Cablegate: Portugal's Economy Surpassing Expectations,

DE RUEHLI #0793/01 0911642
R 311642Z MAR 08




E.O. 12958: N/A

REF: A. 07 LISBON 1839

B. 07 LISBON 0049

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1. For the second year in a row, the Government of Portugal
has exceeded its own economic benchmarks, registering 1.9%
GDP growth in 2007 vs. the projected 1.8 % and lowering the
budget deficit below the eurozone 3.0% limit to 2.6%, a year
ahead of schedule. These positive results validate the
austerity measures PM Jose Socrates has taken since 2005 to
restructure the Portuguese economy, including reducing the
size of the government, revamping social security, and
consolidating various budgets. Socrates has announced that
he plans to loosen the economic belt in 2008, increasing some
ministries' budgets, raising public investment, and lowering
taxes. Despite cautious optimism for 2008, the government
acknowledges that many challenges and risks remain.
Unemployment stands at 8.0%, the highest in twenty years, as
job creation has not kept pace with restructuring. The weak
dollar and the sub-prime crisis will likely prove problematic
as exports, one of the main engines behind Portugal's
recovery, become more expensive and economic growth elsewhere
in Europe slows down.

Overview and 2008 Economic Strategy

2. Since taking office in 2005, PM Socrates has focused his
efforts on reversing the fortunes of the Portuguese economy.
The Socialist Party leader took many difficult austerity
measures to rein in the country's (then) exorbitant 6.1%
budget deficit and implemented tough structural reforms to
stimulate its stagnant economy which grew by only 0.3% that
year. In 2006, the government focus on increasing revenue
via taxes resulted in a decrease in the budget deficit to
3.9% vs. the projected 4.8%, and its efforts to overhaul
public administration and to improve the trade and investment
climate resulted in GDP growth of 1.4% vs. the projected
1.1%. In 2007, the government focus on reducing expenditures
resulted in a decrease in the budget deficit to 2.6% vs. the
projected 3.3%, and continued structural reforms resulted in
GDP growth of 1.9% vs. the projected 1.8%. The government
's 2008 goals include reducing the budget deficit to 2.4% by
increasing receipts by 0.3% and decreasing expenditures by
0.3%. (Note: The 2007 reduction of the budget deficit below
3.0% is a major accomplishment for the Socrates government.
Not only did Portugal reduce the deficit below the 3.0%
eurozone limit a year ahead of schedule as outlined in its
2005 Growth and Stability Pact, it registered the lowest
budget deficit since the creation of the modern Portuguese
republic in 1974. End Note.)

3. With more money in government coffers, Socrates has
announced that he plans to loosen the economic belt in 2008,
increasing public investment by 6%, raising primary current
expenditures by one-quarter percent, and transferring on
average 4.7% more money to local municipalities. (Note:
Transfers were frozen for the last two years. End Note.)
Some economists are calling for an even greater increase in
public investment and for an overall reduction in taxes, and
with the government announcing its intention to decrease
selective taxes, it is no longer an issue of if, but when.

Percent Change
2005 2006 2007 2008* 2009*

Deficit 6.1 3.9 2.6 2.4 1.8
GDP 0.3 1.4 1.9 2.2 2.8
Inflation 3.0 2.4 2.4 2.0

Source: Government of Portugal

Challenges for 2008
4. Despite Socrates's cautious optimism that moderate growth
will continue in 2008, many challenges and risks remain. If
the reforms are to be sustainable, it is important that the
government not ease unpopular measures, such as decreased
social benefits or increased welfare contributions, in
anticipation of 2009 legislative elections. It is also
important for the government to correct lingering imbalances
with a special focus on ongoing fiscal consolidation and
improvement of external financing requirements; and while the
deficit is down and growth is up, reform of public
administration is behind schedule.

LISBON 00000793 002.2 OF 003

5. The sub-prime crisis and weakening dollar have affected
European growth in general and Portuguese exports and
investment in particular. Unemployment also presents a
continuing concern for the Portuguese government, as job
creation has lagged. While acknowledging these worrisome
issues, Finance Minister Teixeira dos Santos has noted that
Portugal is better prepared today to face these uncertainties
than it was a few years ago. Such assurances have done
little to allay the public's pessimism, however. Economist
Antonio Mendonca, for instance, noted that, while Portugal is
better prepared, it is "still not well prepared." On the
positive side, the IMF reported in its October 11, 2007
report that the banking sector is sound and well-supervised.
(Note: Portugal has a tradition of seeing the glass half
empty rather than half full on many issues. Despite
improving economic indicators, a Eurostat survey found that
88% percent of Portuguese thought the economic situation was
bad and 91% thought the employment situation was bad.)

Export and Investment Growth

6. Exports and investment are the two external factors that
have had the greatest impact on the Portuguese economy in
recent years. Export growth has been the principal motor of
the economic recovery as companies have restructured,
becoming more productive and competitive. Furthermore,
businesses have begun to refocus their efforts on higher
value products. Fuel exports, in particular, have proven
very lucrative as Portugal has begun to tap the excess
capacity of its Sines refinery. However, the dollar's
devaluation will continue to hurt Portugal's export growth.
As the European economy begins to slow down, the demand for
Portuguese exports will likely fall, as over 70% of
Portuguese exports are EU-bound. Domestic demand, buoyed by
investment and consumption, will somewhat counterbalance the
decrease in export demand.

7. On the other side of the equation, the government already
has in the pipeline close to 1.5 billion euros in foreign and
national private investment. These investments, mostly in
automobiles and automobile parts, when finalized, will
account for nearly half of the government's 2008 private
investment goal. In addition, increased investment is being
reflected in the greater sales of cement and heavy vehicles.
Furthermore, most economists expect the government to
increase public investment by 6% in 2008 as part of its belt
loosening campaign and by even more in 2009 in the run-up to
that year's national elections. Major projects in the works
include a new airport and high-speed rail system.

Percent Change
2006 2007 2008* 2009*

Gross Capital 2.6 3.3 3.1

Exports 9.1 7.0 4.9 6.0

Imports 4.3 4.1 2.9 3.7

Source: Bank of Portugal


8. Unemployment will be the government's biggest challenge
in 2008 and will likely become an election issue should
conditions not improve prior to the 2009 elections. At 8.0%
in 2007, the rate of unemployment is the highest it has been
in 20 years. Exacerbating the situation, the government has
fallen behind its job creation goal. Although the government
expects job creation to accelerate in 2008, it does not
expect unemployment to decrease until 2009 as more
individuals lose their jobs due to economic restructuring.

9. The government's effort to reduce the size of the civil
service by 75,000 positions by 2009 from an all time high of
748,000 in 2005 further complicates the employment situation,
as it has only succeeded in eliminating close to 40,000 jobs
to date. The government has established vocational centers
to retrain employees who have lost their jobs as a result of
economic reforms. Many newly created jobs are in the mid-
and high-tech fields and provide greater financial
compensation than the national average. The average eurozone
unemployment rate was 7.1%.

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2005 2006 2007 2008* 2009* 2010*

Unemployment 7.5 7.6 8.0 8.0 7.6 6.9
Source: Portuguese National Statistics Institute

2008 Ministry Budget Highlights

10. In 2007, the government cut most ministries' budgets to
help reach its budget deficit reduction goal of 3%. Having
successfully done so a year ahead of schedule, the government
has increased the budget of several ministries central to its
national growth policy, including the Ministry of Economy,
which holds the energy portfolio, and the Ministry of
Environment. The Ministry of Economy's budget saw a 23.5%
increase to be dedicated mostly to supporting small and
medium-sized enterprises and the promotion of renewable
energy. The Ministry of Environment gained from a 13.7%
decrease in its Carbon Fund contribution, 127 million euros
in 2008 vs. 146.1 million in 2007. The increase in the
Ministry of Science and Technology and Higher Education's
budget is designed to create a solid science and
technological base and generate employment in that field,
promote research and development and register new patents,
and boost the number of doctorates granted. The huge
decrease in the Ministry of Public Works budget is due to the
newly designated status of "state-owned enterprise" given to
its roadway division. All costs and revenue generated from
roadworks will not be included in the budget. With regard to
Foreign Affairs, the government decreased that ministry's
budget by 7.1% following completion of its EU Presidency on
December 31, 2007. The Ministry of Defense budget, which
includes a 8.5% increase, focuses on restructuring and
modernizing the armed forces, with particular attention paid
to technical military cooperation and the implementation of a
national oceans strategy. The 8.5% increase is due, in part,
to the new requirement that expenditures be allocated to the
year in which the equipment is acquired, not the year(s) in
which payments are made.

Ministry Percent Change Over 2007 Budget

Internal Administration -0.7
Agriculture 4.9
Justice 7.9
Environment 12.7
Foreign Affairs -7.1
Finance 4.9
Economy 23.5
Public Works -53.6
Social Security 3.9
Health 0.9
Education 0.0
S&T and Higher Education 8.9
Culture 14.9
National Defense 8.5

11. Prime Minister Jose Socrates, Finance Minister Fernando
Teixeira dos Santos, and Bank of Portugal Governor Vitor
Constancio all predict continued moderate economic recovery
for 2008 and 2009 but acknowledge higher than usual
uncertainty. The European Commission, OECD and IMF believe
the government's forecasts are too optimistic, and while
Constancio may agree in some cases, he is quick to point out
that the government has yet to revise predictions made before
the acceleration of the global financial crisis.
Nevertheless, the government achievements paint a mixed
picture, with the country's 2007 GDP growth of 1.9%
registering the highest in the last six years but coming in
as one of the Eurozone's lowest. Much work remains to be
done before Portugal's economy converges with the European
average. Despite outward confidence and optimism, the
government is concerned that Portugal's per capita GDP stands
at 65.6% of the European average, having dropped to 19th
place within the EU-27, behind Estonia, in 2008. This
sobering reality check will likely keep the government's
efforts focused on the economy as the country heads for
legislative elections in 2009. The economy, after all, will
make or break the Socialist Party's chances at reelection.


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