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Fiscal Risks and Public Finance Sustainability 2023

Macroeconomic projections

Demographic developments and productivity growth projected for Portugal over the next 15 years are currently the main long-term macroeconomic risks. The CFP's macroeconomic scenario presented in this report projects an average real GDP growth of 1.2% per year between 2023 and 2037. In the long term, and in the absence of shocks, the Portuguese economy is expected to grow by around 0.7%, the estimated value for its potential growth. Against this horizon, total factor productivity is expected to remain the main driver of economic growth, converging to a contribution of 0.6 p.p., close to its historical average. The contribution of the capital factor is expected to remain relatively stable and the contribution of the labour factor is expected to be heavily penalised by demographic developments, which are projected to reduce the working-age population by 0.3% per year. 

Fiscal risks

Demographic change, in particular an ageing population, poses a downside risk to economic growth and the sustainability of public finances. The ageing of the population affects economic growth directly, through the impact on employment, resulting from the expected decrease in the active population and also through changes in savings and investment patterns, with an impact on consumption decisions and capital stock . According to the most recent demographic projections prepared by Eurostat (EUROPOP 2023), the total Portuguese population should continue to decrease and show a significant change in its age structure, which translates into the aforementioned reduction in the working-age population. Even in an alternative scenario of high migration, the working-age population will always decrease, slightly penalizing economic activity (via the labour market). The expected reduction in the contribution of employment to growth in any of the demographic scenarios considered reinforces the importance of total factor productivity as the main determinant of long-term economic growth. Thus, it can be concluded that the adoption of structuring measures that allow total factor productivity to sustainably exceed its historical average would improve growth prospects and strengthen the conditions for the long-term sustainability of public finances.


In budgetary terms, and based on the macroeconomic scenarios developed by the CFP, it is concluded that the weight of tax and contribution revenue on output should grow in all scenarios considered (baseline, low migration and high migration) until the end of the projection horizon (2037). This growth, which should result from the increase in the weight of most of the components that make up tax and contributory revenue (direct and indirect taxation and social contributions), indicates a considerable degree of resilience of this aggregate in the face of the various macroeconomic and demographic scenarios considered. However, the downside risks to the trajectory of tax and contributory revenues are the erosion of tax bases, due to a lower level of wages resulting from a sharper-than-expected population decrease or a migratory flow based predominantly on low-skilled jobs with salaries legally exempt from personal income tax. In addition, a higher level of underwriting of health insurance and pension schemes implies some growth in fiscal expenditure, although this individual behaviour reduces fiscal pressures on public expenditure.


On the other hand, the evolution of expenditure, in particular social expenditure, which may include expenditure on social benefits and health care, is influenced by factors such as economic cycles, demography, the environment or technological changes, the impact of which is felt in the medium and long term. The combination of changes in the demographic structure and projected changes in productivity and economic growth are decisive for the normal functioning of both pension systems, financed from an intergenerational distribution perspective, and for the ability of a health care system to be maintained. Ageing expenditure, in particular on pensions and health, puts a strong strain on the balance of the budget. In order to better manage these pressures, as well as the growing investment needs, it is necessary to implement an effective public expenditure management system, which prioritises, promotes efficiency in public spending and enables the creation of fiscal space to meet the growing investment needs in areas such as health care,  national defence and other fortuitous and/or conditional risks.


Fortuitous risks include climate change and catastrophic events, which are also relevant fiscal risks. Although demographic and productivity growth currently represent the main fiscal risks for the Portuguese economy, climate change also remains one of the biggest downside risks to economic growth and public finances, both globally and nationally. Portugal, despite having already adopted several agreements, plans and legislation with a view to mitigation and adaptation, is slow to implement, articulate and execute the actions and measures proposed in them, including the one stipulated in the Climate Framework Law. There is still a lack of clarification of the public and private investment needs until 2050 for the effective implementation of these instruments, as well as the respective timing and sources of funding. Regarding the risks associated with catastrophic events, these can be of man-made origin (cyber attacks and geopolitical tensions) and of natural origin (earthquakes and tsunamis), some of which are uncontrollable. The Report presents some indicators of the degree of exposure to these risks.


In terms of national defence, Portugal recorded an expenditure of approximately 1.4% of GDP in 2022, which is also the average value recorded in the period since 2014. This is lower than the amount set out in the "Defence Investment Commitment" made by the Allies of the North Atlantic Treaty Organization (NATO) in 2014, a situation similar to that seen in most EU countries. Indeed, according to the Stockholm International Peace Research Institute (SIPRI), only six EU countries spent at least 2¬¬% of their GDP on defence in 2022. This may result in pressure on public spending, as the allocation to National Defence, in a sustained manner, of 2% of GDP, would require an annual increase in this expenditure of around 0.6 p.p. of GDP.


With regard to conditional risks, those associated with contingent liabilities stand out, which in 2021 amounted to 50.4% of GDP, three quarters of which related to financial entities controlled by the General Government, classified outside the budgetary perimeter. Excluding the liabilities of these financial entities, and using information available for the year 2022, there was a generalised reduction in contingent liabilities as a ratio of GDP to levels below those seen in the pre-pandemic year. Of particular note in this context are the guarantees granted to the financial sector, specifically the extinction of liabilities relating to the portfolio guarantee and the decrease in liabilities relating to Novo Banco's contingent capitalisation mechanism, which helped reduce liabilities with public guarantees to 4.5% of GDP. The debt generated by non-financial public entities classified outside the fiscal perimeter followed this evolution, standing at 3.1% of GDP in 2022, the lowest since 2007, as well as Public-Private Partnerships whose liabilities decreased from 2.2% of GDP in 2019 to 1.7% of GDP in 2022.   


Debt sustainability analysis

According to the deterministic debt sustainability analysis presented in this report, the CFP projects that, in the baseline scenario, the public debt ratio will show a downward trajectory over the next 15 years, stabilising at 87.2% of GDP in 2037. Public debt as a percentage of GDP shows a significant pace of decline in 2023 and 2024, driven by inflation and fiscal consolidation, which is reflected in positive and relatively high primary balances in these years. For the period 2025-2037, a more gradual reduction in the debt ratio is anticipated, mainly due to a less favourable contribution from the primary balance and the dynamic (or snowball) effect, the latter influenced by the effect of nominal growth expected in the macroeconomic scenario. The path of the primary balance is estimated using a fiscal reaction function. Thus, the response of the primary balance to the debt ratio is influenced by a historical behaviour in which years with primary deficits have been punctuated in a context of growing debt and only more recently have primary surpluses been observed. The simulation of the impact of several exogenous shocks on the debt ratio points to a sensitivity of this ratio to shocks to the GDP growth rate and the primary balance.


The CFP also presents, for the first time, a stochastic analysis of debt, which aims to complement the deterministic projection by providing an empirical analysis of the macroeconomic uncertainty surrounding the simulated path of debt. Unlike deterministic projections, the outcome of stochastic projections does not translate into a single baseline scenario, but rather into a distribution of possible forward-looking scenarios for government debt resulting from macroeconomic shocks in the set of variables determining this evolution. In this case, the base case of the deterministic projection is below the median of the trajectories obtained by the stochastic model, at the 30th percentile. In part, this apparently unconservative result obtained in the light of the deterministic block is justified by the size of the past shocks that hit the Portuguese economy, captured by the stochastic model, which are not repeated in the macroeconomic scenario underlying the deterministic projection. 


The downward trajectory of the government debt ratio in the baseline scenario shows that the conditions for the sustainability of Portuguese public finances are in place, so policymakers continue to take the necessary measures to achieve a sufficient primary surplus. As the period after the end of the adjustment programme in 2014 shows, the favourable financing conditions that prevailed, combined with fiscal discipline, created a favourable dynamic for debt reduction, which is mutually reinforcing, via credibility gains reflected in  tight spreads vis-à-vis German debt. A break with this economic policy option, simulated by the CFP in an extreme scenario where the primary balance would return to its historical average since entry into the euro area (-1.3% of GDP), would lead to an upward profile for the debt ratio from 2027 onwards, above 110% of GDP at the end of the projection horizon. As this report concludes, countries whose governments choose to pursue a fiscal policy that repeatedly and persistently neglects to achieve a primary balance sufficient to allow for a reduction in the debt ratio may face considerable risks, due in part to the potential feedback loop  between high government debt and the risk premium.  especially in the case of countries with already relatively high debt balances. In fact, despite the downward trajectory of indebtedness, Portugal remains in a vulnerable position due to the still high ratio of public and private debt, and is therefore subject to a significant increase in financing costs in the absence of a favourable environment and in the event of idiosyncratic events.

Date of last update: 12/12/2023

Risks and Sustainability . Report nº 11/2023 . 12 December 2023