Last Friday, Ulrich Fritsche and I presented the results from our analysis of unit labour costs in EMU compared to regional unit labour cost developments at a workshop in Cambridge (see paper here). When we remarked that Portugal had lost roughly 17 percent competitiveness between the start of EMU and 2006, more than has been ever observed in any German Land or US state within any 8-year-period, one discussant remarked that Portugal has actually improved competitiveness in 2007 and is set to do so again in 2008. So, is Portugal actually turning the corner after years in the doldrum?
This question is of utmost importance, not only for Portugal, but also for the question of EMU governance as a whole. Portugal has changed from being one of the fast-growing and applauded economies in the 1990s to a sad example of a country trapped in EMU’s “rotating slump”, with low growth, a record current account deficit of roughly 10 percent of GDP and a clearly overvalued real exchange rate. Since 2002, Portuguese per-capita-GDP relative to EMU has fallen. Convergence achieved earlier has hence reversed.
As Ulrich’s and mine unit labour cost analysis was conducted in 2007, we only used data up to 2006. While I am losely following the EU commission’s forecast, I have to admit that for the Spring 2008 forecast, I did not look in detail at the Portuguese case.
So, later Friday night, I checked the latest forecast of the EU commission on Portugal. The result: Indeed, Portugal has improved its nominal unit labour cost position vis-à-vis the rest of the euro-area in 2007 and is set to improve its competitive position further in 2008 and 2009. While last fall, the EU commission still had predicted Portugal’s unit labour cost increases roughly in line with those in EMU as a whole, it now seems that Portugal is actually starting to correct its unbalanced. Without any doubt, this is good news for Portugal and for the sustainability of EMU. The doubling of the unemployment rate over the past years to 8 percent has finally led to a slow-down in wage increases.
So does this mean that Portugal will soon leave its position at the bottom of European growth tables? Unfortunately, no. According to the EU commission’s data and forecast, Portugal has improved its relative unit labour cost position by 1.1 percent in 2007, will improve its unit labour cost position by 0.7 percent in 2008 and a further 0.3 percent in 2009. From 2007 to 2009, Portugal will hence have improved its competitive position by 2.1 percent, which equals an annual improvement of 0.7 percent. Compared to what has happened in other adjustment candidates, such as Germany over the past decade, this is still quite slow: From 2002 to 2006 alone, Germany improved its competitive position by 1.5 percent per year.
If Portugal continues to improve its competitive position with the speed projected from 2007 to 2009, it will take about 22 years until it has reached the competitive position it used to have before the start of EMU. Of course, Portugal might have entered EMU at an undervalued exchange rate and some of the real appreciation might be due to the Balassa-Samuelson effect. In addition, being a small country means that effects might be earlier to come about than they did in Germany for which it took almost a decade of falling relative unit labour costs before exports picked up enough to provide the country with a decent upswing.
However, as far as we know from Germany, a prolonged period of stagnating real incomes (which a long wage restraint in Portugal would result in), changes consumers’ expectations and behaviour. To get out of this again, Portugal might actually correct the real exchange rate below the equilibrium level to get the economy growing again at a decent speed.
Moreover, with the government deficit still close to 3 percent of GDP the global downturn might again make new expenditure cuts in Portugal necessary, increasing the pain and further slowing economic growth.
Hence, the Portuguese might still have a long way to go before their income convergence sets in again and they might again climb up in the European growth leagues. While adjustment eventually now looks more likely than half a year ago, the time spans involved are still scary.
