Portugal’s Post-Crisis Challenge

Portugal’s Post-Crisis Challenge

photo: GlynLowe

Portugal is in its 4th year of recovery, following a sudden stop in capital inflows at the beginning of the decade and the severe recession that followed. While the external flow imbalance has been corrected and the sovereign’s full access to financing restored, the stock of public and private debt remains high, labor slack persists, and the rate of economic growth is moderate. This column reviews Portugal’s post-crisis recovery and points to ways to reduce stock imbalances, absorb labor slack, and generate sustainable growth. The Portuguese experience may offer broader lessons to address similar challenges facing a number of countries, including the need to raise underlying growth inside a currency union. 

The recent economic history of Portugal can be viewed through the prism of a Swan diagram, a simple representation of a small open economy. An economy attains internal balance (IB) when it has full employment and stable prices. External balance (EB) requires equilibrium in the balance of payments (Swan 1963, Reinert 2009). Achieving a sustainable growth trajectory requires both internal and external balance over the long term.

Since the mid-1990s, Portugal ran large external deficits accompanied by low competitiveness and, since 2000, near-zero growth (a point below and to the right of the EB line). These deficits could be financed relatively comfortably through large private capital inflows. At the same time, internal balance was largely maintained, with low inflation and low unemployment (a point on the IB line).

Following the sudden stop in capital inflows at the beginning of this decade, the Portuguese adjustment program helped to restore external balance. However, without large private capital inflows that had financed private consumption and public spending over the previous decade, a sharp decline in domestic demand and a large internal imbalance emerged (the move to a point on the EB line). Reestablishing a credible policy mix in order to rapidly regain market access at sustainable yields required a gradual closing of the external imbalance and—at a minimum—stabilizing excessive leverage and public debt levels. That in turn required bringing the unsustainable level of domestic demand in line with  disposable income.

One way to mitigate a large internal imbalance is through  improved external competitiveness, achieved by implementing structural reforms and/or a fiscal devaluation. This would lead to improved external price-cost competitiveness of existing firms and the emergence of new exporting firms. Such an improvement is, however, difficult to achieve in the short run.

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Looking forward, the key macroeconomic challenge for Portugal is to maintain external balance while returning to internal balance by raising competitiveness (and, correspondingly, potential growth) through structural reforms (a movement along the EB line). Conversely, internal balance can conceptually be achieved by a reduction in potential growth without improvements in competitiveness (a shift of the IB line to the left). The former scenario would allow for a reduction in the large labor market slack, while the latter—clearly undesirable—scenario would impose on Portugal years of low growth, high labor market slack, and high unemployment.

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Recent work by IMF staff (Gershenson, Jaeger, and Lall 2016) discusses how these challenges can be addressed. Proposed steps include focusing on creating jobs for the lower skilled, increasing the efficiency of public expenditure and of public administration itself, implementing a systemic approach to corporate debt restructuring, and building sustainable pro-reform momentum. The remainder of this column focuses on one particular aspect of Portugal’s challenge: the need to make the economy more externally competitive.

There are several ways to measure external competitiveness. We argue that rather than focusing on gross exports, policymakers should pay attention to domestic value-added (DVA) exports. DVA exports exclude imported intermediate inputs from gross exports, thereby reflecting the true external demand for domestic products. The Portuguese footwear industry—which has moved steadily up the value chain in recent years, introducing higher-end products and successfully competing on quality rather than price—is a good example of a sector with improved DVA exports (Leiber 2015).

We find that the increase in Portugal’s DVA exports and competitiveness gains are likely  smaller than indicated by the growth in gross exports. Empirical analysis suggests an increase of only 2 to 3 percent of GDP in Portugal’s DVA exports between 2010 and 2013. This implies that the overall growth in gross exports during that period (8 percent of GDP) was to a significant extent due to increase in imports of intermediate inputs and that import compression had played a bigger role in the current account adjustments than indicated by the small decline in gross imports.

Our analysis suggests that DVA exports exhibit strong and robust empirical linkages with a small set of structural indicators, such as the level of employment protection, the degree of manufacturing sector development, the intensity of local competition, and the degree of integration with global value chains. Portugal does not score as well as would be desirable on these indicators, highlighting the need for policymakers to focus their attention on a few key areas, such as labor market flexibility and the development of manufacturing/tradable sectors.

Screen Shot 2016-06-15 at 10.29.42 AMPortugal’s challenges are shared by other slow-growing heavily-indebted members of the euro area. Some persistent structural rigidities—which in the pre-euro era were commonly alleviated by a combination of higher inflation and currency depreciation—remain in place and can only be addressed by making the economy more externally competitive through well-focused structural reforms. Policymakers should identify specific needs in each sector of the economy and ensure that reforms induce the required reallocation of resources from less productive to more productive activities. If successful, the reforms will improve the economy’s competitiveness and allow Portugal and other similarly afflicted members of the euro area to enjoy balanced growth for years to come.


Gershenson, D., Jaeger, A., and Lall, S., editors. 2016. From Crisis to Convergence: Charting a Course for Portugal. Washington: International Monetary Fund.

Leiber, N. 2015. “Portuguese Shoemakers Get Fancy.” Bloomberg Businessweek, September 3.

Reinert, K., editor. 2009. The Princeton Encyclopedia of the World Economy, 1049–1052. Princeton University Press. Princeton.

Swan, T. 1963. “Longer-run Problems of the Balance of Payments.” In Arndt, H. and Corden, W., editors, The Australian Economy, 384-395.