PORTUGAL'S ECONOMIC RECOVERY MODEST BUT CONVINCING

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SIPDIS

SIPDIS

STATE FOR EUR/WE, EUR/ERA, EB/OMA

E.O. 12958: N/A
TAGS: ECON EFIN PO
SUBJECT: PORTUGAL'S ECONOMIC RECOVERY MODEST BUT CONVINCING


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Summary and Overview:


1. Proving the skeptics wrong, Portugal's Socialist
government managed to reduce the budget deficit to 4.6% in
2006 from an all time high of 6.0% in 2005 and increase GDP
growth to 1.4% from 0.3%. Even the ever cautious Bank
Governor noted that Portugal's economic recovery, though
modest, was convincing. Parliament recently passed Portugal's
2007 budget with its focus on science and technology (S&T),
education and personnel resources, equitable social security
distributions, and the EU Presidency. Whereas the 2006 budget
strategy increased revenue via taxes, the 2007 budget aims to
reduce the deficit to 3.7% via reduction of public
expenditures and structural reforms. Socialists and
opposition alike agree that the government must implement the
more challenging reforms during the first half of 2007 as the
entire administration's focus will have turned to Portugal,s
EU Presidency in the latter half.

Proving the Skeptics Wrong:


2. Prime Minister Socrates was able to prove the skeptics
wrong by reducing the budget deficit to 4.6% in 2006 from an
all time high of 6.0% in 2005 and increase GDP growth to 1.4%
from 0.3% during the same timeframe. Even the ever cautious
Bank of Portugal Governor Vitor Constancio noted that
Portugal's economic recovery, though modest, was convincing,
adding that budget constraints had actually held GDP growth
back by 0.6%. Naturally, Portugal's recovery was linked to
the EU's recovery. However, Constancio asserted that 90% of
Portugal,s growth was due to a 9% increase in exports -
fueled surprisingly by an increase in oil exports. In 2006,
Portugal had an excess of gasoline due to the increasing
domestic purchase of diesel cars.) Although Portugal hopes to
increase the use of its underutilized refinery, Constancio
believes future growth should be supported by increased
domestic demand rather than exports.

2007 Key Economic Indicators
2006 2007 2008 2009
Budget Deficit -4.6 -3.7 -2.7 -1.5
GDP Growth 1.4 1.8
Inflation 2.5 2.1
Unemployment 7.6 7.5
Export Growth 8.6 7.2
Import Growth 2.8 3.7

Source: Government of Portugal 2007 Budget Proposal

Defending the 2007 Budget:


3. In defense of the government's 2007 budget, PM Jose
Socrates proclaimed that his administration had accomplished
everything it set out to do in 2006 despite the nay-sayers.
He commented that "Not only are we eliminating the deficit,
but we are also implementing structural reforms that will
guarantee that the country will never suffer another budget
crisis.... We have gone from a country with a total absence
of reform to being one of the most reform minded countries in
Europe." On November 30, 2006, Parliament,s Socialist
majority passed the 2007 budget, approving only nine of the
800 proposed alterations. As expected, the opposition voted
against the budget although some Social Democrats have
admitted that the Socialists are taking economic measures
which they should have taken while in power.

2007 Budget Overview
(in billions of euros/Percentage of GDP)

2005 2006 2007

Total 70.417 (47.8%) 70.669 (46.3%) 72,538 (45.4%)
Expend-
iture
Total 61.523 (45%) 63.541 (41.7%) 66.628 (41.7%)
Receipts
Balance -6 -4.6 -3.7
Publ Debt 94,394 (64%) 102,948 (67.4%) 108,598 (68%)

Source: 2007 Government of Portugal Budget Proposal

Reallocating Resources:


4. Ranked by foreign investors as one of the least
competitive countries in Europe, Portugal is hoping to
increase productivity by strengthening S&T (the budget
allocates a 64% increase in R&D funds),enhancing primary and
secondary education, and bolstering worker qualifications.

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The Minister of Primary and Secondary Education faces the
particularly difficult task of bettering education with an
ever-declining budget. Though consistently ranked as one of
the most unpopular ministers in public surveys, everyone with
whom DepCouns spoke had high praise for the Minister,s
reforms, including her willingness to close schools with less
than ten students and require teachers to double their hours
from 15 to 30 hours a week.

Preparing for the EU Presidency:


5. Portugal places great importance on its upcoming role as
EU President during the latter half of 2007. During this
time, Portugal will focus on the challenges of enlargement,
job growth and competitiveness, liberty, security, justice
and immigration, and enhancing the EU's ability to respond to
external challenges (e.g. UN peacekeeping, Africa, Russia,
China and India). Despite this ambitious agenda, budget
constraints have forced the government to allocate only 45
million euros to the Ministry of Foreign Affairs (MFA) for EU
Presidency-related activities. Although total government
expenditure for the EU Presidency will be slightly greater
than 51 million euros after incorporating all ministeral
contributions, the MFA is relying heavily on corporate
sponsorships to make up any shortfall. As a reference, the
Finnish Presidency allocated 70 million euros for its recent
Presidency and the Germans have allocated 140 million euros
for the current term.

Ministry Budget Allocation for EU Presidency
(in thousands of euros)

Foreign Affairs 45,000
General State Charges 730
Interior 50
Finance & Public Adm. 100
Defense 2,000
Justice 1,820
Environment 57
Agriculture 1,206
Public Works 6
Education 250
Culture 323

Total: 51,542

Source: Government of Portugal 2007 Budget Proposal

Reducing the Budget through Structural Reforms ...


6. The government has promised not to raise taxes as it did
in 2006 but instead aims to reduce the deficit to 3.7% in
2007 via structural reforms and reduction of public
expenditures. All agree that the government must tackle the
most difficult challenges during the first half of 2007
before the leadership is consumed by the EU Presidency. If
not implemented by then, the government will not have the
results necessary for a final push on its economic reform
agenda and will not be able to trumpet them in the run-up to
the 2009 national elections.

... in Public Administration:


7. One of the more pressing problems is a bloated civil
service. The government plans to eliminate 75,000 civil
service positions by 2009 through attrition, retirement and
mobility - a savings equivalent to 2% of GDP. In 2006, it
eliminated 5,900 positions. In 2007, the government plans to
introduce a new civil service system, revise compensation,
introduce merit-based promotion, and eliminate a minimum of
12,000 positions - a savings of 13.42 billion euros in
personnel expenditures.

... in Social Justice, Social Security and Banking


8. The government is also determined to reduce non-socially
justifiable subsidies to wealthy and more equitably
distribute welfare and social security benefits to the
elderly and the poor. In 2006, it increased worker and
employer contributions to the social security system. For
2007, the government announced that it was closing banking
loopholes and raising the sector's - one of the country,s
most profitable - required contribution to the social
security system by 180-230 million euros. Such actions have
resulted in the nation's bankers and trade unionists calling
Finance Minister Teixeira dos Santos arrogant. Despite these
accusations, Finance Minister Teixeira dos Santos decided to
proceed with the proposed reforms after having determined the

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time for talk was over, according to Ministry sources.

Ministry Expenditures:


9. The government has also cut total Ministry expenditures
by 5% - about 2.390 billion euros or 1.56% of GDP. The public
will be most directly affected by budget changes in the areas
of education, health and Social Security.

Expenditure on Ministries
(in billions of euros)

Expend- % Change in % of % of
itures Consolidated Central GDP
Budget from Admin
2006 Expenses

Gen State 3.511 4.1 6.4 2.2
Interior 1.682 4.6 3.1 1.1
MFA (a) .373 6.3 0.7 0.2
Finance and 17.212 3.2 31.5 0.3
Public Adm (b)
Defense (c) 2.046 2.5 3.7 1.3
Justice (d) 1.290 10.9 2.4 0.8
Environment .560 -8.4 1.0 0.4
Economy (e) .705 -46.2 1.3 0.4
Agriculture and 2.058 5.7 3.8 1.3
Fishing
Public Works, .954 -10.5 1.7 0.6
Transportation and
Communications
Work and 7.184 5.9 13.2 4.5
Social Solidarity
Health 8.577 -0.4 15.7 5.4
Education 5.842 -4.2 10.7 3.7
Science & Tech 2.353 7.9 4.3 1.5
and Higher Ed
Culture .236 -7.0 0.4 1.0

Source: Government of Portugal 2007 Budget

a - The Ministry of Foreign Affairs would actually suffer a
5% decrease if not for the additional EU Presidency funds.
b - Much of this expenditure is due to previously accrued
debt.
c - Much of this expenditure is due to prior equipment
purchases.
d - Increase in expenditure due to new accounting measures.
e - Huge decrease in expenditure due to elimination of fees
and services related to de-bureaucratization program.


10. Problems Remain:

Despite having rounded the corner, Portugal still faces a
number of hurdles. Eurostat figures reflect a drop of
Portugal's per capita GDP from 80% of the EU-25 average in
2001 to 71% in 2006, causing the country to drop three
notches to 18th place in purchasing power parity, behind
Greece, the Czech Republic and Slovenia. Such statistics
raise doubts as to whether Portugal's GDP growth will ever
converge with the EU's average. High taxes remain
problematic. While the government has stated that it will not
reduce taxes until 2009 to allow for reforms to take effect,
some Social Democratic opponents have accused the government
of delaying the decrease as an election ploy and want to see
a tax reduction now to stimulate the economy.


11. Comment: Press reports indicate that despite a rocky
start in July 2005, Finance Minister Fernando Teixeira dos
Santos has won the respect of European Commissioner for the
Economy and Monetary Affairs Joaquin Almunia for his hard
work and determination to reduce Portugal's budget deficit
below 3% by 2008. While acknowledging the country's strong
progress on reforms, Almunia has warned that Portugal will be
subject in 2007 to zero tolerance - i.e. no further reform
delays. Teixeira dos Santos also enjoys the continued support
of the Portuguese public - a reflection of the public's broad
support for Socrates,s economic agenda. The Portuguese
understand that there is no quick fix for their current
dilemma. In fact, Portugal has been held up by the EU as an
example of what not to do when joining the Eurozone.
However, most Portuguese appear determined to stick by the
reforms until they bear fruit rather than ceding further
ground to new EU member states.
O'Neal