Thursday 10 March 2011

Portugal needs peace but no Carthaginian peace

Portugal needs to secure stable access to funding at 4% for the next five to seven years and the rest of Europe must offer such funding to Portugal. The conditions that Europe granted to Ireland, namely funding at 5.8%, are a non starter. Consider that from 1999 to 2007 nominal GDP growth in Portugal averaged 4.8% per year. Any cost of funding that is above the nominal GDP growth rate requires a switch from deficit to surplus just to stabilize the debt to GDP ratio. In short, “Irish conditions” imply that, in a scenario where Portugal follows the right set of policies (defined below), debt will start stop increasing in a decade or so. I assume Europe will grant funding to Portugal at 4%. (Assumption1 cost of funding is 4%)

Assessing if Portugal needs a bailout is hard and somewhat subjective as it requires a consistent and uniform analytical model. I sidestep this difficulty by assessing Portugal solvency only using an intertemporal budget constraint (IBC). In words Portugal becomes bankrupt if unable to pay off foreign obligations at their face values, and if this happen the Portuguese IBC would not hold with foreign debts valued at par. I focus on national solvency as opposed to government solvency as I stronlgy believe the priority is on stabilizing the external debt. As a reminder Figures 1 and 2 show the government and the external debt as a share of GDP. On one hand the government debt dynamics are worrysome but hardly justify the risk premium markets are requiring to finance Portugal. On the other hand the external debt dynamics are just explosive and might well scare any international investor.

Eurostat forecasts Portugal nominal GDP growth to be 0% in 2011 and 1.8% in 2012. To extrapolate further into the future I assume that from 2013 on, nominal GDP growth will stand at 4.8% per year. (Assumption 2: nominal GDP growth is 0 in 2011, 1.8% in 2012 and 4.8% from 2013.)

All other things equal, securing access to reasonable rates will not be sufficient to make Portugal solvent. The trade balance has averaged -8.8% per year from 1999 to 2007 and stands at -6.25% in the first three quarters of 2010. If Portugal does not improve the trade balance any attempt to assess its solvency is futile.

Let me illustrate a favourable scenario. Assume that Portugal does initiate a process that transforms the country in a net exporter. I do not discuss specific proposals to achieve such a target and interpret the process as a reduced form of many policies. The process improves the trade deficit (now at -6.25%) by 1% every year starting in 2012 and stabilizes at 6.75% in 2024. This scenario correponds to the blue line in Figure 3. By that year Portugal’s trade balance would resemble the Netherlands’ trade balance (6.7% is the average 1999-2007 Netherlands trade balance). If such a policy is implemented, the Portuguese international investment position stabilizes around 2015 at 136% of GDP and starts to decline the year after. Notice that the external net debt is stabilized before the trade balance turns positive and the subsequent trade surpluses will repay the debt. Things could go worse (yellow line) because of bad shocks or better (green line) maybe if the structural change is complemented with other policies such as a fiscal devaluation that would affect positively the trade balance in the short run. In any case Portugal would remain solvent and the European fixed rate coupled with the Portuguese transformation would have been successful.

Difficult scenario? Challenging. Obviously the “real” policies behind the transformation must be enumerated and discussed but as a target they are necessary to live in the currency union. Realistically the undertaking of such reforms during a period of severe fiscal consolidation might require further help from Europe. One possibility could be to use the EU Structural Funds intertemporal budget constraint and front load all expenditure allocated to Portugal to the next five years period. On paper it would not be an additional transfer from other European partners, call it a timely transfer. In any case square one is to secure funding at a reasonable rate.


  1. excuse the harshness, but this is La-La-Land scenario.

  2. @Thijs

    Excused and ... granted, it is more than a favorable scenario. It will be slower and bumpy. But extrapolating the present will not work even after a default.

  3. @Francesco Franco
    To be intelectualy honest, I would say this is an impossible scenario. Excuse my straight-forwardness but I think this type of scenario-creation is a waste of time. You don't need to be a wizz-economist to know that the current yields are impossible to keep. The only way a bailout is going to work for Portugal or any other state is if the cost of new money comes at 0% (or close to that). That is where the discussion should be at the moment. Any other scenario is not going to work - plain and simple. Portugal will not be able to have a much higher growth in the coming DECADES. We are currently racing to the bottom!

  4. @Paulo

    Dear Paulo as I say in the text, cheap and secure funding is NOT sufficient, nor a is a default. Think of text assumption 2: growing at 4.8% nominal starting in 2013. Same growth as 1999-2007 (so not higher). Further start with an external debt of 120% in 2013. Even if all the stock of external debt commanded suddenly and "magically" (the wizz part?) a 0% interest rate, Portugal would still need to adjust its external balance to make the debt sustainable.