The case of Portugal provides a very illustrative example of the benefits and risks associated with the transition from a high-inflation regime to membership in a low-inflation monetary union. While Portugal has undoubtedly benefited from the lower inflation, lower interest rates, and greater exchange-rate stability brought about by EMU, the process of monetary integration also brought forth a number of imbalances that have contributed to the country's poor economic performance in recent years. Unfortunately, instead of counteracting these imbalances, the Portuguese government more often than not pursued policies that exacerbated them.

After suffering from double-digit inflation and interest rates during the 1980s, Portugal joined the path toward monetary union in 1992 when it became a member of ERM and committed to keeping the escudo within a +/-15% band around a central parity rate with the deutsche mark (DM). Despite some initial turmoil requiring adjustments to the central parity rate, Portugal stayed within ERM until the euro was launched and succeeded in ushering in a period of falling inflation and lower interest rates. The combination of greater exchange-rate and price stability, the falling cost of capital, and comparatively low labour costs within the EU helped the country attract high levels of foreign direct investment (FDI) from multinationals in the automotive and textile sectors. These investments represented a key driver of growth during the 1990s.

The other key growth engine was private consumption, which benefited from an unprecedented credit boom during the latter half of the 1990s. Declining interest rates fuelled credit demand and were accompanied by liberalisation of the financial sector, opening the way for greater banking sector competition and financial innovation. With the probability of EMU and an eventual elimination of exchange-rate risk coming ever nearer, banks enhanced their opportunities to borrow abroad and succeeded in significantly easing liquidity constraints. The result was a financial sector willing and able to meet the increase in credit demand from households. Although household debt rose rapidly, interest payments remained broadly stable since most of the debt was based on short-term variable rates, which continued to come down. This environment allowed private consumption to achieve average growth of some 4.0% from 1995 to 2000, which compares to 2.5% in the Eurozone as a whole.

Given the increasingly loose monetary conditions prevailing ahead of EMU, the focus of fiscal policy would ideally have been on the prevention of overheating in the economy. Unfortunately, the Portuguese government ended up pursuing the opposite course of action, as the reduction in interest payments created illusory optimism about what the state could spend. The increasingly pro-cyclical fiscal stance was evidenced by rates of public-sector employment growth well in excess of those observed in the private sector, as well as a rapid rise in government payroll expenditure. Since the public sector tends to play the role of wage leader in Portugal, the rising payroll expenditure also fuelled wage demands in the private sector, already under pressure from a tight labour market.

After significant progress towards eliminating the positive inflation differential with the Eurozone, increasing wage bills led to mounting price pressures and an increase in the inflation differential after 1998. At the same time, the generosity of public-sector employment policies led to a diversion of resources away from the more productive sectors of the economy. This development began a process of erosion in Portugal's productivity growth and external price competitiveness that hurt the economy considerably once the cyclical downturn of 2001 set in. The external imbalance of the economy grew markedly as productivity growth could not keep up with domestic demand, leading to a surge in imports. At the same time, falling price competitiveness led to a loss of export market share, which was exacerbated by the emergence of stiff competition from lower cost producers of textiles in the Far East. The result was a current-account deficit of more than 10.0% of GDP by 2000, compared with only 0.1% of GDP in 1995.

By the time Portugal joined the euro in 1999, the economy was characterised by mounting imbalances and structural weaknesses. Households were heavily indebted following the credit boom leading up to EMU, while deteriorating competitiveness hampered exports and dented Portugal's attractiveness as a destination for foreign direct investment. The stage was set for the economy to be hit hard by the next cyclical downturn, which arrived in 2001. By this time, however, the fiscal profligacy of the government had resulted in a public deficit in breach of the 3% limit imposed by the Stability and Growth Pact. This development left the government unable to provide a fiscal stimulus to the economy at a time when it would have been needed most. To this day, the government has been struggling to keep the deficit in check, implementing various tax increases and austerity measures that have dampened consumer spending growth. The overall result is that in 2005, Portugal established itself as one of the laggards of the Eurozone.

What lessons, then, can EMU candidates derive from Portugal's experience? The most obvious and important lesson is clearly that fiscal policy must be focused on counteracting the imbalances that inevitably arise during the process of interest rate convergence. By fuelling the frenzy of the late-1990s credit boom and allowing its fiscal position to deteriorate, the Portuguese government created long-term structural problems and limited the scope for policy intervention in cyclical downturns. EMU candidate countries would be wise to avoid the same mistakes.

Contact: Raul Dary

24 Hartwell Ave.
Lexington, MA 02421, USA
Tel: 781.301.9314
Cel: 857.222.0556
Fax: 781.301.9416
raul.dary@globalinsight.com

www.globalinsight.com and www.wmrc.com