Portugal Faces Difficult Choices to Comply With Aid Program

Portugal faces “increasingly difficult” policy choices as it approaches the halfway mark of its aid program and political opposition to austerity measures increases, the International Monetary Fund said.

“The Portuguese authorities have continued with their impressive policy effort to gradually reverse the large economic imbalances accumulated over the last two decades,” the IMF said in a staff report on the fifth review of the rescue program for Portugal. “Policy choices have to strike a balance between going ahead with the additional adjustment measures needed to lower debt and bring the public finances to a sustainable path, and avoiding undue strains on the economy and employment.”

Prime Minister Pedro Passos Coelho is battling rising joblessness and a deepening recession as he raises taxes to meet the terms of a 78 billion-euro ($101 billion) bailout from the European Union and the IMF. Portugal has already been given more time to narrow its deficit after tax revenue missed forecasts and the economy heads for a third year of contraction in 2013.

“There are signs aplenty of adjustment fatigue,” the Washington-based IMF said. “With unemployment high and real disposable incomes falling for several quarters in a row already, the announcement of further austerity measures to underpin the 2013 budget is testing the broad-based political and social consensus that has buttressed the program to date.”

Tax Increases

Portuguese Finance Minister Vitor Gaspar on Oct. 3 said the government plans to implement an “enormous” increase in taxes on wages and other income to meet budget deficit targets in 2013. Levies will increase through a 4 percent surcharge on income and a reduction in the number of tax brackets to five from eight.

“The measures are tilted more to the revenue side than staff would have preferred,” with Portugal already having a “relatively high” tax burden, the IMF report said. “However, the authorities found it challenging to identify more expenditure cuts at this stage.”

The government said in a document submitted to European authorities that it’s also preparing a set of contingency measures to use during 2013 if needed. Gaspar on Oct. 15 reaffirmed a plan to cut spending by about 4 billion euros in the two years through 2014. This year’s revenue from taxes and social security contributions will be about 3.3 billion euros lower than planned in the 2012 budget, he said on Oct. 3.

Deficit Goals

Portugal now aims to reduce its deficit to 5 percent of gross domestic product in 2012 and 4.5 percent in 2013. It will only cut the deficit below the EU’s 3 percent limit in 2014, when it targets a 2.5 percent gap.

Portugal’s debt will peak at 124 percent of GDP in 2014, higher than a July forecast for a maximum of 118 percent in 2013, the IMF said. The increase in the projection is due to the slower pace of fiscal adjustment, the recession, and “more conservative” projections for privatization revenue, the IMF said today.

“With debt set to peak in 2014 and start declining steadily thereafter, the debt outlook remains sustainable, although the room for maneuver has narrowed somewhat,” the IMF said.

Any further deterioration in the economic outlook could threaten the debt goal, the IMF said, adding that more structural reforms were needed to boost potential growth.

‘Decisive Action’

The government projects GDP will shrink 1 percent in 2013 after contracting 3 percent this year. The unemployment rate will rise to 16.4 percent in 2013 from 15.5 percent this year. Economic growth has averaged less than 1 percent a year for the past decade, placing Portugal among Europe’s weakest performers.

“Without more decisive actions to raise competitiveness, employment, and potential growth, adjustment risks being affected through a drawn-out recession,” the IMF said

The IMF’s debt projection is based on the assumption that Portugal returns to markets in the middle of 2013 with yields on medium- and long-term debt of about 7 percent. The fund sees those yields declining to 5 percent over the next four years and holding at those levels, today’s report said.

Portugal’s 10-year bond yield is now about 7.8 percent, while two-year debt yields 4.9 percent. The difference in yield that investors demand to hold Portugal’s 10-year bonds instead of German bunds has narrowed to 6.2 percentage points from 16 percentage points on Jan. 31.

Return to Markets

Passos Coelho has said that if the country can’t tap bond markets by September 2013 due to “external reasons,” it would be able to count on continued support from the IMF and the EU. While Portugal has continued selling bills, it hasn’t auctioned bonds since requesting the bailout in April 2011.

Portugal has to meet a September 2013 bond redemption without relying on the bailout program, which extends until the middle of 2014. On Oct. 3 the country’s debt agency exchanged 3.76 billion euros of bonds maturing in September next year for securities due in 2015, reducing its 2013 repayment burden.

“Staff considers that market access can be regained within the period that IMF resources are outstanding, although there remain risks of delay in market access and euro-area lenders may be called upon their commitment to provide adequate support to Portugal so long as performance under the program is on track,” the report said.

Portugal may issue debt with maturities of two or three years if market conditions allow, the IMF said. The additional financing needs in 2012 and 2013 will be met through increased issuance of treasury bills, the report said.