Draft, 19 November 2001

How convergence turns into divergence:

Portugal's euro holdup

Jorge Braga de Macedo

OECD Development Centre, Paris

International income comparisons are at the heart of development studies because they provide a yardstick – no matter how imperfect – for the potential convergence of standards of living in the long run. For example, Angus Maddison (2001) provides annual estimates of population, gross domestic product and GDP per capita for 124 countries, 7 regions and the world from 1950 to 1998. According to the purchasing power standard used (1990 international dollars), world GDP per capita grew continuously during the period except for 1975, 1982 and 1991, when it dropped by 0.4% in each one of these years. In Europe (defined as EU+EFTA) the years of negative growth were 1975 (-1.0%), 1981 (-0.1%) and 1993 (-0.8%).

Portugal’s GDP per capita relative to the European average declined during the three world recessions, typically with a lag of one to two years. The average rate of decline was 4.5% in 1974/75, 3.3% in 1983/84 and 0.5% in 1993/94. Chart 1 shows two episodes of sustained convergence, from 1959 to 1973 (22 points of GDP in 13 years) and from 1984 to 1998 (14 points in 12 years). It also shows that Portugal exhibited a slower than average growth in standard of living during the 1950s and between the two convergence episodes. If a similar reversal were possible after qualifying for the single currency, this would truly be a "euro holdup".

No matter how impressive the convergence record since membership in the European Community (now EU) 15 years ago, it cannot be presumed to continue. Just like the previous one, it may be interrupted by domestic disturbances. Indeed, economic and political integration were not balanced from membership in the European Free Trade Association (EFTA) in 1960 until meeting the convergence criteria for the single currency became an explicit policy objective, shortly before the first EU Presidency in early 1992. The synchronicity brought to the fore the view of Portugal as a "good student" of European integration. While distancing itself from that view, the government elected in late 1995 made it a political imperative to join the eurosystem in 1998. Shortly thereafter, the imbalance between economic and political integration returned.

The reason for this imbalance varied, but, until 1989, the public sector was frozen by a constitutional ban on widespread privatisation. This reinforced some of the worst features of the fiscal constitution, namely a traditional preference for hidden taxation, including through inflation and a trend towards increasing public expenditures which has remained unchecked in spite of membership in the euro, as in evident in Chart 2.

Before 1974, when democratic institutions were restored, public expenditures were very low: Portugal was economically integrated with but, in spite of NATO membership, politically isolated from the North Atlantic area’s economic interdependence. In the absence of mutual political responsiveness, membership in the Organisation for European Economic Co-operation (now the OECD) in 1948 and the benefits of the Marshall plan were largely ignored in government and opposition circles alike. This may explain why the idea prevailing after the 1974 Revolution was that European integration would serve as an "insurance against dictatorship" rather than as a pressure towards greater reliance on market mechanisms and better governance.

Unfortunately, membership in the eurosystem also signalled the limits of external pressure, illustrated by contrasting the rise in primary expenditure with a vanishing long term interest rate differential (Chart 3). Charts 4 through 6 show the reversal in relative unit labour costs, nominal convergence and real convergence respectively.

The opaque fiscal constitution attempts to protect vested interests and therefore facilitates their resistance to increased integration with neighbouring Spain. This particular outcome of the simultaneous negotiations and membership of Portugal and Spain between 1977 and 1985 tends to exaggerate the importance of "geographic fundamentals". An example of these is provided by surveys in the early 1990s showing the sentiment indicator dropping twice as fast in Portugal when unemployment record was three times better than in Spain. Another example pertaining rather more directly to the fiscal constitution involved the current government jeopardising the "good student" reputation by threatening to veto a merger between a Spanish and a Portuguese bank before the 1999 general elections, only to consent after winning.

After this introduction, the paper contains three sections and a brief summing-up. Section 2 focuses on the fiscal constitution. Section 3 describes the the regime change which culminated in the entry of the escudo into the Exchange Rate Mechanism of the European Monetary System (ERM). Section 4 measures trends in nominal and real convergence and discusses the structural changes needed for Portugal to avoid suffering the "euro hold-up". The conclusion argues that flexible integration may help Portugal earn credibility in Euroland and resume another convergence process.

2.1. Groups and the state

The fiscal constitution describes relations between the state and the population involving both taxes and transfers. It includes the institutions enforcing the social contract and thus incorporates various exchange rate regimes, monetary standards and state revenues. Even though the state is supposed to promote the common good of the population, taxes are viewed as a common resource, whereas expenditures on goods, services and transfers benefit particular social groups. Each one of these groups therefore tries to earmark tax revenues to expenditures or transfers that it can benefit from. The fiscal constitution defines the earmarking process. Social groups are then like a kind of capital that is taxable by the state and can be redistributed through the budget to the benefit of particular social groups.

Very different tax and transfer mechanisms, including implicit or explicit earmarking procedures, are then associated with a certain level of net taxes, or primary budget deficit. In Portugal, the preference has been for hidden taxation, including the one achieved through inflation and excess borrowing by the state. This has discriminated against "informal capital"and also against labour. In other words, banking, monetary and exchange rate policies supported the discrimination against labor evident in the drop in real wages from 1977 to 1985 even though the labour market is not as flexible as real wage adjustment alone would suggest.a had deep historical roots.

As argued elsewhere (Macedo et al 2001a), domain revenues associated with the overseas trade monopolies and collected mostly in Lisbon were more significant than those associated with income taxes, levied since 1641. Centralised revenues were easier to administer and they helped maintain monetary stability in the face of recurrent military expenditures,. However, growing domain revenues gradually narrowed the domestic tax base and divorced taxpayers from transfer recipients and reinforced the discrimination between taxable capital on the one hand and informal capital and labour on the other. Both of these features came to characterise the fiscal constitution of the 1700s; unfortunately they remained even after the apparent economic prosperity of these times disappeared.

In the late 1700s, the combination of foreign and then civil wars, monetary instability and collapsing revenues stunted Portugal’s economic development. The 1820 liberal revolution was associated with the loss of social confidence and financial reputation, making the taxation of capital and the redistribution among social groups difficult. Civil rights were seen as inimical to monetary stability, so that political and financial freedom clashed until the gold standard brought nominal and real convergence with what is now the European average from 1854 until the 1891 financial crisis. Exit from gold standard initiated a period of maximum divergence, which lasted until the postwar European integration boom. Through exports and through migrant remittances, European growth was crucial for the national economic growth. The effects of rising economic interdependence on society, let alone on the polity, were not as simple. Even when expectations of improved standard of living were realised, the isolation of the political regime made the absence of mutual political responsiveness as conspicuous as the consumption of the middle class.

It turns out that neither the redistributive revolutions of 1910 and 1974 nor the ensuing political instability changed the fiscal constitution much. From 1960 until 1985, EFTA allowed Portugal to develop an export base in manufacturing (sometimes called a "pyjama republic"). But European integration did not balance mutual political responsiveness with economic interdependence. Public and private interest groups seeking transfers from the state and thereby holding on to the tax base took advantage of European structural funds. The whole process reinforced some of the interests vested in state intervention. Excessive regulation was pervasive, especially in a financial system dominated by "family" groups.

Where control of corporate behaviour through mergers or take-overs is restricted (and banks are more regulated), firms tend to be committed to their group’s commercial bank, which in turn adopts a more flexible approach and a longer-term view than would be possible in highly competitive and unregulated financial markets. A consequence of the fast economic growth and the excessive financial regulation of the 1960s was therefore that industrial groups needed more finance for their activities than the commercial banks were able to provide. Tight regulation of credit - with ceilings established on an individual bank basis - made it essential for an emerging industrial and financial group to avail itself of a commercial bank.

Most of the seven ‘family’ groups were indeed called by the name of their respective commercial bank. Because of the close links of these groups with the government, the competitive fringe of new conglomerates did not manage to bring about industrial and financial restructuring. Had this fringe been successful, thriving firms might have been able to shop around for more attractive sources of funding, but the financing of the export enclave of small manufacturing firms did not operate in this competitive way. Most firms outside groups were also deprived of the option of borrowing abroad and had to finance their long-term investment through own resources or revolving short-term loans. The oligopoly situation of the seven groups, together with the comfortable external position, explains why non-monetary financial intermediaries failed to develop.

Because of their diversified earnings, large industrial and financial groups, such as those identified with the ‘seven families’, do not require a financial market for investment. In the 1960s the managers of the commercial banks at the core of these conglomerates were nurtured in a type of financial intermediation where most of the operations were internal to the group. As the groups could do without a financial market, after the nationalisation of 1975 they probably took the same view of the nationalised sector as a whole. The closing down of the stock market, shortly after the revolution, reinforced this perception. At the same time, the abnormally high levels of gold and foreign exchange reserves changed the nature of financial intermediation. Urged by revolutionary politicians to put banks ‘at the service of the people’, the managers saw those reserves as collateral against which the nationalised enterprises were borrowing. But when there is imperfect monitoring of projects by banks, a rise in collateral makes borrowers more likely to default. To compensate for this decline in the expected return of a loan, the bank selects riskier borrowers and projects, which cause expected bank returns to fall. To avoid a fall in profitability, the bank will prefer to ration credit, even if there are no macroeconomic disturbances.

This "equilibrium credit rationing" is exacerbated when credit ceilings on private firms are binding. In an inflationary environment, where every borrower, especially the government, faces negative real interest rates, the constraint on private credit may be very strong. Financial repression made private firms more dependent on bank credit at a time when retained earnings were low and there was no substitute in the stock or bond markets. The heavy dependence of firms on bank credit made the financial system more fragile because banks did not expect some of the debts would be repaid. This reinforced the lack of incentives for creditors to monitor borrowers. It it thus no surprise that after the stock market was revived in 1987 it attracted mostly firms with insufficient retained earnings and with low collateral.

During the expansion of 1981-82, with high wage inflation and controlled prices, profits and retained earnings fell. When interest rates were raised in 1982, the adverse selection effect towards riskier borrowers (who are less reluctant to pay higher rates) was probably offset by a less binding constraint on credit ceilings. This allowed banks a better mix of borrowers and projects. But, in so far as deposit rates were administratively fixed, higher lending rates increased the intermediation margin and reduced the profitability of nationalised banks. Arrears and bad debts accumulated, peaking at 15% of credit to non-financial enterprises and individuals in 1986. At the time non-performing loans were three times as large as the equity of commercial banks. Bad debts fell to about 11% of credit in early 1989, but the figures would be much higher for the nationalised banks, which were also saddled with the need to provide for their staff’s pensions. Paradoxically, the role of nationalised banks in collecting hidden taxes through excessively wide intermediation margins may have helped stabilise the system. The hidden taxes were passed on through their forced purchases of public debt. In addition, since nationalised banks were acting as tax collectors, depositors were confident that the state would bail them out.

Ten years after the great nationalisations the government finally authorised new entrants, both domestic and foreign, into the banking sector, even though some of them were direct competitors of the nationalised commercial banks. The new banks avoided holding public debt instruments other than Treasury bills, which had just been introduced, and were reluctant to lend to the troubled state-owned enterprises. This meant that they were less exposed to bad debts. The contrast between ‘clean’ and ‘tainted’ banks might have prompted depositors to run on the riskier banks but, once privatisation was allowed, the state bought the bad debts of nationalised banks. To the extent that depositors believed that ultimately the state would bail out the nationalised banks, this was indeed the appropriate measure. The consequent increase in public debt was in part be offset by the proceeds from the privatisation of most of the state-owned enterprises that were nationalised in 1975.

2.2. Various forms of tax resistance

The spectacular growth of private commercial banks had a strong demonstration effect on banking competition, stronger than the mere increase in the number of players. Nevertheless, banks continued to serve as implicit tax collectors until financial liberalisation was achieved in 1992. The voluntary holding of public debt is restricted to Treasury bills; all other holdings of public debt count as seigniorage (revenue from the foreign counterpart of the monetary base accrues to the foreign state). This is an implicit tax with revenue close to 10% of GDP in the early 1980s which became negligible late in the decade. When the change in the monetary base is used, there is a much smaller decline in tax revenue from seigniorage. The difference is related to the strong external position in 1986-87.

Another implicit tax was imposed on borrowers and depositors in the banking system, which widened the normal intermediation margin (assumed to be 3%). To compute the tax rate, an average rate on deposits can be calculated from the figures for the stock of total deposits and the interest bill paid by banks. The loan rate for the 91- to 180-day maturity (which was administered until September 1988) is the representative rate for loans extended by commercial banks during the sample period. Credit ceilings implied that these loans were a relatively small share of banks' total assets. If the tax base is private credit, then the hypothetical implicit intermediation tax ‘revenue’ peaks at almost 10% of GDP in 1982, falling to close to 4% in 1987.

When compared with other experiences, namely those of the Nordic countries, Portugal’s financial liberalisation was remarkably problem-free. No banks went bust and there was no sudden surge in careless lending. This had little or nothing to do with the quality of banking supervision – Portugal’s central bank had no experience with supervising competitive banking activity as banks, whether private (pre-1974) or state-run (post-1974), had hitherto always been closely regulated, with nominal credit limits and effective barriers to entry. The major difference between Portugal’s liberalisation and that of the Scandinavian countries was that Portugal’s took effect in an economic downturn, when bank’s were in a cautious mood, concentrating on recovering outstanding debt rather than exploring new lending opportunities. By contrast, the Scandinavian countries liberalised their banking regulations in an economic boom and banks rapidly overstretched their limits of prudent lending. The lesson is that the authorities should not wait for a "favourable" economic climate to liberalise – if anything, it is better to do so in an economic downturn when decision-makers are more cautious.

The habit of implicit taxation is also visible in the resistance to a broader domestic tax base. The time it took to introduce personal income taxation is a striking example: the first attempts were made before the 1974 Revolution but the new taxes on individuals and corporations were not introduced until 1989. Since then, there have been several attempts at pursuing tax reform, especially in what pertains to administration, but they have all failed. In 2001, an attempt at taxing capital gains was reversed after a few months and led to the replacement of Pina Moura, the minister responsible for the measure. The effectiveness of the resistance of public and private interest groups to broadening the tax base or to tightening the link between taxpayers and transfer recipients has been so remarkable that the fiscal constitution could be described as "get out of my tax!"

The clear preference for credibility until the qualification for the euro in 1998 was accompanied by increases in primary expenditure. As for the attempted merger of the Economy and Finance Ministries after the 1999 elections, two agencies with profoundly different traditions in the budget process, only helped solve the reversal in EU policy associated with the veto of a cross border merger by Sousa Franco. The experience was short lived and Oliveira Martins, who is also responsible for parliamentary affairs, was sworn in as Finance Minister after the approval of emergency measures for expenditure reduction in Spring 2001. This allowed the promised tax reform to be postponed while expenditure control is harder to apply in a deteriorating external environment because the pressure of increased transfers coming from redistribution objectives interacts with the falling tax revenue.

The fiscal constitution exacerbates the deficit bias and threatens the role of Minister of Finance in dampening the "common pool" problem, at least in a democratic government. Under democracy, the strategic dominance of the Minister of Finance is associated with strong majority governments between 1985 and 1995, in spite of the oscillations between the need to earn credibility abroad and sell stability at home. In the minority governments after 1995, removing the responsibility for public administration to the office of the Prime Minister weakened this strategic dominance. Without strategic dominance, the deficit bias has not been resisted and the semi-presidential regime has become more unstable than with the reform-minded governments of 1987/95, even though the President of the Republic and the Prime Minister belong to the same party.

The resistance to the cross border merger with a Spanish bank announced in Summer 1999 is also a reflection of interests vested in the fiscal constitution, exacerbated in this case by the traditional fear of Spanish domination. Thus, bringing about free trade with Spain was the (almost unintended!) effect of EU membership. Because of the geographical proximity, Spanish imports and investment were resisted, especially in agriculture and banking. The attempted cross border merger led the Prime Minister to say on television "we are not a banana republic!" and block the deal, only to accept it after the elections a few months later.

To pursue a defensive strategy with respect to one partner and remain co-operative with respect to others is equivalent to preferring implicit taxation. It is also consistent with the ambiguous responses to external liberalisation which prevailed before meeting the convergence criteria for the single currency became an explicit policy objective.

The ability of the banking system in protecting their role as implicit tax collectors also reflects a fiscal constitution where primary expenditure only stop growing under threat of balance of payments crisis. This is what happened in planned economies where both a multiannual fiscal adjustment strategy (MAFAS) and a pre-pegging exchange rate regime (PPERR) were required to bring about structural reforms. As described in Branson et al (2001) and in Branson (2001), the PPERR avoids the "inconsistent trio" of fixed exchange rate, free capital movements, and independent monetary policy by freeing monetary policy to be targeted on external balance, represented by a suitable reserve position. The MAFAS then sets fiscal policy to maintain internal balance, as represented by a low rate of inflation.

Chart 2 shows the trend in primary expenditure of general government (narrower than the entire public sector), incorporating the IMF forecasts from late 2000. The increase in public spending has been predominantly in larger transfer payments and in bloating even further the civil service. In a relatively short period, Portugal has reached Nordic levels of public spending, while retaining Third World quality of public services. In addition to explaining how divergence followed convergence, this state of affairs hurts corporate governance and the fight against corruption.

The gradual change in Portugal’s economic regime towards price stability and currency convertibility featured several exchange rate regimes before ERM membership. Not all helped the regime change, and one almost reversed it (as shown in Chart 3). After membership, though, the system became unstable and the last realignment took place more than three years after the 1992 EU Treaty introduced economic priorities based on low inflation, sound public finance and a medium-term stability framework.

The case of Portugal is one where the regime change was gradual because of the need to combine selling political stability at home and earning credibility abroad. After qualifying for the euro, given that it no longer provided policy credibility to the government, this pattern was replaced by the threat of the euro holdup.

3.1. The hard escudo 1989-91

In September 1989, the escudo entered the ECU basket at a rate of 172. With hindsight, this marks the beginning of the change in the economic regime, which eventually would move the escudo into the euro. Two kinds of measures define the change. Some, like a constitutional amendment reversing the 1976 freeze on privatisation, were public but their relation to financial liberalisation was not immediate. Other measures, like the MAFAS presented to the Commission services, were relevant but not public.

In spite of these reforms, neither the government nor social partners saw ERM membership as imminent. The cabinet was reshuffled shortly after the 1989 local elections, further delaying public awareness of the ongoing regime change. Due to the inheritance of inflation and exchange controls, the central bank determined macroeconomic policy almost completely until after the 1991 general elections.

The reason is that the crawling peg policy introduced in 1977 upon advise from the IMF was replaced sometime in the spring of 1990 by a shadowing of the DM, known - but not officially acknowledged - as "hard escudo" policy. Since the change was not announced publicly, it couldn’t be interpreted as a PPERR that would complement the MAFAS. But a very low level of unemployment coupled with a strong upward pressure on public sector wages led to strong inflationary pressures and to the appreciation of the real exchange rate. Moreover, the fear that financial freedom would threaten monetary control and the soundness of the banking system was ingrained at the central bank that administered the exchange controls. These controls were reinforced before the 1991 general election with explicit reference to the threat to monetary and exchange rate policy that was posed by excessive capital inflows. The tightening of controls was supposed to help prevent inflation from accelerating while the associated increase in the cost of servicing the public debt was looked at with benign neglect.

The central bank’s foreign reserves more than doubled from 1989 to 1991, with disastrous consequences for the bank’s operating results. This opaque arrangement managed by the central bank also allowed banks to delay adjusting to a single market in financial services. In short, while and shadowing the DMark, so as to fight inflation, the bank was accumulating huge dollar deposits earning 5 %, while paying 20 % on the escudo debt being issued to mop up the resultant "excess" liquidity. The first stage of EMU was signalled by a speculative attack in favour of the escudo and the punt. The volatility of Nordic currencies in late 1991 also suggested that controls on capital movements could help stabilise the currency. These episodes notwithstanding, the first two years of stage one were rather tranquil.

3.2. The ERM code of conduct and domestic controversies 1992-95

The National Adjustment Framework for the Transition to Economic and Monetary Union (QUANTUM) was proposed in July 1990, but it was not until after the 1991 elections that a convergence program combining MAFAS and PPERR with capital account liberalisation was submitted to the Ecofin and discussed in parliament. In spite of this program (called Q2 to stress the continuity of the gradual regime change), the decision to request entry of the escudo in the ERM was a genuine surprise. On 4 April, 1992 - the weekend following the approval in parliament of the 1992 budget - the Community responded to the government’s application to join the ERM at a rate of 180 escudos agreed upon at a special cabinet meeting on Friday afternoon. Even though there was a precedent with sterling, the prior declaration of a parity generated great resistance among several members of the Economic and Financial Committee (whose members were acting as personal representatives of the then twelve minister/governor pairs who meet with the Commission in the so-called informal Ecofin). Under the alleged fear that, on the eve of the British general election, the announced parity of 180 might induce a speculative attack against sterling, a parity closer to the market rate was sought. Finally, the notional central rate of 178,735 - that is the one prevailing since the entry of sterling in October 1990 - gathered consensus.

After the cabinet meeting, the social partners were briefed on the structural policies included in the Q2 and in the budget, especially the role of the public sector in providing leadership in wage moderation. The following week ERM entry was debated in parliament. In spite of these efforts, the rule-based exchange rate regime which culminated the gradual change in economic regime and the code of conduct it supported were neglected at home. But, with the benefit of hindsight, the lengthy discussion in Brussels showed the precarious position of the ERM grid, which was going to imply the departure of the lira and of sterling a few months later. It also suggests that the escudo would have been unable to join the ERM in time to meet the EMU criterion of two years’ membership. Rather than accompanying the peseta inside the parity grid, it would have trailed with the Greek drachma outside.

Putting the counterfactual in another way, after the realignment of the peseta in March 1995, the escudo would not have kept the central rate around 196 without the benefit of the ERM code of conduct. The episodes of domestic controversy, amplified by the ERM crises, also look minor compared to recent European policy disputes, especially as the fears of a severe economic downturn interact with the greater insecurity brought about by the September 11 attacks on the United States.

The episodes also provide early tests for the credibility of Portugal’s policy. The restoration of full convertibility by the central bank on 16 December 1992 turned out to be extremely difficult to bring about, as the board reluctantly agreed to have controls renewed for shorter and shorter periods. The elimination was not announced until 13 August 1992, under the threat that legislative action would be taken to withdraw the central banks’ power to administer exchange controls.

The central bank’s board enjoyed the virtual rule on policy-making in 1990-91, including the derogation to the 4^th Brussels directive negotiated by Greece and Portugal until 1995. This made it even more difficult for the central bank to accept that the derogation to the 4^th Brussels directive should expire in 1993 or 1994 (which is when Greece finished its own liberalisation in a remarkable response to an ongoing attack on the drachma). The restoration of full currency convertibility was seen as too risky, especially because it would lower the central bank’s control on monetary policy. To lessen these fears, procedures to establish a dialog between the treasury and the bank were introduced.

The central bank was, it is true, publicly urged to adjust to the time of full currency convertibility and to pay attention to the accumulating evidence that the recession was hitting the domestic economy. Nevertheless, two implications of convertibility that had been raised in the sessions with the bank’s board were not made explicit in this plea. First, allowing for greater banking competition. Given the soundness of the banking system (at least in relation to what was happening in Scandinavia), this implied a tighter supervision than the regulators could muster. Second, lowering money market rates even if it meant letting the escudo slide towards the middle of the 6% ERM band rather than being glued to the top. Better banking supervision, namely in enforcing greater transparency in effective rates being charged on credits, would lead to a decline in the cost of credit without the need to change the stance of monetary policy. Flexibility within the top of the band would reflect the benefit of the ERM code of conduct relative to opaque DMark shadowing. Some days later, Reuters aired rumours that the governor of the central bank was to resign (in the footsteps of a vice-governor who had been an outspoken advocate of the hard inconvertible escudo policy). While the rumours did not materialise, the adjustment to convertibility was depicted as a crisis rather than as a natural adaptation to greater financial reputation.

The socialist opposition, which was openly questioning the stability-oriented policy contained in Q2 and calling instead for a slower disinflation and an autonomous depreciation of the currency, pretended to see the independence of the central bank threatened by an "authoritarian" government. To the social-democratic business elite, still under the shock of ERM entry, the pressure on the monetary authority suggested a reversal in the orientation of macroeconomic policy. Domestic controversy contributed to slow down the learning process for firms and citizens about the benefits to be derived from financial reputation. As ERM partners believed the code of conduct would be upheld the domestic controversy had no noticeable international impact.

The hypothesis about the acquisition of financial reputation during ERM turbulence can be confirmed by weekly measures of exchange rate volatility, using a technique of analysing changes in the variance of the exchange rate which was first applied to the US stock market. Macedo et al (1999) report probabilities of the volatility of the weekly exchange rate between the D-Mark and the Portuguese escudo comparing specifications with two, three, four and five volatility states and argue that the best specification has five volatility states. The sample period goes from January 7, 1987 until October 15, 1998 (614 observations). In Tables 1 and 2, the results from the best specification were updated until December 30, 1998 following Macedo (2001). In the last weeks before the creation of the euro, a rise from the "very low" to the "low" volatility state is observed. Yet during the period preceding the widening of the bands in August of 1993 the results remain essentially the same. When the difference between the original results in MNC and the ones in Tables 1 and 2 is greater than or equal to 5%, this is reported after the date.

The episodes of domestic controversy mentioned above happened during the period reported in tables 1 and 2, beginning with the last accession to the ERM before the crisis and including some of the realignments involving the peseta and the escudo. In Table 1, the shift from "high" to "very high" volatility shows the incidence of a currency crisis. The few instances of "very low" volatility in the sample show instead massive intervention by the central bank shortly before the November 1992 realignment. In Table 2, there is no instance of this "artificial stability", suggesting that the code of conduct had meanwhile been learned by the central bank. Given that the financial reputation of the country was not fully established as the regime change was quite recent, this serves as an illustration of the power of the ERM code of conduct as a convergence instrument. A related reason is that testing the ERM parity made sense when the real appreciation was perceived as excessive by export-oriented firms and the government may have been sensitive to their pressure.

In the turbulence that followed ERM entry, the lack of credit familiarity with Portugal also had to be overcome. Yet, the central bank, along with favouring capital controls, discouraged international borrowing, which it still associated to situations of looming payments crises rather than to the promotion of the nation’s credit abroad. Exceptionally high foreign exchange reserves where another inheritance from the past, and therefore were not used to boost the Treasury’s credit rating: Portugal’s external debt issues had been assigned a rating of A1 by Moody’s Investors Services in late 1986 and A by Standard and Poor’s two years later. The divergence between the two agencies remained until late 1991, when Standard and Poor’s upgraded to A+.

As soon as the currency was fully convertible, therefore, a strategy of making the treasury known in international markets was designed, involved a planned return to international borrowing, successively in yen, marks and dollars. Standard and Poor’s decided the upgrading of Portugal’s foreign debt to AA- in May 1993, even though the previous upgrade had been decided less than 18 months earlier. International investors were ready to believe then that economic policy in Portugal would retain a medium term orientation also because this was the first such move since Ireland had been upgraded in 1989. Nevertheless, the strategy was ignored domestically. Shortly after the global dollar issue of September 1993, the deterioration in the deficit, whilst keeping non-interest expenditure at the nominal amount included in Q2, increased the deficit and had a much greater impact domestically than the credibility earned abroad.

The ERM crises were felt by the lira and sterling, which left the grid on 17 September, 1992 when the peseta also realigned but the escudo did not. The opinion at the central bank was to deny the "geographic fundamentals" and to stick to DMark shadowing, while recognising that exchange rate policy was a competence of the government. Exporters, on the other hand, were impressed by the bilateral rate with the peseta and had been pressing for a devaluation of the escudo relative to the peseta. As it turned out, the realignment of 23 November was matched and those on 14 May, 1993 and 6 March, 1995 were followed in part, without ever facing the loss in financial reputation associated with initiating a realignment. Quarterly data on capital flows are reported in EC (1997), confirming that external credibility was achieved in late 1992 and that it remained unperturbed by subsequent peseta realignments. As there was no memory of speculative attacks against the escudo, the domestic turbulence of March 1993 may just reflect the tension between treasury and central bank, or echo fears about the liberalisation of capital movements on the part of the banking community. On the other side, the more flexible policy of following the realignments of peseta would probably not have been possible to enforce as smoothly without the required change in the bank’s operating procedures.

The MAFAS retained in the Revised Convergence Program (PCR) approved with the 1994 budget kept the nominal ceiling on non-interest expenditures from Q2 but adjusted the deficit for the revenue shortfall. This was well accepted by international investors who heavily oversubscribed a global bond issue of one billion dollars in September and by the monetary committee who approved the PCR in November. A cabinet reshuffle was announced shortly before the December local elections, but economic policy remained consistent with the PCR. In early 1994, a global bond issue in ECU was received with the same success as the previous one. Yet the government’s call for lower interest rates, while directed at a domestic business audience, had foreign repercussions, especially when they were thought to have the approval of the prime minister. In this context, an Austrian news agency reported rumours of a military coup in Portugal. While entirely groundless, the story was picked up by Bloomberg and led to a renewed attack on the escudo. Differences on banking supervision led to the replacement of most of the central bank board in June 1994. This drastic move was well accepted, for - just like the previous year - it was understood that the tension did not originate in monetary policy.

3.3. Continuity and reversals in the run-up to EMU

The reason why the convergence process was not hurt by the decision to widen the band was that external credibility, while necessary for medium term policy credibility of any nation-state, is never sufficient. This was again apparent in the turbulence in early March 1995, which led Spain to ask for a new realignment in spite of fairly sound fundamentals. The lack of political stability was undermining the confidence in the currency. As it turns out, after this realignment, Italy joined the ERM in late 1996 and Greece followed in early 1998, consolidating their own regime changes. At one time or another, therefore, all of the EU member states followed the ERM code of conduct. Austria joined with accession in 1995 and Finland in October 1996. Sweden shadowed the ERM before the 1991 banking crisis.

The single market for financial services, established by the Banking Law (Decree Law º 298/92 of 31 December), also built on the operation of the ERM code of conduct. By calling for greater supervision and competition, it also forced the central bank to adjust. In effect, the gradual acceptance of stability oriented policies is at the heart of such code of conduct. This is why it remained valid after the widening of the bands, even though the obligation of compulsory intervention for unlimited amounts at the agreed bilateral limits was unlikely to be applied. The need to reach a consensus for modifying a central rate remained, as the parity grid was not changed by the decision to widen the fluctuation bands. It is also noteworthy that the economic priorities of the EU Treaty remained undisputed among member states and Community institutions, stressing the need for convergence to establish and maintain stable exchanges rates.

Another reflection of the continuity of the MAFAS is that the PCR proposed in 1993 extended the expenditure ceilings into 1997. The PCR remained the basis for the excessive deficit procedures until a Convergence, Stability and Growth Program from 1998 to 2000 was approved by the Ecofin in May 1997. It was followed by a Stability and Growth Program for 1999-2001 shortly after the escudo joined the euro at a rate of 200,482. The MAFAS continued listing structural reforms, especially in the public administration but unfortunately dropped the nominal ceiling on non-interest expenditures that was essential in the face of a vanishing long term interest differential ( Chart 3). The role of the public sector in providing leadership in wage moderation was also abandoned, and the effects on relative unit labour costs are apparent in Chart 4

The rise in primary expenditures reflects the inability to reform the public sector. Between 1991 and 2000, all other countries in the EU significantly lowered their ratio of public spending to GDP – by 4 percentage points on average in the EU, by 13 percentage points in the case of Ireland. During the same period, Portugal increased the weight of its public sector in the economy by no less than 7 percentage points, to over 50% of GDP in 2001.

The Stability and Growth Pact, approved by the Ecofin Council to ensure that the entry conditions for EMU would continue to be met after the euro was created has evident limits. Nevertheless, continued external pressure did help further changes to be introduced to the statutes of the central bank to make it more independent from the government, to introduce some accountability in parliament and to improve regulation and supervision procedures.

Portugal achieved a remarkable degree of convergence, both nominal and real, in the decade following accession to the European Community. As can be seen from charts 5 and 6, inflation was reduced from double digits in the 1980’s to 2% in 1997 and GDP growth was consistently higher than the European average through 1998 (with the exception of the 1993 and 1994, during the global recession). The pattern of disinflation is even more dramatic in terms of the harmonised consumer price index used for assessing inflation in the eurosystem. Data for 1997, the year used in the report on which countries would qualify for the euro, inflation in Portugal was actually below the EU average. The differential quickly turned positive, though, and rose to about 2%, which was the value achieved in 1994/95. It fell in 2000 and is expected to drop again in 2002, like the GDP deflator used in Chart 5.

Portugal’s experience with convergence shows the critical importance of monetary and exchange policies in taming inflation, and that it is possible to reduce inflation and achieve high economic growth simultaneously (strong nominal and real convergence were attained concurrently through 1992). It also shows, however, that nominal convergence does not guarantee real convergence. In fact, the reticent liberalisation of exchange controls by the central bank maintained interest rates too high during the 1991/92 global recession. This made Portugal’s recession in 1993 much more severe than it need have been, with resultant real divergence in 1993 and 1994.

Portugal’s experience also points to the possibility of simultaneously having both nominal and real divergence. Since 1997, inflation in Portugal has exceeded the EU average every year, while real convergence has been slowing down each year since 1998, actually turning negative in 2000 and with both real and nominal divergence expected to increase in 2001 and 2002. One of the major gains of nominal convergence and financial liberalisation, the significant decline in real interest rates, generated a windfall gain equivalent to a fiscal balance improvement of some five percentage points of GDP per annum since 1998. This permitted Portugal to be the only Euro-zone country to meet the EMU criteria without enacting any major curtailment of fiscal spending. Instead of using the interest-windfall to finance the transition costs of needed structural reforms, the government used that margin to fund popular measures like a price freeze on gasoline prices, increased transfer payments and large increases in the number of civil servants.

Abundant lip service has been paid by policymakers to desiderata such as increased competitiveness and innovation while, at the same time, the political expedients needed to ensure political survival led to the enacting of policies that did just the opposite. The procrastination relative to unpopular reforms was so pronounced in Portugal that it led to a stagnating economy and higher inflation. By not taking care of the needed structural reforms when they had the opportunity, the Portuguese authorities laid the ground for simultaneously having both nominal and real divergence from 1999 into the foreseeable future.

Put in another way, the credibility of Portugal’s MAFAS/PPERR must be fed by additional measures of a microeconomic and structural nature, designed to enhance the competitiveness of production and therefore sustain the catching-up process. As emphasised by Baleiras and Macedo (2001), structural measures need to be taken at all levels of government, so that cities and regions also benefit from the newly acquired financial reputation of the sovereign. This is another example of the benefits flexible integration schemes bring in terms of appropriate policies.

Among cohesion countries Portugal gained most from single market according to EC simulations (.7% p.a. growth gain from 1995 to 2010). The economy is still more open on the trade than on the capital account, but this changed fast due to both large FDI into Brazil in the late 1990s and large outflows after entering the eurosystem. It is unclear that government policy mattered, as the instruments were available since 1992.

The opportunity for structural change afforded by euro was lost and with it the improvements in fiscal discipline and structural reforms. The macro situation became unsustainable shortly after qualifying for the euro, with a current account deficit reaching 10% of GDP. Private credit also rose to 140% of GDP, with limited effects on capital accumulation. Worse yet, structural reforms went into reverse gear, with a punitive tax reform and indulgent public sector wage negotiations.

Belonging to the eurosystem only prevents a currency and a public debt crisis. Instead, bank credit remains largely domestic and the current boom could be suddenly reversed. If that happened, there may not be a spectacular crisis but the current belated attempt at limiting public expenditure growth is likely to have to be pursued over the long haul. Just when the international environment would require more security, Portugal may find itself exposed to a lasting divergence with the EU and with Spain.

Once again, the credibility of the MAFAS was lost because public sector reform has been delayed until now. This lingering internal imbalance and the failure to carry out public sector reform makes for an unfavourable business environment, which has led to a recent acceleration of outward direct investment. The absence of reforms has included the rejection of a regionalisation proposal in 1998, which would surely have led to greater bureaucracy. Indeed, since the drive towards business internationalisation is not accompanied by reform in tax administration, justice and decentralisation towards municipalities, let alone social security and public health, it has eroded the legitimacy of integration through the "euro hold-up".

Policy credibility turns out to be more important than proximity to EU markets in attracting "right" FDI. As shown by Wei (2000), corruption discourages FDI and favours bank loans, another piece of evidence showing that globalisation improves governance (Bonaglia et al 2001). Relative unit labour costs deteriorated after the last ERM realignment, from a rate of about 1% p.a. in 1996/97 to a rate of over 2.5% in 1998/2001. To compare, the rate of deterioration in 1993/95, at the time of ERM turbulence, was about 2% p.a. The trend, illustrated in Chart 4, was so dramatic that there was a warning from the central bank in early 2001. Deteriorating competitiveness helped win 1999 election, but at the cost of long term policy credibility and social disruptions.

As it was argued in this paper that some of the features of the fiscal constitution may be over one hundred years old, it is worth summarising why the change can no longer be postponed. The narrow domestic tax base and the divorce between taxpayers and transfer recipients were first coupled with a convertible currency. Before the advent of political freedom though financial stability was lost and it took 50 years of political strife to recover it. Paradoxically, tax reforms associated with the 1820 liberal revolution had a less fundamental effect on the fiscal constitution than the demise of the currency and the default on the public debt in 1797. The myth that democratic governance is inimical to financial stability, born in the early 1800s, was reinforced by one hundred years of currency solitude between 1891 and 1992. The perceived novelty of financial freedom for Portuguese residents is not a feature of monetary history but rather a reflection of monetary myths.

The negative effects of the euro hold up are all the more lamentable since, together with the Schengen agreement, the ERM is an example of flexible integration. Given the complexity of the EU institutional architecture, successful flexible integration schemes such as the euro have a "snowballing" effects which applies both to the other three current EU members and to prospective ones. With respect to the latter, convergence requires that the ten applicants define their exchange rate and their fiscal policies according to the same code of conduct. This has been argued with respect to the exchange rate regime (Macedo 2001, Macedo et al 2001b). More generally with respect to flexible integration in the Nice Treaty, see Baldwin et al 2001.

The benefits of a stable and common currency do not materialise when fiscal policies are unsustainable. Moreover, deficient tax administration undermines the social legitimacy of taxes as means to provide for the "common good". By itself, the euro cannot change the fiscal constitution of Portugal, or of any of the other Euroland countries. Hence reforms will continue to stall, making Portugal a victim of the "euro hold up". There is no substitute for domestic reform and in Portugal the first priority is to change the fiscal constitution which has proved resilient to the political, social and economic changes brought about by 15 years of European integration.

References

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