IMF Concludes Portugal Article IV Consultation

Washington, DC: The Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation^[1]with Portugal on June 13, 2023.

The economy sustained its dynamic recovery from the pandemic into 2022. GDP surpassed the pre-pandemic level in the first quarter and growth averaged 6.7 percent for the year—among the highest in the euro area. The momentum continued through early 2023 with growth at 2.5 percent (year-on-year) in Q1. While headline inflation peaked in late 2022, core inflation has been stickier amid limited economic slack, high profit margins and tight labor markets. Wage growth has accelerated, partly reflecting minimum wage hikes and labor shortages.

Growth is projected to soften for the rest of the year to average 2.6 percent in 2023 and 1.8 percent in 2024. Inflation is expected to continue to ease over 2023 but remain above 2 percent in the near term. The current account deficit is expected to narrow as terms-of-trade normalize and external demand strengthens.

Despite new fiscal support measures, the fiscal deficit narrowed significantly to reach 0.4 percent of GDP in 2022, mainly reflecting stronger tax revenues. Public debt fell below its pre-pandemic level to 113.9 percent of GDP. In 2023, the fiscal position is expected to be broadly similar to 2022. Public debt is set to remain on a downward path in 2023 and over the medium term.

The banking system and household and corporate sectors have been resilient to recent shocks so far. However, tighter financial conditions, amid a buoyant housing market, have increased financial risks.

Executive Board Assessment^[2]

Portugal's strong recovery continued till early 2023, but near-term growth is expected to soften. Domestic demand growth is projected to be dragged down by high cost of living and export growth to soften. After peaking in late 2022, inflation is expected to gradually ease over 2023 but remain above its target for some time, reflecting the broad-based nature of inflationary pressures.

Risks to the outlook are broadly balanced. Tighter financial conditions—potentially accompanied by a sharp correction in housing prices―or a deeper global or regional slowdown, and persistently higher energy prices would further hurt growth and increase risks. Conversely, continued strong tourism momentum and a resilient labor market are the main upside risks.

Maintaining a contractionary fiscal policy stance in 2023 is appropriate to build fiscal space and support monetary policy in reducing inflation pressures. If growth weakens appreciably, automatic stabilizers should be fully deployed; conversely fiscal overperformance must be saved. Further fiscal support should be reserved only for severe downside scenarios and designed to be temporary, non-price-distortionary, and targeted to the most vulnerable households.

A stronger medium-term fiscal effort relative to the baseline, comprising both revenue and expenditure measures, would build fiscal space and mitigate debt-related risks further and improve resilience to contingency risks. On the revenue side, simplifying the tax system and eliminating tax distortions, rolling back reduced VAT rates, reinstating carbon taxes and improving tax administration are key reforms. On the expenditure side, reforms to contain age-related spending pressures from pensions and health care are long-standing priorities. The spending composition should increase the share of public investment relative to current spending. Other important medium-term reforms include strengthening of the medium-term budgetary framework, strengthening the financial sustainability of SOEs, and further improving the social safety net.

Financial policies need to maintain focus on containing systemic risks, which have risen on the back of tighter financial conditions and rising housing market vulnerabilities. Banks and supervisors should continue to maintain vigilance on credit quality, market and interest rate risk, and liquidity management. Continuously improving capital headroom would serve as an important safeguard. Efforts to contain risks from transnational money laundering should continue.

To address the build-up of vulnerabilities in the residential real estate sector, the authorities could gradually phase in a sectoral systemic risk capital buffer. Such a measure would need to be holistically calibrated considering other macroprudential measures, the cost of complying with resolvability requirements, and avoiding procyclical effects. Further supporting housing supply and affordability, without generating market distortions, would alleviate housing market strains.

Structural policies should continue focusing on boosting productivity growth. Timely implementation of the NRRP—which focuses on raising R&D, improving the education system, judicial system and business regulations, and scaling up green investment—is crucial. Reforms to improve labor market performance and dynamism, supported by active labor market policies and support for skilling and re-skilling workers would spur further private sector driven growth. Receding energy prices provides an opportunity to gradually increase carbon taxes, combined with targeted measures to protect the most vulnerable. Efficient planning, budgeting, implementation, and oversight will be key to maintain strong investment absorption capacity of EU funds in the economy.