The Portuguese economy gained ground in 2021 after a deep pandemic-induced recession. Reflecting the relevance of tourism, the economy was harder hit than the euro area (EA), but a decisive and comprehensive policy response, bolstered by the response at the EU level and by the ECB, helped moderate the effects of the pandemic on households and firms. A strong vaccination drive allowed for early lifting of activity restrictions and has supported the recovery through early 2022. Despite lower increases in domestic energy and electricity prices relative to the EA―reflecting policies to limit pass-through to retail prices―inflation pressures have broadened. However, wage inflation remains contained thus far and below the rest of the EA.
But the economy is now facing new risks posed by the war in Ukraine. Although direct linkages with Russia and Ukraine are limited, spillovers from the war through higher commodity prices, greater supply bottlenecks, weaker confidence, softer external demand, and tighter financial conditions will weigh on the recovery and raise prices.
Economic outlook and risks
Growth is expected to ease to about 4.5 percent in 2022 and 2 percent in 2023. This represents a cumulative downgrade of about one percentage point relative to pre-war. Growth is expected to be led by private consumption—supported by a faster normalization of household savings rate to pre-pandemic averages—NGEU-backed public investment, and exports, with tourism reaching its pre-pandemic level in 2023. Over the medium term, growth is projected to moderate to below 2 percent, with output still remaining some 2 percent below its pre-pandemic trend by 2027. Inflation is projected to rise to 6 percent in 2022 and start receding in 2023 on the back of declining energy and food prices.
However, risks are tilted to the downside. The key risks stem from the exceptional uncertainty surrounding the war and potentially new virus waves. Tighter financial conditions could hurt growth and the fiscal position. The effects of the end of loan moratoria have not yet fully materialized, and could eventually expose higher insolvencies, lowering investment and bank capital. Slower use of NGEU funds pose additional risks. Moreover, despite its projected decline, public debt will remain uncomfortably high and rising real estate prices constitute an added vulnerability. On the upside, a continuation of the strong tourism recovery, further bounce-back from pent-up demand supported by the high vaccination rates, and higher payoffs from NGEU investments would brighten the outlook.
Policy priorities
Policies will need to balance short-term urgencies and dealing with high energy prices and other impacts from the war in Ukraine with a smooth transition to private-led growth, rebuilding fiscal space and advancing reforms for a more resilient economy. In the medium term, structural reforms—including in the context of the Recovery and Resilience Plan (RRP)—sustained public investment, and fiscal consolidation within a medium-term plan will build a more dynamic and resilient economy. These efforts are critical to accomplish the long-standing priority to raise Portugal’s growth potential and accelerate income convergence to the rest of the EA.
Fiscal Policy
After the much-needed fiscal support in 2020-21, the unwinding of the COVID-19 measures, while maintaining a broadly supportive fiscal policy in 2022 is appropriate. The robust recovery in employment and consumption, along with the full reopening of the economy, justify the further unwinding of the exceptional COVID-19 economic support measures in 2022. Excluding these measures―which are expected to be replaced by higher private demand—a projected fiscal deficit of 2.4 percent of GDP is appropriately accommodated. The government has recently taken measures to mitigate the impact of high energy prices. NGEU grant-financed spending provides additional support to the economy. Nonetheless, some 2 percent of GDP of the 2020–21 fiscal measures are expected to be permanent. It is important to ensure that further support is sufficiently targeted and temporary in nature. In this context, the broad-based price measures, and tax cuts in response to the energy shock should preferably be replaced with more targeted and temporary support for vulnerable households and viable firms, while preserving price signals for most users. Fiscal policy will also need to be nimble to identify further targeted contingency measures under severe downside risks, while being ready to achieve more ambitious fiscal savings should the economy surprise to the upside.
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