Brian C. Stuart
The impact of the 1973-74 increases in world oil prices was amplified for Portugal by the economic effects of the Revolution of April 25, 1974. This event brought a major shift in the distribution of income toward labor, the nationalization of a substantial part of Portugal’s resource base, and the independence of the former overseas territories. By the summer of 1976, the country had made a peaceful transition to democratic government. On the other hand, the rates of inflation and unemployment had also risen to very high levels by the end of 1977, and foreign exchange reserves had been depleted to the point where the Bank of Portugal was obliged to begin selling its own gold holdings.
Portugal and the International Monetary Fund had in the course of 1977 begun discussions on the possibility of a stand-by arrangement in the upper credit tranches, and a suitable stabilization program was agreed in May 1978. The recovery in Portugal’s balance of payments (BOP) that followed was very rapid. The external current account moved from a large deficit in 1977 to virtual balance in 1979; the overall BOP improved from an equally large deficit in 1977 to a substantial surplus in 1979 (see Chart 1). The turnaround was all the more remarkable in that it was achieved with a minimum cost in terms of economic growth as the economy continued to grow substantially in 1978 and 1979 (see Chart 2).
Chart 1Principal components of the BOP
Source: Data provided by the Portuguese authorities.
Chart 2Growth rate of real GDP, 1973-79
Sources: IMF, International Financial Statistics and Direction of Trade.
A more detailed analysis of this topic is available in Economic Stabilization and Growth in Portugal by Hans O. Schmitt, IMF, Occasional Paper 2, 1981.
Some transitory elements in the external improvement are likely to disappear and a deficit may reemerge in the external current account. A portion of the increase in workers’ remittances, for example, represented the repatriation of savings accumulated abroad during the crisis years in addition to current earnings. Also, the substantial increase in exports took up existing slack and will not be sustained at the same rate once that slack is taken up. However, it is altogether appropriate for moderate deficits to be associated with growth for a country at Portugal’s stage of development. These deficits should continue to be manageable as long as foreign borrowing is used for productive purposes. Development in the context of an open economy seems all but assured, therefore, as Portugal prepares for full membership in the European Community.
Social and political change
For several years before the Revolution, the Portuguese economy had experienced high rates of growth, low unemployment, rising inflation, and substantial surpluses in its external accounts. These developments can be traced to the mid-1960s, when Portugese labor began emigrating abroad in growing numbers, attracted by higher paying jobs in Northern Europe. By 1973 about 14 per cent of the total Portuguese labor force was employed in Northern Europe, leaving few workers unemployed at home. The remittances of these workers to Portugal, which in 1973 represented 10 per cent of gross domestic product (GDP), raised domestic demand and—with a fixed exchange rate—contributed to sharp increases in official international reserves and the domestic money supply. Exports of goods and services (mainly through tourism) also rose quickly during this period, and real GDP grew at an annual average rate of 7½ per cent between 1968 and 1973. The external accounts remained strong—the current account surplus amounted to US$340 million or 3 per cent of GDP in 1973.
However, inflation had also become an increasingly serious problem, and the high level of demand combined with shortages of labor began to create pressure for rises in real wages. Workers were not allowed to form independent trade unions and the right to strike was severely limited; as pressures on the labor market intensified, the growing impatience of the labor force took a political form. One of the prime economic objectives of the April Revolution in 1974 was to raise the standard of living of workers as quickly as possible.
The Portuguese Revolution came at a time that was not propitious to the quick achievement of its economic goals because the economy was being adversely affected by developments in the world economy. The quadrupling of the international price of oil in late 1973 added about $400 million to Portugal’s oil import bill. The world recession that followed this price increase reduced the demand for Portuguese exports, the travel of tourists to Portugal, and the demand for Portuguese labor abroad, which slowed the growth in workers’ remittances. The BOP position was also weakened markedly by events at home. The decline in exports accelerated as a result of rising costs, disruptions of production, and substantially reduced sales of goods to Portugal’s former territories in Africa in the wake of their independence. The growth of workers’ remittances from abroad was arrested between 1973 and 1975, reflecting a loss of confidence by workers abroad, and tourism declined in the light of social unrest in Portugal. The external current account swung from a surplus position of $340 million in 1973 to a deficit of $815 million in 1975, and the overall BOP from a surplus of $328 million in 1973 to a deficit of over $1 billion in 1975.
This was a time of great social and political transformation in Portugal. To remove some of the perceived barriers to higher incomes for labor, a substantial proportion of cultivable land and heavy industry was nationalized. Wages began to rise sharply, not least because the minimum wage (introduced in May 1974) substantially raised the earnings of one half of the labor force. To hold down price increases and thus ensure a rise in real wages, the exchange rate was kept fixed. To the same end, the authorities resorted to widespread use of price controls and subsidies. Investment was reduced in the aftermath of the shift of income to labor. However, the tendency of total demand to fall was somewhat mitigated by higher consumption and large public sector deficits. The social goals of the Revolution required a considerable expansion of public sector expenditures largely for subsidies and transfers; notwithstanding some increases in tax rates, revenues did not keep pace. Thus the public sector shifted from a surplus equivalent to 1 per cent of GDP in 1973 to a deficit equivalent to 5 per cent of GDP in 1975 (see Chart 3).
Chart 3Selected indicators, 1973-79
Source; Data provided by the Portuguese authorities.
1 Excluding rents
On balance, the growth of the economy slowed down markedly in 1974, and real GDP declined in 1975. With the return of Portuguese settlers from the former territories adding substantially to the population, and with reduced demand for Portuguese labor abroad, unemployment rose in 1975 at least to the officially recorded level of 5i per cent. Laws were passed preventing the dismissal of workers, which helped in the short run to hold down the rate of unemployment. Relatively little was done to reduce the BOP deficit, though an import surcharge of 20-30 per cent on a substantial proportion of imported goods was introduced in May 1975.
Throughout this period, the International Monetary Fund and Portugal maintained close contacts. Portugal made several purchases of foreign exchange from the Fund, including purchases under the 1975 oil facility early in 1976 and a purchase under the compensatory financing facility in the summer of 1976 (see the table). However, the rate at which the country was losing external reserves in 1974 and 1975 was regarded as likely to be unsustainable, particularly since the reserve losses were to a large extent financing consumption rather than productive investment. In this situation, Portugal would be able to purchase foreign exchange from the Fund under the regular credit tranche facilities only if the authorities could devise a set of policies that would give reasonable assurance that its BOP position would become sustainable in the near future. In brief, the program would have to halt reserve losses and stimulate the earnings needed for repayment of the foreign exchange to the Fund within three to five years. Also, to qualify for Fund support, such a policy package should not include the extensive use of import restrictions or other controls on current international transactions. In the spring of 1977 Portugal announced that it was applying for full membership in the European Community by 1983—a step that reinforced the need for the country to achieve high rates of growth in the context of an open economy.
Toward a viable strategy
However, stabilization did not look attractive in the early part of 1976. The external deficit was widely thought to be structural in character. It was being argued that the country had lost important export markets in the former territories, that it was trying to export products for which world demand was weak or declining—one half of the value of exports in 1975 was accounted for by textiles and traditional exports of cork and other agricultural products—and that the oil import bill had increased sharply. Therefore, many observers argued, fiscal stimulus and hence large government deficits were needed to offset the effects of the BOP deficit on domestic income and employment. It was also hoped that perhaps a rise in output would lead to a rise in productivity that might help validate the increase in real wages that had occurred. Although international reserves had fallen sharply during the past two years, they still represented several months of imports, even with gold valued at the official price of about $42 an ounce.
|Stand-by arrangement||Other purchases|
|Date of arrangement||Amount||Date purchased||Date||Type||Amount|
|April 1977||49.3||May 1977||July 1975||Gold tranche||27.0|
|June 1978||69.5||No purchases||Dec. 1975||Gold tranche||8.2|
|were made||Jan. 1976||1975 oil facility||85.7|
|Apr. 1976||1975 oil facility||47.9|
Approximate amounts: purchases were denominated in SDRs
Approximate amounts: purchases were denominated in SDRs
On balance, therefore, the authorities opted for a policy of reflation. Government expenditure was increased sharply. To help the profit position of the private sector, a legal limit on nominal wage increases was imposed and price controls were liberalized. Some gradual, unpublicized depreciation of the Portuguese escudo also took place in the first half of 1976, but this was stopped when it led to speculation against the currency. Interest rates were kept constant and, to contain the BOP deficit, the import surcharge was raised.
The deficit of the Government rose substantially in 1976, as did the rate of increase of domestic credit (see Chart 4). Real output rose by 7 per cent, reflecting mainly higher public consumption and a resumption of stock-building after the considerable destocking which had taken place in 1975. Employment benefited little; many firms had been holding excess labor because of the legal barriers against dismissals, and the unemployment rate rose to almost 7 per cent. The BOP deficit also rose and the net official reserves of the Bank of Portugal declined by close to $1 billion in 1976, largely accounted for by short-term borrowing against gold collateral.
Chart 4Money and credit, 1973-79
Sources; IMF, International Financial Statistics and data supplied by Portuguese authorities.
Early in 1977 the Fund and the Portuguese authorities agreed on a stand-by arrangement for $50 million covering the first credit tranche. The arrangement followed a 15 per cent depreciation of the escudo and was predicated on a target for a reduction in the rate of domestic credit expansion of the banking system, and only a modest increase in the deficit of the Government. However, the rate of credit expansion and the government deficit could not be contained; both rose sharply during 1977 and the external accounts also worsened substantially.
Aware of these trends, 14 industrial countries met in Paris in June 1977 and agreed to provide Portugal $750 million over a period of 18 months in medium-term BOP support. Most of the countries that participated in these “Paris credits” had already provided short-term financing, much of it against gold collateral. The new credits were not tied to gold nor did they represent project financing. But most of the loans were contingent upon Portugal reaching an agreement with the Fund on a stand-by arrangement involving purchases in the upper credit tranches. Conditionality in the upper tranches would be much greater than with the first tranche arrangement agreed earlier in the year. Most contributors thought that the added conditionality would help ensure that the need for extraordinary assistance would be temporary.
The most important issue to be settled in the discussions that followed between the Portuguese authorities and the Fund was the extent to which the external deficit would respond to price incentives. There was, first of all, considerable reluctance to undertake a further substantial depreciation of the escudo. Certainly the results of the depreciation in Feburary 1977 had been disappointing. According to one view, the reason for the inability of the earlier depreciation to reduce the deficit was explained in terms of a structure of exports and imports insensitive to changes in relative prices. If this were so, an additional depreciation would do no more than raise the external deficit in terms of the local currency and thus would have a purely deflationary effect on the domestic economy. In any event, to be successful, a depreciation would have to produce a decline in real wages, and this was regarded as an unrealistic expectation.
Opposed to this view was the argument that the depreciation of February 1977 had not gone far enough to restore the competitiveness of Portuguese labor to its 1973 level. Given the change in the underlying economic situation since then, particularly the need to create employment opportunities for a much larger labor force, a further depreciation would be necessary to restore external balance at full employment. At a minimum, until inflation in Portugal was brought more closely into line with inflation abroad, periodic exchange rate changes would have to be made. A policy of gradual depreciation of the exchange rate—a crawling peg—was therefore advocated. The actual rate of depreciation needed to restore equilibrium still had to be decided.
There was also the question of how far domestic interest rates would have to be raised. It was argued on the one hand that the general expectation that the escudo would depreciate, combined with very low domestic interest rates, had left the yield on domestic financial assets well below the expected return in escudos on foreign currency assets. In fact, the higher yield on foreign currency assets could be seen as having reduced the attractiveness of saving in the form of domestic money balances and having contributed, therefore, to considerable capital flight. Much of the capital flight was reflected in the current account statistics—overinvoicing and underinvoicing of merchandise trade, a decline in workers’ remittances, and a decline in the amount of foreign currency earned from tourism and deposited in Portuguese banks. Savings could be transferred abroad by advancing the payment for imports and delaying the delivery of foreign currency receipts from exports. In addition, low domestic interest rates had fostered a rapid expansion in domestic credit and biased it in favor of inventory accumulation, particularly of imported goods.
Against this view, it was argued that financial markets were not sufficiently integrated with those abroad to require parity between expected yields on domestic and foreign assets. It was also doubted that interest rate changes would encourage the public to shift from holding goods to holding financial assets. Instead, the rise in interest rates would increase the cost of working capital and reduce the volume of productive investment, and perhaps even of exports.
Against the background of these uncertainties, it was accepted that the stabilization program would need to include quantitative limits on domestic credit expansion and on increases in credit to the Government, if it was to be supported by a stand-by arrangement. These limits would, it was hoped, make certain that total expenditure would be kept within the overall resource constraint. Policy changes strong enough to give reasonable assurance that the public sector deficit would be reduced had to be put in place. On a more technical level, to monitor progress under the standby arrangement the limits on financial variables would have to be set on a quarterly basis, and the seasonal pattern of these aggregates had to be determined.
In August 1977 a crawling peg for the escudo was introduced (after a further limited discrete depreciation), and interest rates were raised. These measures proved to be inadequate. The demand for escudo money balances was affected only marginally, the rate of credit expansion continued to rise, and the BOP continued to worsen. An alternative approach—to tackle the BOP difficulties by a substantially tighter control of imports in the Government-controlled sector—was also considered. As a practical matter, however, the external deficit would have remained unsustainable unless the authorities were prepared to proceed with more decisive actions. Accordingly, the risks inherent in more substantial exchange rate action and yet higher interest rates had to be accepted, and a stabilization program regarded as more consistent with the problem was put in place in May 1978. In June the Fund granted a stand-by arrangement for $70 million in the second credit tranche to support it.
The external current account deficit was estimated to have reached $1.5 billion in 1977, and the target for the deficit in the agreed program was set at $1 billion during the 12 months to March 1979. Since the inflow of nonmonetary capital was projected to be $200 million, this left a maximum permissible loss of net foreign assets by the banking system of $800 million. This figure was made a performance clause, in the sense that drawing on the Fund would be contingent on compliance with it. Following a further depreciation of the escudo, the monthly rate of depreciation and rise in interest rates were increased. Both would be managed flexibly in light of changes in the net foreign asset position of the banking system. Limits were set on domestic credit expansion and on credit to the public sector. Finally, the program included a timetable that stipulated reductions in the import surcharge.
The response of the BOP to this program was very rapid (see Chart 1). The external current account deficit was all but eliminated by 1979. The overall balance moved from a deficit of $1,430 million in 1977 to a surplus of $1,355 million in 1979. The volume of exports rose quickly in 1978 and particularly in 1979, regaining their 1973 market shares. In addition, the volume of imports declined in 1978, reflecting in part the destocking of imported goods, and grew much less quickly than exports in 1979. Workers’ remittances rose very sharply in both years. The improvement in the external balance was mainly responsible for the continued growth of the economy, as domestic demand in real terms was severely restrained by the rise in interest rates and the administrative procedures that were implemented to control the expansion of credit. Real output rose by over 3 per cent in 1978 and by almost 5 per cent in 1979, or more quickly than the weighted average for Portugal’s main trading partners (see Chart 2). The BOP constraint on economic growth in Portugal had thus been largely removed.
Reasons for success
The success of the program can be attributed to several factors. First, the change in the exchange rate improved the country’s competitive position beyond its 1973 level. Changes in interest rates were also important. The greater willingness of the public to hold escudo money balances meant a smaller loss of net international reserves for a given increase in domestic credit, while at the same time the growth of domestic credit slowed considerably. The rise in interest rates in combination with exchange rate policy reduced the attractiveness of inventories of imported goods as an inflation hedge, which reduced imports and made a higher proportion of credit available for more productive purposes. Unfortunately, public sector expenditure could not be contained. Rather than declining as had been budgeted, the current deficit of the public sector widened by a large amount and capital expenditure rose sharply. Part of the increase in private saving that was stimulated by the interest rate increase was therefore needed to finance the larger-than-anticipated public sector deficits. Nevertheless, the authorities were able to keep on schedule in phasing out the import surcharge.
The response of the system to the changes in exchange rate and interest rate policy was much greater than had been anticipated. The limit on domestic credit turned out to be much more restrictive than would have been necessary, although the limits on credit expansion to the public sector were exceeded. For various reasons, not the least of which was the fact that the basic measures included in the program were proving to be so effective, no new public finance measures were taken to meet the limits nor were the limits in the stand-by arrangement renegotiated. With the improved external position, Portugal did not need to make any purchases from the Fund under the terms of the 1978 stand-by arrangement.
The character of the stabilization program of May 1978 evolved over a period of several years. The country entered the postrevolutionary period with a very low level of external debt, which made it possible to extend the time in which the details of a stabilization program could be developed. In addition, there was time for the domestic situation to become more settled and for world markets to stabilize following the 1973-74 oil price increase and the recession of 1974-75. Also of considerable importance, it allowed time for the authorities to take the administrative measures that were needed for the actual implementation of the program.
The unexpected size of the turnaround in the BOP resulted in large part because much of the problem was essentially one of capital flight—concentrated on workers’ remittances and officially recorded tourist receipts—and these factors responded to the increase in domestic interest rates. However, throughout this period it was often maintained that Portugal was the type of country where changes in exchange rates and interest rates would not have much effect. Yet export and import volumes responded sufficiently to the measures that were taken to maintain a surprisingly high growth rate of GDP in Portugal.
This article should conclude with a brief word about the role of the Fund in Portugal throughout this period. The Fund worked closely with Portuguese officials from the very early days of the postrevolutionary period. When it came time to discuss the type of program that could be supported by a stand-by arrangement, there were few surprises on either side as to the corrective measures that needed to be incorporated into the program. Portugal’s experience during this period demonstrates once again that, for a stabilization program to be successful, it is necessary for the authorities to agree that the program can succeed, that they work to make it effective, and that they have the administrative machinery to implement it.