Economic Bulletin. December Lisbon, 2016

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3 Economic Bulletin December 2016 Lisbon,

4 Economic Bulletin December 2016 Banco de Portugal Rua do Comércio, Lisboa Edition Economics and Research Department Design and printing Communication Directorate Image and Graphic Design Unit Print run 25 ISSN (print) ISSN (online) Legal Deposit no /06

5 Contents I Projections for the Portuguese economy: Box 1 Projection assumptions 13 Box 2 Impact of uncertainty measures on the Portuguese economy 29 II Special issue Life below zero: monetary policy transmission under negative interest rates 37

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7 I Projections for the Portuguese economy: Box 1 Projection assumptions Box 2 Impact of uncertainty measures on the Portuguese economy

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9 Projections for the Portuguese economy: Projections for the Portuguese economy: Introduction Over the projection horizon, the Portuguese economy is expected to maintain the moderate recovery trajectory that has characterised recent years (Table 1.1). Thus, following 1.2 per cent growth in 2016, gross domestic product (GDP) is projected to accelerate to 1.4 per cent in 2017, stabilising its growth rate at 1.5 per cent for the following years. This implies that at the end of the projection horizon, GDP will reach a level identical to that recorded in In the period , GDP growth is expected to be close to, albeit lower than, that projected for the euro area, not reverting the negative differential accumulated between 2010 and 2013 (Chart 1.1). This lack of real convergence with the euro area reflects persisting structural constraints to the growth of the Portuguese economy, in which high levels of public and private sector indebtedness, unfavourable demographic developments and persisting inefficiencies in the employment and product markets play an important role, requiring the deepening of the structural reform process. Table 1.1 Projections of Banco de Portugal for Annual rate of change, in percentage Weights EB December 2016 EB October 2016 EB June (p) 2017 (p) 2018 (p) 2019 (p) 2016 (p) 2016 (p) 2017 (p) 2018 (p) Gross domestic product Private consumption Public consumption Gross fixed capital formation Domestic demand Exports Imports Contribution to GDP growth net of imports (in p.p.) (a) Domestic demand Exports Employment (b) Unemployment rate Current plus capital account (% of GDP) Trade balance (% of GDP) Harmonized index of consumer prices Sources: Statistics Portugal and Banco de Portugal. Notes: (p) projected, (p.p.) percentage points. For each aggregate, this table shows the projection corresponding to the most likely value, conditional on the set of assumptions considered. (a) The demand aggregates net of imports are obtained by subtracting an estimate of the imports needed to meet each component. For more information, see the Box entitled The role of domestic demand and exports in economic activity developments in Portugal, in the June 2014 issue of the Economic Bulletin. (b) Total employment, in number of persons according to the national accounts concept.

10 8 BANCO DE PORTUGAL Economic Bulletin December 2016 This projection is part of the Eurosystem s projection exercise recently published by the European Central Bank (ECB). According to this exercise assumptions, the Portuguese economy s external environment should remain favourable, albeit with a downward revision of international trade flows in comparison to previous exercises (Box Projection assumptions ). Following a slackening in 2016, external demand should accelerate over the projection horizon, even though more slowly than that observed prior to the international financial crisis. Furthermore, monetary and financial conditions are expected to remain generally accommodative. In turn, over the projection horizon, energy and non-energy commodity prices should reverse the downward trajectory observed in recent years. Against this generally favourable background, exports of goods and services should be more dynamic than external demand, as observed in recent years. Therefore, exports will continue to be the overall demand component with the greatest contribution to economic growth. The greater buoyancy of the Portuguese economy vis-à-vis 2016 will be underpinned by an acceleration in gross fixed capital formation (GFCF), based on a recovery of business investment. In turn, private consumption should decelerate compared to that observed over the last few years, growing in line with potential output expectations. The strong momentum in consumption in recent years is associated with expenditure on durable goods, resulting in part from purchasing decisions delayed during the recession. Developments in activity should be accompanied by the gradual recovery of the labour market situation, with continued employment growth, despite the progressively more moderate pace, and the continued downward path of the unemployment rate. Inflation measured by the Harmonised Index of Consumer Prices (HICP) should increase over the projection horizon, remaining at levels close to the euro area average. The acceleration of prices to about 1.5 per cent at the end of the horizon reflects domestic and external upward pressures. Over the projection horizon, the Portuguese economy is expected to maintain an external net lending position, albeit at lower levels than in recent years. This profile is determined by developments in the income and capital accounts. The trade balance as a percentage of GDP, following a temporary increase in 2016, will remain Chart 1.1 GDP In percentage and index (2008=100) (p) 2018 (p) -5.0 Annual rate of change Portugal (rhs) Index (2008=100) Portugal Annual rate of change euro area (rhs) Index (2008=100) euro area Sources: Statistics Portugal, ECB and Banco de Portugal. Note: (p) projected.

11 Projections for the Portuguese economy: relatively unchanged compared to 2015 for the rest of the projection horizon. Thus the economic growth pattern projected in which exports and GFCF are the components presenting a dynamism above that of GDP is compatible with a more sustained recovery of the Portuguese economy, especially in a situation in which external net lending is maintained and additional reductions in private sector indebtedness are projected. 2. Recent Information The projections for the Portuguese economy presented in this Bulletin include the information set available until 24 November 2016 and the technical assumptions underlying the Eurosystem s projection exercise, recently released by the ECB (Box Projection assumptions ). In the first half of 2016, GDP grew moderately at 0.9 per cent in year-on-year terms, prolonging the deceleration that started in the second half of In comparison with the previous semester, economic activity increased by 0.5 per cent. The slackening of activity in year-on-year terms was the result of smaller positive contributions from domestic demand and exports, as observed in the second half of Weaker buoyancy in domestic demand in year-on-year terms essentially reflected the fall in investment, with a reduction in GFCF of 2.7 per cent in the first half of 2016 (+4.5 per cent in 2015). Developments in this aggregate are largely explained by the falls of GFCF in construction and in machinery and equipment, as investment in transport equipment maintained robust growth, albeit lower than in the second half of In turn, more moderate export growth in the first half of 2016 reflected the negative developments of fuel exports, whose import content is quite significant (about 95 per cent). To a lesser extent, there was also a reduction in services exports excluding tourism. Considering the aggregates net of imports (i.e. deducting from each demand component an estimate for the imports necessary to meet that demand), it is estimated that GDP developments in the first half of 2016 are associated with a deceleration in domestic demand, as export growth net of imported components stabilised versus the preceding six month period (Chart 2.1). In a context of further improvement in terms of trade, and notwithstanding the stronger volume growth in imports than in exports, the trade balance surplus as a percentage of GDP increased in comparison to the first half of However, the current plus capital account surplus fell, 1 reflecting the increase in the primary income account deficit and the fall in the balances of the secondary income and capital accounts. In the first half of 2016, the labour market continued to improve, with a reduction in the unemployment rate (of -1.2 percentage points (p.p.) compared to the same period of 2015) and an increase in total employment (quarterly national accounts concept) of 0.9 per cent in year-onyear terms (Chart 2.2). Strong acceleration of economic activity in the third quarter of 2016 In the third quarter of 2016, according to the flash estimate released by Statistics Portugal (Instituto Nacional de Estatística INE), GDP increased by 1.6 per cent in year-on-year terms, growing by 0.8 per cent on quarter-on-quarter terms (Chart 2.3). The breakdown of GDP into its main expenditure components was only released after the cutoff date for this Bulletin. Therefore, the analysis of GDP aggregates in the third quarter of 2016 is based on recent short-term indicators and the qualitative information contained in the flash estimate press release. Thus, the acceleration in economic activity, in year-on-year terms, was driven by an acceleration in exports and a slightly higher growth in domestic demand. In turn, the strong growth compared to the second quarter of 2016 reflected the positive contribution of exports of goods and services, in contrast to the negative contribution made by domestic demand.

12 10 BANCO DE PORTUGAL Economic Bulletin December 2016 Stronger growth of private consumption and further decline in investment Against a background of real disposable income growth, declining unemployment rate and particularly high levels of consumer confidence, it is estimated that private consumption has grown sharply, more than the GDP growth rate observed in the third quarter. The acceleration of this aggregate in year-on-year terms has essentially reflected the acceleration of non-durable consumption, visible in the marked increase in the deflated retail turnover index and ATM withdrawals and payments. On the other hand, there was a deceleration in expenditure in consumer durables for the second consecutive quarter, explained by the slowdown in purchases of light passenger vehicles (note that this item grew strongly in the first quarter of this year, largely reflecting purchases brought forward due to the increase in the Tax on Vehicles with the entry into force of the State budget for 2016 at the beginning of April). The strong growth of this aggregate in recent years has to be seen against a background of the recovery of the passenger car stock following the particularly expressive declines accumulated throughout the recent recession in the Portuguese economy. In contrast, GFCF is estimated to have registered a fall in year-on-year terms, albeit less marked than in the two previous quarters. Developments in GFCF continued to reflect the decline in the construction component, in line with developments in cement sales, conditioned by the marked fall in public investment. In terms of investment in machinery and equipment, short-term indicators available, in particular nominal imports of this type of goods, point to an increase in the third quarter, after the falls observed in the previous three quarters (Chart 2.4). The weakness of this component of GFCF in the second half of 2015 and the beginning of 2016 likely reflected postponed investment decisions, against a background of heightened domestic and international uncertainty (Box Impact of uncertainty measures on the Portuguese economy ), combined with a level of capacity utilisation that remains below the historical average. Furthermore, the lower Chart 2.1 Net contributions to GDP growth, in year-on-year terms In percentage points Chart 2.2 Employment and unemployment rate Levels in thousand persons and in percentage of the labour force H H H H H H H H H H H H H H H H H H H H H H H H H H H H1 Domestic demand Exports GDP (%) Employment Unemployment rate (rhs) Sources: Statistics Portugal and Banco de Portugal calculations. Note: The demand aggregates net of imports are obtained by subtracting an estimate of the imports needed to meet each component. The calculation of import contents was based on data for For more information, see the Box entitled The role of domestic demand and exports in economic activity developments in Portugal, in the June 2014 issue of the Economic Bulletin. Source: Statistics Portugal (QNA and Monthly Employment and Unemployment Estimates). Note: The unemployment rate data (15 to 74 years old) is seasonally adjusted.

13 Projections for the Portuguese economy: distribution rate of European funds in the first half of the year, possibly reflecting the transition to a new National Strategic Reference Framework (NSRF), may also have conditioned developments in this variable. Finally, GFCF in transport equipment decelerated, reflecting less positive developments in sales of heavy commercial vehicles, as well as a base effect associated with the import of aeroplanes in the same quarter of Acceleration of exports In the third quarter of 2016, the volume of exports is expected to have presented a quite buoyant growth rate in year-on-year terms, exceeding that of the previous quarter and the estimate for external demand. The acceleration of exports was common to the goods and services components, with emphasis on the strong increase in exports of goods excluding fuel and the recovery of services exports excluding tourism. Tourism exports remained quite buoyant, growing at a rate similar to that observed in previous quarters, against a background of especially robust growth in recent years. Note that developments in goods exports in the third quarter were partially affected by the delivery of military equipment sold by Portugal to Romania. However, this operation had a practically neutral impact on GDP, given that the positive effect on exports was offset by a negative effect in public investment in machinery and equipment. Considering data for the international trade in goods in nominal terms, there was an acceleration in the third quarter, in year-on-year terms, in goods exports excluding fuel. Regarding the developments by country of destination, there was resilience in exports to European Union (EU) countries, whose contribution to total export growth has remained high. Particularly noteworthy in the third quarter is the buoyancy of sales to Spain. In turn, the contribution of exports to countries outside the EU was substantially less negative during this period, reflecting a smaller fall in exports to Angola and a rebound in exports to Brazil and China (Chart 2.5). In what concerns the recovery in exports of services excluding tourism, the nominal information for Chart 2.3 Gross domestic product Real rate of change, in percentage Chart 2.4 GFCF in machinery and equipment, in real terms Year-on-year rate of change, in percentage Q Q Q Q Q Q Q1 Quarter-on-quarter change 2016 Q Q Q Q Q Q Q Q1 Year-on-year change 2016 Q Q Q Q Q Q1 Indicator for imports of machinery, in nominal terms GFCF in machinery and equipment GFCF in machinery and equipment, annual rate of change Source: Statistics Portugal. Sources: Statistics Portugal and Banco de Portugal.

14 12 BANCO DE PORTUGAL Economic Bulletin December 2016 the third quarter of the services account balance shows a smaller fall in year-on-year terms in the item passenger transport by air (-1.8 per cent, following per cent in the first half of 2016) (Chart 2.6). Furthermore, following weak developments in the second quarter, improvements were registered in exports of telecommunications and IT services and in exports of other services related to advertising and market research activities and to trade. Finally, the volume of imports is expected to have accelerated in year-on-year terms in the third quarter. These developments stem from an underlying acceleration in imports of goods (reflecting developments in expenditure aggregates with high import content, namely GFCF in machinery and equipment) and tourism, and a recovery of imports of other services. The increase in imports during this period is estimated to have been higher than import-content weighted final demand, leading to a more marked year-on-year increase in the level of import penetration than in the previous quarter. an acceleration in private consumption and a smaller decline in GFCF, offset by a deceleration in exports, notwithstanding the impact on tourism exports of an important international event held in Lisbon. With regard to quarter-on-quarter developments, considering that growth in the third quarter partially reflected factors of a temporary nature with emphasis on the dynamism of goods exports to certain destinations, 2 as well as the carrying out of investment decisions postponed in previous quarters the pace of growth is expected to weaken in the last quarter of 2016 to levels close to those observed in the first half of the year. In the fourth quarter, GDP is expected to continue growing at the same rate in year-onyear terms. This profile is estimated to reflect Chart 2.5 Nominal exports of goods excluding fuel by country of destination Contributions to the year-on-year rate of change, in percentage points Chart 2.6 Nominal exports of services Contributions to the year-on-year rate of change, in percentage points (a) Intra-EU Brazil 2015 Q Q Q2 Angola China Other extra-eu countries Total (%) 2016 Q (a) Travel 2015 Q Q Q2 Transport Other services Total (%) 2016 Q3 Source: Statistics Portugal (International Trade Statistics). Source: Banco de Portugal. Note: (a) Until September. Note: (a) Until September.

15 Projections for the Portuguese economy: Box 1 Projection assumptions The projections in this Bulletin are based on a set of assumptions regarding the Portuguese economy s external environment. These assumptions reflect the information underlying the Eurosystem s most recent projections, released on 8 December. The main technical assumptions are contained in Table 1 and are based on information available up to 24 November. With regard to the international environment, the current assumptions point to a gradual acceleration of world activity and trade over the projection horizon. Despite these positive developments, global economic growth over the projection horizon is assumed to remain below the average recorded prior to the financial crisis. In this context, it is expected that the external demand directed at the Portuguese economy will grow more in 2017 (3.4 per cent, following 2.0 per cent in 2016) but below the average growth rate of 7 per cent observed in the period from 1995 to 2007 remaining relatively stable at about 4 per cent in 2018 and The acceleration compared to 2016, common to the intra and extra euro area markets, is more marked in the latter case, where the fall had been greater. Nevertheless, euro area import demand should continue to grow more robustly than that of the remainder economies. Considering the assumptions of previous projection exercises, the external demand for Portuguese goods and services has been revised downwards over the projection period. Considering the path implied by futures markets at the cut-off date, it is estimated that, in annual average terms, oil prices (in dollars and euros) will fall in 2016 vis-à-vis the previous year, continuing a trend observed since This falling trend should be interrupted in 2017, with an expected average increase in oil prices of approximately 15 per cent. In the following years, this growth rate should slowdown. Compared to the October Economic Bulletin, there is an upward revision of the level estimated for For 2017 and 2018, the assumptions for oil prices in dollars are slightly higher than those included in the June Economic Bulletin. The scale of these revisions is sharper when prices are measured in euros, given the downward revision of the technical assumption for the respective exchange rate. The developments assumed for the three-month EURIBOR are based on expectations implicit in futures contracts. According to this information, the short-term interest rate is expected to remain slightly negative in the period, partly reflecting the broad range of monetary policy measures adopted by the ECB. A rise is assumed at the end of the projection horizon, with a zero interest rate expected in In turn, the long-term interest rate for Portuguese debt, whose calculation methodology is based on an estimate of the implicit rate considering an assumption for the interest rate for new issuances, should be about 3.4 per cent in the period, falling slightly in Short interest rates and long-term interest rates for sovereign debt remain essentially unchanged compared to the assumptions in previous projections. The technical assumption for exchange rates is based on the maintenance over the projection horizon of the average levels observed in the two weeks prior to the cut-off date. Therefore, following a significant depreciation of the euro in 2015, it is assumed that there will be an appreciation of the effective exchange rate in annual average terms in 2016 and 2017 that is slightly more expressive than that included in the October Economic Bulletin. The projections relating to the public finance variables incorporate the policy measures already approved (or very likely to be approved) and that are specified with sufficient detail, in line with the procedure adopted within the scope of the Eurosystem s projection exercises.

16 14 BANCO DE PORTUGAL Economic Bulletin December 2016 With regard to the State Budget for 2017, the main measures considered include the remaining effect of the phased elimination of the surtax on income tax (IRS) during 2017, the changes announced in terms of increasing indirect taxation and increasing pensions. The current projection for 2016 points to a 1.0 per cent change in public consumption in real terms, largely resulting from growth in intermediate consumption expenditure, which is influenced by the increase in costs associated with public-private partnerships in the road transport sector. Furthermore, a very slight increase in public employment has been considered, as well as a preliminary estimate, surrounded by uncertainty, of the impact of the reduction in the normal working hours of public sector employees in the second half of From 2017 onwards, moderate growth in public consumption is projected, reflecting the assumption of a reduction in the costs with public-private partnerships (in line with the State Budget Report for 2017) and the near stabilisation of the annual average number of public sector employees. In terms of the public consumption deflator, positive rates of change are expected along the projection horizon. In 2016 and 2017, these developments reflect, in particular, the gradual reversal of public employees pay cuts and, in 2018 and 2019, has an underlying assumption of a wage update in line with inflation. In 2016, public investment should fall significantly, only partly explained by the delivery of military equipment sold and the reversal of the effect associated with the acquisition of real estate by Oitante in For 2017, there is expected to be a recovery in public investment, as included in the State Budget Report for 2017, and in subsequent years developments in this aggregate are expected to be approximately in line with nominal GDP. Table 1 Projection assumptions EB December 2016 EB October 2016 EB June International environment World GDP yoy World trade yoy External demand yoy Oil prices in dollars aav Oil prices in euros aav Monetary and financial conditions Short-term interest rate (3-month EURIBOR) % Implicit interest rate in public debt % Effective exchange rate index yoy Euro-dollar exchange rate aav Sources: ECB, Bloomberg, Thomson Reuters and Banco de Portugal calculations. Notes: yoy year-on-year rate of change, % per cent, aav annual average value. An increase in the exchange rate corresponds to an appreciation. The implicit interest rate on public debt is computed as the ratio between interest expenditure for the year and the simple average of the stock of debt at the end of the same year and at the end of the preceding year.

17 Projections for the Portuguese economy: Supply, demand and external accounts Recovery in activity and employment, amid low productivity growth Following 1.6 per cent growth in 2015, GDP is expected to grow by 1.2 per cent in 2016, accelerating to 1.4 per cent in Its growth rate should be relatively stable in (1.5 per cent). These developments would imply that GDP levels at the end of the projection horizon will stand close to those seen in 2008, when the international financial crisis began. In sectoral terms, a lower annual rate of change is projected across most of the main sectors of activity for 2016, particularly in construction and manufacturing, whose value added declined in the first half of the year (Chart 3.1). Over the projection horizon, activity is expected to recover in these sectors. Activity in the services sector with a share of approximately 74 per cent in gross value added (GVA) is projected to accelerate moderately in the period, following a slight deceleration in This sector should continue to benefit from buoyant exports, particularly of tourism, but also as regards services associated with exports of goods, in line with a greater allocation of productive resources to the sectors most exposed to international competition. Labour market developments are expected to remain favourable over the projection horizon. Therefore, following strong growth in 2016 higher than GDP and close to that seen in 2015 (1.5 per cent) the pace of growth in employment should stand at around 1 per cent in , more in line with the historical relationship between employment and activity (Chart 3.2). Employment is projected to grow in the private sector, given that public employment should remain relatively stable. These developments in employment, together with the assumption of a virtual stabilisation in the labour force, imply that the unemployment rate will follow a downward trend over the projection horizon, from 11 per cent in 2016 to 8.5 per cent in 2019 (Chart 3.3). Developments in economic activity and employment translate into very weak labour productivity dynamics in the recent recovery period. Following a slight reduction in 2016, annual labour productivity growth is projected to be approximately 0.5 per cent over the projection horizon. Chart 3.1 Overall and sectoral GVA Index 2008=100 Chart 3.2 GDP and employment Annual rate of change (p) (p) (p) (p) GVA Agriculture, forestry and fishing Industry Construction Services Employment GDP Sources: Statistics Portugal and Banco de Portugal. Sources: Statistics Portugal and Banco de Portugal. Notes: (p) projected. The projections for sectors are based on simple models that take into account developments in the expenditure components that are more important for each branch of activity. Note: Values for are projections.

18 16 BANCO DE PORTUGAL Economic Bulletin December 2016 These developments in productivity against a background of economic recovery fall well short of those seen in previous cycles, which is common to other advanced economies, including the euro area (Chart 3.4). However, the recession period prior to the current recovery also posted atypical productivity developments, reflecting employment losses that exceeded those in activity. The marked fall in investment during the recessions of the period, and particularly its impact on the adoption of new technologies and new productive processes, may have limited efficiency gains across most sectors. The allocation of capital in the economy exhibits distortions which limit activity growth, although there is no evidence available for the most recent period. 3 Furthermore, the allocation of the labour factor is also inefficient, to the extent that the greater weight of employment remains concentrated in sectors that are less productive than average. However, available data point to a continued reallocation of employment to more productive sectors of activity or with greater productivity growth, in line with that seen since the onset of the adjustment period. 4 The profile projected for GDP per capita is similar to that in activity, under the assumption that the population will remain stable. Breaking down economic growth, developments in GDP per capita are still largely explained by contributions from labour (0.7 p.p. on average over the projection horizon), given the projected profile for employment (Chart 3.5). The contribution of the capital factor should continue to be virtually nil over the projection horizon, given that, despite an upturn in investment, the latter should remain at levels that only make it possible to offset the capital depreciation. This limits potential GDP growth, to the extent that new technologies are incorporated into the productive process via the capital factor. Human capital, measured using as proxy the average number of years of completed schooling, should Chart 3.3 Employment and unemployment rate In percentage Chart 3.4 Labour productivity: comparison between countries of developments vis-à-vis their previous economic recoveries Cumulated deviations vis-à-vis the average of previous cycles, by country (p) Employment (yoy rate of change) (p) (p) (p) Unemployment rate (rhs) (p) 2018 (p) Euro area Germany Spain France Italy Portugal Sources: Statistics Portugal and Banco de Portugal. Note: (p) projected. Sources: European Commission (AMECO), Statistics Portugal and Banco de Portugal. Notes: (p) projected. The economic recoveries considered were determined on the basis of the Portuguese business cycle and started in 1984, 1993, 2003 and The 2009 recovery was not considered due to its limited duration. For each country the values presented correspond to the cumulated change considering 2013 as the reference year minus the cumulated average change of the years 1984, 1993 and 2003.

19 Projections for the Portuguese economy: also make a substantial contribution to average GDP per capita growth over the projection period (0.5 p.p.). Finally, growth in GDP per capita should benefit from a favourable contribution from total factor productivity (around 0.2 p.p., on average, over the projection horizon), partly due to improvements in the allocation of resources in the economy. Maintenance of stable growth in domestic demand, with a recomposition favourable to investment Taking into account expenditure components net of their import content, the slowdown in 2016 points to a smaller contribution from domestic demand, more specifically investment (Chart 3.6). Investment components with low import content (e.g. construction) are projected to decrease. In the case of exports, the deceleration in 2016 is associated with components with high import content. As such, although the gross contribution of exports to GDP is expected to decrease, the same does not hold true when their import content is subtracted. For the period, the contribution from exports net of import content is projected to broadly stabilise. This component will continue to make the highest contribution to GDP growth. Nevertheless, the moderate acceleration in activity in 2017 and 2018 is expected to be determined by a greater contribution from domestic demand, associated to a recomposition, which points to an upturn in investment and lower consumption growth compared with projections for In 2019 this composition is expected to be virtually unchanged. Over the projection horizon, private consumption is expected to grow slightly less than activity. Projected developments indicate that the level of consumption will remain marginally above that seen in 2008 at the end of the projection horizon (Chart 3.7). The relatively buoyant developments in private consumption in the most recent years and those Chart 3.5 Breakdown of the growth in real GDP per capita Contributions in percentage points (p) Capital stock per capita Employment per capita Total factor productivity Human capital GDP per capita (a.r.c., in %) Sources: Barro and Lee (2013), Quadros de Pessoal, Statistics Portugal and Banco de Portugal. Notes: (p) projected. The growth accounting exercise of GDP per capita is based on a Cobb-Douglas production function. The measures of human capital were constructed from the data of Barro and Lee (2013) A new data set of educational attainment in the world, , Journal of Development Economics 104, pp For Portugal, these series were annualized and extended using the profile of the average years of education of employment of Quadros de Pessoal (until 2012) and of the Labour Force Survey of Statistics Portugal (in 2013 and 2014).

20 18 BANCO DE PORTUGAL Economic Bulletin December 2016 projected for 2016 reflect a substantial contribution from consumption of durable goods (Chart 3.8). This profile is typical during recovery phases of the cycle and is associated with the postponement of the purchase of durable goods during crisis periods, which gives rise to pent-up demand. This demand results in very substantial increases once the recovery starts, but which only imply a return to the target optimal stock of durable goods. During the latest recovery phase, this effect was more marked than in the past, possibly because the severity and duration of the recession that preceded it were also higher, and was also influenced by more favourable financing conditions (Chart 3.9). Over the projection horizon, this effect is expected to unwind, which should result in the stabilisation of the share of consumption of durable goods in GDP. Consumption of non-durable goods should continue to grow by approximately 1.5 per cent in , above projected developments for real disposable income. Real disposable income growth should remain relatively stable over the projection horizon, reflecting a background of muted growth in compensation of employees although higher than that seen since 2008 and the impact of fiscal measures with a positive effect on nominal disposable income included in the State Budgets for 2016 and 2017, as well as the effect of an acceleration in the private consumption deflator. These developments in consumer prices partly reflect the unwinding of the downward pressure on prices stemming from the reduction in oil prices over the most recent years (Section 4. Prices and wages). Projected developments in private consumption and disposable income should lead to a reduction in the savings rate in 2016, thus extending the downward trend seen in the previous two years. For the period, the projection indicates that the household savings rate should stand, on average, at 3.6 per cent. Following 4.5 per cent growth in 2015, GFCF should decrease by 1.7 per cent in 2016, returning in to rates of change close to those seen in The reduction estimated for 2016 results from the behaviour of the public GFCF and residential GFCF. Public investment should decrease markedly in 2016, posting relatively muted average growth during the following Chart 3.6 Gross and net contributions to GDP In percentage points Chart 3.7 GDP breakdown Index 2008= (p) 2017 (p) 2018 (p) 2019 (p) (p) 2017 (p) (p) (p) Private consumption Public consumption Investment Exports Imports GDP (a.r.c in %) Sources: Statistics Portugal and Banco de Portugal. Notes: (p) projected. For each year, the left-hand bar refers to gross contributions from each GDP component and the right-hand bar to the corresponding net contributions. GDP GFCF Sources: Statistics Portugal and Banco de Portugal. Note: (p) projected. Private consumption Exports

21 Projections for the Portuguese economy: years (Box Projection assumptions ). Developments in this component during 2016 are subject to particular uncertainty due to the late entry into force of the budget for this year and taking into account the expenditure profile associated with investment projects co-funded by European Union funds. The transfer of EU funds to final beneficiaries in the first half of the year was lower than usual, amid a transition to the NSRF This is expected to also have affected GFCF in the private sector over the same period. GFCF in housing is expected to decline by 3.4 per cent in 2016, only to grow moderately, by around 2 per cent, over the remaining projection horizon. Developments in this sector have been negative almost without interruption since 2000, reflecting the sector s restructuring in response to structural constraints. In projections point to a return to positive rates of change, although subdued, as a result of gradual improvements in labour market conditions and the maintenance of favourable financing conditions. Developments in this variable should continue to be limited by the evolution of the resident population, which has presented a downward trend, and by the high indebtedness of households. Projections indicate that corporate GFCF will accelerate, from 1.9 per cent in 2016 to 5.6 per cent in 2019, in line with improved domestic and external demand expectations, against a background of sustained favourable financing conditions, which should continue to benefit from the impact of the ECB s non-standard monetary policy measures (Special issue Life below zero: monetary policy transmission under negative interest rates ). Over the projection horizon, the share of this component in GDP is expected to increase, which would lead to a return to the average value posted in However, in 2019, the corporate GFCF level is projected to remain below that seen in 2008, although the deviation should be lower than for the remaining GFCF components by institutional sector (Chart 3.10). From 2016 onwards, the total GFCF recovery profile is projected to be relatively weak compared with previous recovery periods, being mostly in line with the upturn that followed the 2003 crisis (Chart 3.11), despite the fact that the current crisis has been much more marked than previous ones. These comparatively weaker developments in GFCF have also been recorded in other Chart 3.8 Private consumption and disposable income Rate of change in percentage and contributions in percentage points Chart 3.9 Weight of durables consumption on GDP In percentage of GDP (p) 2018 (p) Non-durables consumption Durables consumption Private consumption (a.r.c. in %) Real Disposable inome (a.r.c. in %) Sources: Statistics Portugal and Banco de Portugal. Notes: (p) projected (p) 2019 (p) Sources: Statistics Portugal and Banco de Portugal. Notes: (p) projected. The shaded areas denote the beginning of the recovery periods of the Portuguese business cycle, which occurred in 1984, 1993, 2003 and The 2009 recovery was not considered due to its limited duration.

22 20 BANCO DE PORTUGAL Economic Bulletin December 2016 euro area countries, particularly Spain and Italy (Chart 3.12). A number of factors is contributing to this relative weakness which, although also relevant at the European level, may be amplified in the case of Portugal. Against this background, it is worth noting that the outlook for private GFCF over the projection horizon is limited by private sector deleveraging needs, given that, despite some reduction since the onset of the financial crisis, indebtedness of households and nonfinancial corporations remains high compared with other EU countries (Chart 3.13). This downward trend in indebtedness is expected to continue over the projection horizon, in the case of both households and non-financial corporations, but more marked for households (Chart 3.14). 160 Chart 3.10 Breakdown of GFCF by institutional sectors Index 2008= (p) 2017 (p) 2018 (p) 2019 (p) Total GFCF Business Residential Public Sources: Statistics Portugal and Banco de Portugal. Note: (p) projected. Chart 3.11 Developments in GFCF in different economic recoveries Index T=100 Chart 3.12 Comparison between countries of developments in GFCF vis-à-vis previous economic recoveries Cumulated deviations vis-à-vis the average of previous cycles, by country T T+2 T+4 T+6 T+8 T (p) 2017 (p) 2018 (p) Euro area Germany Spain France Italy Portugal Sources: Statistics Portugal and Banco de Portugal. Sources: Statistics Portugal and Banco de Portugal. Notes: The economic recoveries considered were determined on the basis of the Portuguese business cycle and started (T) in 1984, 1993, 2003 and The 2009 recovery was not considered due to its limited duration. The dotted line corresponds to the projection period. Notes: (p) projected. The economic recoveries considered were determined on the basis of the Portuguese business cycle and started in 1984, 1993, 2003 and The 2009 recovery was not considered due to its limited duration. For each country the values presented correspond to the cumulated change considering 2013 as the reference year minus the cumulated average change of the years 1984, 1993 and 2003.

23 Projections for the Portuguese economy: Developments in private GFCF may be limited by the downward revision to medium-term economic growth expectations, a factor also associated with the slow pace of recovery in private investment in several euro area countries. The projected profile of public investment also differs from previous recovery periods, reflecting the current need for fiscal consolidation. Very strong growth in exports, leading to continued market share gains Following very buoyant growth in 2015 (6.1 per cent), exports of goods and services are expected to decelerate in 2016 (3.7 per cent), recovering to a pace of growth of 4.8 per cent in 2017 and 4.6 and 4.4 per cent in 2018 and 2019 respectively. The slowdown in 2016, which is not expected to hinder new market share gains, reflects a deceleration in external demand (Box Projection assumptions ) and a number of temporary factors, such as reduced production in industrial plants of the automotive and energy sectors. Furthermore, in 2016 exports continued to reflect the unfavourable performance of sales to a number of non-eu markets, particularly Angola (despite a lower decrease in the second half of the year). In 2017 the unwinding of these factors, together with a projected acceleration in external demand, should contribute to a return of exports to more buoyant growth. Exports of goods should also benefit in 2017 and 2018 from the improved productive capacity of an automotive plant, which should contribute to keeping growth in this component above external demand. Exports of services are also projected to grow more than external demand over the projection horizon. Although tourism exports are projected to decelerate, they should remain highly buoyant. As a result of these developments, the Portuguese economy is expected to continue to post market share gains over the projection horizon, although gradually more subdued, leading to the slight deceleration in exports projected for 2018 and 2019 (Chart 3.15). These market share gains are more marked in 2016 (as in 2015) if external demand assumptions are refined by taking into account the specific developments in the Angolan economy over this period. The buoyancy of exports over the projection horizon is Chart 3.13 Debt of the non-financial private sector, in the European Union, in 2015 End of period figures in percentage of GDP Chart 3.14 Debt of the non-financial private sector in Portugal End of period figures in percentage of GDP and disposable income Cyprus Luxembourg Ireland Netherlands Denmark Sweden Portugal Belgium United Kingdom Finland Spain France Malta Greece Austria Italy Estonia Croatia Bulgaria Germany Latvia Slovenia Hungary Slovakia Poland Czech Republic Romania Lithuania (p) Non-financial corporations Total debt (a) (as a % of GDP) Households debt (b) (as a % of disposable income) 2019 (p) Source: Eurostat. Sources: Statistics Portugal and Banco de Portugal. Notes: (p) projected. Consolidated values. (a) It includes loans granted to non-financial corporations by other institutional sectors; commercial paper and bonds issued by non-financial corporations held by other sectors and trade credits received from other sectors. (b) The debt of households corresponds to loans and debt securities issued by the sector and trade credit and advances.

24 22 BANCO DE PORTUGAL Economic Bulletin December 2016 expected to result in the continued increase in their share of GDP, even when excluding their import content. Therefore, in 2019 the share of exports in GDP should stand at 48 per cent, compared with 32 per cent in 2008 (net of import content, this share should increase from approximately 20 per cent to around 27 per cent in the same period). The current projection points to a deceleration in imports of goods and services in 2016, to 3.5 per cent, following very substantial growth in 2015 (8.2 per cent). In the period, imports are expected to accelerate further to near 5 per cent, only to decelerate to 4.5 per cent in This profile reflects developments in imports closely in line with their historical elasticity to import-content weighted overall demand, implying a continued increase in import penetration over the projection horizon, although more moderately than in more recent years (Chart 3.16). The analysis of the allocation of imports to expenditure components according to their import content, i.e. the counterpart of Chart 3.6, shows that over the recovery period that started in 2013 expenditure components which made the largest contribution to import growth were exports, with its annual variability being largely due to the energy component, and private consumption (Chart 3.17). The importance of the latter reflects the effect of the purchase of durable goods, due to its high import content. Over the projection horizon, as this effects unwinds, exports should remain the main component behind import growth. The very buoyant developments projected for exports and imports are expected to imply that the upward trend, more marked since 2010, in the openness of the Portuguese economy (measured by the average share of both trade flows in GDP, in nominal terms) will continue, following a slight decrease in 2016 (Chart 3.18). However, there is no such temporary reduction when the indicator is calculated in real terms. Lower external net lending compared with previous years The current projection points to the maintenance of a net lending position of the Portuguese economy, measured by the combined current plus capital accounts balance, although below the levels seen in recent years. Therefore, Chart 3.15 Exports of goods and services and external demand Annual rate of change, in percentage 2 Chart 3.16 Imports and import-content weighted final demand Annual rate of change, in percentage (p) Cumulative change in market share (p.p.) Exports External demand External demand adjusted for Angola effect 2018 (p) (p) Import penetration (p.p.) Imports 2017 (p) 2018 (p) Weighted final demand 2019 (p) Sources: Statistics Portugal, IMF, ECB and Banco de Portugal. Notes: (p) projected. The change in market share was computed with the external demand not adjusted for the Angola effect. Sources: Statistics Portugal and Banco de Portugal. Note: (p) projected.

25 Projections for the Portuguese economy: after reaching 1.7 per cent of GDP in 2015, the combined current plus capital accounts balance is projected to decline to 1.1 per cent of GDP in 2016, standing close to this level up to the end of the projection horizon. The reduction in the balance as a percentage of GDP in 2016 will be broadly based across the main accounts, excluding the trade balance. Namely, the secondary income account has been affected by lower emigrant remittances in particular, from Switzerland (the second most important issuer of remittances to Portugal, with a share of approximately 26 per cent in 2015) and other private transfers. This impact is assumed to persist over the projection horizon. In the case of the capital account, EU funds have been transferred to final beneficiaries to a lesser extent than in the previous year, which may be associated with the current transition to a new NSRF. The current projection points to some recovery in these flows during the second half of 2016 and a stabilisation in the capital account balance as a percentage of GDP over the remaining projection horizon, to a level close to that seen in The primary income account deficit as a percentage of GDP is expected to increase in 2016, only to follow a slight downward path until the end of the projection horizon, benefiting from the technical assumption for the implicit interest rate on public debt. The trade balance surplus as a percentage of GDP is expected to increase somewhat in 2016 and decline in 2017 to a level close to that seen in 2015, and to stabilise over the remaining projection horizon. This variability in the balance reflects developments in terms of trade, partly offset by volume and price effects (Chart 3.19). Changes in terms of trade seen since 2012, which only partly result from oil price developments, made a very substantial contribution to the external adjustment in the Portuguese economy. Between 2012 and 2015, cumulative change amounting to 2.5 p.p. of GDP in the trade balance can be imputed to terms of trade gains, while in the case of the trade balance excluding energy goods the terms-of-trade effect stood at 1.4 p.p. of GDP. The reduction in net lending in 2016 reflects a decrease in aggregate savings in the economy and, to a lesser extent, capital transfers as a percentage of GDP, only partly offset by a low investment rate. For , rates are expected to follow an upward path in terms of both savings and investment compared with projections for Chart 3.17 Allocation of imports to expenditure components Contributions to the annual rate of change in percentage points Chart 3.18 Exports, imports and degree of openess In percentage of GDP (p) 2017 (p) 2018 (p) Private consumption Public consumption GFCF Change in inventories Exports Imports (a.r.c, in %) 2019 (p) (p) (p) Imports Exports Degree of openness Sources: Statistics Portugal and Banco de Portugal. Note: (p) projected. Source: Statistics Portugal and Banco de Portugal. Note: (p) projected. The degree of openess is measured by the ratio of the average of exports and imports to GDP, in nominal terms.

26 24 BANCO DE PORTUGAL Economic Bulletin December , although still below those seen in The private sector s net lending as a percentage of GDP should remain relatively stable in the period, although below in the levels for 2016, for both households and enterprises. Downward revision of GDP growth from June projections and slightly upward revision from October projections Current projections point to GDP growth in 2016 slightly above that underlying projections published in the October issue of the Economic Bulletin. This upward revision resulted from the incorporation of information for the third quarter, particularly exports net of import content, which reflected higher than expected growth during that quarter. Compared with the June 2016 issue of the Economic Bulletin, projections for GDP growth in 2016 and 2017 were revised down (0.1 p.p. in 2016 and 0.2 p.p. in 2017), due to more muted prospects for domestic demand. For 2016, the revision of domestic demand was chiefly due to GFCF, reflecting the incorporation of quarterly national accounts data for the second quarter of 2016 and annual accounts for For 2017, the revision of domestic demand largely reflects expectations of more muted developments in private consumption. By contrast, exports were revised upwards for 2016 and 2017, despite the downward revision of the external demand for Portuguese goods and services, reflecting the incorporation of the latest available data. For 2018, projections for GDP growth and its composition are relatively unchanged from the June issue of the Economic Bulletin. Projections for the current plus capital account balance as a percentage of GDP were revised downwards from the June issue of the Economic Bulletin and, in the case of 2016, also from the October issue of the Economic Bulletin. These revisions reflect the incorporation of the latest balance of payments data. 4. Prices and wages Inflation, as measured by the rate of change in the HICP, is expected to stand at 0.8 per cent in 2016, compared with 0.5 per cent in Along the projection horizon, inflation should increase progressively (1.4 per cent in 2017 and 1.5 per cent in 2018 and 2019) as a result of growing positive contributions of the non-energy component, in parallel with a less negative contribution 6.0 Chart 3.19 Decomposition of the change in the balance of goods and services account In percentage points of GDP (p) 2017 (p) 2018 (p) 2019 (p) Volume effect Price effect Terms of trade effect Change in the balance of goods and services account (as a % of GDP) Source: Banco de Portugal. Notes: (p) projected. For more details on the methodology used, see Box 4.2 Change in the goods account balance in the first half of 2012, Economic Bulletin Banco de Portugal, Autumn 2012.

27 Projections for the Portuguese economy: of the energy component in 2016, becoming positive in the following years (Chart 4.1). Compared to the figures published in the June and October issues of the Economic Bulletin, inflation levels for the period remained mainly unchanged. In comparison with the projections for the euro area released by the ECB on 8 December, inflation is expected to remain 0.6 p.p. above the euro area average in 2016, chiefly reflecting a lower fall in energy prices in Portugal, amid rises in taxes associated with these goods. For the following years, the differential vis-à-vis the euro area is expected to narrow, becoming slightly negative at the end of the projection horizon (Chart 4.2). The inflation rate should increase somewhat in 2016, to 0.8 per cent, reflecting a lower fall in energy and non-energy industrial goods prices and a slight acceleration in services prices. In particular, these developments in services are quite evident in segments related to more dynamic sectors such as tourism. On the other hand, food prices are expected to decelerate, with special notice to the projected slowdown in processed food prices. With regard to the impact on consumer prices of taxation measures applied in 2016, the estimated effect is relatively small, since the positive effect resulting from the rise in taxes on various products (notably oil products, vehicles and tobacco) was partly offset by a reduction of VAT in restaurants, which entered into force in July this year. In 2017 consumer prices are expected to accelerate significantly, to 1.4 per cent, largely as a result of the expected recovery in energy prices (approximately 3 per cent growth, after -2.1 per cent in 2016), in line with the path assumed for oil prices. This positive base effect is expected to dissipate in the following years, with projections pointing to progressively lower increases in energy prices. In this vein, the slight rise in inflation in 2018 is chiefly accounted for by an acceleration in the non-energy component. For 2019 inflation is projected to stabilise at 1.5 per cent. The upward path expected for inflation excluding energy in the period reflects an underlying increase in domestic and external inflationary pressures, fostered by economic growth at national and global levels, the positive impact of monetary policy measures adopted by the ECB, and the incorporation of technical assumptions of a rise in commodity prices in euros. Although broadly based, the upward profile is particularly Chart 4.1 Harmonised index of consumer prices Contributions to the annual rate of change, in percentage points Chart 4.2 Harmonised index of consumer prices in Portugal and in the euro area Annual rate of change, in percentage (p) 2017 (p) 2018 (p) 2019 (p) (p) 2017 (p) 2018 (p) 2019 (p) Excluding energy goods Energy goods HICP (%) Portugal Euro area Sources: Eurostat and Banco de Portugal. Sources: ECB, Eurostat and Banco de Portugal. Note: (p) projected. Note: (p) projected.

28 26 BANCO DE PORTUGAL Economic Bulletin December 2016 noticeable in non-energy industrial goods prices, which recorded negative rates of change since In this scenario, the growth rate of nonenergy goods import prices is projected to be approximately 2 per cent in , compared with a reduction in Moderate wage growth and slight acceleration in the private sector GDP deflator Developments projected for inflation show an underlying profile of gradual acceleration in wages per employee, in a scenario of increase in productivity and gradual improvement in the labour market situation. Unit labour costs are expected to continue to grow at a relatively stable rate in the period, both in the economy as a whole and the private sector. In this context, a slightly upward growth path is projected for the private sector s GDP deflator, 5 reflecting the absence of further inflationary pressures (on average, the contributions from unit labour costs and the gross operating surplus per unit of output are relatively similar) (Chart 4.3). The trend of the private sector GDP deflator in 2015 and 2016 reflected on the one hand a marked increase in the gross operating surplus per unit in 2015 influenced by improved terms of trade and on the other the impact of a 5 per cent rise in the minimum wage in Increase in inflation expectations Inflation expectations for the next 12 months (calculated on the basis of data released by Consensus Economics) follow an upward path both in Portugal and the euro area. However, the expected levels are substantially lower than the ECB s price stability objective, which envisages a rate of change in the HICP close to but below 2 per cent in the medium term (Chart 4.4). 5. Uncertainty and risks Downward risks for economic activity in and for inflation in 2018 This section presents a quantified review of risks and uncertainties surrounding the current projection, which corresponds to the most likely scenario, given the set of assumptions considered. However, the non-materialisation of these Chart 4.3 Decomposition of the private sector GDP deflator Contributions to the annual rate of change, in percentage points Chart 4.4 Inflation expectations for a 12-month horizon Annual average rate of change, in percentage (p) 2017 (p) Unit labour costs Gross operating surplus per unit of output Indirect taxes less subsidies Private sector GDP deflator (%) (p) (p) Jan.13 May 13 Sep.13 Jan.14 May 14 Portugal Sep.14 Jan.15 May 15 Sep.15 Jan.16 May 16 Euro area Sep.16 Sources: Statistics Portugal and Banco de Portugal. Note: (p) projected. Sources: Consensus Economics and Banco de Portugal calculations.

29 Projections for the Portuguese economy: assumptions, as well as the possibility of occurrence of factors that, for their characteristics, were not taken into account in the current projection, give rise to risks and may alter the relevant levels of uncertainty surrounding the central scenario. Although the business cycle recovery phases are always associated with a greater degree of uncertainty, the unprecedented nature of large adverse shocks that have affected the Portuguese economy in the past few years causes perspectives to become more uncertain in the projection horizon. Hence, by conditioning economic agents expectations with regard to future economic prospects, uncertainty may be an important factor limiting economic growth (Box: Impact of uncertainty measures on the Portuguese economy ). Against this background, the uncertainty around the United States economic policy guidelines, as well as the evolution of the United Kingdom s relations with the European Union and a possibly weaker recovery of emerging market economies give rise to risks of a potentially less dynamic evolution of activity and trade flows at the global level over the course of the projection horizon. These risk factors may translate into lower growth of the external demand for Portuguese goods and services and a further appreciation of the euro in , also leading to higher uncertainty levels. The possibility of renewed tensions in financial markets cannot be excluded, and there is also some uncertainty as to the configuration of the ECB s non-standard monetary policy over the projection horizon. In addition, the vulnerability of the banking system or the fiscal position in a number of euro area countries may lead to a rise in sovereign debt interest rates. These aspects assume a special relevance at domestic level, in a context of persistent risks for financial stability in Portugal. 6 These factors may lead to an increase in the economy s financing costs, with an impact on private consumption and investment. In addition, one should consider the possible need for additional fiscal consolidation measures to comply with the objectives assumed in the medium term, with a negative impact on domestic demand developments. Downward inflation risks are considered for , given that the pressure on prices stemming from a weaker evolution of activity is reinforced by the risk of inflation expectations in the euro area remaining below the ECB s monetary policy objective, which may have a negative impact on prices. In addition, a downward risk for prices in resulting from the maintenance of production overcapacity at global level is also considered, which may create competitive pressures with an impact on inflation. Finally, the possibility of a further rise in the minimum wage in 2017 has also been taken into account. As a result of this assessment of risks and uncertainty, a 55 per cent probability was considered of a more unfavourable evolution of external demand and a sharper appreciation of the euro than considered in the central scenario in (Table 5.1). Developments in domestic demand components were also assessed as potentially weaker than in the projection, with a 53 per cent probability in private and public consumption and 55 per cent in investment. In addition, the possibility of more marked wage growth in 2017 was considered (with a 60 per cent probability), as well as of a more moderate evolution of inflation in (with a 55 per cent probability). This analysis implies downward risks for activity in Inflation risks are considered balanced in and downward in 2018 (Table 5.2 and Charts 5.1 and 5.2). 7

30 28 BANCO DE PORTUGAL Economic Bulletin December 2016 Table 5.1 Risk factors Probability of an outcome below the implicit in the projections In percentage Projection assumptions External demand Exchange rate Public consumption Endogenous variables Private consumption GFCF Wages HICP Source: Banco de Portugal. Table 5.2 Probability of an outcome below the projections In percentage Weights Gross domestic product Private consumption GFCF Exports Imports HICP Source: Banco de Portugal. Chart 5.1 Gross domestic product Rate of change, in percentage Chart 5.2 Harmonized index of consumer prices Rate of change, in percentage Baseline projection 40% confidence interval % confidence interval 80% confidence interval Source: Banco de Portugal.

31 Projections for the Portuguese economy: Conclusions The Portuguese economy has maintained a moderate recovery trajectory since 2013, particularly when compared to that observed in previous comparable phases of the cycle. The projections in this Bulletin point to an activity growth in Portugal at a level close to that projected for the euro area in the period. In a progressively more favourable external framework, the economic recovery is likely to continue to be supported by the buoyancy of exports. As regards domestic demand, a recomposition is projected, characterised by a deceleration of private consumption with growth slightly below that of GDP and dynamic behaviour of GFCF. These features are consistent with the ongoing reorientation of productive resources towards sectors more exposed to international competition and also more productive, with the additional net creation of jobs and a further reduction in unemployment, with the maintenance of a surplus in external accounts and the continuation of the process of non-financial private sector s indebtedness reduction. Hence, the pattern of the projected economic growth presents a set of features that reflect a more sustained recovery of the Portuguese economy. However, various structural constraints to Portuguese economic growth persist, including the high level of indebtedness of the different economic sectors households, non-financial corporations and public sector unfavourable demographic developments, a high level of long-term unemployment, and a recovery pace of investment falling short of that observed in previous recoveries. The impact of these factors tends to be exacerbated in the current context of uncertainty, at the domestic and external levels. Therefore, it is important that the structural reform process is deepened, thus increasing incentives to innovation, factor mobility and investment in human and physical capital, paving the way for a sustained increase in productivity and the economy s growth potential. In addition, against a background of prevailing relatively high uncertainty levels, the maintenance of a predictable institutional and tax framework will contribute to preserve investor confidence and ensure a favourable environment for investment. The initiatives under way to reduce financial and banking sector s specific vulnerabilities will also tend to contribute to this result. The effort to reduce private economic agents level of debt should be pursued so as to reinforce the resilience to shocks that affect their debt service capacity. Finally, additional fiscal consolidation is key to ensure that the level of public indebtedness shows a downward path that is sustained and robust to adverse shocks. The temporary nature of the current broad set of non-standard monetary policy measures in the euro area reinforces the urgency and importance of structural progress in these various dimensions. Box 2 Impact of uncertainty measures on the Portuguese economy The purpose of this box is to assess the impact of uncertainty on economic activity developments (GDP) and gross fixed capital formation (GFCF) in Portugal in recent years. Uncertainty has often been considered as a driver of weak developments in advanced economies following the 2008 financial crisis. Although several possible channels point to a negative link between uncertainty and economic activity, this type of association has yet to be empirically analysed in greater detail in the case of the Portuguese economy. 8 When deciding on consumption, investment and other expenditure, economic agents must form expectations on relevant future events on the basis of available data. These expectations focus on

32 30 BANCO DE PORTUGAL Economic Bulletin December 2016 uncertainty about the likelihood of alternative events. Therefore, economic uncertainty reflects the unforeseeability of the future economic outlook, to the extent that the likelihood of alternative events is unknown or impossible to gauge with precision. Economic theory suggests that there are several transmission channels of uncertainty to economic activity, more specifically through the postponement of agents consumption and investment decisions, in conjunction with their potential effects on the labour and financial markets. 9 The purpose of this box is to review developments in a number of uncertainty measures available for Portugal and gauge the impact of these variables on macroeconomic developments in recent years, particularly on GDP and GFCF. Indeed, several empirical applications to assess the effects of uncertainty on economic agents decisions focus precisely on economic activity measures and investment. The uncertainty indicators addressed in this Box are: Banco de Portugal s composite financial stress indicator for Portugal (Portuguese acronym: ICSF), analysed in Braga et al. (2014), and the economic policy uncertainty indicator for Europe presented in Baker et al. (2015). These indicators differ, as they focus on financial and political aspects respectively. 10 The purpose of the financial stress indicator for Portugal is to capture systemic stress in the economy, combining information from several indicators that makes it possible to capture volatility in five market segments, more specifically the money, bond, stock and foreign exchange markets, as well as financial intermediaries. In turn, the economic policy uncertainty indicator is built based on the counting of press articles mentioning uncertainty, economy and an expression relevant to the economic policy in the four largest euro area economies and the United Kingdom. No such indicator has been specifically built for the Portuguese economy, but given its features as a small open economy, its degree of integration euro area and the EU as well as its exposure to economic and political developments at European level, the measure built for Europe shows a high negative correlation with the Portuguese business cycle (Chart 1). Chart 1 shows developments in uncertainty measures 11 since 2002, during which they have posted a negative correlation with the year-on-year rate of change in GDP. A shaded area in the chart signals the last three recessions in Portugal, with the last two being also observed in the euro area. All indicators point to an increase in uncertainty in 2008 (with the collapse of the Lehman Chart 1 Evolution of the uncertainty indicators Economic policy uncertainty indicator for Europe Composite indicator of financial stress for Portugal Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q1 EPU GDP (y-o-y rate of change) (inverted rhs) ICSF Sources: website Economic Policy Uncertainty ( and Banco de Portugal. Note: The shaded areas denote periods of recession in Portugal. 12

33 Projections for the Portuguese economy: Brothers) and 2011 (euro area sovereign debt crisis), although in the case of the economic policy uncertainty indicator this increase was very muted during the 2008 international financial crisis. These diverging performances during recessions, as well as in the most recent period, are likely to be related to the nature of these indicators. The recession that began in 2008 started as a financial crisis, and therefore its impact on uncertainty is better assessed by looking at the financial stress indicator. Furthermore, the sovereign debt crisis gave rise to questions as regards the euro area institutional framework and, as such, is more relevant in terms of the economic policy uncertainty indicator. This indicator also increased further in the most recent period, in the wake of the outcome of the UK s referendum on EU membership (so-called Brexit). The importance of uncertainty to macroeconomic developments was estimated on the basis of Bayesian structural VAR (SVAR) models 13 for GDP and GFCF in levels. 14 This analysis was similar to that described by the European Commission (2015) and Deutsche Bundesbank (2016). The models were initially estimated in a reduced version that includes a number of regressors that are typically considered in literature. 15 This version was re-estimated by adding both uncertainty measures alternately. Finally, a third version was estimated covering the previous two plus a measure of private sector leverage. 16 Therefore, in its comprehensive version, the model for GDP includes as covariates an uncertainty measure, inflation, employment, the stock of loans to households and non-financial corporations (as proxy for indebtedness levels) and the short- -term interest rate. In the case of GFCF, the set of covariates in the model is similar, with the exclusion of employment and the proxy for household indebtedness. The out-of-sample conditional forecast ability of these models was analysed in the period following the sovereign debt crisis. As such, it is possible to assess whether uncertainty measures would have helped explain recent macroeconomic developments, assuming that all model variables were known. Results show that, overall, both on an individual basis and together with indebtedness measures, uncertainty measures have improved the model forecasts for GDP and GFCF. These results are confirmed by a dynamic analysis using a mean-adjusted SVAR model fitted to the first differences of the series. 17 Charts 2 and 3 show the impact of uncertainty on GDP (assessed on the basis of the composite financial stress indicator) and GFCF (on the basis of the economic policy uncertainty indicator). 18 The uncertainty indicator included in the model for each macroeconomic aggregate was chosen on the basis of the indicator that originated the lowest conditional forecast errors for the period following the sovereign debt crisis. The chart shows that uncertainty may have a non-negligible impact on GDP and GFCF, with a one standard deviation shock 19 on the uncertainty indicator having a maximum impact close to -1 percentage point on the macroeconomic aggregate under review. These estimated models may be used to break down the rate of change in GDP and GFCF over time. Chart 4 illustrates the outcome of this approach for GDP, up to the third quarter of The results show that although changes in GDP have been determined by other shocks other than those originated by uncertainty, it had a substantial negative impact during the recessions associated with the financial crisis and the sovereign debt crisis. In turn, uncertainty factors had a positive effect in 2014, which may be associated with the conclusion of the Economic and Financial Assistance Programme. More recently, this positive effect has been unwinding, turning negative as of the first quarter of 2016, when perceived uncertainty increased across Europe, closely associated with a relatively negative review of the European banking sector and, subsequently, with the consequences of the outcome of the UK s referendum. In the case of the GFCF, results were similar (Chart 5) when estimating the model up to the second quarter of In this case, it is worth noting that in the first half of 2016 the fall in GFCF in Portugal was largely due to an increase in uncertainty.

34 32 BANCO DE PORTUGAL Economic Bulletin December 2016 Chart 2 Impact on GDP of a standard deviation shock measured by the ICSF In percentage points Chart 3 Impact on GFCF of a standard deviation shock measured by the EPU In percentage points Number of quarters after the shock Number of quarters after the shock Impact on GDP level 95 % confidence band Impact on GFCF level 95 % confidence band Chart 4 Historical decomposition of GDP y-o-y rate of change with the Composite Index of Financial Stress Contributions in percentage points Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q3 Contribution of uncertainty Overall except uncertainty GDP (%) Sources: Statistics Portugal and authors' calculations. Chart 5 Historical decomposition of GFCF y-o-y rate of change with the Economic Policy Uncertainty Indicator Contributions in percentage points Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q1 Contribution of uncertainty Overall except uncertainty GFCF (%) Sources: Statistics Portugal and authors' calculations.

35 Projections for the Portuguese economy: References Baker, S. R., Bloom, N. and Davis, S. J., Measuring Economic Policy Uncertainty. NBER Working Papers 21633, National Bureau of Economic Research, Inc. Braga, J. P., Pereira, I. and Reis, T. B., 2014, Composite indicator of financial stress for Portugal, Banco de Portugal Financial Stability Papers, issue 1. European Commission, 2015, Investment dynamics in the euro area since the Crisis, Quarterly Report on the Euro Area, Vol 14, number 1. Deutsche Bundesbank, 2016, Determinants of investment activity in the euro area from the perspective of an SVAR model, Deutsche Bank Monthly Report, January. Dieppe, A., Legrand, R., and van Roye, B., 2016, The BEAR toolbox, European Central Bank Working paper series, number 1934, July. Haddow, A., Hare, C., Hooley, J. and Shakir, T., 2013, Macroeconomic Uncertainty: What is it, How Can We Measure It and Why Does it Matter?, Bank of England Quarterly Bulletin, 53. IMF, 2012, How Does Uncertainty Affect Growth, Box 1.3, Chapter 1, World Economic Outlook, October. Jarociński, M. and Smets, F., 2008, House Prices and the stance of Monetary Policy, European Central Bank Working Paper Series, number 0891, April. Schneider, J. and Giorno, C., 2014, Economic Uncertainties and their Impact on Activity in Greece compared with Ireland and Portugal, OECD Economics Department Working Papers, No. 1151, OECD Publishing, Paris. Gunnemann, J., 2014, The impact of policy-related uncertainty on the economy: New evidence from Europe, mimeo.

36 34 BANCO DE PORTUGAL Economic Bulletin December 2016 Notes 1. Considering non-seasonally adjusted data, the current plus capital account balance as a percentage of GDP was negative ( 1 per cent) in the first half of 2016, having fallen compared to the first half of 2015 ( 0.1 per cent). Based on seasonally-adjusted data, this balance was positive albeit lower than that recorded in the first half of In particular, nominal goods exports to Spain showed a year-on-year rate of change of 9.3 per cent in the third quarter of 2016, compared to 3.7 per cent in the first half. 3. Dias, D., Marques, C. R. and Richmond, C., Resource allocation, productivity and growth in Portugal, Economic Bulletin, October 2014, Banco de Portugal. 4. See the box entitled Productivity and job reallocation in Portugal, Economic Bulletin, October 2016, Banco de Portugal. 5. The private sector GDP refers to total GDP excluding public compensation of employees and fixed capital consumption. 6. See the November 2016 issue of the Financial Stability Report. 7. This Economic Bulletin is the first where the projection horizon exceeds 3 years, and thus it is not possible to quantify the risk assessment for 2019, since the methodology used requires information on historical projection errors for every horizon. The methodology used in this section is based on the article published in Pinheiro, M. and Esteves, P. (2010), On the uncertainty and risks of macroeconomic forecasts: Combining judgements with sample and model information, Empirical Economics, pages Schneider, J. and Giorno, C. (2014), present a comparative analysis of the impact of uncertainty in Greece, Portugal and Ireland, which focuses solely on stock market volatility as uncertainty indicator, thus limiting its comprehensiveness. Gunnemann, J. (2014) develops national economic policy uncertainty indices, based on newspaper news, for nine European countries, including Portugal, and studies their impact on industrial production and unemployment. 9. See Haddow, A., Hare, C., Hooley, J. and Shakir, T. (2013) and references herein, and the IMF (2012). 10. Other indicators were also addressed, more specifically an application of the approach described by the European Commission (2015), according to which uncertainty indicators were based on the dispersion of replies to opinion surveys of households and enterprises. However, these indicators led to worse results than the economic policy uncertainty indicator for Europe and the composite financial stress indicator and, therefore, are not included in the analysis presented in this Box. 11. Standardised variables were used, i.e. net of the average and divided by the standard deviation computed over the sample period. 12. These were defined on the basis of the cycle s turning points, corresponding to periods between a peak in GDP and a through prior to the following upturn. The peaks were selected as the quarter that preceded at least two consecutive quarters with negative quarter-on-quarter rates of change of GDP. The troughs in the cycle were identified as the quarter that preceded at least two consecutive quarters during which the quarter-on-quarter rate of change in GDP was positive, following a peak. 13. Models were estimated using the MATLAB-based toolbox presented in Dieppe, A. et al. (2016). 14. Models were estimated with one lag, given that this assumption maximises the model s likelihood compared with the most common assumption in literature (4 lags), a result that may be related to the relatively low number of observations. 15. See, for instance, Haddow et al. (2013) or European Commission (2015). 16. The structural decomposition of shocks was based on the Cholesky method. 17. For more details on the methodology, see Jarociński, M. and Smets, F. (2008). 18. These results are based on model estimated over the full sample. 19. In 2008 (the onset of the international financial crisis), the financial stress indicator increased by approximately 3 standard deviations, and the economic policy uncertainty indicator increased by 1.5 standard deviations.

37 II Special issue Life below zero: monetary policy transmission under negative interest rates