Portugal is in the midst of a deep recession as the collapse of external demand and tight financial conditions have affected all parts of the economy, particularly exports and investment. Activity is expected to contract throughout 2009, before recovering very slowly in 2010 as the global economy and financial conditions gradually improve. The unemployment rate is set to reach double digits. Sharply lower commodity prices and the large negative output gap will leave inflation at very low levels.
The fiscal position will deteriorate significantly in 2009 reflecting weaker economic conditions, lower revenues, and spending rises to support the economy. Fiscal consolidation and structural reforms will be required in the medium term to enhance growth prospects, reduce long-term unemployment and help place the public finances on a more sustainable footing.
Activity collapsed at the end of 2008 under the weight of the global economic crisis, particularly the huge decline in external demand. Exports and investment have been particularly weak and the unemployment rate is rising. Preliminary data indicate that output contracted further by an annualised rate of just over 6% in the first quarter of 2009. The latest indicators suggest that the level of output will fall further through the year. Headline inflation turned negative early in 2009 as energy prices fell significantly from their mid–2008 highs. Core inflation has also moderated. Financial conditions for the private sector remain tight as stricter lending standards and wide bond spreads have offset the ECB‟s low policy rate and credit support initiatives.
Despite the ongoing fiscal consolidation programme, the 2008 budget deficit of 2.6% of GDP was higher than expected as the recession hit revenues hard at the end of the year. In 2009 the fiscal position is set to deteriorate significantly further. Fiscal stimulus measures focusing on public investment, support to companies and exports, and social assistance will directly increase the budget deficit by 0.8% of GDP in 2009. Sharply weaker activity will cut revenue further, raising budget deficits above 6% of GDP in both 2009 and 2010. Although the near-term increase in the deficit is mainly cyclical, the large and growing structural deficit and public debt mean that a credible medium-term fiscal consolidation plan is critical.
GDP is projected to fall by 4.5% in 2009. Tight credit conditions, a rapidly weakening labour market and low consumer confidence will reduce consumption. The large drop in activity in major export markets points to further important falls in exports. Together with tighter credit conditions and weak internal demand, this will significantly reduce investment. The deterioration in economic conditions will lead to large falls in employment and the unemployment rate is likely to surpass 10%. The economy is expected to recover only gradually in 2010, supported by an easing in financial conditions and firming external demand. Lower commodity prices, a large negative output gap and a high unemployment rate should reduce core inflation toward zero by the end of 2010.
On the downside, rising default rates due to the recession could add to pressures on domestic bank balance sheets from the financial crisis and the deteriorating state of public finances makes it possible that markets will demand even larger premiums for holding government debt. On the other hand, if financial conditions ease earlier than anticipated and growth in Portugal‟s major trading partners picks up more than expected, the recovery could be somewhat faster in 2010.
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