This Survey is published on the responsibility of the Economic and Development Review Committee of the OECD, which is charged with the examination of the economic situation of member countries.The economic situation and policies of Portugal were reviewed by the Committee on 3 July 2012. The draft report was then revised in the light of the discussions and given final approval as the agreed report of the whole Committee on 16 July 2012.The Secretariat’s draft report was prepared for the Committee by David Haugh, Álvaro Pina, Stéphane Sorbe and Ildeberta Abreu under the supervision of Pierre Beynet. Statistical assistance was provided by Desney Erb.The previous Survey of Portugal was issued in September 2010.

Portugal has started down a long road of economic adjustment to boost growth and correct an excessive reliance on debt. The government is resolutely implementing the EU-IMF financial assistance programme of fiscal adjustment and reform. Accordingly, significant legislation has been passed, with broad political support, to improve the performance of the labour and product markets. In addition, many OECD recommendations of the last survey have been adopted. The authorities should ensure effective implementation of these ambitious reforms. Returning to a sustainable fiscal position is a pre-condition for restoring confidence, investment and growth. The authorities should therefore aim to meet the headline deficit targets in the EU-IMF programme. However, the government may need to let automatic stabilisers play at least partially if risks materialise and growth turns out much lower than projected in the programme, while sticking to its structural fiscal targets to restore investors’ confidence. At the same time, credit to the economy should be supported by promoting swift recognition of bad loans, and ensuring that the banks maintain the required capital ratios and the pace of convergence towards the indicative target for the loan-to-deposit ratio does not thwart economic activity. Special attention should be paid to the financing conditions of small and medium-sized enterprises, notably by making firms more reliant on equity and less on debt, and by re-directing EU funds. Fundamental structural reforms are central to boosting potential growth and shifting economic activity from low-productivity domestically-orientated sectors to tradable goods and services. Vigorous reforms of the labour market would combat duality and boost competitiveness.

The government should aim to meet headline deficit targets in the programme, notably through abiding by the budgeted expenditure at all levels of general government. If risks materialise significantly and growth is far lower than projected in the programme, the automatic stabilisers could be allowed to operate at least partially.

The global crisis exposed underlying weaknesses and imbalances in the Portuguese economy, which has entered a deep recession with high unemployment. Labour market regulation had long been ill-equipped to create jobs and wide-ranging structural reforms were needed to help get the unemployed back to work and foster reallocation of labour from non-tradable to tradable sectors. International capital flows have dried up and weak growth prospects resulted in a loss of market confidence and sharply rising interest rates, despite the fact that Portugal has steadfastly implemented an ambitious three year European Union-International Monetary Fund (EU-IMF) financial assistance programme since May 2011 ().

Owing to slow growth and a relatively weak fiscal position, Portugal’s public debt had been rising for almost a decade when the global crisis struck, sharply increasing the deficit. The loss of confidence in Portuguese and other euro area sovereign bonds required international financial support. Weak fiscal performance reflects a wide range of fiscal structural problems resulting in poor control of expenditure. At both the central and local levels, this was compounded by the non-transparent accumulation of payment arrears, future spending obligations via public-private partnerships (PPPs) and off-balance sheet debt in state-owned enterprises (SOEs). In line with the EU-IMF programme, the government is steadfastly implementing an ambitious front-loaded consolidation plan underpinned by a wide range of structural reforms. In a context of weak private sector demand, the government’s ability to regain control over public debt dynamics depends crucially on avoiding spending overruns. This will require reinforcing the fiscal framework to improve expenditure control, tackling payment arrears and avoiding further negative surprises from loss-making SOEs, PPPs and local governments. The success of the programme will also require maintaining social consensus around it, notably through continuous attention to its implications for the poorest. If growth is far lower than projected in the programme, the automatic stabilisers could be allowed to operate at least partially to reduce the risks of a deeper recession and higher unemployment.

Low growth and huge current account deficits have characterised the Portuguese economy over the past decade. Easy credit in global markets, combined with the absence of incentives to limit loan-to-deposit ratios until recently, made it possible to finance internationally high levels of consumption and investment relative to gross domestic product (GDP) through over reliance of the banking sector on wholesale funding. This led to high households’ and firms’ indebtedness and made banks vulnerable to shifts in investor sentiment. However, investment and credit were mostly directed to sheltered sectors, giving rise to an oversized road infrastructure, electricity generation capacity and housing stock. Weaknesses in labour market institutions further held back productivity and hampered wage adjustment, making it harder to gain cost competitiveness.The deleveraging process set in motion by the loss of access to foreign financing is helping to rapidly reduce external deficits, but also has the potential to generate a damaging credit contraction, which enhances the importance of alternative financing strategies for firms, such as greater reliance on equity. To restore growth, Portugal needs to foster the reallocation of both labour and capital, essentially towards the tradable sector. Building on recent policy initiatives or commitments, this will require reforming public policies that have long distorted investment allocation, ensuring that banks adequately recognise and provision problematic loans and, on the employment front, reducing labour market segmentation and increasing targeted training. Reforms in wage setting, labour taxation, unemployment benefits and activation policies will foster job creation, thus enhancing output growth while avoiding high unemployment becoming entrenched and threatening social cohesion.

Active labour market programme