After entering the European Union in 1986, the Portuguese economy has experienced one of the highest economic growth in its history. This historical landmark meant, initially, alongside with the underlying policies, increased credibility and improved perspectives on the Portuguese economy and a big widening of a soon-to-be free market for Portuguese potentially exporting firms. In a second stage, we should not forget the creation of the European Economic and Monetary Union, which was divided in three phases:
1. Starting from July 1990, there was the liberalization of capital movements between Member States.
2. Creation of the European Monetary Institute with the main aim of preparing the establishment of the European Central Bank.
3. Introduction of the single currency in the 1st of January, 1999.
The combination of national policies, the direct effects of EU entry and decisions at European level (such as the creation of a single market and a single currency) led to a rapid economic growth, fueled mainly by transfers from the European Union and the massive inflow of capital. The evolution of capital inflows is well described in the chart below where it is easily seen that Portugal experienced a huge capital inflow in this period: the net transactions with the Rest of the World increased from 0.186 milliard euros (1986) to 1.721233 milliard euros. (1992).
We propose a short analysis of this period under the TNT model framework. An increase in capital inflows such as the one Portugal has experienced probably means a higher level of absorption. With prices unchanged, the economy would produce the same amount of goods (since the price to producers remains the same) but consumers would want to consume more of both tradable and non-tradable goods. As the non-tradable goods cannot be imported, the excess demand for this type of goods will translate into a rise in their prices relatively to the price of tradable goods.
The increase in the relative price of non-tradable goods will lead to a second round of effects because entrepreneurs will perceive the opportunity to invest more in on-tradables and consumers will substitute more towards tradables. In the end, we should expect an equilibrium in which there is again an internal balance but the economy has a (higher) external deficit (the consumption exceeds the production of tradable goods).
Did this happen to the Portuguese economy? The figure below describes the evolution of employment in services (which is used as a proxy for non-tradable goods) and in manufacturing industry (tradable sector). As expected, the huge capital inflow and the consequent real exchange rate appreciation were accompanied by a reduction in employment in the tradables sector and by a rise in employment in the non-tradables sector. We can see that employment in services in 2012 represented about 65% of total employment while in 1986 this value was only about 44%. Moreover, in 1986, manufacturing accounted for about 30% of total employment, while in the last year the same value was around 15%. Thus, the empirical data is very consistent with the results predicted by the theory: the data may suggest that the huge capital inflow caused a move toward the non-tradable sector. Data on the real exchange rate (measured by AMECO as the real value of the domestic currency relative to the remaining former 15-EU countries; an increase in the index means an exchange rate appreciation) is also consistent: throughout the majority of the period, Portugal has been experiencing an exchange rate appreciation.
The last two or three years provide hence a fairly good explanation for what has been happening in Portugal: since 2009 and mainly from 2011 hence, there has been an attempt to devalue the Portuguese production (in real terms, of course) in order to pay for the immense external debt the country has been accumulating. We are now in the beginning of the repayment phase, during which employment is expected to be redirected towards tradable goods as this sector’s production gets relatively more expensive.
The TNT model also predicts what could happen to the economy should the repayment phase be not as smooth as what is depicted in a diagram: in case production fails to adjust to prices (due to lost learning economies during the illusory boom phase) or if prices (namely, that of non-tradables) resists falling, there will be unemployment in this sector as a consequence of excess supply of the goods.
Entering the EU and the EMU proved to be explosive to the Portuguese economy, which sat vulnerable to massive Push factors and to the binding European rules regarding the abolishment of any type of capital controls. The next big challenge is to stop the climbing markup of the main players in the non-trabable sector so that prices can reflect wages and the adjustment can proceed.
Filipe Silvério, 617
João Garcia, 618