The left-wing coalition government of Portuguese prime minister António Costa has silenced critics with what has so far been an effective financial policy. Now it must convince the ratings agencies and Portugal’s international creditors. Peter Wise reports.


Few could have forecast how events have unfolded in Portugal over the past 18 months. In a general election in October 2015, António Costa, leader of the centre-left Socialist Party (PS), lost to the centre-right coalition that had steered the country through a painful international bailout, yet succeeded in depriving the government parties of their overall majority in parliament.

In the ensuing weeks of political disarray, Mr Costa put together an alliance with the radical Left Bloc (BE) and old-guard Communist Party (PCP), who agreed to provide parliamentary support for a minority PS government dedicated to reversing austerity measures introduced as part of a 2011-14 adjustment programme overseen by the EU and the International Monetary Fund (IMF).

This ‘historic compromise’ between the moderate and hard left had never been tried in Portugal, nor was it put before voters as a possibility before the ballot. Opponents dismissed Mr Costa as a power-hungry opportunist, predicting dire consequences for the economy and the rapid downfall of a pact that conservative critics dubbed the geringonça, Portuguese for an ill-conceived contraption.

But in the year-and-a-half since Mr Costa was sworn in as prime minister, sceptical economists, the European Commission and credit ratings agencies have had to reassess the Socialist leader and what many saw as his presumptuous pledge to “turn the page on austerity” without any easing in Portugal’s commitments to its bailout creditors on deficit-reduction targets and complying with eurozone regulations.

The right answer

The government has answered critics who doubted its commitment to meeting EU fiscal targets with a sharp drop in the 2016 budget deficit. Finance minister Mário Centeno guarantees that at no more than 2.1% of gross domestic product (GDP) it will be the lowest since democracy was restored in Portugal in 1974. This compares with 3% of GDP in 2015 (4.4% including extraordinary measures) and falls far below an initial commission forecast of 3.4%, subsequently revised to 2.3%.

GDP growth has also held up reasonably well, dropping only slightly to 1.4% last year from 1.6% in 2015. Year-on-year growth reached 2% in the fourth quarter of 2016, its highest level since 2010, leading some economists to revise their 2017 growth forecasts upwards.

“On the basis of stronger-than-expected growth at the end of last year, we have moved our forecast for 2017 up from 1.4% to 1.7%,” says Rui Constantino, chief economist at Banco Santander Totta. “Most importantly, the underlying trend is for a continuing recovery.” After three consecutive years of expansion, the commission forecasts GDP growth at close to 1.6% in 2017 and 2018. Over the past two years, Portugal’s recovery has also been one of the most job-rich in Europe, according to EU figures, with unemployment falling by two percentage points in 2016 to about 10.5%.

Buoyed by having cut the deficit to a record low during a year of export-led growth and government stability, Mr Costa believes he has proved that his pact with the ‘hard left’ and the reversal of austerity measures are compatible with a strong commitment to complying with the EU’s fiscal rules and sound economic policy. So far, however, financial markets, ratings agencies and international creditors remain unconvinced.

Winning confidence

Government borrowing costs are the best evidence of this scepticism. Yields on 10-year government bonds have been hovering around 4% in recent months, their highest levels since early 2014 and a significant increase from about 1.6% a year ago. The spread between Portuguese and benchmark German 10-year yields has also been widening at a faster pace than for Spain and Italy.

“The higher yields on government debt show that investors still see Portugal as vulnerable to external shocks because of its high levels of government, corporate and household debt,” says José Maria Brandão de Brito, chief economist at Millennium bcp. “To restore confidence, the country has to show that it can generate sufficient growth to ensure a sustainable reduction in public and private debt.”

Nor has Mr Costa’s deficit-cutting government done enough to persuade ratings agencies to lift Portugal’s sovereign debt rating above ‘junk’ status: Fitch, Standard & Poor’s and Moody’s all continue to rate Portugal below investment grade, as they have done since 2011. This means Lisbon’s access to the European Central Bank’s government bond-buying programme and, to a large extent, bank funding remains dependent on the country’s single investment-grade rating from DBRS, a little-known Canadian agency.

The public debt-to-GDP ratio is estimated to have risen from 129% at the end of 2015 to 130% in 2016, largely due to extra government debt raised to finance a planned recapitalisation of state-owned Caixa Geral de Depósitos, the country’s largest bank. The EU and other forecasters see a downward trend for the debt ratio from 2017 onwards.

Unexpected benefits

“Portugal has been cutting the cost of state financing by replacing existing debt, including IMF loans, with new debt at lower interest rates and longer maturities,” says Mr Constantino. “The top priority for showing investors that the country is continuing on the trajectory that began with the bailout and moving towards more sustainable debt levels is maintaining a focus on reducing the budget deficit.”

Another concern is whether the government is doing enough to support growth. A boom in tourism, as Portugal benefits from the security concerns affecting some other destinations, and a buoyant real estate market are helping the economy expand.

But the EU and IMF are urging the government to press ahead more decisively with reforms in areas such as transport, ports, the court system, energy and business services regulation to remove bottlenecks in product and labour markets that are restricting productivity growth. Long-term unemployment accounts for about 60% of the jobless rate and more than one-quarter of young people are out of work. The commission warns that this “increases the risk that jobless people will disengage from the labour market, gradually losing their skills and employability”.

“Potential output is a debatable concept,” says Mr Brandão de Brito. “But the fact that, according to commission measurements, it remains below the EU average and has yet to regain pre-crisis levels suggests Portugal will struggle to raise growth significantly above current levels without continued and concerted reforms.”

Low levels of investment are also undermining the potential for stronger growth. Net foreign direct investment was negative between 2011 and 2015 and gross fixed capital formation is estimated to have fallen 1.5% in 2016. The hefty cut in the 2016 budget deficit was largely achieved by reining in public investment and freezing departmental spending. Teodora Cardoso, head of the Public Finances Council, warns that such measures are not sustainable in the long term. “To resolve the problem of public expenditure we need a reform that will ensure the better management of spending, quality of investment and efficiency gains over the medium term,” she says.

Strong bond

In terms of government stability, Mr Costa’s left-wing alliance has held together more firmly than possibly even the participants in the pact expected. The moderate PS has traditionally been politically closer to the centre-right Social Democrats, now the main opposition party, than to the hardline PCP or to BE, an anti-establishment forerunner to Greece’s Syriza and Podemos in Spain that was founded in 1999. In March, Marcelo Rebelo de Sousa, Portugal’s centre-right president, said the broad left pact appeared to be “as solid as reinforced concrete”.

Mr Costa also enjoys an opinion-poll lead that must be the envy of Europe’s other centre-left leaders. In part this reflects the popularity of anti-austerity measures that have put more money in people’s pockets and cut working hours. Public sector workers have benefited most because the government restored their pay, hours and holidays to pre-bailout levels. The minimum wage has also been increased, despite criticism from Brussels and the IMF, and four bank holidays abolished in 2013 have been reinstated.

The prime minister has also tapped into a strong feeling, to some degree accepted by the country’s former bailout supervisors, that Portugal was subjected to too harsh a degree of austerity and an adjustment programme that was not as effective as promised. “It’s completely wrong to think that a European country like Portugal could become more competitive on the basis of third-world competitiveness factors,” Mr Costa said at the beginning of his premiership. “The future is not about working longer hours or having fewer or more bank holidays. It’s about investing more in education, science, technology and innovation.”


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