Carlos da Silva Costa: Sovereign debt crisis, risks or opportunities
Address by Mr Carlos da Silva Costa, Governor of the Bank of Portugal, at the 2nd
ReutersTSF Conference: "Sovereign debt crisis, risks or opportunities", Lisbon, 28 February 2011.
* * *
According to the latest data available for 2010, the Portuguese economic situation can be
summarised as follows:

A fiscal deficit estimated at around 7% of GDP compared with deficits of 6.3% in the
euro area and 10.5% in the UK;
 A public debt around 83% of GDP, compared with 84.1% in the euro area;

A growth rate of 1.4% in 2010, compared with 1.8% in the euro area;

Financing needs of the Portuguese economy as measured by the combined current
and capital account amounting to 8.7% of GDP in 2010;

A net debtor international investment position above 100% of GDP, and a net
external debt equivalent to 85.3% of GDP in 2010, of which 48.0% corresponds to
the general government sector.
These figures only provide a snapshot, which needs to be considered in the context of the
underlying driving forces. More specifically, to understand where we are today, we need to
know where we came from and where we are going. There is no other way to assess and
understand the size of the challenges faced by the Portuguese economy and the consistency
of its path. Therefore, it is important to remember that in the last decade the Portuguese
economy recorded:

A weak rate of growth in the years that preceded the international crisis - with an
annual average growth rate of 1% between 2001 and 2008;

A steady decline in the potential growth rate, as a reflection of the reduction in the
growth of labour productivity, capital and total factor productivity;

An increase in public indebtedness from 48.7% of GDP in 2000 to nearly 83% of
GDP in 2010, mirroring a rise in public expenditure of virtually 8 percentage points
during the same period. This despite a reduction in debt servicing costs resulting
from the adoption of the euro in conjunction with the benefits of the so-called Great
Moderation period;

An increasing level of household indebtedness, which rose from less than 80% of
disposable income in 1999 to more than 120% in 2008, reflecting easier access to
consumer and mortgage credit, in terms of both volume and cost;
 A rising level of external indebtedness, resulting from recurrent external deficits, as
a reflection of the expansion of domestic, public and private demand, and a
deterioration in the net international investment position, which shifted from -39.6%
in 2000 to -108.5% in 2010.

Finally, a gap between deposits and loans resulting in external financing
dependency. Such gap mirrors the key role played by the banking system in the
financing of the Portuguese economy and the increasing shortage of domestic
savings to meet the financing needs of the State, corporations and households.
This is the background that should be borne in mind,

First, to understand the questions raised by foreign investors about the sustainability
of both public and external debt of the Portuguese economy;

Second, to understand that the consolidation of public finances is inevitable and,
hence that budget execution in 2010 is extremely important as well as the
achievement of the objectives set for 2011 and 2012. At the same time, it is also
vital to understand that achieving these objectives is important, but not sufficient to
ensure medium to long-term sustainability of public finances;

Third, to understand that the imperatives faced by the Portuguese economy go
beyond fiscal consolidation, which is a necessary but not sufficient condition to solve
our economic troubles. Solving the problems of the Portuguese economy, implies an
increase in household savings, a rise in the self-financing capacity of corporations
and a boost in the growth rate of potential output;

Finally, to understand the importance of the stability and efficiency of the financial
system for the dynamics of the Portuguese economy, namely to meet the financing
needs of the productive sector and to enhance resource allocation.
Therefore, it is important to remember that the Portuguese economy must continue to rely on
foreign investors, as it is not realistic to think that the external deficit can be immediately
rebalanced. Thus, the confidence of foreign investors is crucial for the development of the
Portuguese economy. Such confidence should rest on a sustainable path of public debt and,
hence, of the fiscal deficit, as well as on the sustainability of external indebtedness. The
sovereign debt crisis results from increasing indebtedness, in a context of heightened risk
aversion and higher scrutiny of the repayment capacity of indebted countries. Investor
confidence depends not only on the indebtedness level but also on the repayment capacity,
which in turn depends on potential output growth and on the nature of the development
process. That is, the confidence of foreign investors varies in direct proportion to the
robustness of the Portuguese economy's growth, or more specifically it depends directly on
the sustainability of its development process.
Second, it should be borne in mind that the process of reduction of the fiscal deficit (which
had been pursued over past years but was interrupted in 2009 in the context of the financial
crisis) was resumed in 2010 and is an important step in the critical and wider process of
reforming public finances. I have already referred to this process on other occasions, so
today I will not go into further detail. I only insist that this process not only has an institutional
and regulatory dimension but also it requires a multi-annual and binding programme that
ensures the reduction of the public debt to GDP ratio, while setting a limit to the growth of
public expenditure. The latter is crucial to restrain tax increases and to safeguard the
attractiveness of the country as a destination for investments that support potential output
and employment.
Third, there is a need to rebalance the development model, by creating favourable conditions
for the expansion of the tradable goods sector; for the growth of capital and labour
productivity, as well as total factor productivity; and for innovation as regards both production
processes and technologies and products. It should be recalled that the growth and
employment creation model of the past years is not sustainable: it relied on the expansion of
public demand, reflected on the imbalance of public finances and on the expansion of private
demand. In turn, the latter was fuelled by the favourable financing conditions enjoyed by
households, mirrored in rising indebtedness and lower savings. The growth and employment
creation model of the past years triggered an increasing indebtedness ratio, which would
become unsustainable if it were not corrected. The Portuguese economy must create
employment in the tradable goods sector, in order to:

absorb the employment that, due to the adjustment of domestic demand, the
nontradable goods sector will not be able to retain; and

offset the reduction in the incorporation of labour per unit of output, which will result
from a broad-based and imperative rise in productivity.
The sustainability of the development model implies more far-reaching structural reforms,
with priority to those that have an immediate impact on competitiveness, on available
capacity and on the value added of the goods and services export sectors. I would like to
emphasize that there are no mechanical and definite causalities in the growth of potential
output. The future is shaped by the way resources are allocated between alternative uses, by
the quality of public policies (most notably, by their impact on incentives) and by corporate
strategies.
In this regard, the role of the so-called national innovation system should be stressed, i.e. the
network of public and private sector institutions and the interaction mechanisms behind the
production, use, diffusion, absorption and exploitation of new knowledge and technologies by
a company or group of companies. Empirical evidence shows that R&D expenditure, the
level and type of education and the articulation between the educational and professional
training subsystems are responsible for the position of countries within the international
division of labour and, in particular, for the specialisation pattern (intersectoral specialisation,
or as an alternative, intrasectoral vertical specialisation). On the one hand, the articulation
between the three subsystems (research, education and professional training) should be
enhanced. On the other hand, the articulation between the national innovation system and
corporate needs, in particular in the tradable goods sector, should also be improved.
Finally, I would like to point out the critical importance of maintaining and strengthening the
stability of the financial system. This system plays a fundamental role in the functioning of the
Portuguese economy and, in particular, in an efficient allocation of internal and external
resources, channelling them to the sectors and economic agents with funding needs.
The Portuguese banking system is solid. It was not exposed to the sub-prime crisis or to the
speculative bubble in the real estate sector. Own funds are adequate given the current level
of balance sheet risk: the Tier 1 capital ratio stood at 9% in 2010 and the core Tier 1 capital
ratio at 8.2%. Obviously, the banking system suffered from the impact of the international
crisis and the decline in growth. As expected, between 2007 and 2010, the total ratio of
non-performing loans increased from 1.5% to 3.3% and the return on equity decreased from
14.63% in 2007, to 7.37% in 2010, after having dropped to 3.44% in 2008.
However, the Portuguese financial system shows some specificities that should be
addressed.
First, as a reflection of the above-mentioned imbalance between domestic savings and
domestic borrowing requirements - resulting from the development model of the Portuguese
economy in the past few years - the transformation ratio of deposits into loans stands at 1.44
for the Portuguese financial system as a whole. Due to this fact, there is a significant
dependence on external financing. This explains the reason why the Portuguese banking
system became heavily exposed to the sovereign debt crisis.
Second, the capital adequacy of banks is a dynamic reality. Therefore, it must be seen in the
context of both the current level of balance sheet risk and of the negative impact that a
deterioration in the Portuguese economic situation may have on the quality of assets.
Moreover, it must also be viewed in terms of the additional capital requirements arising from
the new prudential rules, known as Basel III, and the fact that investors and their
counterparties tend to consider the new prudential rules as financial soundness benchmarks
even before their enforcement.
In this context, Portuguese banks must bear in mind that the environment in which they
operate imposes the narrowing of the gap between deposits and loans and an increase in
own funds.
Portuguese banks should therefore embark on orderly de-leveraging, through a selective
sale of assets, namely credits, that will allow them to soften the impact on the financing of the
productive sector, in particular of the companies more dependent on bank financing. In this
regard, it would be welcome that the large companies that have or may have access to
external financing and to the capital market would reduce their recourse to domestic credit.
Second, Portuguese banks, being aware that this will be key to the assessment by
counterparties and investors, should further strengthen their own funds. We all know that
conditions in the capital market are particularly difficult. Therefore, it is crucial that banks
envisage other ways of expanding or reinforcing their shareholder basis.
Third, given the critical importance of preserving profitability as well as the rigidity of the
financial margin that results from the relative weight of mortgage credit, Portuguese banks
must pay particular attention to their efficiency ratios.
Finally, and in the very short term, Portuguese banks like the other European banks will
undergo very tough tests. The new round of stress tests is aimed at examining bank
performance under a far more adverse scenario than in 2010. It is crucial that banks show
that capital shortages resulting from the accommodation of losses induced by a weaker
economic environment can be adequately met. Therefore, and as a result of the commitment
by EU Member States, we will have to prepare the mechanisms that, if needed, will be
activated to reinforce banks' own funds. Such mechanisms may rely on the individual
financial institutions or public funds (the so-called back-stop facility).
In sum, and as I mentioned at the beginning, the results for 2010 provide a snapshot that
must be considered in the context of the underlying driving forces. We must keep in mind
where we started and where we are going. We come from a growth path underpinned by the
expansion of domestic demand. Now we want to be on a path of sustained development
supported by an increase in value added per head and employment creation, coupled with
sustainable public finances and external accounts. The first step was given in 2010.
However, the way ahead is very hard, requiring more than fiscal consolidation: it implies a
range of structural reforms inducing entrepreneurial dynamics and productive investment that
strengthen the competitiveness of the Portuguese economy in a sustained manner. That is
the challenge.