3rd June 2013: Portugal Deficit Update

Portugal’s long and arduous process of fiscal adjustment has not been without obstacles and the latest stumbling blocks have threatened to undermine much of the recent progress.

Two years on from Portugal’s €78 billion bailout and opinion remains divided on the success of the government’s broad-based and painful reforms. Indeed, despite extensive cuts in 2012, the deficit climbed to 6.4% of GDP (from 4.4% in 2011) due, in part, to a larger-than-anticipated 3.2% slump in activity which has sapped government revenues. Despite this, the Southern-European nation has gained plaudits from its Troika of lenders for its commitment to debt reduction, a faith which has culminated in EU finance ministers granting an extension on loan maturities in the hope that Portugal will ease away from bailout funds. The country took a giant step towards this in May, nearing the milestone of a return to long-term bond markets, with the first sale of 10-year bonds since it requested a bailout in 2011.

That said, other recent eventshave not all been as bright as the government’s resolve to overcome the unsustainable debt burden is being severely tested. The 2013 budget represents the harshest spending plan ever presented to the nation and objections have been widespread, from trade unions to public sector workers. The opposition to the draconian nature of the proposals were made clear in April, as the constitutional court rejected four of the nine measures in the budget, a decision which forbade the implementation of €1.3bn worth of savings. Following three months of discussions, the court decided that a scheme to reduce public sector pay and pensions, via withholding Christmas and summer bonus payments was deemed to be unconstitutional and consequently rejected.

With a large proportion of the €5.3bn debt reduction measures in 2013 driven by taxation, the prime minister was eager to keep the target on course without additional tax hikes, which would further undermine activity. As such, Coelho managed to locate €800mn worth of alternative spending measures, while bringing forwards cuts from 2014’s budget. It was not the first time the constitutional court has intervened in the government’s plans, as the court made a similar play last year. This highlights the domestic restraints and rigidity facing the government’s adjustment plans, not to mention the wave of protests that have met austerity measures. However, the swift response demonstrates Portugal’s commitment to slashing the deficit and improving the country’s fragile position within the Euro area.

Meanwhile, the government has announced its latest austerity plan, to keep the economy on track in the medium-term, with €4.6bn of cuts by 2015. Alarmingly though, the latest cuts risk causing a rift within the ruling coalition as policies which include 30,000 job cuts in the public sector, increased working hours and a higher retirement age, proved to be unpopular with the coalition party, the Democratic and Social Centre – People’s Party.

Another concern is the persistent lack of activity as the economyentered its tenth successive quarterly contraction in 2013q1. The lack of activity is a result of the short space of time within which fiscal imbalances have been addressed. This heightens the risk of tax revenues being insufficient to meet deficit targets and with activity expected to contract by a further 2.7% in 2013, downside risks to this year’s 5.5% target remain. Despite missed deficit targets, Portugal has undoubtedly made structural progress since the 2011, which is important for its long-term sustainability. Provided political tensions do not escalate and the passage of new cuts are permitted without violating constitutional fundamentals, Portugal can continue to make credible steps towards cutting the deficit to 4% in 2014 with the ultimate goal of reaching 2.5% by 2015.

Written by Thomas Crowdy