Portugal’s “Euro hold-up”

JOSÉ BRAZ

National Bank of PolandMarch 21-22, 2002

Convergence and Divergence in Euroland

ContentsI. EvidenceII. Lessons

Evidence 1 nominal convergence

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Evidence 2 real convergence

-1

-0.5

0

0.5

1

1.5

2

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Evidence 3� Convergence instruments and policies

� Fiscal discipline� Monetary and exchange rate policies� Wage and financial moderation� Structural reforms – tax system,

privatisations, infrastructure� Convergence – quality matters, not just

quantity (a game with no final whistle)

Evidence 4The “Euro hold-up”

Chart 5:Primary Expenditures % GDP

22%

27%

32%

37%

42%

47%

1974

1977

1980

1983

1986

1989

1992

1995

1998

2001

2004

� Nominal and real convergence are possible simultaneously –

it’s not a case of either/or

� BUT, so is simultaneous divergence!

Lesson 1

Lesson 2� Full benefits of currency stability do not

materialize when fiscal policies are unsustainable

� Policy credibility is more important than proximity to EU markets

Lesson 3� Nominal convergence can give

temporary illusion of fiscal discipline

� There is no substitute for genuine reforms – even “New Economy” visions require “Old Economy” virtues

Lesson 4

� The “Euro hold-up” –not just a risk for Portugal!

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Portugal’s Euro hold-up

Jorge Braga de Macedo OECD Development Centre

Paris jbmacedo@oecd.org

José Braz TEcFinance Ltd

Lisboa jbraz@mail.telepac.pt

1. Introduction The idea behind the title is this: being part of the Euro makes it easier to avoid the usual punishment that currency markets tend to give a country whose policies go off course. Once a country has a common currency, such market punishment no longer can occur and therefore bad fiscal policies (tax and expenditure) are allowed to continue for a longer time. This will end up having the perverse effect of slowing down, or holding up, the convergence process. In a more dramatic way, one can think of this as a hold-up in the sense of having something stolen from you at gunpoint. To the extent that the Euro is the promise of welfare gains, of the common good being pursued in the country, this hold-up can actually prevent the gains from materialising. It is like having part of your dreams and part of your vision stolen. The authors were finance minister and treasury secretary when, on 4 April 1992, the Portuguese currency became part of the Exchange Rate Mechanism of the European Monetary System (ERM). This personal account reflects the questions of convergence we confronted in 1991/93. They are illustrated in charts 1 through 4 - with the benefit of hindsight. Chart 1 shows the decline in the differential between inflation between Portugal and the other European Union members (measured by the harmonised consumer price index). Data are shown from the early 1990s, when the inflation rates in Portugal were above 10%, having come down from 25-30% 4-5 years earlier than that but there was already a strong process of deceleration of inflation under way. By 1997, catching up with Europe had already taken place in terms of price differentials, although this nominal convergence was relatively short-lived. In terms of real GDP growth differentials between Portugal and the EU, again the story told by Chart 2 is one of general catching up of between 0.5 and 1.5 percentage points on average per annum. The exceptions are 1993 and 1994, years during which there were strains in the relationship between the Central Bank and the Finance Ministry. After those two years the real convergence occurs again and it goes on until 1999. Monetary and exchange rate policies were responsible for the apparent conversion to fiscal discipline required to qualify for Euro entry. Chart 3 shows the pattern of wage and financial moderation, with reversals in 1990/91 and after 1995. What the government meant by financial moderation was taking steps to make sure that the interest rates being

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paid by firms in Portugal were not too much higher than abroad. A process of financial liberalisation was also underway, opening Portuguese financial markets to international competition. This was not an easy process, but it helped deliver the convergence in inflation and in real growth rates depicted in charts 1 and 2. Structural reforms are as important as monetary and fiscal policies. The process of privatisation, which was taking place then, the reform of the tax system, improvements in infrastructure, issues in markets for labour and for real goods are all structural reforms allowed by financial stability. Nevertheless these reforms were resisted by social groups used to the protection of the state. This is why the issue of convergence is not just a question of looking at the numbers and making sure that we get the quantity right. Quality is also important. To take but one example, if you spend more on education, are you simply building more schools, perhaps some of which will be empty once the current baby boom is over, or are you actually taking steps to improve the quality of education? If you are doing the first, probably it will not be followed by much improvement in growth or in the quality of the workforce, whereas it is much more useful to improve the quality of education. Also, convergence is not a game in which you work strongly towards convergence and once you get there you can then rest because it has been done. It is a game without a final whistle. Even if you have a long history of convergence, if policies are not maintained, you can well lose that lead, you can well then enter into a phase of divergence, which is what has been happening in Portugal over the past 2-3 years. Chart 4 shows primary expenditure as a percentage of GDP. If one looks at the years from 1996 to 2000, there was a very sharp increase. And, going back to the earlier point about the quality, not just the quantity, virtually all of this increase was due to increases in the size of the public sector, in the number of autonomous agencies (without very clear purpose of what they were set up for) and in transfer payments. These were expenditures not directly linked to productivity and economic growth. Another way of illustrating the Euro hold-up would be to look at the level of general government expenditure, which in Portugal is now over 50% of GDP. Perhaps more worrisome than the level itself, was the divergence relative to the EU average. In roughly the ten years from 1991 to the year 2000, spending increased by 7 percentage points of GDP, whereas the EU average fell by about 4 points! In addition to this introduction and a conclusion deriving eight lessons from Portugal's Euro accession experience, both of which follow the presentation at the National Bank of Poland by the second author, the paper contains two sections. Adapting Braga de Macedo (2002), section 2 analyses the gradual change in policy regime towards the Euro. The experience of the entry of the escudo into the Exchange Rate Mechanism of the European Monetary System (ERM) and suggestions on how to avoid the Euro hold-up through structural reforms are especially emphasised. Section 3 gives an example of failed structural reform. Following Braz (2002), it describes the failure to take effective action in pursuing policies directed at improving the competitiveness of the Portuguese economy in the area of ICT (Information and Communication Technologies).

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2. A gradual change in policy regime towards the Euro 2.1. The good student has a bad fiscal constitution Portugal ’s successful experience with international economic interdependence, beginning with the Organisation for European Economic Co-operation (the predecessor of the OECD) and the European Payments Union, has been largely ignored. On the contrary, acknowledgement of the success of the accession to the European Community in 1986 and to the Euro in 1998 is widespread: this is the view of Portugal as a “good student” of European integration. But the good student has a bad fiscal constitution. The fiscal constitution describes relations between the state and the population involving both taxes and transfers. It includes the institutions enforcing the social contract and thus incorporates various exchange rate regimes, monetary standards and state revenues. The concept of fiscal constitution is useful because it shows the root causes of unsustainable fiscal policies, which prevent the benefits of a stable and common currency from materialising. For example, deficient tax administration undermines the social legitimacy of taxes as a means to provide for the common good and prevents the reform of public administration from being initiated, let alone carried out. Since, by itself, the Euro cannot change the fiscal constitution, reforms continued to stall until the imminent danger of a budget crisis in 2002 made Portugal a victim of the Euro hold-up. Since the previous crises had involved the balance of payments, there are still those who doubt an excessive government budget deficit qualifies as financial crisis and would rather call it a legal nuisance After the April 25th Revolution, the Portuguese economy circled around macroeconomic equilibrium for five years and came close to attaining it in 1980. Then in 1981 a new vicious cycle began and the adjustment towards external balance required an IMF-sponsored programme in 1983. This was followed by a period of rapid growth, which fed inflationary expectations, in spite of the hard escudo policy followed at the beginning of the 1990s. The drop in the “feel good factor” delayed the effects on public opinion of the regime change associated with ERM entry. That the effect of excessively high expectations can be perverse has been widely noted in the process of transition from plan to market, from dictatorship to pluralistic democracy. It certainly occurred in the wake of the good student phase - even though the recorded impact of the 1992-93 European recession was pretty mild. Unfortunately for high expectations, the process of catching up needs to be coupled with economic restructuring. The banking sector, through privatisation or other means, had to absorb the overhang of inefficiency. As with trade and industry, the pressure for financial readjustment came mostly from European integration, as no excessive regulation in Portugal was likely to last without severe damage to financial development, because business would go across the border to Spain. International capital mobility and free trade in financial services, by greatly increasing the competition among banks, was bound to make Portuguese banks unwilling and unable to finance the deficits of the public sector at

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rates substantially below comparable borrowers. Financial openness clashed with the fiscal constitution, insofar as it threatened the implicit intermediation tax collected from depositors, borrowers and shareholders and redistributed in the form of subsidies to state-owned enterprises, including banks. The new behaviour began in 1985 with the new banks and became stronger as banks began to be privatised in the 1990s. At the same time, the liberalisation of capital movements on a Europe-wide scale was delayed until after capital controls had become ineffective. Initially coupled with credit ceilings, exchange controls kept interest rates artificially low, indicating that they operated as stringent barriers to capital outflows (the average covered interest differential against the dollar between 1984 and 1988 was 0.6% in Spain and about - 3.0% in Portugal). These means of alleviating the burden of public debt showed again how the fiscal constitution helped obscure the political element in financial discipline. The only credible measure to end the direct financing of the Treasury by the banks would have been an agreement among the Central Bank, the Ministry of Finance and the main "spending ministries" on a plan of deficit reduction involving both expenditure and revenue, and including tax reform. This is the essence of a multi-annual fiscal adjustment strategy (MAFAS) which, combined with a pre-pegging exchange rate regime (PPERR), would support a programme of structural reforms capable of sustaining the global competitiveness of Portuguese firms. Specifically, PPERR avoids the "inconsistent trio" of fixed exchange rate, free capital movements, and independent monetary policy by freeing monetary policy to be targeted on external balance, represented by a suitable reserve position. MAFAS then sets fiscal policy to maintain internal balance, as represented by a low rate of inflation. As discussed in the following subsections, the restoration of currency convertibility was delayed by a succession of exchange rate regimes and the required changes in the fiscal constitution were delayed by failed attempts at reforming public administration. In short, domestic policy co-ordination never matched the commitment at the EU level, thus setting the stage for the Euro hold-up. 2.2. Successive exchange rate regimes The gradual change in Portugal’s economic regime towards price stability and currency convertibility featured several exchange rate regimes before ERM membership. Not all helped the regime change, and one almost reversed it. After membership, though, the system itself became unstable and the last realignment took place in 1995. We first describe the exchange rate regimes prevailing until the Euro became fully credible. In September 1989, the escudo entered the ECU basket at a rate of 172. With hindsight, this marks the beginning of the change in the economic regime, which eventually would move the escudo into the Euro. Two kinds of measures define the change. Some, like a constitutional amendment reversing the 1976 freeze on privatisation, were public but

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their relation to financial liberalisation was not immediate. Other measures like the MAFAS presented to the Commission services were relevant but not public. In spite of these reforms, neither the government nor social partners saw ERM membership as imminent. The cabinet was reshuffled shortly after the 1989 local elections, further delaying public awareness of the ongoing regime change. A Foreign Exchange Law where criminal charges were replaced by fines had been approved in the fall of 1989 and was heralded by the finance minister as a major reform. Yet the administration of exchange controls remained with the Central Bank, so that it determined macroeconomic policy almost completely until after the 1991 general elections. The crawling peg policy was replaced sometime in the spring of 1990 by a shadowing of the DM, known - but not officially acknowledged – as the hard escudo policy. Since the change was not announced publicly, it couldn’t be interpreted as a PPERR that might complement a MAFAS. But a very low level of unemployment coupled with a strong upward pressure on public sector wages led to strong inflationary pressures and to the appreciation of the real exchange rate. Moreover, the fear that financial freedom would threaten monetary control and the soundness of the banking system was ingrained at the Central Bank that administered the exchange controls. Decree law 13/90 of January 8 allowed the Central Bank to reinstate several controls, which remained under Decree law 176/91 of 14 May, in spite of the principle of freedom stated in article 3. The Foreign Exchange Law gave the Central Bank competence to issues avisos (regulation notices signed by the finance minister) where capital controls could be introduced or relaxed. On 21 May, the first aviso was used to introduce an interest free deposit of 40% of loans contracted abroad (except when the operation related to financing of current transactions) and a prohibition of forward purchases of escudos between resident and non-resident banks (forward sales were still not allowed). The controls were reinforced before the general election (aviso 7 of 5 July 1991) with explicit reference to the threat to monetary and exchange rate policy that was posed by excessive capital inflows. The tightening of controls was supposed to help prevent inflation from accelerating while the associated increase in the cost of servicing the public debt was looked at with benign neglect. The Central Bank’s foreign reserves more than doubled from 1989 to 1991, with disastrous consequences for the bank’s operating results. This opaque arrangement managed by the Central Bank also allowed banks to delay adjusting to a single market in financial services. In short, while shadowing the DMark, so as to fight inflation, the Central Bank was accumulating huge dollar deposits earning 5 %, while paying 20 % on the escudo debt being issued to mop up the resultant “excess” liquidity. Under credible shadowing no exchange rate changes are expected so that this translates into a 20% rate in dollars. The volatility of Nordic currencies in late 1991 suggested that controls on capital movements could help stabilise the currency. Then the beginning of the transition towards the Euro was signalled by a speculative attack on the escudo and the punt. These episodes notwithstanding, the first two years of stage one were rather tranquil.

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2. 3. Earning credibility under ERM turbulence In July 1990, a National Adjustment Framework for the Transition to Economic and Monetary Union, known as QUANTUM, had been proposed. Yet, it was not until after the 1991 elections that a convergence program combining MAFAS and PPERR with capital account liberalisation (but called Q2 to stress the continuity of the gradual regime change) was submitted to the Ecofin Council and discussed in the Portuguese Parliament. In spite of Q2, the decision to request entry of the escudo in the ERM was a genuine surprise. On the weekend following the approval in parliament of the 1992 State Budget - the Community responded to the government’s application to join the ERM at a rate of 180 escudos agreed upon at a special cabinet meeting on Friday afternoon. Even though there was a precedent with sterling, the prior declaration of a parity generated great resistance among several members of the Monetary Committee (whose members were acting as personal representatives of the then twelve minister/governor pairs who meet with the Commission in the so-called informal Ecofin). Under the alleged fear that, on the eve of the British general election, the announced parity of 180 might induce a speculative attack against sterling, a parity closer to the market rate was sought. The treasury secretary, who was a member of the Committee, felt the unstated fear of the German authorities that allowing a small Southern partner to decide on its rate of entry would undermine popular support in Germany for the system that was to replace the Dmark with the Euro. Finally, the notional central rate of 178,735 - that is the one prevailing since the entry of sterling in October 1990 - gathered consensus. After the cabinet meeting the finance minister had briefed the social partners and the following week ERM entry was debated in parliament. Nevertheless the rule-based exchange rate regime which culminated the gradual change in economic regime was neglected at home. In any event, the central rate the escudo kept after the realignment of the peseta in March 1995, around 196, would have been difficult to reach without the benefit of the ERM code of conduct. The lengthy discussion showed the precarious position of the ERM grid, which was going to imply the departure of the lira and of sterling a few months later. It also suggests that, had the decision been delayed, the escudo would have been unable to join the ERM in time to meet the EMU criterion of two years’ membership. It would have trailed with the Greek drachma outside the parity grid, rather than accompanying the peseta inside. Evidence to this effect comes from weekly measures of exchange rate volatility against the Dmark during some episodes of domestic controversy, which coexisted with the ERM crises. As shown in Braga de Macedo et al. (1999, updated in Braga de Macedo 2001), the episodes also provide early tests for the credibility of Portugal’s policy. The restoration of full convertibility by the Central Bank on 16 December 1992 turned out to be extremely difficult to bring about, as its board reluctantly agreed to have controls renewed for shorter and shorter periods. The elimination was not announced until 13 August 1992, and even then only under the threat that legislative action would be taken to withdraw the Central Bank’s power to issue avisos.

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The Central Bank’s board enjoyed the virtual rule on policy-making in 1990-91, including the management of the derogation to the 4th Brussels directive negotiated by Greece and Portugal until 1995. This made it even more difficult for the Central Bank to accept that the derogation should expire in 1993 or 1994 (which is when Greece finished its liberalisation). The restoration of full currency convertibility was seen by the Central Bank as too risky, especially because it would lower its control on monetary policy. At the same time, there was accumulating evidence that the recession was hitting the domestic economy, leading the Finance Ministry to urge the Central Bank to adjust to the time of full currency convertibility. Two implications of convertibility that had been raised in the sessions with the bank’s board were not made public in the finance minister's plea of March 1993. First, allowing for greater banking competition. Given the soundness of the banking system (at least in relation to what was happening in Scandinavia), this implied a tighter supervision than the regulators could muster. Second, lowering money market rates even if it meant letting the escudo slide towards the middle of the 6% ERM band rather than being glued to the top. Better banking supervision, namely in enforcing greater transparency in effective rates being charged on credits, would lead to a decline in the cost of credit without the need to change the stance of monetary policy. Flexibility within the top of the band would reflect the benefit of the ERM code of conduct relative to the opaque DMark shadowing followed before joining. Some days later, Reuters aired rumours that the governor of the Central Bank was to resign in the footsteps of a vice-governor who had been an outspoken advocate of the hard escudo policy. While the rumours did not materialise, the adjustment to convertibility was depicted as a crisis rather than as a natural adaptation to greater financial reputation. Thus, the socialist opposition, which was openly questioning the stability-oriented policy contained in Q2 and calling instead for a slower disinflation and an autonomous depreciation of the currency, pretended to see the independence of the Central Bank threatened by an "authoritarian" government. To the social-democratic business elite, still under the shock of ERM entry, the pressure on the monetary authority suggested a reversal in the orientation of macroeconomic policy. Domestic controversy contributed to slow down the learning process for firms and citizens about the benefits to be derived from financial reputation but there were no negative international effects and ERM partners believed the code of conduct would be upheld. In the turbulence that followed ERM entry, the lack of credit familiarity with Portugal also had to be overcome. Yet, the Central Bank, along with favouring capital controls, discouraged international borrowing, which it still associated to situations of looming payments crises rather than to the promotion of the nation’s credit abroad. Exceptionally high foreign exchange reserves where another inheritance from the past, and therefore were not used to boost the Treasury’s credit rating: Portugal’s external debt issues had been assigned a rating of A1 by Moody’s Investors Services in late 1986 and A by Standard and Poor’s two years later. The divergence between the two agencies remained until late 1991, when Standard and Poor’s upgraded to A+.

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As soon as the currency was fully convertible, therefore, a strategy of making the Treasury known in international markets was designed, involved a planned return to international borrowing, successively in yen, marks and dollars. Standard and Poor’s decided the upgrading of Portugal’s foreign debt to AA- in May 1993, even though the previous upgrade had been decided less than 18 months earlier. International investors were ready to believe then that economic policy in Portugal would retain a medium term orientation also; this was the first such rating move since Ireland had been upgraded in 1989. Once again, the strategy was ignored domestically. Shortly after the global dollar issue of September 1993, the deterioration in tax revenue collections, whilst keeping non-interest expenditure at the nominal amount included in Q2, increased the deficit and had a much greater impact domestically than the credibility earned abroad. The ERM crises were felt by the lira and sterling, which left the grid on 17 September, 1992 when the peseta also realigned but the escudo did not. The opinion at the Central Bank was to deny the “geographic fundamentals” and to stick to DMark shadowing, while recognising that exchange rate policy was a competence of the government. Exporters, on the other hand, were sensitive to the bilateral rate with the peseta and had been pressing for a devaluation of the escudo relative to the peseta. As it turned out, the realignment of 23 November was matched and those on 14 May 1993 and 6 March 1995 were followed in part, without ever facing the loss in financial reputation associated with initiating a realignment. Quarterly data on capital flows (and daily intervention data subsequently released by the Central Bank to extend the results of Braga de Macedo et al 1999) confirm that external credibility was achieved in late 1992 and remained unperturbed by subsequent peseta realignments. As there was no memory of speculative attacks against the escudo, the domestic turbulence of March 1993 may just reflect the tension between Finance Ministry and Central Bank, or echo fears about the liberalisation of capital movements on the part of the banking community. 2.4. Selling stability at home in the run-up to the Euro The MAFAS retained in the Revised Convergence Program (PCR) approved with the 1994 State Budget kept the nominal ceiling on non-interest expenditures from Q2 but adjusted the deficit for the revenue shortfall. This was well accepted by international investors who heavily oversubscribed a global bond issue of one billion dollars in September 1993 and by the Monetary Committee who approved the PCR in November. A cabinet reshuffle was announced shortly before the December local elections, but economic policy remained consistent with the PCR. In early 1994, a global bond issue in ECU was received with the same success as the previous one. Yet the new finance minister's call for lower interest rates, while directed at a domestic business audience, had foreign repercussions, especially when they were thought to have the approval of the Prime Minister. In this context, an Austrian news agency reported rumours of a military coup in Portugal. While entirely groundless, the story was picked up by Bloomberg and led to a renewed attack on the escudo. Differences on banking supervision led to the replacement of most of the Central Bank board in June 1994. This drastic move was well

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accepted, for - just like the previous year - it was understood that the tension did not originate in monetary policy. Just like the ERM code of conduct moved the escudo into the euro, the Treaty on European Union and the Banking Law (Decree Law 298/92 of 31 December), which introduced the single market in financial services and called for greater supervision and competition, forced the Central Bank to adjust. Further changes have thus been introduced to the statutes of the Central Bank to make it more independent from the government, to introduce some accountability in parliament and to improve the regulation and supervision procedures. Another reflection of the continuity of the MAFAS was that the PCR proposed in 1993 extended the expenditure ceilings into 1997. The PCR remained the basis for the excessive deficit procedures until a Convergence, Stability and Growth Program from 1998 to 2000 was approved by the Ecofin in May 1997. It was followed by a Stability and Growth Program for 1999-2001 shortly after the escudo joined the euro at a rate of 200,482. The MAFAS continued listing structural reforms, especially in the public administration but unfortunately dropped the nominal ceiling on non-interest expenditures. The subsequent yearly revisions culminated in a recommendation by the European Commission, issued on 30 January, 2002 "with a view to giving early warning to Portugal in order to prevent the occurrence of an excessive deficit". The Ecofin decided against making the recommendation because of the commitments of the outgoing government but a new Stability and Growth Program will of course follow the revision of the 2002 State Budget by the incoming government. Meanwhile, the surge in non-interest expenditure illustrated in Chart 4, based on IMF forecasts dated December 2000, diverged from the EU average and placed Portugal’s primary expenditure/GDP at a level some 4 percentage points above such average. One implication of this lack of co-ordination is that Portugal’s regime change remained misunderstood by public opinion until after the general elections in October 1995. Aside from domestically generated disturbances that obscured the significance of the change, the combination of recession and system turbulence must be recognised. The lack of credit familiarity with Portugal would have been bad enough for firms and citizens in tranquil periods. In the turbulence which followed ERM entry it was of course much worse and may have contributed to slow down the learning process, especially in the midst of a severe recession and the domestic political instability which preceded the 1995 elections. This lesson is difficult to apply in the so-called ERM2 grid to which currencies from candidate countries might belong, together with the Danish krona. Nevertheless, it reinforces the need for balance in the rising economic interdependence and mutual political responsiveness, which Portugal on occasion lacked. Moreover, the role of domestic and international media in spreading news about financial reputation to citizens should not be underestimated. It has certainly been far more striking in the reversal of mid-1999 due to the pre-election refusal of a merger between a Portuguese and Spanish bank than it was in 1990-91 when television was still a state-owned monopoly. Some

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oscillations in the integration path are explained by political and social variables. Macroeconomic indicators like productivity and relative prices of goods and factors tell the same story, once account is taken of the succession of exchange rate arrangements. Thus, wage increases and long-term interest rates converged and diverged before they converged again to the European average. The pattern shown in Chart 3 was divergent as the gradual regime change began in 1989 and during its reversal in 1990-91, but both fell in 1992-93, remained low in 1994 and rose in 1995. Wage and financial immoderation certainly contributed to obscure the significance of the PPERR for firms, trade unions and the general public before joining the ERM and after 1995. In 1997, the expectation of Euro entry ensured financial moderation, though wage moderation was reversed and reached the 1996 level of about 3% in 2000-01. The associated reversal of nominal convergence was shown in chart 1. 2.5. Qualifying for the Euro and being held up Membership in the Euro seems to suggest that the experience of Portugal was an unqualified success, relative to Greece. Yet, inflation may not have been fully eradicated in Portugal, where it is currently higher than in Greece. Put in another way, the credibility of Portugal’s MAFAS/PPERR must be fed by additional measures of a microeconomic and structural nature, designed to enhance the competitiveness of production and therefore sustain the catching-up process. Since the credibility of the MAFAS was not supported by public sector reform, it made for an unfavourable business environment, which led to an acceleration of outward direct investment. As the business internationalisation drive was not accompanied by reform in tax administration, justice and decentralisation towards municipalities, let alone social security and public health, it eroded the legitimacy of integration, exacerbating the Euro hold-up. The absence of reforms does not always have negative consequences – it included the rejection of a regionalisation proposal in 1998, for example, which would surely have introduced an additional layer of government. Nevertheless the end result is an unsustainable weight of the public sector in the economy, which keeps increasing. Instead, between 1991 and 2000, all other countries in the EU significantly lowered their ratio of public spending to GDP – by 13 percentage points in the case of Ireland! The increase in public spending has been predominantly in larger transfers payments and in bloating even further the civil service. In a relatively short period, Portugal has reached Nordic levels of public spending, while retaining Third World quality of public services. Portugal was perhaps in a unique position in that it was able to meet the Euro criteria without any fiscal adjustment. The significant decline (of some ten percentage points) in inflation rates – and interest rates – in the early 1990’s gave the budget a “free ride” equivalent to about five percentage points of GDP in the late 1990’s. In this sense, nominal convergence brings with it the risk of giving a temporary illusion of fiscal discipline, facilitating the emergence of conditions that lead to the Euro hold-up.

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The Euro hold-up is a reflection of the limits of external pressure on national policy making. It threatens all EU members and also the ten applicants from central and Eastern Europe. If national governments avoid taking unpopular measures because they fear loosing the next election, then populism and nationalism interact in a perverse way. The common good is dissipated. If joining the Euro stalls structural reforms, the national economy would become less competitive as a production location in the global economy. The case of Portugal is rightly seen as a success of EU accession, but the accession strategy was mostly defensive, as business circles and civil society doubted they could “make the grade”. Inappropriate domestic policies persisted due to resistance on the part of potential losers from integration. The lack of confidence in the country’s capacity to transform and an exaggerated fear of negative influence from Spain prevailed even during the good student phase. Yet, several ERM realignments initiated by Spain and partly followed by Portugal actually dampened the escudo’s real appreciation ahead of entry into the Euro. The opportunity for sustained structural change afforded by the Euro and the associated improvement in fiscal discipline has heretofore been lost, making Portugal a victim of the Euro hold-up. Public administration has remained incapable of reforming itself in areas such as justice, home affairs, social welfare, education and others. The absence of structural reforms is especially grave in what pertains to the enlarged public sector and the discretionary regulation of private enterprise. This is why the MAFAS/PPERR was such a decisive signal of the change in economic regime. As it turned out, from the 1993 recession until mid 2002, the (general and local) election cycles have hindered the implementation of public sector reform. The example of ICT is especially enlightening. 3. Convergence speeches and divergence reality Every level of government has come under pressure to issue declarations of the priority to be given to technological excellence or to reducing unemployment, to create special task forces or even agencies to promote innovation, to provide special incentives to encourage “industries of the future” (as if anyone can predict what they will be). This trend derives from another one, which increasingly makes the workings of public administration transparent and subject to popular scrutiny. With few exceptions, all this activity is an exercise in political deception – a public relations exercise to show that the government is concerned with issues that are current and that public opinion deems important even though it realises that achieving results is not within its power. Portugal is a good example of this tendency to make the right noises and fail in the substance. The last Portuguese presidency of the EU, in the first semester of 2000, gave special importance to issues of innovation, competitiveness and employment. The tone was set by a Presidency Document in January on “Employment, Economic Reforms and Social Cohesion – toward a Europe of Innovation and Knowledge”. In March, a special meeting of the European Council in Lisbon and a Ministerial Conference in Noordwijk focused on “Knowledge and Innovation for European Competitiveness” and set targets for improvements in R&D, the use of ICT and the importance of benchmarking, all with

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a view to catching up with and then overtaking the USA as the world leader in technological innovation. In June, the Feira Summit achieved a promise of possible, distant harmonization of taxation, meant to contribute to European cohesion. Again, the Summit conclusions were replete with references to innovation, reforms, flexibility, pragmatism, dynamism, entrepreneurship, employment and growth. All the right sounds had been made and the Summit could be declared a success. When the politicians returned from the summer holidays, the rude reality of having to get a Budget approved made the government look for support wherever it was most forthcoming, which happened to be on the left and came with severe strings attached. A Social Security “reform” entrenched the status quo and made it impossible even for Parliament to make significant changes without the explicit approval of the unions. A tax “reform” paved the way for the lifting of bank secrecy, sharply raised effective taxation on small enterprises and introduced capital gains taxation on equity transactions. Just a few months after the commitments to dynamism and growth, the Portuguese economy was in considerably worse shape - not only cyclically but also structurally - than it was before the fine speeches and the summits. Portugal is a good case study of what needs to be done to make the economy more competitive and so raise average incomes. By most measures of competitiveness used in benchmarking exercises, Portugal is at or near the bottom of the list. Comparative data shows Portugal to be somewhat or very much at a disadvantage relative to the EU average, the USA and Japan when measured by indicators of: Enterprise investment R&D spending in education Number of researchers in industry Attitudes to new technology Quality of ICT infrastructure Cost of Internet access Levels of higher education Labour legislation inflexibility The solution to this problematic situation is easy to prescribe but difficult to implement. Improving competitiveness and productivity calls for lower public current spending and more investment in improving education and training, reducing effective tax rates to promote new productive investment, making labour legislation more flexible to promote employment, increasing competition in the provision of utilities and ICT services so as to reduce costs and improve quality, and improving the functioning of the judiciary and of official bureaucracy. In most of these areas, technology could give an invaluable assist in the form of more efficient procedures and greater productivity, but that would require tough political decisions in terms of closing down redundant divisions or departments and retraining or laying off personnel, something which is always difficult to do.

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The bursting of the Nasdaq bubble showed that “New Economy” firms could not forever ignore “Old Economy” management principles. Similarly in the management of national economies, there is no escaping the need to adhere to the “Old Economy” virtues of prudent fiscal management, good governance, investor-friendly legislation and tax structures and a well-trained labour force. In the case of Portugal over the past decade, a favourable external environment has been squandered while populist policies have made the country less competitive, in spite of all the lip service paid to the desirability of sound economic policies. 4. Eight lessons from Portugal's Euro accession 4.1. Simultaneous nominal and real convergence Nominal and real convergence may happen simultaneously. It is not necessarily a case of either/or. In other words, there was no evidence here for Phillips curve-type effects. Maybe there is some of that effect under some circumstances, but in Portugal’s case at least the benefits of the credibility bonus, if you want to call it that, or a sort of virtuous circle effect, actually overruled the Phillips curve trade-off. So it is not always the case of having to choose to either have deflation or growth in the early part of charts 1 and 2, which we saw earlier. It was possible to have both at the same time. However, the opposite is also true and that is shown by the later part of the same charts. Going back to 2000 to 2002, we have real divergence as well as nominal divergence - we have slower growth together with prices rising more rapidly than in the rest of the countries in this group. So simultaneous divergence is also possible. 4.2. Fiscal sustainability needed for Euro benefits to materialise If fiscal policies are not sustainable, then the benefits of currency stability do not materialise in full. In the recent example of Portugal, a very favourable international and domestic situation did not really lead to improvements in terms of living standards or even in terms of political stability. The December 2001 local elections created a political crisis, where the government, which had been elected two years earlier, resigned in the middle of its expected term in office. In March 2002, the social democratic party returned to power in a coalition government that recognised that fiscal policy was not sustainable, and introduced a rectifying State Budget which attempted to reinstate the credibility of the MAFAS, coupling it with a reform of public administration. It is too early to tell whether this new attempt will be successful - after having failed ten years earlier - but it is clear that without fiscal sustainability the Euro benefits will not materialise. 4.3. Policy credibility is stronger than market proximity Even though proximity to EU markets is important for many goods, the policy credibility and the sustainability of that policy credibility is a lot more important than simple

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proximity to EU markets. And this is specifically true for foreign direct investment. In the earlier period, in 1985-92 roughly, we had very strong external investment in Portugal, whereas in the more recent years, we have actually had net divestment - investment by Portuguese companies abroad has been much higher than foreign investment in Portugal. So even though Portugal’s proximity to EU markets was the same in both periods, policy stability was more important than that. 4.4. Interest rate free ride The fourth lesson we can draw from Portugal’s experience is one that is especially applicable in times of a reduction of inflation from moderate to low levels. In Portugal we had roughly 60% of GDP as the level of debt and in the early 1990s interest rates were between 15 and 20% in nominal terms, which means in real terms they were about 7 or 8%. With the stabilisation of prices and especially with the stabilisation of the exchange rate, this declined quite dramatically to an average rate in real terms of 3 or 4%. In terms of the interest rate component in the national budget or in expenditure, this is a very significant decline, equivalent to about 5 percentage points of GDP. So the nominal convergence in this case made it possible for Portugal to have an illusion of fiscal discipline in that the fiscal criteria for EMU were much easier to obtain because we were getting this "interest rate free ride". While virtually all countries had to make some real adjustments of fiscal variables to meet the EMU accession criteria, Portugal was able to join without really doing anything painful or significant, simply by using up this interest rate free ride. So nominal convergence can give the illusion of fiscal discipline, but there is no substitute for genuine reforms; the illusion of fiscal discipline is not enough. 4.5. Timing of financial liberalisation. A further lesson from the Portuguese experience has to do with the timing of financial liberalisation. When compared with other experiences, namely those of the Nordic countries, Portugal’s financial liberalisation was remarkably problem-free. No banks went bust and there was no sudden surge in careless lending. This had little or nothing to do with the quality of banking supervision – Portugal’s Central Bank had no experience with supervising competitive banking activity as banks, whether private (pre-1974) or state-run (post-1974), had hitherto always been closely regulated, with nominal credit limits and effective barriers to entry. The major difference between Portugal’s liberalisation and that of the Scandinavian countries was that Portugal’s took effect in an economic downturn, when banks were in a cautious mood, concentrating on recovering outstanding debt rather than exploring new lending opportunities. By contrast, the Scandinavian countries liberalised their banking systems in an economic boom and banks rapidly overstretched their limits of prudent lending. The lesson is that the authorities should not wait for a “favourable” economic climate of strong growth to liberalise – if anything, it is better to do so in an economic downturn when decision-makers are more cautious. 4.6. New economy visions require old economy virtues

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A sixth lesson is that even new economy visions require old economy virtues. The bursting of the NASDAQ bubble showed that even for new economy firms, it was not possible eternally to ignore the old economy measures of market conditionality. Firms that never give profits, in the end went under, even if during a certain period the new economy hype kept them afloat at very high prices. This is also true for countries and the area of Information Technology is particularly relevant, as is evident from what happened just two years ago during the Portuguese presidency of the European Union in the first half of 2000. The so-called “Lisbon Strategy” was heralded as a strategy for Europe to catch up and ultimately to overtake the United States in terms of technological innovation. A lot was said about innovation, flexibility, about entrepreneurship, about dynamism, about growth of employment and economic growth generally. All these desiderata were the theme for numerous meetings during the Portuguese presidency and featured strongly in the statement at the end of the European Summit. Shortly thereafter, though, the reality of trying to get the 2002 State Budget approved left the Portuguese government facing serious difficulties in finding a partner to help approve the budget. In the end, the ruling socialist party opted to accept the support of parties on the left to get the budget approved. In terms of policies, this meant not more favourable conditions for productivity or enterprise but rather higher taxes on small companies and more restrictive policies in terms of solving the problems of unpaid pensions into the future. When it came to the actual policies implemented, the reality turned out to be in direct opposition to what had been said about innovation and dynamism. Even visions of the new economy require the old economy virtues, which are fairly well known: prudent fiscal management, good governance, investor-friendly legislation and tax system, and a well-trained workforce. These are real sector elements and they matter immensely for economies to succeed. 4.7. Credibility bonus Ten years ago the debate on the credibility bonus was quite strong, as inflation in Portugal was around 10 %, so it was still quite far from being at the European Community average inflation rate. The question then was whether the accession helps in catching up more rapidly, being an assist, or whether it should, instead, be seen as a prize at the end of the road. The answer to this question was crucial in determining when the Escudo was to enter the ERM. The Central Bank preferred the idea of a “prize”, in other words putting our own house in order was seen as a priority before joining the club. The Finance Ministry, however, was more inclined towards the “assistance” option, namely using the locking-in of the exchange rate as a way of bringing about price stability more rapidly. This distinction between the positions of the Finance Ministry and the Central Bank is important for the policy regime. The experience from Portugal points to an asymmetric attitude between the two institutions. For the Central Bank at the time what mattered the most was to have the lowest possible inflation regardless of consequences for the economy. The record of relatively high inflation produced a belief that any let up in the

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monetary policy would bring back a high inflation rate. For that reason, the policies applied at the time, even in terms of exchange controls (like a strict ban on capital inflows), made the domestic banking club very cosy as they had large margins on interest rates they could charge. To the Central Bank, this was seen as providing an extra advantage of minimising solvency risks in the banking sector. The Finance Ministry was concerned about the negative impact of high real interest rates on the productive sectors and tried to accelerate the liberalisation process by removing the capital controls. In the end the Central Bank was forced to do that but a period of tension emerged between the two institutions. 4.8. Earning credibility abroad while selling stability at home The eighth lesson to draw from Portugal's Euro hold-up is the importance of earning credibility abroad while selling stability at home when the Central Bank and the Finance Ministry are of a different culture. Elected officials tend to worry more about short-term goals, like unemployment and growth. Although we believe a strong and independent Central Bank is essential, one must be aware that any collection of human beings possesses experiences and biases reflecting where they come from. In Portugal at the time, most of the people at the Central Bank came from the commercial banking sector, during a period when banks were mostly state-owned. Therefore they were much more sensitive to the arguments of the commercial bankers, who didn’t want their cosy position of high margins threatened by the opening of the banking sector to foreign competition. The Treasury had great difficulties in convincing the Central Bank, in its supervision function, to force banks to be more transparent on what rates they were charging. After many years of credit controls, the Central Bank didn’t want banks to compete using lower credit interest rates for their clients, as it felt that might cause problems to some of the banks. For the Central Bank it was preferable to have a sound banking system even if it meant charging higher interest rates. This example of the relationship between accountability on one hand and independence on the other is a lesson that goes beyond political theory, into financial policy practice. This is something that many countries besides Portugal have found out needs to be looked at quite carefully, especially in cases where the central bank has the dual role of conducting monetary policy at the same time as supervising the commercial banks.

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References Braga de Macedo, Jorge, The euro in the international financial architecture, Acta Oeconomica, vol 51 (3) 2000/2001, pp. 287-314. Braga de Macedo, Jorge, Portugal's European Integration: the limits of external pressure, in Portugal Strategic Options in a European Context, edited by Maria de Fátima Monteiro de Brito and José Tavares, Cambridge: Lexington Books, 2002 (a more complete version appeared as Nova Economics Working Paper nº 369, December 1999 Braga de Macedo, Jorge, Luís Catela Nunes and Francisco Covas, Moving the escudo into the euro, CEPR Discussion Paper no. 2248, October 1999 Braz, José, “Technology, investment and development –some reflections from Portugal” in Technology and Poverty Reduction in Asia and the Pacific, Paris: Asian Development Bank and OECD, 2002, pp. 201-206.

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Chart 1 Nominal convergence

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Chart 2 real convergence

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Chart 3:Wage and financial moderation (%pa)

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C h a r t 4 :P r im a r y E x p e n d i t u r e s % G D P

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