Portugal and the European Monetary System

This thesis discusses the macroeconomic implications of the potential full participation of the Portuguese escudo in the Europe an Monetary System (EMS). The thesis is organized in two parts with seven main chapters. The first part - chapters 1 to 4 - makes a number of contributions. Firstly, in chapter 2, we integrate sever al theoretical arguments which suggest that semi-industrialized countries should not engage in extensive and simultaneous real and financial external liberalisation. This is particularly true if the economy starts from a situation of high inflation, a large fiscal deficit financed by money creation, underdeveloped financial system, high barriers to international trade and stringent capital controls, conditions which describe roughly the state of the Portuguese econo my when the country joined the EC in 1986. We also extend the existing literature on balance of payments crisis to study the stabilizing effects of the announcement of a currency band. Second ly, in chapter 3 we estimate income and price elasticities in Portuguese foreign trade. Simulation exercises are carried out in order to compare some of the quantitative consequences of different choices facing the escudo (gradualist v s . immediate ERM-entry). Thirdly, in chapter 4 we measure the degree of real and financial market integration of the Portuguese economy and we advance a systematic study on the role of capital controls in the Portuguese economy. We discuss in detail the nature and extent of the risk premia on escudo denominated assets. In the second part of this thesis - chapters 5 to 7 - we assume that the current account has been successfully liberalised and that the fundamental factors behind the inflationary process (budget deficits and money printing) have been corrected. In this part our contribution is as follows. In chapter 5 we dis cuss the macroeconomic incentives that governments might have in "tying their hands" during a disinflationary process. We suggest that if the output costs of disinflation are to be minimized ERM participation in itself cannot be a substitute for other measures directed at alleviating product and labour market distortions. In chapter 6 we look at the experience of disinflation in the 1980s in some selected countries. Our own analysis and the conclusions drawn from a critical survey of the literature suggest that the reputational effects of ERM-membership might be less important or at least more difficult to realise than the theoretical literature on credibility effects suggests. In chapter 7, we study the recent experience of costless disinflation in Portugal (1985-87). We find evidence that supports the idea that a decisive turn-around in expectations occurred in Portugal in 1987 and this could be the reason why the disinflation was costless. Such a change in expectations coincided with the beginning of the implementation of an incomes policy explicitly directed at breaking inertial inflation and can be seen as a measure of the success of that policy. We also argue that fundamental more than reputational factors are at the root of the interruption of the disinflationary process in Portugal (1988-89) and that an immediate entry into the ERM would only force the country to discontinue the gradualist approach to disinflation. The policy conclusions are that the soft—ERM option appears to be the second-best choice for Portugal in the early 1990s and that without a fundamental transformation of the economy a cautious approach to financial de-regulation and opening-up is necessary.