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Decision Time in Lisbon

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Officials from the ECB/EU/IMF arrived in Lisbon this week to carry out the fifth assessment of Portugal's €78bn bail-out. During previous visits the "troika" has heaped praise upon the government for the progress made on its reform programme. Yet it is becoming increasingly clear that the budget deficit is drifting off target. This leaves the troika facing a dilemma: should it demand further sacrifices from Portugal's population or should it agree to give the adjustment more time?

The impact of the programme has already been severe. Living standards have fallen and unemployment has soared. The youth unemployment rate is now above 36%--below the levels observed in Spain and Greece, but unprecedented in Portugal nonetheless. Despite the harsh austerity measures, any lingering hopes that the government will meet its target for a budget deficit of 4.5% of GDP in 2012 were put to rest by budget data published last week. These show that although public spending fell by more than expected during January-July, revenues under-shot their target by more. With Portugal's two year recession expected to endure well into 2013, making up the shortfall will be all but impossible.

The feasibility of cutting a budget deficit during a deep recession has been hotly debated by economists in recent years. Portugal's experience is proving instructive. Tax receipts fell by 3.5% during the first seven months of this year, compared with a targeted increase of 2.6% during 2012 as a whole. The main cause of the shortfall was a drop in indirect tax receipts, as the state lost revenues across the board. Weak consumer spending meant that VAT receipts fell, despite higher rates. Vehicle tax rates also went up, yet revenues fell by almost one half. Meanwhile, direct tax revenues are also down, as higher receipts from personal income taxes (after tax increases) were more than offset by a sharp fall in receipts from the corporate sector.

The news is not all bad--at least from the troika's perspective. State spending remains below year-earlier levels, a decline that is unprecedented in Portuguese history. Capital expenditure has been slashed by almost 25%--though this hardly bodes well for the prospects of economic recovery--while current spending edged down slightly as a result of efforts to slim down the public administration and contain costs. Less favourable are developments that are outside the government's immediate control, such as interest costs and the social security accounts. High unemployment has both pushed up spending on benefits and reduced contributions, causing the social security surplus to halve.

Staff costs have proved key to controlling spending. A decision to scrap holiday bonus payments for civil servants (equivalent to one month's salary) in June was the main cause of a 16% fall in the public sector wage bill. A similar cut will be applied at the end of 2012, but the constitutional court has declared that such cuts are illegal and cannot be repeated as planned in 2013. The finance ministry is still considering how to fill the €3bn gap created by the ruling and may impose a tax on bonuses across the workforce.

Portugal's government has all but admitted that it cannot meet its budget target this year. We think a figure between 5% and 6% of GDP is more realistic. It is difficult to judge how the troika will respond. On the whole, the creditors appear satisfied with Portugal's progress and may well accept that further austerity measures would be counterproductive. The rebalancing of the Portuguese economy between internal and external demand is proceeding much more rapidly than expected (which partly explains the slower progress on the fiscal front). Staff reductions in the public sector are on target. And reasonable progress has been made in implementing structural reforms.

The government itself is reluctant to request more time and thereby validate the calls by the opposition Socialists for a longer adjustment. Yet the troika will surely find it hard to resist the conclusion that the 2012 budget target should be relaxed. Of course, this would make a deficit target of 3% of GDP in 2013 even more unrealistic. It seems very likely, therefore, that Portugal will need additional financing from late next year, when the existing bail-out programme foresees a return to commercial funding markets. In return, the Portuguese government will probably have to commit to some additional reforms. However, these could include options beyond further tax rises and spending cuts, such as privatisations and renegotiation of a multitude of public private partnerships to reduce the government's financial obligations.

Portugal may well be the country where the eurozone's solidarity is put to the test. Patience with the Greek government's foot-dragging is wearing thin, but Portugal has done all that has been asked of it. If the response to missed deficit targets is to simply call for more austerity regardless of the impact this would be a clear sign that the limits of what the creditor countries are able or willing to do to keep the eurozone together have already been reached.