Carlos da Silva Costa: Portugal - reform and growth within the euro
area
Opening speech by Mr Carlos da Silva Costa, Governor of the Bank of Portugal, at the Bank of
Portugal-International Monetary Fund conference "Portugal - Reform and Growth within the Euro
Area", Lisbon, 25 March 2019.
* * *
As prepared for delivery.
Good morning,
It is with great pleasure that I welcome you to our joint conference with the International Monetary
Fund on the paths for reform in Portugal, as a euro area member.
Growth periods like the one we are currently in involve a greater propensity to take on excessive
risk and to postpone structural reforms. We also know regulation tends to be procyclical,
meaning that it is loosened when it should be tightened and vice versa. This is why it is crucial in
the current environment to bear in mind the lessons from the last crisis and, above all, to prevent
the resurgence of the factors that led up to it.
With this in mind, I think now is an important time to speak about:
1. the process leading up to the crisis that hit the Portuguese economy,
2. the adjustment initiated with the financial assistance programme, and
3. the current challenges to sustainable growth.
Before the assistance programme
The process that led Portugal to the most recent assistance programme started in the
mid1990s, in a context of broad internal and external balance.
Financial liberalisation and the prospect of joining the euro made financing cheaper and more
accessible, bringing about a strong credit expansion and a fall in the household savings rate.
Between 1995 and 2007, credit to the private sector, measured as a percentage of GDP, almost
tripled from 52% to 131%. During the same period, the household savings rate almost halved,
reaching 7% in 2007. The largest slice of credit was channelled to financing consumption and
low-return investments, largely in non-tradable sectors.
Credit to the private sector grew much faster than GDP
Loans to non-financial corporations and households, as percentage of GDP
Source: Banco de Portugal
In parallel, the rise of Asian competition in the low-technology sectors and the challenge posed by
the enlargement of the EU to Central and Eastern European Countries, which captured foreign
direct investment in the medium-technology sectors, brought difficulties to Portuguese exports.
Such reshuffling of comparative advantages had a bearing on the performance of firms operating
in the tradable sector.
As a result of these different shocks, Portugal lost export market share in international markets,
imports grew and the current account deficit deteriorated, without a corresponding expansion of
the economy's growth potential. Between the mid-1990s and the eve of the global financial crisis
in 2007, the Portuguese current and capital account went from near balance to a deficit of 8.6%
of GDP, whereas gross external debt rose from approximately 60% to 195% of GDP. At the
same time, annual potential growth declined from around 3% to just below 1%.
Domestic demand grew faster than potential output, contributing to external deficits
Source: Banco de Portugal and Statistics Portugal
External indebtedness was to a large extent intermediated by the Portuguese banking system.
Banks raised (mostly short-term) funds in the euro money market and converted them into
(longterm) loans to the private sector, creating an important maturity mismatch in their balance
sheets. The loan-to-deposit ratio for the whole banking system rose from 89% in 1998 to 156% in
2007.
A macroprudential policy and a countercyclical fiscal policy would have helped contain the risks
associated with the expansion of domestic demand. However, macroprudential policy was
simply not part of the standard toolbox and the mostly pro-cyclical fiscal policy that was followed
aggravated the macroeconomic imbalances. In the period from 1995 to 2007, the budget deficit
averaged 4.3% of GDP, and was always above the Maastricht threshold of 3% of GDP.
When the international financial crisis broke, the weak potential output growth and rising external
indebtedness fuelled investors' doubts about the capacity of Portuguese economic agents to pay
their debts. Between 2009 and 2011, external financing to banks fell by around 30 percentage
points of GDP. As a result, banks had to turn to the Eurosystem, whilst at the same time the
volume of Portuguese sovereign debt placed with domestic banks increased.
In the first half of 2011, following twelve months in which interest rates on ten-year government
debt had almost doubled to just over 9%, mounting doubts among investors about the
sustainability of the public finances and external debt lead to a shutdown of access to
international funding markets. Recourse to external financial assistance became unavoidable,
under a programme negotiated with the European Union and the International Monetary Fund.
This was not the first time Portugal had to resort to official financial assistance. As many here in
the audience will remember well, we had already negotiated adjustment programmes with the
IMF in 1977-1978 and 1983.
The root cause of the accumulated imbalances was then essentially the same: excessive
domestic demand growth in relation to the productive capacity of the economy, leading to
external debt accumulation.
However, given that we were not part of a monetary union and had full monetary autonomy in the
1970s and 1980s, the symptoms of the crisis and the policy prescriptions produced at the time
show some important differences when compared to the most recent crisis episode.
In a context of monetary sovereignty, the imbalances translated into currency depreciation,
international reserves depletion and high and rising inflation rates.
With monetary policy fully available at national level, financial repression was the name of the
game. The policy prescription consisted of interest rate increases, credit growth targets, capital
controls and the devaluation of the escudo to contain domestic demand and restore export
competitiveness.
As a result of the adjustment strategy, the real value of wages, pensions and savings declined
sharply and wealth was transferred from creditors to debtors. Money illusion blurred the
perception of the adjustment costs and of the fundamentally unbalanced burden-sharing. Also,
as nominal variables were targeted and competitiveness was restored in the short term,
structural supply-side imbalances and long-term competitiveness failed to be properly
addressed. As a consequence, the country's competitiveness remained fragile and anchored in
low wages.
In the first decade of the 2000s, being part of a monetary union facilitated a longer and larger
accumulation of imbalances. Nominal stability, low interest rates and ample credit availability
created the illusion that credit constraints had disappeared and masked persistent losses of
competitiveness for more than a decade.
The symptoms of the emerging crisis no longer included persistent exchange rate pressure,
reserve depletion or high and rising inflation, but rather a sudden unwillingness on the part of
international investors to finance the Portuguese economy.
Without the monetary instrument, money illusion was no longer there and the policy prescription
had to be different. As a result, the need for deleveraging and structural supply-side reforms
became inescapable.
The financial assistance programme
The execution of the economic and financial assistance programme set out in 2011 brought
about noteworthy progress:
The budget deficit declined significantly, which created the conditions for the current
downward trend of sovereign debt;
the private sector initiated a deleveraging process; and
the banking sector became more robust, with stronger liquidity, higher solvency and, in the
most recent period, improved asset quality.
This success was based on three key factors:
first, political ownership, socioeconomic awareness and social dialogue. Policymakers
were committed to the programme's goals and showed deep knowledge of the virtuous
response mechanisms to be activated in the critical sectors. On the other hand, the public
understood the urgency and even-handedness of the programme. The political
compromises achieved between policymakers and social partners were key to ensuring a
broad and collective ownership of the programme, which in turn determined its effective and
timely execution.
second, which grew by
the positive, intense and fast response by the export sector,
around 45% in real terms between 2008 and 2017. This contributed to the correction of the
current account deficit, to put external debt on a downward trajectory, and to mitigate the
impact of lower domestic demand on the non-tradable sector. This positive response by the
tradable sector was much stronger than expected and was not driven exclusively by foreign
markets' growth, given that there were important market share gains during this period.
third, the maintenance of the general public's confidence in the financial system, as
evident in the consistent stability of aggregate deposits. This allowed the financing of the
economic activity to proceed without major disruptions and prevented the resort to capital
controls. The fear and deposit drain observed in other economies that were subject to
assistance programmes did not occur in the Portuguese case. This was not by accident,
since there was an active and persistent effort by the authorities to preserve confidence in
the financial system throughout the implementation of the programme.
After the assistance programme
The macroeconomic adjustment initiated by the economic and financial assistance programme
has continued after the programme ended in 2014, with encouraging results.
GDP has been growing at an average annual rate above 2%, reflecting the continued dynamism
of the export sector and, more recently, the rebound of private investment. Fiscal consolidation
proceeded, with the budget balance expected to be around -0.5% in 2018 and public debt
entering a downward trend. The current and capital accounts were kept in surplus and the
cleanup of banks' balance sheets has intensified, with NPLs declining from over 50 billion euro in June
2016 to about half this amount in end 2018.
Despite the undisputed progress, there is no room for complacency. The history of the past 40
years teaches us that the initial impact from an assistance programme will only be sustainable if
there are structural changes that foster higher potential growth.
Over the recent past, Portuguese per capita GDP has remained 30-40% below the European
Union average, without converging towards the richest economies. A lasting trajectory of growth
and convergence towards our European partners depends on our ability:
to promote efficient resource allocation, namely through sustained maximisation of
investment returns, and reallocation towards the tradable sector;
to reach higher levels of productivity;
to generate and maintain high levels of employment; and
to ensure that the combination of capital and labour generates an output that is desired and
valued by the market.
Public policy has a key role to play by upholding continued structural reforms that will, inter alia,
help:
increase aggregate savings in the economy;
strengthen firms' capitalisation;
provide, through capital markets, adequate instruments to finance innovation and exports;
promote regulatory and tax predictability and, more generally, a business-friendly legal
framework;
the separation between firm ownership and firm management;
red tape reduction; and
a better functioning of the judicial system.
Such reforms are, on the one hand, imperative for pursuing the correction of the macroeconomic
imbalances that led Portugal to the past crises and, on the other hand, extremely hard to
implement after the conclusion of the assistance programme.
Why do I say that structural reforms are extremely hard to implement in the current context? Let
me highlight three critical challenges.
1. First, in the current context of strong global competition, firms need to adapt permanently to
the fast-changing competition, requiring accordingly adaptable support services by the State.
This means that we need a State that is lean and efficient, while being able to safeguard
social cohesion at the same time.
2. Second, transferring resources towards the tradable sector is crucial for avoiding a return to
external imbalances, but may jeopardise social cohesion. Indeed, adapting to competition is
always challenging and there are losers in this process. These situations have to be
supported by sustainable social safety nets.
3. Finally, in the absence of a sense of emergency, of imminent financial market pressure and
of money illusion, reform ownership by policymakers and social consensus become much
harder. The costs from each reform become clearer and must be carefully balanced by
perceived offsetting benefits.
The nature of these challenges transcends pure economic models, encompassing social
equilibria. Overcoming them requires, thus, social and political consensus, only attainable
through an open, broad and informed debate.
I am confident that this conference will contribute to such a debate and that by the end of the day
we will have gained many useful insights into what paths to take for effective reform and the
strategies to adopt in order to remove the obstacles in the way.
Thank you very much for being here.