Read with perspective the eleventh review

The IMF eleventh review of Portugal is available online (here). The review is balanced and technically sound. It offers a detailed analysis of the macroeconomic developments, the fiscal stance, the debt  sustainability analysis (both public and external) and the state of goods and labor markets functioning. Finally it contains the IMF staff recommendations.

A synthetic summary of the conclusions is:

1. the economy performance has improved in the last four quarters,

2. the plans to continue the external rebalancing, to anchor on a sustainable trajectory both private and public debt and to effectively implement the structural reforms, must be embedded in a medium term political economy strategy. 

My purpose in this post is to provide the reader with information that he can process to form an opinion on the current state and expectations on the future of the Portuguese Economy. (In wonkish jargon I want to feed the reader with an information set). The twist is that I provide information on the same variables over three different time spans (three different samples).

I choose to show the evolution of four variables: gross domestic output, total employment, total unemployment and the trade balance. 

First time span: the last four quarters

(click to enlarge) The second quarter of 2013 marks a turning point: GDP, employment and unemployment have improved for three consecutive quarters (and are projected to continue for a fourth). Even more promising the trade balance turned positive for the first time since … statistical records exist. News are good. (Process this information: form an opinion and expectations on the Portuguese Economy)

Second time span: the "troika" period 

(click to enlarge) The second figure starts in the 2011q2, when Portugal asked financial assistance to the EU and the IMF. The fall in GDP and employment and the increase in unemployment have been large, very large indeed. The bright spot is the persistent improvement in the trade balance. The economy is finally rebounding, but the adjustment period under the troika appears to have been costly and painful. (Process this information: form an opinion and expectations on the Portuguese Economy)

Third time span: the last decade

(click to enlarge) The third figure starts in 2003q4 and shows the last decade. GDP stalled around 2007. Employment was flat for 5 years and started to decrease rapidly at the end of 2008. The number of unemployed was also flat for 5 years until the end of 2008 when it also rapidly increased. The trade balance was persistently negative and the its improvement coincided with the beginning of the assistance program. When the "troika" came in, the economy had been worsening for at least three years; rapidly worsening. After all you do not call for external assistance if you are not in need for help. (Process this information: form an opinion and expectations on the Portuguese Economy.)

This pedantic exercise does not have the ambition to be a proper experiment but the more modest objective to be a suggestion: you need to maintain a sufficiently broad perspective to form your opinion and your expectations.

Let me now turn to the comprehensive sample (the information I process) and present the evolution of the interest rate on bonds, the real GDP growth rate, the current account ratio to GDP and the real exchange rate.   

The broader perspective

A comprehensive story for the macroeconomic performance of Portugal starts in 1995, a year in which the net international investment position of Portugal as well as the current account were close to zero. Blanchard (here) gives the first coherent narrative of the 1995-2006 period. For an updated version you can read the second section of a recent paper I wrote (here). The Figure shows the boom (real GDP growth) fuelled by the interest rate convergence towards German rates. A boom financed through a very large increase in the current account deficit and the simultaneous real appreciation against euro partners first and later (with the euro appreciation) the non-euro trading partners. Then came the crisis and the sudden recognition by the markets of the imbalances, their questioning of the sustainability of these imbalances and the difficulties to address them in an incomplete currency union. Finally the ECB Peelian assumption of responsibility and now a rebound.  The reader will forgive me to unduly compress the argument. He can find in the links a more detailed analysis that also addresses the fiscal and debt challenges for Portugal and the euro-area architecture and performance issues.      

The rationale of the IMF prescriptions

To conclude I propose to first process the complete sample information and then go back and read the eleventh review. Then, and only then, the reader can form an educated opinion and expectations on the Portuguese economy. The IMF prescriptions do not only aim at rebalancing the economy and permit Portugal to create the resources to repay their loan. They clearly aim at strengthening the structure of the economy in order to avoid future build-up of excessive imbalances and permit less costly and painful adjustment periods in face of new adverse shocks. In jargon these prescriptions are an international public good.     

Debt Sustainability: we don't need wrong arithmetic to make it unpleasant

 Figure 1

The Observatório sobre Crises e Alternativas (OSCA), affiliated with the University of Coimbra, published yesterday an interesting document on the sustainability of Portuguese debt. The authors conclude that debt restructuring is unavoidable, while suggesting a possible scale for this operation. This post questions some of the analysis in the document and its conclusions.

The document gauges debt sustainability from the common statement of the government dynamic budget constraint:

Δb_t = -d_t +(i – g) b_t-1

where b_t stands for the debt/GDP stock in year t, d_t the primary surplus in the same year, i the interest rate on government bonds and g the growth rate of nominal GDP.

Using this equation, the authors simulate three scenarios:

• A debt sustainability scenario, i.e. the conditions under which Δ b_t < 0
• The scenario according to the Fiscal Compact whereby the debt/ GDP ratio has to fall every year by 5% of the difference between the current ratio and 60% i.e. Δ b_t < 0.05(b_t-1 - 0.6)
• And a similar scenario but requiring the annual correction of 1/20^th of the difference between today’s b_t = 126.6% and 60%, which they refer to as the President’s interpretation of the Fiscal Compact: Δ b_t < 0.05

The document defends the inevitability of debt restructuring essentially by reduction ad absurdum. In the summary graph of the document (Figure 1 here) the authors purport to show that “in the last ten years the conditions of debt sustainability or fulfillment of the Fiscal compact have never been verified” (p. 6).

With d = 1.8% and g = 2.6%, the debt/ GDP ratio would approximately stabilize at current levels, so the authors conclude that debt sustainability would only apply for higher levels of both variables (the red rectangle in the northeast). The dots represent the combinations of d and g over the last decade, and since these never overlap with the red area, the constraints for enforcing debt sustainability are unreasonable. The conditions to comply with the Fiscal Compact are even more stringent.

But wait, if we try solving the equation above we actually get a straight line, rather than a point. It is obvious that d and g are substitutes and that, for instance, debt sustainability may still be achievable with primary deficits if higher nominal growth compensates for that. Figure 2 represents the correct version of this exercise and highlights the areas of sustainability missed by the OSCA document.

Figure 2

 So, contrary to the OSCA document, debt sustainability was achieved during the past decade, namely before the crisis. In fact, there is a second mistake in the analysis, as the authors use the implicit interest rate on government debt (i.e. a measure of the past cost of credit) to make a judgment about future sustainability. It is idle to remember here the discussions about the mythical 7% threshold that would prevent us from rolling over our past debt stock.

Currently, the implicit rate hovers at about 4% and the authors used this value in their analysis. With 1% inflation this translates into a 3% real interest rate, which is perhaps an optimistic view of our future cost of credit. Indeed, from all the variables in the equation i must be the most volatile. It is well known that sovereign debt markets can have multiple equilibria, and that a change in sentiment can turn what used to be sustainable into a debt problem. Consequently, long-term projections of debt sustainability must be taken with many grains of salt – especially if assuming constant interest rates (i). Or, putting it another way, the Euro crisis reminded us of the need to consolidate during periods of growth and avoid pro-cyclical fiscal policies.

The authors of the OSCA document are right in pointing that under constant assumptions about growth (g) and interest rates (i), sustainability will require painful and long consolidation through primary surpluses. They are also probably correct in arguing that consolidation (d) may harm growth (g) and become counterproductive for sustainability, at least in a midst of a deep recession. And it is finally unclear how the country can climb down the current debt level without some sort of restructuring, in the absence of higher inflation.

But markets react both ways, as the recent decrease of the yields on Portuguese debt is there to show (10-year bonds were paying 6.3% 6 months ago and 3.8% now). This is not the occasion to discuss whether these yields are more driven by the consolidation effort of the Portuguese government or the liquidity policies of the ECB, but at a time when the government is able to rollover debt at quite low rates (and even pre-finance some of next year’s needs), it is questionable that restructuring is now more urgent than it was a year or two ago.

Finally, the OSCA document proposes a ‘possible scenario’ for restructuring – rather than renegotiating an extension of maturities, the authors suggest a writedown of close to half of the current debt stock and a halving of the interest rate on the remainder to 2% nominal. This would amount to more than 75% haircut of current debt claims (similar to the Argentinean 2002 default). Given that a large share of Portuguese debt is currently owned by the official sector, it would be interesting to hear how the OSCA proposes to achieve such figures while avoiding immediate political aggravation and the future costs from a default of this magnitude. I, for one, think the authors stopped where they should have started the document.