III. ECONOMIC TRENDS AND OUTLOOK MAJOR TRENDS AND OUTLOOK After two years of progressively weakening growth, Portugal slipped into recession in 1993. The Bank of Portugal estimates that the economy contracted 1 percent last year. This estimate may be revised downward, as data on the external sector is incomplete due to a reporting problem caused by the entry into force of the EU Single Market. Most observers are cautiously optimistic that Portugal has begun a modest recovery in 1994. Estimates of real growth are between 0.5 And 1.5 percent. Growth is being led by exports which may expand by 3 to 5 percent in 1994. Inflationary pressures appear to be under control. Most observers expect a modest decline in inflation this year, and the average inflation in 1994 should be in the 5.5-6.0 percent range. The 1993 recession was Portugal's first since joining the economic union in 1986. It was also the first time, during this period, that Portugal's economy fared worse than the EU average. The recession was fundamentally explained by a fall in exports and reduced domestic spending. The 3.2 percent decline in exports reflected both a decline in Portuguese competitiveness and a recession in the EU, which is the destination of 75 percent of total exports. Domestic spending fell 0.5 percent in 1993 compared to a 4.3 percent growth in 1992. Reduced domestic spending was influenced by a stagnation in real wages and increased unemployment. At the end of 1993, official unemployment was 6.2 percent, up from 4.1 percent a year earlier. Reduced domestic spending was particularly evident in a 12 percent fall in automobile sales. Stagnant real wages, increased unemployment, and productivity gains led to a decrease in the annual inflation rate from 8.9 percent in 1992 to 6.5 Percent in 1993. The inflation rate in tradeable goods was 5 percent, compared to 9 percent in non-tradeables. The inflation differential between Portugal and the EU average was +3 points at the end of 1993. PRINCIPAL GROWTH SECTORS Industrial production fell a sharp 5.1 percent, the worst performance since the 1983 recession. Production in all industrial categories, except food, contracted. Hardest hit were the transportation materials and textile sectors which posted dips of 16.5 and 15 percent, respectively. The recession impacted negatively on the financial sector through slowing demand for credit and increases in non-performing loans. Short-term interest rates were reduced 4 points but remain high in real terms. The banks attempted to protect profit margins by increasing fees and commissions and developing the incipient consumer credit market. The agriculture sector was buffeted by increased intra-EU competition and extensive sectoral restructuring. Output is estimated to have declined 5 percent. OUTLOOK FOR U.S. AGRICULTURAL EXPORTS Since 1991, when the EU preferences were introduced, the U.S. corn exports dropped from $91 million in 1990 to $6 million in 1991 and to zero in 1992. Consequently, the U.S. agricultural exports to Portugal have been decreasing ever since: $330.0 million in 1990, $228.4 million in 1991, $238.3 million in 1992, and $215.5 million in 1993. With the re-opening of the corn market owing to the introduction of the corn quota of 500,000 MT to be acquired in the world market, the U.S. exports are already benefitting from it ($10 million dollars in the first three months of 1994, compared to zero imports in the same period of 1993). Therefore, it is clear that the drop in U.S. farm exports to Portugal, which had been rather steep in the last three years, could be reversed. The hormone issue together with EU tight sanitary regulations are the main constraints for U.S. red meat exports. Under the new rule of the GATT agreement, that only scientific-proven constraints will be accepted to ban any imports, the U.S. might be able to open this market to U.S. meat exporters. Other U.S. products with export value include tallow (a traditional U.S. export to Portugal), feed ingredients, seeds (with seed corn by far the most important among them), almonds, walnuts, poultry parts and gizzards. Soybean exports, the single commodity with the highest value among U.S. agricultural exports to Portugal, were increased, both in value and quantities, during 1993. Cotton, and hides and skins (including finished leather) are Portugal's main farm imports, and there is scope for expanding U.S. share of these market if U.S. exporters can be more aggressive and price competitive. The market for U.S. high-value products of the consumer/retail type is relatively small and difficult to expand, but there is scope for some growth, if U.S. exporters respond to requests for relatively small orders, often from firms new to importing but willing to fill a latent market demand. There are several constraints affecting U.S. exports to Portugal. In addition to EU subsidies, health and sanitary constraints, the U.S. exporters are mainly faced with price competition, transportation costs, and higher duties applicable for third countries. In addition, the U.S. exporters have not been aggressive in this market. GOVERNMENT ROLE IN THE ECONOMY While market forces are increasingly important and the government has embarked on an extensive privatization program, public expenditures still account for 52 percent of GDP, several points higher than the OECD average. Even this figure understates the predominant role of the government in the economy. With high domestic interest rates, government approval of modernization grants for industry is critical for many companies. Additionally, the private sector looks to the government to set minimum wage increases. The government also maintains a rent control system which allows an estimated 80 percent of housing units to be rented at below market value. The government parastatals also are predominant in the provision of basic services such as energy, telecommunications, port, and rail services. The general government deficit rose to 8.2 percent of GDP in 1993 compared to a deficit of 5.2 percent of GDP in 1992. The widening in the deficit, primarily on the revenue side, was due to both cyclical and structural factors. Expenditures declined in real terms as the government held the line on salaries and benefited from lower interest rates. The 1994 budget projects a reduction in the fiscal deficit to 7 percent of GDP due to a modest economic recovery, a continued fall in interest rates, and stepped up tax collection. However, government expenditures are up in real terms, thus raising the government's share of GDP from 50 to 53 percent. Since the inception of the privatization program 30 companies have been partially or fully privatized. The revenues from these operations have been used in large part to reduce public debt. In 1993, privatization operations yielded only 67 billion escudos ( USD 1 = 170 escudos, June '94), less than half of the 175 billion expected in the budget. This shortfall was due in part to the recession, and the fact that many of the best companies have already been privatized. The government hopes to reinvigorate the privatization program in 1994. Some 200 billion escudos are expected to be raised through the sale of a bank, cement companies, and an insurance company. Even larger privatizations are expected in 1995 with the announced partial privatization of energy and telecommunication holdings. BALANCE OF PAYMENT SITUATION The trade deficit narrowed in 1993 to approximately 8.0 Billion dollars compared to the 9.4 Billion deficit in 1992. Reduced import volumes and prices explain this result. The traditional surplus on services also narrowed, reflecting reduced emigrant remittances and increased interest payments. Overall, the current account moved from equilibrium in 1992 to a small surplus of about 0.7 percent of GDP. Capital outflows were very large (as high as 8 billion dollars), reflecting in large part local uncertainties about the escudo's stability. Net external borrowing jumped substantially, paced by the Portuguese government's return to the international capital markets. The government raised 2.5 billion dollars in the international market via three jumbo bond issues. Net foreign investment tumbled from 1.8 billion in 1992 to an estimated 1.2 billion dollars. Reserves fell 2.7 billion dollars and closed the year at 21.8 billion dollars. External debt at the end of 1993 stood at 30 billion dollars or 33 percent of GDP. Debt service represents 22 percent of exports. The monetary authorities' key focus was to maintain exchange rate stability. However, this goal was compromised by the desire to lower interest rates to stimulate domestic activity and the turbulence in the European Exchange Rate Mechanism (ERM). The escudo was devalued 6.5 percent against other ERM currencies in May, and effectively depreciated a total of 10 percent over the year. TRADE AND INVESTMENT BARRIERS Portugal is an open economy, in which exports and imports comprise 50 percent of GDP. This international trade to GDP ratio is double the current ratio for the American economy. With the entry into force of the Single EU market in January 1993, Portugal's trade regime has largely been harmonized with the EU regime. Temporary exceptions exist in areas in which Portugal has secured derogations. One such area is the public procurement regime where Portugal applies a more liberal non-discriminatory national legislation to non-EU bidders than the existing EU regime. Portuguese procurement procedures are transparent. In many sectors, there are few national competitors, thus American companies enjoy a favorable edge. Portuguese television legislation passed in 1990 contains language transposed from the EU's 1989 broadcast directive requiring a "majority proportion" of works to be of "Community or European" origin. Such broadcasting restrictions are intended to discriminate against imports of non-EU origin. Portugal requires authorization for the acquisition by non-Portuguese of more that 20 percent of capital shares of Portuguese companies. To date, no foreign company has been denied consent. Portugal also reserves the right to limit foreign equity participation in companies undergoing privatization. These limitations introduce uncertainty in the investment climate. LABOR FORCE The recession has increased the unemployment rate from 4.1% in 1992 to 6% in 1993. Unemployment is expected to increase to 7% in 1994 as companies restructure to meet increase competition. There are labor shortages especially for skilled technicians and managers. Labor shortages have driven up wage and benefit bills, particularly in non-traditional industries such as the financial sector. In recent years labor/management relations in the private sector have been generally good. U.S. companies report high worker productivity. The labor law is quite rigid, making the dismissal of workers not covered by limited term contracts difficult. Strikes in the private sector are rare, except in the mining sector. Public sector labor disruption is common, especially in the transport sector. MAJOR LOCAL & THIRD COUNTRY COMPETITORS The stiffest competition comes from EU countries, which dominate most market sectors. Major EU competitors are Spain, France, Germany, and the U.K. These four countries together account for 60 percent of Portuguese imports and 70 percent of foreign investment. The Spanish have been particularly aggressive in the financial sector. British and French competitors have been particularly aggressive in the retail and automotive sectors and in major projects. The French and Spanish are strong in the agricultural sector. Germans are strong in capital equipment such as telecommunications, medical equipment. MAJOR INFRASTRUCTURE PROJECTS UNDERWAY The government is investing large sums to bring Portugal's underdeveloped infrastructure up to EU standards. Most of these infrastructure projects are supported with EU structural funds. Between 1994-1999 Portugal will receive 20 billion dollars in structural funds. These funds are employed in most every sector of the economy. A large amount will be applied in highways, ports, subways, and rail lines. The ten top infrastructure projects underway with large EU funding include: Expo 98 (1.2 billion dollars) New Tagus river bridge (980 million dollars) Northern rail line modernization (700 million dollars) National gas pipeline (680 million dollars) Porto subway (500 million) Lisbon airport (800 million dollars) Lisbon subway (1.4 billion dollars) Low-cost housing (2 billion dollars) Alqueva dam (380 million dollars) Odelouca dam (99 million dollars) American equipment and services enjoy an excellent reputation and have numerous opportunities in the modernization of the Portuguese economy. Aggressive marketing of a carefully selected product line is a necessity.