Portugal budget risks 'non-compliance' with European Union rules

Portugal's left-wing coalition government receive some mixed news on Friday, when its budget for 2016 was judged to be "at risk of non-compliance" with European Union (EU) rules.

Last minute changes to the budget meant that the European Commission (the executive arm of the EU) accepted the budget, although it remained concerned about the level of planned economic reforms.

"Following intense technical and political contacts, the Commission did not have to request a revised draft budgetary plan from the Portuguese authorities. Nevertheless, the government's plans are at risk of non-compliance with the rules of the Stability and Growth Pact," European Commission Vice-President Valdis Dombrovskis said in a statement posted online on Friday.

Porto, Portugal.
Patrik Bergstrom | Getty Images
Porto, Portugal.

The country had previously received a warning about its draft budget, which it submitted more than three months late, from the European Commission.

The controversy surrounding the budget — which will reverse public wages cuts implemented by the previous center-right government — highlights the challenges faced by Socialist Prime Minister Antonio Costa. He must balance appeasing his coalition partners with a commitment to fiscal consolidation under EU rules.

"The government remains stuck between EC deficit reduction requirements and the demands of its far-left allies for a roll back of reforms made by the previous government (including tax increases and salary and pension cuts)," Royal Bank of Scotland analysts led by Alberto Gallo said in a report on Thursday.

Following earlier discussions with Brussels, Costa and his colleagues have cut Portugal's 2016 projected budget deficit to 2.4 percent of gross domestic product (GDP) from 2.6 percent and increased spending cuts to 0.4 percent from 0.2 per cent. However, the European Commission sees Portugal's deficit at 3.4 percent this year, above the 3 percent threshold that EU member countries must aim to meet or be below.

Portugal has cut its growth forecast to 1.9 percent from 2.1 percent for 2016, after Brussels said the estimate in its draft budget was also overly optimistic. The new figure remains above the European Commission forecast of 1.6 percent.

However, the Leftist Bloc — one of Costa's Socialist Party's major allies in parliament — has called on the government not to cave into demands for further adjustment measures.

"Costa is likely to choose political stability over pleasing Brussels, meaning that it is unlikely that the government will alter its plans significantly. This is because the short-term negative impact of a potential standoff with the Commission would be relatively limited," said Antonio Barroso, senior vice president at Teneo Intelligence, in a research note last week.

As well as limiting their budget deficits, EU member countries are required to work to limit their public debt to 60 percent or less of GDP. Portugal's deficit came in at 4.2 percent in 2015, with gross public debt at 129.1 percent of GDP, according to estimates from the European Commission.

The 2016 budget is one of the first major challenges facing Portugal's fragile left-wing coalition government. It is led by the moderate Socialist Party, but relies on votes from an alliance of parties that includes the Communist and Green parties, with the risk of new elections being held after April.

Italy, Austria, Lithuania and Spain are also judged as "at risk of non-compliance" with EU rules.

Royal Bank of Scotland said that reforms were necessary in Portugal, because the country's public and private sectors remain heavily indebted and productivity growth has fallen behind Spain and Ireland. That's despite Portugal posting growth of 1.5 percent in 2015 and seen expanding by 1.6 percent by the European Commission.

"The main driver of growth has been domestic consumption, while investment remains stagnant. In our view, the lack of investment and productivity growth could hinder the sustainability of Portugal's growth," Gallo said.

— Follow CNBC International on Twitter and Facebook.