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Analyzing paper on Portugal’s Competitiveness

November 2004 - McKinsey Quarterly

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The paper argues that Portugal’s main problem - low productivity - is mostly a non-
structural problem that could be solved by removing the barriers to productivity growth.
Let us walk through their though process.

To frame the problem let us give a timeline of Portuguese GDP growth. Since the 30’s
Portugal dived into a fascist-inspired dictatorship that lasted until 1974. In the 70’s
Portugal was a backward economy with great potential for catching-up that would be
triggered by the accession to the European Union (EU). In 1986 Portugal joined the EU.
Its low wages allowed the country to become a low-cost manufacturing pole for Europe.
The access to a large free-trade area allowed Portugal to growth through exports. The
considerable structural funds it received from the EU and the privatization of key
industry contribute to explain the rapid growth the country experienced in the late 80’s.
GDP per capita growth rates were above the EU average until the 90’s at around 6%1.
The 90’s were characterized by macroeconomic stabilization and Portugal’s average GDP
growth rate was 3% (against an EU average of 1.7%). From 2000 to 2004, this rate
decreased to an average of 1.2%, while the EU average decreased to 1.5%.

Let us now quantify the problem. Labour productivity is only 52%2 of the average of the
levels in Germany, France, Italy, the Netherlands and Belgium. The average GDP per
capita remains at 70% of the top 5 EU countries.

What are the causes of low productivity? What are the barriers to productivity growth?

1) Structural Causes
The structural factors only account for one-third of productivity gap. The combination of
low income per capita and a small total population (10 million) is an obstacle for firms to
reach optimal size and per costumer profit margin3. The analytical framework adopted by
McKinsey to study the revenues by costumer might suggest a ‘trap situation’ of multiple

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All GDP figures taken from OECD (approximate figures)
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According to TheMcKinseyQuarterly calculations for year 2004
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In most service industries the per costumer costs are fixed. If each individual Portuguese costumer spends
less than EU costumers, than the per costumer profit margins are bound to be lower in Portugal.

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equilibria. If low per capita income (partly) explains why Portuguese firms are not
competitive/profitable and this drives down the per capita income, than this is a trap
scenario with a sub-optimal steady state (Portugal since 2000) and an optimal steady state
(richest European countries).

2) Non-Structural Causes
It is probably more fruitful to focus on the other two thirds of the productivity problem
(non-structural), where policy changes can affect the outcome. The findings point to three
main non-structural barriers to productivity growth: distorted competition, deficiencies in
the public sector and rigid labor markets.

A - Distorted competition
Some industries (like construction and food-retailing) are still protected from
international competition which slows down productivity growth, but the main obstacle
to competition is the informal economy. The gray economy counts for 23%4 of Portugal’s
economy. The example of the construction industry shows how the evasion of labour
taxes creates a vicious circle, by cheapening the cost of labour relative to the cost of
capital. The consequence of this is that it becomes less appealing to invest in
productivity-enhancing machinery since it would shift the cost structure of this business
into one that entails more taxes. Another consequence of tax evasion is that it gives a 3%
profit margin advantage over the larger, more efficient and law-abiding companies. In
difficult times, these small informal companies will outlive their larger and more efficient
competitors who pay their taxes. Since these companies can only avoid the ‘tax radar’ by
remaining low, the result is a very fragmented and inefficient construction industry.
Another major cause of distorted competition is the red tape that increases the cost of
doing business and gives an unfair advantage to local, less efficient companies, especially
in tourism and construction. With a complex and opaque regulation system, the local
players that have strong connections can cut through the red tape, crowding out more
efficient national players. The second major non-structural barriers to productivity
growth are public-sector deficiencies.

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According to the International Monetary Fund

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B - Public-Sector Deficiencies
The high wages received by employees in the public sector is the main problem. The
premium over the private sector wages is 51% in Portugal, whereas in Germany the
premium is only 7%. This high cost increases the tax burden, which means that the
Government transfers these costs to the companies working in Portugal. This is a major
deterrent for FDI. Privatization would partly solve this problem. Finally, another major
problem that is often cited is labour rigidity.

C - Rigid labour markets


Indeed, most companies mention the rigidity of the labour market as a considerable
obstacle to investing in Portugal. Progress has been made in this area, but many industries
are still locked by a number of regulations. Companies find it harder to adapt to the fast
pace environment (seizing opportunities or avoiding threats) with rigid labour regulations.
The seasonality of the tourism industry or the cyclicality of the automotive industry are
the most difficult challenges for companies locked by rigid labour regulations.

Beyond these problems, Portugal still lacks more R&D expenditure, venture capital
investment and the promotion of start-ups. The report finishes by stressing the
importance of these reforms as Portugal tries to join the group of EU leading countries
that have high productivity, high added value and, as a consequence, high wages.

The report lacks a number of important points. Let us try to build upon the conclusions of
the report. Let us try to portray differently the drastic decrease in GDP growth over the
last two decades in Portugal. Let us think first about the relationship between GDP
growth and FDI/Structural Funds.

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Does GDP follow FDI?
Portugal: What kind of growth?
Inflow of FDI and
GDP per capita
Structural Funds
growth rate

100% 6%
GDP
5%

80% FDI and 4%


Structural Funds
3%

60% 2%

1%

40%
1986 1990 1994 1998 2002 2006

As we can see in the graph above, inflows of FDI and Structural Funds had fuelled
growth during the boom of the Portuguese economy. We can therefore ask ourselves
what kind of growth did Portugal experience during the 80’s and 90’s. Was it a
sustainable growth, focused on productivity increase or was it a capital inflow that
boosted GDP? We could also look at what kind of FDI was brought into the country. Did
the FDI create linkages with the local economy, train the local workforce and vertically
integrate or was it an low skill assembly-model FDI that merely used cheap available
labour? To try to understand the unusual decline in the GDP growth rate, let us think of
Low Wages as a comparative advantage for attracting FDI. Let us try to map the FDI
competitive landscape in Europe in 1986 (Portugal’s accession) and the EU in 2006.

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1986 - Portugal’s Positioning within the EU
Comparative Advantage: Low Wages
Productivity
Leaders Why would you invest in Portugal?

Germany
Luxembourg
France Belgium Danger Zone

Spain

Ireland

Portugal (1986)
Greece
Low Wage
Leaders

As we can see Portugal had, in 1986, a leadership positioning relative to its most similar
countries (Spain, Greece, Ireland), in that it offered the lowest wages in the European
Union. In red dashes we have outlined the position dominated by Portugal. The center
circle represents a Danger Zone where the country has no competitive advantage to
attract FDI. In 1986 Portugal held a very comfortable and differentiated position within
the EU competitive FDI landscape. However this is no longer the case.

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2007 - Portugal’s Positioning within the EU
Comparative Disadvantage: Higher Wages
Productivity
Leaders Why would you invest in Portugal?

UK

Germany
Luxembourg
France Belgium Spain Danger Zone
Ireland

Greece Portugal (2007)

Czech Republic

Poland
Bulgaria

Hungary

Portugal (1986)
Romania

Low Wage
Leaders

As we can see above, the wages in Portugal started to increase, which undermined the
most distinctive discriminator for attracting FDI. Portugal Wage/Productivity Profile
changed considerably in two decades. It went from being LowWage/LowProductivity
(1986) to being HighWage/MediumProductivity (2007), which makes the country less
attractive to FDI, since the cost (wage) benefit (productivity/output) analysis is much less
interesting now than it was in 1986.

Other important aspects that should impact Portuguese competitiveness are Education,
Savings Rates, Consumption Patterns, Public Spending, Fiscal Discipline, Venture
Capital (only briefly mentioned), R&D Spending Incentives and Political Economics
(why did Portugal fail to reform?).

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Education seems key to achieving productivity growth. Not only would Portugal need to
shift resources into Portugal, but it would also need to place a premium on
innovation/adaptability and on professional/commercial orientation.
Savings Rates are known to be drivers of growth. Throughout the 90’s Private Sector
savings have decreased continuously. As of 1996, Private Sector savings rates were
negative.
Consumption Patterns are known to determine the current account balance. If Portugal
has a current account deficit, it means that Portuguese people are consuming more than
what they are producing. Having a balanced current account is vital to implementing
other economic policies. Moreover, if the money ‘borrowed’ abroad is not spend into
productivity ventures, than the country will be even more indebted.
Fiscal Discipline is another serious problem if the Portuguese Government spends more
than it earns. As we have seen, it will have to levy more taxes to pay for its inflated
expenses.
Public Spending remains an important factor to determine tomorrow’s competitiveness.
The Government must invest in the areas that appear to be the bottleneck of the economy.
For the last two decades, Portugal has undertaken what is called the ‘cement policy’. If
we acknowledge the decreasing marginal returns to scale, we will realize that the
marginal returns of investing in more infrastructures is smaller than spending on
Education or R&D. Portugal has renewed all of its highways, it has a new high-speed
train liking two Portuguese cities to Madrid, it hosted the Expo 98, which meant a lot of
infrastructure investment, as well as the Euro 2004, where the Portuguese Government
spend millions rebuilding the new stadiums. There are now advanced plans to demolish
the existing international airport and rebuild a new one.
The Venture Capital industry needs to modernize in Portugal so that high potential ideas
can find the capital to yield returns. There is the need to create, strengthen and
institutionalize the VC industry in Portugal.
R&D Spending Incentives are also lagging behind the levels of the most advanced nations.
The marginal return on this investment would be greater than the marginal return on
Infrastructures, thus the policy recommendation towards public spending is downscaling

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the investments in Infrastructures and a shifting of Government resources to Education,
R&D Incentives and Venture Capital incentives.
Political Economics seem to be one of the major barriers to productivity growth and
therefore one of the major barriers to Portuguese competitiveness. Since Portugal has
known, since the 90’s, which reforms it must undertake, a more fruitful question in
discovering is ‘what are the barriers to productivity’ would be: who would have an
interest in blocking the reforms. This is the most useful path to follow with further
research on this topic. Once we have identified the forces hostile to reform and we have
addressed their problems, than the reforms might become viable and unlock a lot of
productivity potential. The most advanced countries have managed to dismantle the
barriers to productivity growth. These countries will more often than not have a small
Productivity Distribution (the difference between the most productive firm in one
industry and the least). The reason for this is competition and flexibility. The graph below
compares Productivity Distributions.

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The importance of removing the barriers to productivity
Compared Productivity Distribution
Outperforming
Productivity EU countries
levels

Removing
Barriers to
Productivity

Portugal

Companies

As we can see, the outperforming economies do not have a universe of underperforming


companies. Efficient economies have dismantled these rigidities that prevent the
resources to migrate to the most productive companies, where the resources (capital and
labour) will produce more wealth. In Portugal, there is a still a large portion of the
companies within an industry that are underperforming (including fragmented gray
industry). These companies live side by side with some of the most productive companies
in Europe, namely in the banking, food retailing and telecom industries. If the rigidities
were dismantled and the resources would shift to the most efficient Portuguese
companies, the GDP of Portugal would boost again. Thus, this is the importance of
dismantling the rigidities that distort competition, constraining the growth of productivity.

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