Wednesday, October 26, 2016

Portugal Stuck in a "Vicious Cycle" of Economic Stagnation

The Great Recession in Portugal, which lasted from 2010 to 2014, screwed over the Portuguese government by making it nigh impossible to pay off government debt without assistance of third-party actors, most notably the International Monetary Fund (IMF).  Although the €78 million loan helped Portugal avoid crashing out of the eurozone, it did not result in long-lasting economic reform.

Fast-forward to the beginning of October 2016. Portugal has sovereign bond junk ratings from Moody's, Standard and Poor's, and Fitch. There is one other credit rating firm that has not rated Portugal as junk bonds: Canadian firm DBRS. The European Central Bank recognizes four credit rating firms: Moody's, Standard and Poor's, Fitch, and DBRS. How DBRS ranks Portugal's investment grade rating is significant because DBRS is the last recognized credit rating agency that does not consider Portugal to be in junk bond range. If all four credit rating firms consider Portugal to be junk bonds, Portugal would no longer be eligible for the ECB's bond-purchase program, which, as you can imagine, would cause Portugal some issues.

Fortunately, DBRS ranked Portugal with an investment grade rating this past Friday, which means that Portugal has averted crisis for the time being. Whether or not DBRS gave this ranking to Portugal because it was concerned about political ramifications or because it honestly believes Portugal is not yet in junk bond range remains unknown. What I do know is that Portugal is not out of the woods yet. The chief economist from DBRS, Fergus McCormick, stated earlier this month that Portugal is in a "vicious cycle, stuck with low growth and large structural problems." To what extent should we worry about Portugal?

The International Monetary Fund (IMF) released its Article IV Consultation on Portugal only last month, and the report found that the economic recovery is losing momentum due to weaker export growth and sluggish investments (p. 1). Even with improvements in current account deficit and unemployment (current rate is at 11.8 percent), a sluggish economy, combined with banking sector vulnerabilities and high debt, create additional challenges for the Portuguese economy (ibid.). The good news is that there have been considerable strides made since the beginning of Portugal's sovereign debt crisis. Much like with DBRS, there is a concern about medium-term growth with regards to public finances. Much of the recovery has been driven by household consumption, which has led to an unprecedentedly low savings rate, which sat at around 3 percent as of Q1 2016 (p. 4). Growth outlook has also weakened (p. 8), which is both bad for investors and trying to lower the debt-to-GDP ratio of 129 percent (p. 5). The banking sector for Portugal is particularly worrisome since supply and demand for credit are particularly weak (p. 12).

Unsurprisingly, the Banco de Portugal has rosier 2016-2018 projections than the IMF, but not by much. Even so, the Banco had to reduce its GDP projections by 0.2 percentage points in comparison to its projections back in March (p. 20). The Banco is expecting, on the whole, a moderate recovery, much based on a more favorable external environment. The Banco does still recognize the high levels of indebtedness and structural weaknesses in the Portuguese economy (p. 23).

The Organization for Economic Co-Operation and Development (OECD) has a view similar to that of the IMF. In its June 2016 economic outlook, it stated that high corporate leverage and weak bank conditions have been holding back investment. Public debt is high, and would require adjustments for fiscal consolidation, which implies that the current trajectory for Portugal's debt-to-GDP ratio is not one of decline. While the Portuguese economy has relied on consumer spending to drive its economy, a historically low savings rate and slow job creation will slow that consumer-based growth down. The OECD finds that if Portugal can focus on corporate debt and repairing banks' balance sheets, investment would flow better to improve the economic state.

You can also take a look at the European Commission's take on Portugal here, but with a consumption-driven recovery losing steam, private indebtedness, and a banking sector in disarray, Portugal's economy is not doing well, to say the least. Even Left-leaning economist Joseph Stiglitz thinks that Portugal should leave the eurozone. Given its level of economic freedom (see here and here), I can't say that I'm terribly surprised. Unless the Portuguese government acts to make some serious economic reforms, Portuguese economic collapse would not be as far behind as some think.

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