ben Bernanke's multiple references in "The Euro At Five" to the eurozone as a great experiment, a "natural experiment in monetary economics"). We economists have to learn to live with the experimental nature of our science, even if the "rats in the maze" may get somewhat frustrated with our efforts at times.

Now if we look at the chart below we can see that if quarterly growth in Portugal is sluggish, this sluggishness has in fact been operative over quite a long period of time.

In fact since Q1 2000 Portugal has had 2 recessions (when defined as two successive quarters of negative growth): in Q3/Q4 2002, and Q3/Q4 2004. There have also been 7 more quarters where growth has been negative: Q2 2000, Q1 2001, Q2 2003, Q3 2005, Q3 2007, Q1 and Q3 2008. That is out of a total of 30 quarters, the Portuguese economy has contracted in 11, or around 30% and the average GDP growth rate has been 0.37% per quarter or 1.48% per annum. For a country whose per capita income is the lowest in the EU15, and which is badly in need of "catch up" growth this is hardly a happy situation, and beyond the national administration should be giving food for thought for those resposible for economic policy across the Eurozone, and also among those among the EU10 who have recently joined, or are set to join, the common currency area.

Even more worryingly, Portuguese growth seems to have gone through three phases since the early 1980s, with each "wave" being weaker, and indeed during the years since entering the eurozone Portugal seems to have gotten absolutely no "boost" whatsoever.

No Housing Crash Or Pile Of Toxic Debt In Portugal

So what could explain this evidently "sub-par" performance? Well, during the years of ERM participation (the precursor of the euro) Portugal's nominal interest rates dropped from 16% in 1992 to the 4% eurozone entry rate at the start of 2001 - while real interest rates dropped from 6% to zero - so the problem doesn't appear to be - prima facie - what you could call an overly tight monetary regime: post euro-creation ECB interest rate policy has been largely accommodative to Portugal, and in particular interest rates were, by and large, negative during the entire period between the end of 2001 and the end of 2006. Yet, economic activity remained sluggish throughout this period, and even the construction sector showed little sign of life.

In fact the last house price spike Portugal had was in the years 1998/99, and during most of the years since Portugal joined the euro (as can be seen in the chart below) house prices have in fact been falling.

(Please click on image for better viewing)

And if we look at the construction output charts, during all of 2006 and throughout the first half of 2007 the Portuguese construction industry seems to have been in something of a deep slump.

Even more preoccupyingly, Portugal's construction industry seems to have past its historic peak in 2000, with the output index declining steadily ever since.

While the banking system may not be the most splendid of health (remember there is that little issue of the current account deficit to finance), it has not taken any kind of "full frontal" hit from the global financial turmoil - having little exposure to US sub-prime type debt, and no large pile of housing loan defaults set - Spansih style - to arrive and spoil the party. So Portuguese Prime Minister Jose Socrates may well have been right when he reiterated recently his government's view that no major Portuguese banks are likely to fail.

However, since the global financial crisis hit major U.S. and European banks last October, the Portuguese government has reacted by offering state guarantees of up to 20 billion euros on bank loans and 4 billion euros in capital for local banks. Portugal's top banks - Millennium BCP, Banco Espirito Santo and Banco BPI - all seem to weathered the crisis relatively well so far. The government has had to nationalize the small private bank Banco Portugues de Negocios (BCN) while a consortium of larger banks have been invovled in rescuing Banco Privado Portugues (BPP), but the financial problems here preceded the current global financial crisis and seem to have been merely exacerbated by the credit crunch.

The 2009 prospects for Portugal's construction sector seem pretty bleak for 2009 - after the sector probably failed to expand in 2008, following six previous years of decline. Manuel Reis Campos, president of the Portuguese Federation of Construction Industry and Public Works (FEPICOP), expects turnover to be around 20 billion euros in 2008, a similar number to 2007.

"At the start of the year we were saying the sector was going to grow 2.5
percent and what happened is that we have lost another year," Reis Campos told
Reuters. "The overall sector progress is going to stagnate in 2008," he said.
"The situation is so bad and the employment issue so serious that any (2009)
forecasts have to be very cautious."

Campos said the industry has been in decline since 2002 "and it's not a result of the current international situation". He expects the situation to improve in 2009 on the back of government infrastructural project (see below) but his outlook for residential construction is for yet another decline - possibly by between 3 percent and 5 percent. Residential construction has the heaviest weighting in the construction sector (38 percent) and the industry accounts for 5.6 percent of gross domestic product employing 11 percent of the workforce (560,000 jobs).

Real Effective Exchange Rate

One explanation which is often offered when people come to look at Portugal concerns what has been happening to what is called the Real Effective Exchange Rate. Now the Real Effective Exchange Rate (or REER) of a country is an instrument which can be used to assess price or cost competitiveness relative to the position of the country's principal competitors. The REER is an instrument which is widely favoured by economists since competitiveness depend not only on exchange rate movements but also on cost and price trends. Eurostat offers us one such measure of REER, and the REER used in the construction of the Eurostat Indicator has been deflated by nominal unit labour costs (for each economy as a whole) against a panel of 36 countries (EU27 + Australia, Canada, United States, Japan, Norway, New Zealand, Mexico, Switzerland, and Turkey). A rise in the index means a loss of competitiveness (taking into account productivity changes via the movement in comparative unit costs), and as we can see in the chart below, Portugal has substantially lost competitiveness against Germany since 1995. Were a convergence in living standards taking place between Portugal and Germany via a more effective use of a pre-existing labour force, or a boost in productivity achieved through a shift across productive sectors (eg away from agriculture and into knowledge economy products) the we would not expect to see this pattern, since any increase in living standards would be accompanied by a maintenance in the competitive position. (This point, in Portugal's case, is unfortunately highly theoretical, since as we will see below, convergence in living standards is not in fact taking place. That is, Portugal really is stuck).

In fact I have been a little naughty here, since I have also included Spain in the comparison. I have done this since the argument that Portugal has lost competitiveness against Germany is fine as far as it goes, but as an explanation for why Portugal's growth has stagnated post 2000 it is clearly insufficient, since growth in Spain - at least up to 2007 - has been rather stellar, so the question should really not be why is Portugal so different from Germany, but why is Portugal so different from Spain (as I said above, we shouldn't be dividing Europe simply along a north south axis, and that the differences within regions (like also the Germany-Spain one) are also interesting and very, very revealing.

Now basically it seems to me that you can say either one of two things, but not both of them at the same time. Either Portugal should have had the same growth as Spain (all other things being equal), or Spain should have had as little growth as Portugal did. In reality the likelihood is that both countries have had their growth paths rather skewed (in opposite directions) by participation in monetary union, but going further along this path at this point would take us well beyond the matter in hand.

So what we have here is a very strange state of affairs indeed, and it should lead us to ask ourselves just what it is than has been going on in Portugal over all this time? In addition, and as can be seen below, Portugal's relative GDP per capita (vis a vis the EU27) has declined steadily since euro membership, after reaching a high point in 1999.

So What Is The Root Of The Problem?

Just what has been going on all this time in Portugal then? Perhaps the most systematic piece of work to date is a paper written by MIT Professor and Current IMF Research Director Olivier Blanchard - Adjustment within the euro. The difficult case of Portugal. Blanchard's argument, which is certainly the most coherent "mainstream narrative" we have at this point - and I hope I am not simplifying his argument excessively - would seem to run as follows:

In the first place Blanchard divides Portuguese growth into two periods. During the first of these - running roughly from 1995 to 2001 - Portugal experienced reasonably healthy GDP growth, a steady decrease in unemployment, all acompanied by a rapidly growing current account deficit. During the second period, roughly since 2001, there has been continuously weak economic growth, a steady increase in unemployment, while the current account deficit has remained stubbornly high, and even (since his paper was written) increased.

Blanchard argues that the proximate cause of Portugal's mid 1990s boom was participation in the ERM and in the build up to the euro (the longer term cause would, I feel, be some yet to be identified underlying structural transformation that was going on, trying to get to grips with this is the point of this article). This participation combined with expectations that participation in the euro would lead to faster convergence and thus faster growth for Portugal, lead to an increase in both consumption and investment. But, of course, as we have seen, this convergence did not take place, nor does it appear likely to do so.

During this phase Portugal's budget deficit decreased slightly, although discretionary fiscal policy was generally expansionary. Blanchard makes the point that between 1995 and 2001 the cyclically adjusted primary deficit (adjusted for the effects of lower interest rates and output growth) increased by roughly 4%. This choice of dates does seem to me however to be rather tendentious, since - as we can see from the chart below - the main increases in the deficit came after 1999, and in that sense are not really part of the period that should most concern us, which is the one immediately prior to the domestic consumption and construction fixed investment blow out. One possibility here would have be that the budget deficit simply "crowded out" private activity, and placed an excessive burden on an already overstrained capacity. But if we come to look closely at the timing of things, this argument may be harder to sustain than seems at first sight (and indeed government spending as a percentage of GDP only really started to rise sharply after 1999 - see chart further down the post - and thus post dates the contraction in private consumption).

The fiscal deficit was in fact reducing from 1994 to 1999, and only started to rise again after 1999. On the other hand, if we look at private consumption growth, we find a rather different pattern, since private consumption growth peaked in Q1 1999, and then dropped back steadily all the way through to Q2 2001, at just the time the fiscal deficit was increasing.

So the increase in government spending can be thought of as a knock-on consequence of the decline in private consumption growth and not the other way round. It was simply due to the automatic stabilisers coming into action. So the big question is why, in the Portuguese case, the construction and consumption boom came to an end when it did, while it continued and even accelerated in Spain and Greece, rather than why the fiscal deficit started to increase.

The drop in unemployment which accompanied the initial boom lead to significant labour market tightening, and this tightening - coupled with rising EU convergence expectations and talk of Harrod-Balassa effects and suchlike - produced a situation where wages increased rapidly in comparison with other EU countries. Again we should note the similarity between what happened in Portugal and what has been happening over the last two or three years in Eastern Europe, where certainly the comination of sharp decreases in unemployment and strong euro area membership expectations has acted like putting a lighted match to a tinderbox.

To take just one example, when Portugal joined the EU in 1986 workers without college education earned only 50% of corresponding French wages in PPP terms, while college graduates earned 72%. By 1994 unskilled and skilled wages had risen to 67% and 93% of French wages respectively. In addition, nominal wage growth was significantly higher than labour productivity growth, leading unit labor costs to rise at a substantially faster rate than the euro area average. Hence Portugal's competitiveness deteriorated, as did its goods trade deficit.

Blanchard takes the view that unemployment at the start of the first period was above what he terms "the natural rate" - since, he argues, while an unemployment rate of 7.3% (1996) is not especially high by EU standards, it was high in terms of what Portugal had become accustomed to by the early 1990s. Thus he considers that capacity existed for some growth in excess of "normal" was not problematic. By the end of the 1990s - so the argument goes - unemployment had become lower than the "natural rate" and non-inflationary "catch-up" growth started to become problematic - again it would be interesting to make a comparison with what just happened in Eastern Europe in this context.

Blanchard also takes the view (and I thoroughly concur) that some degree of current account deficit was clearly justifed in Portugal in the mid 1990s (since if everyone runs a suplus the whole global system cannot work), given that the arrival of both a lower real interest rate together and expectations for faster "catch-up" growth is likely to stimulate higher private spending, be this from private consumption or be it from investment. The real real issue is that this boom, in theory at least, should lead to a structural transition to higher productivity and higher value added activities, and the issue in Portugal's case is that the needed and anticipated higher labor productivity growth simply did not materialize. Instead, productivity growth nearly vanished, averaging 0.2% per year from 2001 to 2005.

The end result was that the investment boom came to an end as household spending effectively stalled due to the high levels of household debt which were accumulating and the deterioration in future prospects which was taking place (can anyone else smell the Baltics here??). So private consumtion growth stalled and household saving increased.

The end consequence has been that, in an environment where increasing exports to drive GDP growth became very difficult due to the absence of an independent currency and monetary policy and a lack of price competitiveness, the slower rate of consumption growth and the consequent weak investment demand have led to an enduring output slump, while Portugal's unemployment rate has now returned to its former higher level (7.9%) and the current account deficit has steadily increased, reaching 9.4% of GDP in 2007.

Spain, Portugal and...... Hungary

Several commentators have drawn attention to the similarities which may be discovered by scrutinising Portugal in the context of recent events in the East of Europe (see this example from Christoph Rosenberg), and I would like to take this opportunity to draw attention to the remarkable common points I have been finding between what happened in Portugal in the 1990s and what has been happening in Hungary since 2005 (or see this earlier post). In the first place because both countries found themselves faced with a twin deficits crisis, both saw fiscal spending surge sharply upwards as a response to a sudden drop in domestic consumption, both have been unable to sufficiently ramp up exports as a result of excessive downward rigidity is the wage setting process, both have had absolutely stagnant employment growth, and both, and here is the really unusual detail, were experiencing downward movements in their population at the time their problem really got going. Quite what connection one thing has with the other reamins to be established, but I beg to suggest that this correlation is far from incidental.

If we look at the Portuguese case we can see the downtick in overall population numbers quite clearly when we look at the relevant chart (see below), the unusual thing about the Portuguese case this is more the by product of "freedom of EU movement" outmigration (more appropriate to the Baltic and South East Europe connection than the Hungary one) than it was to the impact of lowest-low fertility, since while Portugal's fertility has been below replacement level since 1982, it only really fell below the critical 1.5Tfr rate in 1994.

If we look at the long term migration chart, we can see where the root of the problem was.

And if we also look at the chart below and see how the supply of remittances has dried up (ie all these potential young consumers have now become a net loss to the economy) we can perhaps begin to understand how it was that domestic consumption started to stagnate.

In theoretical terms economists have long spoken about the possibility of having multiple "equilibria", and how economic processes are to a certain degree "path dependent", well in the cases of Spain and Portugal we couldn't have a clearer example I think. If we look at net migration between 2000 and 2008, the difference between the two countries is plain to see. Spain went up and up.

While Portugal went down and down (see below). We couldn't have a clearer example of the contrast between positive and negative feedback processes, illustration of how most contemporary migrant flows are "labour market driven".

And again, if we think about house prices (see earlier Portugal chart) Spain was going through an enormous asset price inflation boom during these very same years.

So Spain and Portugal were receiving one and the same monetary policy, with very different results in each case, since while Spain's inflation accelerated during the highpoint of monetary easing, Portugal's rate even dropped. This should give some food for thought to all those who simplistically talk about the "pernicious" effects of low interest rates.

And again, as can be seen in the next chart, one and the same monetary stimulus lead to very different domestic consumption paths.

Indeed while Spain's unemployment fell during the first years of euro membership, Portugal's unemployment actually went up.

And yet if anything average annual wage cost growth in Portugal has been lower.

In Conclusion - Going Off The Rails In Portugal?

This is where Portugal is today. In the absence of policy changes, the most likely scenario is one of competitive disinflation, a period of sustained high unemployment until competitiveness has been reestablished, the current account deficit and unemployment are reduced............ It is a process fraught with dangers, both economic and political, and one which can easily derail.
Olivier Blanchard - Adjustment within the euro. The di±cult case of Portugal, November 2006.

Well what we most certainly have not seen in the Portuguese case in any sort of credible process of competitive disinflation (which makes me wonder about the extent to which any such process could work in an East European context like Latvia or Hungary, if the prospect of Eurozone membership is dangled out just before them - falling wages never prove popular anywhere, and politicians have a strange habit of not carrying through things which turn out to be unpopular). So has Portugals economic and political development process been thrown off the rails. I fear it has.

Possibly the clearest example of the extent to which Portugal's economy has been "derailed" is to be found in the stagnation of the labour market. After shooting up as the turn of the century (possibly in a process which involved deep "whitening" of the submerged economy, see chart) the number of people employed in Portugal has actually marked time, and now during the present global recession it may even drop back again, to what would effectively be pre 2000 levels.

And now with a global economic crisis breathing down our necks the situation is likely to get worse not better. Indeed Portugal has just announced a 2.2 billion euro package to boost its flagging economy. No harm in that, but when will we really bring the fiscal deficit adjustment to a satisfactory conclusion? The package will focus on investment in schools, boosting technology and alternative energy. The finance minister has said the package is expected to give a 0.7 percentage point boost to GDP in 2009.

In 2008, the general government deficit was forecast at 2.25% of GDP, down from 2.6% of GDP in 2007, but this number now seems to be out of date hardly before the ink was dry.

In fact the government deficit is now projected to rebound to over 3% of GDP in 2009, this is hardly alarming given the global backdrop, but it is also far from being a positive development. On the revenue front, the economic downturn is expected to take a significant toll on tax proceeds, while on the spending side, some acceleration is expected on the back of higher social transfers, which reflect, first, the (partial) indexation of cash transfers to the previous year's inflation rate; second, recent policy measures, and, third, no further decline in unemployment benefits.

Among new spending plans there is a 43 billion euro public-private infrastructure development plan (which is set to run through to 2017), and which includes projects to build a new international airport near Lisbon and a bridge over the Tagus river. The government has also approved an economic stimulus package worth nearly 2.2 billion euros.

For 2010, applying a simple no-policy change assumption, the EU commission currently forecast the government deficit to be around 3.25% of GDP, thus after falling in 2007, the government debt to GDP ratio is projected to resume its upward trend and reach 66.5% of GDP by 2010. And this on a "best case" (no policy change assumption) scenario, when clearly there is abundant downside risk to any present forecast.

Of course another of the problems Portugal will have in 2009 is that of financing and reducing its current account deficit, which is estimated by the IMF to have hit 12% of GDP in 2008. In particualr I would draw attention to the structural damage to the income account (see chart below) which has been caused by the external financing required by so many years of running such large deficits. Thus as we get into 2010/11 the risk of a serious financing problem on the back of a pair of "twin deficits" which simply get worse and worse is hardly to be taken lightly.

Is There A Deflation Risk?

Portugal is currently undergoing something of a strong disinflation process, with the annual CPI falling from a high of 3.4% in June to 1.4% in November. Not only that, the general HICP index has actually declined on a month on month basis for four of the last five months.

And the danger is that demand falls Portugal could be dragged off behind it into deflation territory. And the coming contraction could be a sharp one with both Bank of America and Deutsche Bank predicting that the economy of the 16 nations that share the euro will shrink by 2.5 percent this year.

European Central Bank council member and Bank of Portugal Governor Vitor Constancio is aware of the danger and has indicated that the ECB is prepared to reduce borrowing costs further to prevent inflation slowing “significantly” below its 2 percent ceiling, even going so far, if necessary, as to introduce some variant of quantitative easing. He still thinks it won't happen, but he is well aware of the possibility, as indeed we all should be.

“Any risks of inflation settling well below that level must be preventively contained with interest-rate reductions.........In the middle of the year, we may have some months of negative inflation,” though “not deflation,” Constancio said “the priority” for European governments is “to limit a recession that became inevitable but that has to be contained in order to avoid scenarios of depression and deflation.” If deflation “gains momentum, it’s very dangerous,” Constancio said. “It’s very difficult to escape from a process of deflation.”