Portugal in Trouble...

PORTUGAL IN TROUBLE:
AN INWARD LOOK ONTO THE PROBLEMS

Beginning with late 2008, the global economic crisis firstly seen in the USA hit also the countries of Eurozone. Along with Greece, Spain, Italy and Ireland, Portugal was also the Eurozone country which was affected from the global crisis mostly. This article investigates the possible root causes of the crisis in Portugal, and the determinants of competitive disinflation and whether the crisis stemmed from the entry of Portugal into EMU. Multiple regression analysis was used for the period between 1999 and 2009. The results of the empirical analysis show that the monetary policy of the ECB (interest rate) and the entry into EMU (productivity, inflation) have negative effects on the current account imbalance of
Portugal.

Keywords: Current Account Deficit, ECB Interest Rate, Productivity, Competitive
Disinflation

1. Introduction
Originating from USA subprime loan crisis as of 2007, the current global economic crisis has affected the world economy. In the USA, the underestimation of subprime asset risks and securitization problems mainly led to this crisis. As globalized financial institutions have been tied to each other even stronger, the contagion possibility of the crisis effects has increased.

The crisis in the USA was firstly seen in Europe and then other emerging countries in the world (Blanchard, 2009). Although the annual report on Euro area says that euro prevented the countries in the crisis and the Euro area countries became more attractive (Annual Report, 2009), the fact is different. Many countries in Euro area (the so-called PIIGS) are suffering from the crisis (Chorafas, 2009). Recently, Greece case draw the urgent attention of the European institutions and for this country, some measures have taken by the European Council (Brussels, 2010). Portugal and some other EU countries were subjected to Excessive Deficit Procedure (Brussels, 2009) and recommended to take required actions. The reasons behind the pains of
the countries differ from each other.

In Portugal’s case, the current account deficit seems to be the most problematic issue in its economy (Shelburne, 2008). Along with the global economic crisis which affected emerging and low income countries through declining demand for exports (IMF, 2009), being a member of EU increases the current account deficit as percentage of GDP (Shelburne, 2008) and with being even a member of Eurozone, the current account deficit increased more (Blanchard and Glavazzi, 2002).

In academic field, Portugal economy was analyzed in various studies. Blanchard and Glavazzi (2002) give a historical perspective of Portugal deficits (current account and budget) with reasons and policy actions taken to counteract the deficit. Blanchard (2004) analyzed the overall economic status of Eurozone and particularly Portugal and Spain. Again, Blanchard (2006a) and Blanchard (2006b) told the problems of country’s economy with reference to European Economic and Monetary Union. Shelburne (2008) investigated the current account deficit in European emerging markets like Portugal, Spain and Greece. Abreu (2006) developed an analytic approach to Portugal’s boom and bust. Andini (2008) gives some insights on the relationship between competitive loss and unemployment. The names above are some of the analysts mostly referred and on whom the implications in the paper mostly depended.

In this paper, Portugal economy is analyzed in the light of some macroeconomic indicators. The economic history of approximately two decades are explained and then some major determinants of the current account deficit are tried to be explained with the help of an econometric model.

2. Portugal Economy in the Light of The History
When it is assessed, two peaks in the Portugal economy stand out; 1995-2001 and 2001-2005. In the second half of the 1990s, Portugal economy started to grow rapidly in order to catch up with other EU economies and take place in the Economic and Monetary Union of Europe. With these expectations to participate in the euro, growth rates became higher (Blanchard, 2006a).

After the EU membership, Portugal’s GDP increased until the ERM crisis in 1993. After
1993, growth rate was increased again expecting to be a member of European Economic and Monetary Union. Between the periods 1995-2001 and 2001-2005 there exists a clear
difference. The growth rate of GDP became even lower. In 2008 and 2009, growth rate was below the ones of Eurozone (ECOFIN, 2009) and in 2009 it became even negative with the effects of the crisis.

Expactations to join the euro brought also confidence and decreased the country risk. These were the main reasons behind the rapid growth of economy.

At the end of the first peak in 2000s, unemployment rate was at lowest levels and even below the rates of EA-15. By reaching the low employment levels, nominal wages increased more than the productivity growth level.

Besides the wage growth, the unit labor cost also increased even higher than EA-15.

The nominal wage growth and unit labor cost increase brought competitive disinflation for Portugal economy (Andini, 2008). That means, domestic producers stand in a disadvantaged position against the exporting countries to Portugal (Martins and Opromolla, 2010).

Sharp decrease in interest rates before the EMU membership in 1999 enhanced credit
possibilities of banks. However, the deposits were below the level of credits (Constâncio, 2004). As a result, the current account deficit increased.

It was seen that with raised expectations and a boom in credit and consumptions, current account of Portugal got imbalanced sharply till early 2000s. During 2000 and 2003, there was a slight improvement in imbalanced position due to slight decrease in unit labor cost and relatively sharper decrease in nominal wage growth.

There have been some adjustment mechanisms for countries in order to balance the current account status and gain competitiveness. The current account can be balanced again by increasing the exports or the value of exports faster than imports.
Lowering the nominal wages until the unit labor costs decreased can be a way of gaining competitiveness. EMU has brought both costs and benefits to participating countries by bringing a single currency and reducing exchange rate volatility. International trade volume increase can take into account as benefits of joining an economic and monetary union as single currency reduces the transaction cost. To fulfill the objective of synchronization of business cycles, the same interest rate determined by European Central Bank (ECB) is used (Rose, 2000). Along with the single currency, countries cannot devaluate/revaluate its national currency. A single
interest rate and the prohibition of devaluation/revaluation aimed at avoiding the participating countries from using policies in favor of their national market and therefore deteriorating the functioning of the European Single Market. However the suitability of single interest rate determined by ECB is questionable. In his mostly referred work, Taylor (1993) has made a formulation in order to determine the appropriate interest rate for a country.

According to Molodtsova, Rzhevskyy, and Papell (2009), the difference between the natural rate of unemployment and unemployment can be used instead of output gap, but in the graph below, output gaps were used. The desired interest rate of Portugal according to Taylor rule and the interest rate applied by ECB is calculated.

The interest rate applied by ECB is approx. 3,5 % below the desired interest rate for Portugal. This difference is quite big. As seen in other graphs above, the basic tools of a country for adjusting the competitive disadvantages are in the hands of ECB, not of the country itself. So, a crash like the current global crisis needs to be compensated by a supranational institution. In Portugal’s case, it is
surely ECB.

2. Empirical Analysis

2.1. Objective
In year, third stage of European Economic and Monetary Union has started, and the countries joining EMU have transferred their monetary sovereignty to European Central Bank. Interest rate used in the countries has been determined by ECB as of 1999. Therewith, for different scaled economies there has been used now just one interest rate, which may be disadvantageous for some countries, like Portugal. The current account imbalance (deficit for Portugal) is one of the most important and urgent issues of Portuguese economy. The main objective of this empirical analysis is to show how the current account deficit as percentage of GDP of Portugal has been effected by chosen independent variables as of 1999.

2.2. Methodology and Dataset

The annual data between 1999 and 2009 is used for Portugal. The start year is taken as 1999 with entry of the country into EMU. The data is collected from OECD, ECB and AMECO databases.
The independent variables are ECB interest rate (absolute value), inflation (harmonised index of consumer prices) and productivity growth (percentage change) whereas the dependent variable is current account deficit as percentage of GDP.

The paper employs OLS and Multiple Regression Model. The empirical analysis is conducted using the program EViews 5.

Multiple Regression Model
Estimated Econometric Model:
CADPOR = β1 + β2*ECBINTERESTRATE + β3*LINF + β4*LPRODUCTIVITYPOR
CADPOR: Current Account Deficit to GDP ratio (%)
ECBINTERESTRATE: Interest rate determined by Eurpean Central Bank (%)
LINF: Logarithmic Inflation Rate (%)
LPRODUCTIVITYPOR: Logarithmic Productivity Growth (%)

Hypothesis:
Ho: β=0 (independent variables have no effect on the current account deficit of Portugal)
H1: β≠ 0
The significance level was taken as 5% (0,05).
Dependent Variable: CADPOR
Method: Least Squares
Date: 04/11/10 Time: 04:24
Sample (adjusted): 1999 2009
Included observations: 13 after adjustments
Variable Coefficient Std. Error t-Statistic Prob.
C -10.44539 1.121832 -9.311010 0.0000
ECBINTERESTRATE -1.607414 0.291255 -5.518933 0.0003
LINF 4.863633 0.772765 6.293806 0.0001
LPRODUCTIVITYPOR 1.098111 0.341750 3.213195 0.0093
R-squared 0.931031 Mean dependent var -6.635714
Adjusted R-squared 0.910340 S.D. dependent var 3.579989
S.E. of regression 1.071967 Akaike info criterion 3.211824
Sum squared resid 11.49113 Schwarz criterion 3.394412
Log likelihood -18.48277 F-statistic 44.99732
Durbin-Watson stat 2.316320 Prob(F-statistic) 0.000004
Table 1: Estimation Output

CADPOR = -10.44539275 - 1.607414466*ECBINTERESTRATE + 4.863633374*LINF +
(-9.311010) (-5.518933) (6.293806)
1.098110809*LPRODUCTIVITYPOR
(3.213195)
R2=0,93 and Durbin-Watson stat=2.316320
⎯R2=0,91 each variable added to the model have an increase effect of coefficient of
determination, so⎯R2 shows the real effect.

The values in brackets are t-statistics and⎯R2 shows the interpretation power of the model.

3. Findings
In this paper, ECB interest rate, Inflation rate and Productivity growth are employed together as regressors of Current Account Deficit of Portugal.

Null hypothesis was rejected since the probability values in brackets are lower than 5% significance level. Multiple regression model is able to explain 91% of real relationship between the dependent and independent variables. Durbin-Watson statistics are 2.316320 and higher than 2. The probability value of F statistics is lower than 5% significance level and the Multiple Regression Model is generally significant.

The regression shows that LINF and LPRODUCTIVITYPOR have positive effect and
ECBINTERESTRATE has negative effect on current account deficit of Portugal. It means
that an increase in the inflation and productivity also increases the current account deficit, and an increase in ECB interest rate decreases the current account deficit of Portugal. The results obtained are also consistent with the theoretical basis.

4. Conclusion
As of early 1990s to 2001, Portugal economy has experienced a boom mainly due to the
expectations to join the European Economic and Monetary Union. This is called a catching up period. Expansionary fiscal policies during the boom and easy access to cheaper credits increased the demand for housing by households. Unemployment rates decreased, wages increased. But the productivity growth level remained under the growth rate level of nominal wages. That was the beginning point of Portugal competitive disinflation.

Higher production costs led customer to import goods, and Portuguese firms couldn’t compete with cheap importers. Devaluation might be an adjustment tool, but it is prohibited since it might deteriorate the functioning of the European Single Market.
The result of all disadvantaged positions is high current account deficit. As seen in the multiple regression analysis, inflation that is affected by the unemployment rates and productivity growth have negative effects (an increase in these parameters also increases the current account deficit) and an increase in ECB interest rate has positive effect on current account deficit.

What Portugal needs now is emergent adjustment to the loss of competitiveness. Since it cannot do this by using monetary policy tools, labor market may be an exit way. Depending on the labor market rigidity, Portugal can lower the wages and unit labor costs until the productivity growth level be over the nominal wage growth, and at the end until it gain its competitiveness against importers again.

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