Portugal's Unrepentant Debtor

by Raymond Zhong,  editorial page writer for The Wall Street Journal Europe.

On this tiny island in the northern Atlantic, best-known for its rich wines and as a stopover for transoceanic cruise ships, debt has been an inescapable topic of late.

Lisbon's debt, but Funchal's too. The capital of this autonomous region of Portugal has lately seemed like an ugly epitome of Club Med fiscal misbehavior. In September, the regional government announced that it had discovered €1.1 billion in unreported debt among its books, increasing the already-huge previous total by a fifth. Global markets shuddered; Moody's downgraded Madeira paper out of concern for "grave irregularities" in the region's budget reporting. A former Portuguese finance minister told The Wall Street Journal recently that "We are looking at Madeira like the Germans look at Portugal."

But here as elsewhere in Europe's periphery, the matter of today's debt is making the equally important question of tomorrow's growth harder to answer. Policy makers seem to hope that the debt crisis will simply rattle sleepy southern economies out of decades-long complacency. Examples like far-off Madeira's suggest, however, that belt-tightening on the EU and International Monetary Fund's model is more likely to grind them deeper into the ground than to spring them back to life. If promoting growth looks like a bleak prospect in Portugal and southern Europe, it can seem near-impossible in Madeira. The island's remoteness makes shipping prohibitively expensive—Madeira is closer to Casablanca than to Lisbon. Many of Madeira's 250,000 inhabitants still work the land, and more than half of the island's area is a nature reserve on which development is illegal. The place hardly has the obvious makings of an economic powerhouse.

What Madeira does have is the power of taxation—or lack of taxation, as it were. Since 1983, foreign companies have enjoyed preferential tax treatment by registering through the Madeira International Business Centre (IBC). Discounts on everything from VAT to capital-gains and withholding taxes have attracted thousands of firms and holding companies to set up shop on the island. Today the IBC is responsible for nearly a fifth of the regional government's tax take. That's pretty good by most standards, but Funchal wants to do even better. At the moment, though, the EU classifies the IBC as a form of state aid, which means that its ability to offer certain incentives is circumscribed. Since 2002, financial firms have been prohibited outright from setting up through the IBC. There are de minimis financial-privacy protections, and companies are not exempted from any of Portugal's famously sclerotic labor laws. That Madeira is not its own state also restrains its autonomy in making tax policy. Companies in the IBC are largely unshielded from Lisbon's fiscal decisions.

These are huge disadvantages considering Madeira's competition just among Europe's low-tax jurisdictions. But cutting a better deal for Madeira is looking harder now that the island's name, both on the Portuguese mainland and in EU policy circles, is inseparable from its debt. Lisbon and Brussels have been eyeing the IBC with suspicion for many years now. The EU has periodically halted new listings to investigate the IBC; it has already forced Funchal to withdraw a number of tax and regulatory goodies that were on offer. The parliament in Lisbon is contemplating amendments to its 2012 budget that would subject non-residents to withholding tax on dividends disbursed by IBC companies. Austerity may have provided the means, and the justification, to finally kill the tax haven off.

The man seen these days as responsible for bringing dark clouds of debt woe to sunny Madeira is Alberto João Jardim, the 68-year-old president of the regional government. After taking office in 1978, Mr. Jardim filled his coffers with EU regional aid and transfers from Lisbon, and set off modernizing Madeira. He built roads and bridges to connect the island's towns and villages. He bored tunnels through the mountains and erected hospitals and schools. It worked. In less than 30 years, Madeira went from one of Portugal's poorest regions to its second-richest, after Lisbon. But then, around the time the euro went into circulation, Madeira's GDP surpassed the national average, and funding from Lisbon was reduced accordingly. Mr. Jardim kept right on building, though, and Madeira borrowed its way into a deep hole.

Today, telltale signs of overinvestment dot the island. Industrial parks and marinas sit abandoned and half-ruined. Amid a cluster of luxury hotels, a beautiful green park is empty nearly every day, built too far out on the rocky shore to be accessible. After a while, even the roads and tunnels and bridges here can start to seem a little too nice for such a small place, as if they were never, ever going to be used quite enough to justify their expense.

The debt scare hasn't halted Mr. Jardim's designs for Madeira, or his strong-armed style. In July he declared that Moody's inspectors were banned from the island after the agency downgraded Madeiran debt. His hand was only strengthened last month when he won his 10th straight regional election, making him one of the longest-serving democratically elected executives in the world. To his detractors, Mr. Jardim is a populist despot whose contempt for democratic niceties is only exceeded by his regard for his own majesty as eternal leader of the Madeiran people. But behind the bluster, Mr. Jardim has shown himself to be a friend to Madeira's pro-enterprise ways—even if cutting ribbons at road projects is still the more reliable vote-getter. He is a vocal defender of the IBC. In 2007, he declared that he wanted to turn Madeira into the "Singapore of the Atlantic." By making the island attractive to foreign business through low taxes and first-class infrastructure, his government would create a "knowledge economy" dominated by professionals and skilled high earners.

The words aren't Mr. Jardim's own, exactly. In 2000, the European Council met in Lisbon to formulate a plan to make the EU "the most competitive and dynamic knowledge-based economy in the world." Why the Lisbon Agenda's promised revolution never came is no great mystery. See "Southern Europe, Economies of." Yet changing the development paradigm in these economies will take scrappy ingenuity at home and international support, both of which are now under threat in Madeira. It will be a long time before Madeira is Singapore. But in economic history, much more has been made of much less. The question is whether Brussels and Lisbon will let anything be made of it at all.

This month the IMF delivered its latest report on Portugal's fiscal consolidation, saying "The envisaged adjustment program for the troubled autonomous region of Madeira will provide an opportunity to signal that errant fiscal behavior at the regional and local levels will no longer be tolerated." Whether "fiscal errancy" includes tax incentives like the IBC is yet to be made clear, but even the policy world's language of crisis resolution tips discussion toward the punitive and away from the genuinely recuperative. Recall Ireland's struggle to hold on to its 12.5% corporate tax rate against French and German pressure.

The wide attention that September's debt revelations received outside of Madeira rankled those on the island who have for years raised concern about Mr. Jardim's spending. But as tiny Madeira steps into the ring with Lisbon and its international creditors, Mr. Jardim may be the island's only hope of defending its prospects as a place for business. The president is something of a hustler for Madeira on the mainland: He has gotten Lisbon to forgive Madeira's debt twice in the past. Mr. Jardim is said to be preparing to take his fight for the IBC all the way to the European Commission and its Portuguese president, José Manuel Barroso.

Madeira—and Portugal, and Europe—probably could have used fewer politicians like Mr. Jardim back when he was building and borrowing like an addict. But mere repentance will not reduce debt or promote competitiveness. Mr. Jardim does not need to be contrite to be useful for Madeira and for Portugal in its moment of opportunity.