Recent developments. Real GDP grew by an estimated 1.2 per cent in 1994, following a decline of equal magnitude in 1993. The main stimulus to growth came from exports of goods and services, driven by strong market growth. Gross fixed investment, responding to prospects of rising output and increased profitability, staged a modest recovery, thereby reversing the fall in final domestic demand. Rising cement sales point to a recovery of construction investment, which accounts for about one half of total gross investment. Restrained by continued job insecurity and falling real wages, consumer [TABULAR DATA OMITTED] demand was more hesitant in supporting the economic expansion. Car sales plunged in the second half of 1994. On the external side, a sharp decline in transfer receipts shifted the current account into deficit in 1994 to the extent of 1.3 per cent of GDP.
While employment picked up in the second half of 1994, job gains were too small to stop the rate of unemployment climbing to 7.1 per cent in the fourth quarter of 1994, almost 1 percentage point higher than a year earlier and 3 points above the previous unemployment low in the second quarter of 1992. The speed and size of this rise in joblessness have no precedent since the first oil price shock in the mid-1970s, although the flexibility of the Portuguese labour market has ensured that the unemployment level remains low by international standards. Increased labour market slack has had a strong disinflationary effect on nominal wage growth, which halved from 14 per cent in 1992 to 7 per cent in 1993 and eased further to around 5 per cent in 1994. Coupled with pro-cyclical gains in productivity, nominal wage moderation enabled consumer price inflation (excluding rents) to fall to 5.2 per cent in 1994, within the official target range of 4 to 5.5 per cent. At 4 per cent, the rate recorded over the 12 months to December 1994 was the lowest in 25 years. However, the increase in the standard value-added tax (VAT) rate in January 1995 pushed up 12-month consumer price inflation to 4.5 per cent in March.
Policies and other forces acting. Following a substantial deficit overrun in 1993, the 1994 fiscal outcome was significantly better than expected, the general borrowing requirement subsiding to an estimated 5.7 per cent of GDP from 7.1 per cent in 1993. Stronger tax revenues more than offset the effect from higher-than-expected interest rates and lower net transfer receipts from the European Community. In 1995, the official projection points only to a stabilisation of the general government borrowing requirement, at 5.8 per cent of GDP, despite continued spending restraint, cyclical revenue gains and higher yields from VAT. This target, however, is likely to be undershot. Indeed, the OECD Secretariat projects a gradual decline of the deficit from 5.4 per cent in 1995 to 5 per cent of GDP in 1996, as output growth gathers further speed.
Monetary policy continues to be geared towards achieving inflation convergence with the best performing countries in the European Union, the stability of the nominal exchange rate being the intermediate target. In March, speculative attacks on the Spanish peseta in the context of more generalised exchange market turbulence led to a realignment of central rates in the European Exchange Rate Mechanism (ERM), including a reduction in the central value of the escudo by 3.5 per cent. This was the escudo's third devaluation since it joined the ERM in April 1992, linked, in each case, to peseta realignments. While the nominal effective exchange rate appreciated somewhat in the wake of the latest devaluation, yields on 10-year government bonds exceeded the German equivalent by around 5 percentage points in early May. With underlying inflation easing and the budgetary position improving further, risk premia should narrow, but the process could be slow if the scheduled pace of budget consolidation is not increased.
Prospects. A continued strong expansion of export markets, along with the coming-on-stream of new export capacity may lift export growth in 1995 into double figures. Together with a related acceleration in gross fixed investment, export buoyancy is projected to push real GDP growth to around 3 per cent in 1995, rising to 3 1/4 per cent in 1996. Stronger fixed investment will reflect both improved profitability and projects financed by the European Community. Consumer demand may firm with the brightening of employment prospects, reinforcing the domestic stimulus to economic growth. The rate of unemployment is projected to fall to 6.3 per cent in 1996, which would still exceed the estimated natural rate of unemployment (NAIRU), albeit by a small margin. The consequent deceleration of nominal wages should allow consumer-price inflation to ease in 1995 to the upper half of the 1995 official target range of 3.5 to 4.5 per cent. On the external side, rising transfer payments may shift the current account back into surplus in 1995-96, outweighing a cyclically-induced deterioration of the trade account.
The main risks attached to the projections concern interest rates, the exchange rate and fiscal consolidation. The escudo like other currencies remains vulnerable to renewed international exchange market turmoil. Investors' attitudes have remained cautious following the latest escudo devaluation, but would probably be reassured by indications that any unexpected revenue buoyancy was being used to reduce the budget deficit.