Probabilistic assessment of external sustainability in Portugal

Portugal is one of the most externally indebted economies in the eurozone. The deeply negative net international investment position (NIIP) suggests that large current account surpluses will be needed in the future to restore external sustainability. Despite significant interest in the scope for external adjustment within a monetary union, little is known about the magnitude or likelihood of the relative price change required to facilitate this adjustment. Drawing on a new probabilistic framework of external sustainability, this paper estimates the likelihood that a real effective depreciation is needed to lower Portugal’s net external liabilities to more prudent levels. Contrary to conventional thinking, we find that the NIIP is sustainable without real depreciation with fairly high probability, estimated between 32 and 43 percent. We highlight the predominance of financial account shocks over current account shocks in this assessment. To provide context to the assessment, we also apply the framework to Ireland. Despite a weaker NIIP than in Portugal, the probability that the external position is sustainable in Ireland is higher, estimated between 54 and 60 percent, predominantly reflecting forecasts of large and sustained trade surpluses.