Portugal(Euro Debt Crisis)

By: Kumar Nittin

A Brief Overview
Portugal was the third country in Europe that had to request for international financial assistance from European Union and the IMF on 7 April 2011. Since the financial crisis of 2008, Portugal had gone through result of high government expenditure and very low growth(less than 1% in 200010), Portugal had to go for financial assistance. In 200809 it came to be known that the two banks BPN and BPP were running through losses

Any Interesting Fact prevailing at the time/Background of the Crisis/

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It is to be noted that Portugal always had trade deficit and in the last 236 years there were only 7 years when it had a surplus. It might be possible that due to the opening up of the economy and Euro acceptance, its competitiveness was not able to get adjusted with the rest of the countries which resulted in the present crisis.
negative real growth rates of 0.1, -2.6 and -1.5 in 2008, 2009, and 2011 respectively. Unemployment rate has been increasing in Portugal since 2002 from approx. 4.9% to 13% in 2011. Public debt increased from 66% of GDP in 2008 to 112% in 2011. Due to high public debt as well as external debt held by Portugal and high fiscal deficit which was a which were hidden. Since BPN was a very big bank, in order to avoid banking crisis the banks had to be bailed out. All these things taken into account and spending by Portugal government in order to stimulate the economy, Moodys cut sovereign bond rating of Portugal down two notches

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leading to an increase in bond yield. Portugal did not have enough

finances to even cover the debt service coverage ratio.

Causes
In hindsight, several causes can be attributed to Portugal Crisis: Participation in Exchange Rate Mechanism and adoption of Euro: Due to this policy, Portugal was having accession to Euro Bond Market whereby the integration of EU led to an increase in the amount of money and thereby decreased the interest rate. Portugueses nominal interest rate decreased from 16% in 1992 to 4% in 2001 and real interest rate decreased from 6% to 0%. Due to this there was too much consumption as well as too much investment with less private savings. This resulted in high growth and less unemployment due to which nominal wage growth was high making the country less competitive but at the same time creating more opportunities for import by the country. This led to increase in current account deficit from 0.1% in 1995 to 9% in 2001. Moreover it needs to be noted that that 70% of Portugal exports was within the European Union. Please see Figure 1 at the end of the document for GDP growth and interest rate and other figures. But, in spite of high growth due to large current account deficit, the debt was increasing. As debt increases it results in payment of interest rates. If this payment is not offset by decrease in wages which consequently might lead to decrease in prices making the economy more productive, the current account deficit will further rise and output will be above normal. This finally results in huge debt and deterioration of the economy. But the more important question is could not the economy be stimulated by internal demand. The reason of slump in 2001 as stated above was overvaluation of the economy which includes wages and labor productivity due to which tradable goods came from outside inside the country as well as the inflow of FDI went to other economies due to its overvaluation. The demand could only have been created by excess public sector employment which increases the deficit a lot. This could have been corrected through making the economy more productive and decreasing of taxes like VAT et al and for which progress was of course made but not to the required extent to make Portugal comparatively competitive with respect to its competing nations. This thing continued till 2010 and Portugal had to go for financial assistance. Please see figure 2 for economic figures of Portugal. The above point is exactly seen in the case of Portugal. A point comes to be noted. Whenever an economy grows above its natural growth rate there is bound to be some sort of bubble being created.It is seen in the case of Japan that deliberately manipulating exchange rate as well as the extremely high hosing pricxe resulted in the slump in 1990. Similarly, is the case with the US where housing price above normal created recession. The important thing that is to be noted is that the central bank and the government must try

to curb growth above normal rate. In case of India as well the easy liquidity that was allowed into the market from 2002-07 created a CAD and the growth rate of approx 10% was most probably above its normal rate. It is to be seen that government curbs such demand by increasing interest rates or by taxing the inflow of money or imports. Moreover as is seen in case of Portugal the labour market should be made too flexible to be competitive although India and China can devalue their currency which was not in the case of Portugal. Similar is the case with China where investment has been too much above the natural rate. Moreover, in case of Portugal the labor productivity growth was a dismal 0.2% from 20012005. Investment growth ended and the high accumulated debt and poor future prospects led to an increase in household savings which was offset by increasing government expenditure as unemployment was rising. Due to the lower competitive index of Portugal, it was not able to increase its exports.

Also, Portuguese exports about 60% of its products in low-tech areas and it faced huge competition from emerging market economies like China and India. The end of Multi Fibre agreement in the beginning of 2000s had a huge impact on export sector as textile export contributed to about 33% in the early 1990s. This fell to 13% in 2006.

Impact (GDP, unemployment, debt etc.)

The impact of the crisis can be seen from the graphs given at the end of the article for GDP growth rate, Unemployment as well as debt. It is seen that GDP growth rate and Unemployment go together. If one rises the other fall. It is seen that every negative factor is on rise. Unemployment si rising. GDP growth has been

All these factors led to huge current account deficit from 1996-2007 and the unemployment rate also started to increase because of low labor productivity which was benefited by other Euro countries, poor education which did not produce enough skilled labors for high productive jobs as well as increasing government spending in order to dampen high unemployment rate which recruited the highest number of redundant employees. These things led to huge fiscal deficit in years after 2008 as written above. Hence, combined with global recession and its own problems as described above Portugal had to go for Financial assistance.

negative. Public debt has been increasing.CAD although becoming less exhaustive is still in the positive region. Fiscal deficit, although decreasing, is still in the negative zone. Labor productivity is 52% of EU. Bond yield although not to the extent of 2012 is still 5%. Either Portugal has to give away and live with its own currency or it has to go a long way as per labor productivity is concerned as well as producing high-tech products.

Measures Taken
Finally Portugal had to go for a bailout from EU and IMF for 78bn Euro.If we talk of measures taken by Portugal, measures in little steps were taken since 2002 itself to improve the economy. But if we consider the point from

2008 onwards, there were measures taken to undo the past wrong things. It started with Greece when in 2010 due to huge problems of Greece which was very clear to investors, Portuguese 10 year bond rates reached 4.725 because of the fact that fiscal deficit of 2009 which came at that time was 10.1 percent much higher than anticipated. Responding to this market pressure when Portuguese bonds rose, the Portugal government said that the target fiscal deficit for 2010 and 2011 would be 7.3% and 4.6% respectively although 2010 fiscal deficit was 9.1%. The deficit could have been even higher but the government cut down on expenditure and personnel costs as well as tightening revenue side measures. This led to a decrease in bond yield in July 2009.To calm the market sentiment, government presented an austerity budget on 15 Oct 2009. In November 2010, Portuguese parliament approved the toughest austerity budget in the last 30 years which aimed to reduce 2011 deficit to 4.6%. It cut all public sector salaries by 5%. In spite of high

unemployment, it stopped any recruitment in public sector jobs and all promotions and salary hike was stopped. Social benefits and allowances were reduced and pensions frozen. In order to increase the revenue, VAT was increased by 2% and 1% increase in employee contribution towards social security security. In order to provide relief to the Euro zone countries, EU set up EFSF and ESM (European Stability Mechanism) along with private sector participation where private creditors would also participate in line with IMF rules. The bailout was granted on the basis of tough measures that were to be adopted by the government which was done. The adoption of Treaty on Stability, Coordination and Governance in the European Monetary Union was adopted by Portugal as well. This treaty ensures that the government deficit does not exceed 3% of the GDP and that government debt does not exceed 60%of GDP. Even for the budget of 2014, tough austerity measures have been adopted where proposals have been made to cut public sector pay by 12%.Planned cut in state pension is also on the

anvil. Troika had said that Portugal need to cut its budget deficit to 4% in 2014.Also, the government said that it aimed to cut corporate tax to below 19% gradually. Moreover, along with VAT as mentioned above timely revaluation of property projects will be done, approx. 5 million which will increase the tax receipt of the government. Tax courts have been established to resolve tax-disputes which have been very encouraging. PPP(Public private partnerships) projects have been given significant push which have saved the fiscal situation of the government in 2013.

Loopholes/Impact of Measures & Recovery

People can say that the tough measures taken have loopholes. Already when economic growth is negative, cutting down government expenditure does have a huge setback on employment factor. The point is that growth cannot be triggered when austerity measures are taken. During recession, demand weakens and unemployment and the fear that there will be job loss drives down demand and consequently prices as

well as wages. But, along with the austerity measures the government should focus on increasing labour productivity as well as paying more importance to education and especially higher education. Moreover, since EU is comprised of these nations + Germany, Germany should try to invest in these countries in order to create employment. The point is that as austerity measures are taken into account, unemployment increases and profits of industries plunge die to which tax receipt might decrease and if extra tax is added it would not be beneficial for the industry. VAT is a different concep0t whereby implementing VAT it increases the export competitiveness of the country. The effect of austerity is depicted by the below graphs.

amount of debt which results in too difficult situations. As well as wherever there is poor labor productivity, and the country is subject to free trade and free flow of money et al, it is bound to destabilize. India has a very important lesson to learn from it. Portugal could have been a successful case had its productivity been high which resulted in it making uncompetitive products. India too should focus on labor laws in order to make them productive. India needs to shift focus on highly skilled labor as well as putting huge importance on skill development. Bureaucracy should be curtailed to make environment more productive. Easy flow of money needs to be curtailed to a certain extent

Portugal could have been successful had it got its own currency kept on floating exchange which could itself have taken care of competitiveness, inflation. The case is that since Portugal cannot go out of EU now, ECB can make a rule that the surplus countries of the EU need to contribute some % of their trade surplus to a buffer fund of ECB which can be used in times of crisis. This is not to say that fiscal responsibility should not be managed. It needs to be managed which the EU is already doing. The reason I say this is that if trade surplus countries like Germany is competing with poor competitive countries, had there been several currencies Germany could not have gone on without making its product less competitive. But if this is not the arrangement whereby Germany is taking advantage of such a situation it has to pay a part of trade surplus. It would

What lessons can be learnt from Portugal Crisis Portugal Crisis has a very important lesson. It can be seen that countries which go beyond their means in terms of fiscal deficit as well as CAD take huge

as well as huge increase in labor costs should be prevented. The central bank should be able to observe the bubbles in the market and prevent it. But one of the most important things is that

be just like one EU with several states under it. Even if this is not the case, the concept of one currency can be given away with, with several currencies competing against each other and EU acting as a regulator.

Data Charts and Graphs

Figure 1

Figure 2

Figure 3

Figure 4

Figure 5

Figure 6

Figure 7

Figure 8(10 year yield on Government bonds)

Figure 9

Figure 10
References:
http://www.bloomberg.com http://www.projectsyndicate.org/commentary/aft er-austerity http://economics.mit.edu/files/ 740 http://www.indexmundi.com http://www.imf.org http://www.iie.com/publicatio ns/papers/lourtie20110913.pdf