Carlos da Silva Costa: The challenge of inclusive growth
Address by Mr Carlos da Silva Costa, Governor of the Bank of Portugal, at the Delphi Economic
Forum IV "The challenge of inclusive growth", Delphi, 1 March 2019.
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As prepared for delivery.
Good morning ladies and gentlemen,
I would like to thank the organisers for the kind invitation to join you today and to Mr Mitropoulos
for his introductory remarks. It is an honour to be here.
Ten years on from the start of the great financial crisis, the Portuguese economy is in a growth
phase. Economic activity has accelerated in recent years, economic agents continue to benefit
from favourable financing conditions, public accounts are improving and the banking sector is
getting stronger.
While growth is a critical ally in this rebalancing process, we cannot ignore the fact that growth
periods involve a greater propensity to take on excessive risk. This is why it is crucial in the
current environment to bear in mind the lessons from the crisis and, above all, to prevent the
resurgence of the factors that led up to it.
With this in mind, I thought now was the right time to speak about: (i) the process leading up to
the crisis that hit the Portuguese economy, (ii) the adjustment process initiated through the
financial assistance programme, and (iii) the current challenges to sustainable growth.
1. 1995-2007 - Capital inflows from euro adoption were misallocated, leading to
macroeconomic imbalances
This is a story that begins in the mid-1990s, a period when we might argue the economy was
broadly in (internal and external) balance.
By then, the prospect of euro adoption translated into cheaper and more accessible financing,
leading to strong credit expansion, and to a contraction in private savings. The stock of credit to
the private sector increased by more than 3⁄4 of GDP, whereas the private savings rate almost
halved during this same period.
The increase in indebtedness was mainly used to finance consumption and low-return
investments, mostly in the non-tradable sector. As a result, imports expanded and large current
account deficits emerged, without a corresponding expansion of the economy's growth potential.
Between 1995 and 2007, the general government budget deficit averaged 4.3% of GDP and,
according to the most recent data, was never below the 3% upper threshold. The large interest
savings and windfall tax revenue coming from the plummeting interest rates and booming private
spending of the second half of the 1990s were used to finance higher current public spending.
Following the introduction of the euro, interest rates stabilised as they had broadly converged to
the best performers and tax revenue fell as a result of decelerating activity in the early 2000s,
causing a sharp deterioration in the public accounts.
Large and persistent current account deficits translated into a sharp deterioration of the
Portuguese economy's international investment position, which also went from being close to net
zero in the mid-1990s to almost -90% of GDP in 2007. The behaviour of gross external debt over
the same period - growing from around 60% to 195% of GDP - is even more striking.
This rising external indebtedness was largely intermediated by the Portuguese banking system.
Banks raised (mostly short-term) funds in the international financial markets and converted these
into (long-term) loans to the private sector. The banking sector's loan-to-deposit ratio increased
from nearly 89% in 1998 to around 156% in 2007. The public sector also resorted to foreign
finance extensively.
2. 2008-2010 - Global crisis tackled through fiscal expansion disregarding accumulated
imbalances
These imbalances made the Portuguese economy extremely vulnerable to the international
financial crisis and its contagion effects.
When the crisis hit, a highly expansionary fiscal policy was pursued, disregarding the existing
imbalances and the lack of fiscal space. In 2010, the public budget deficit was above 11% of
GDP and gross public debt was around 96% of GDP - of which, more than half was external
debt.
With potential output growing very slowly, rising external indebtedness fuelled investors' doubts
about the country's ability to service its debt. As a result, domestic banks and the government
found it increasingly difficult to obtain external financing: banks had to turn to the Eurosystem,
whereas public debt was increasingly placed in domestic banks. A perfect doom loop embrace.
Investors' concerns eventually led the country to be shut out of the international financial markets
in the first half of 2011, after the 10-year yields had nearly doubled in the previous year. This led
to a request for official financing under a financial assistance programme negotiated with the
European Union and the International Monetary Fund.
3. 2011 onwards - Macroeconomic rebalancing and financial deleveraging: notable
progress, but no room for complacency
Notable progress was achieved with the implementation of the financial assistance programme:
The budget deficit significantly declined and public debt is now on a downward trend;
Private sector deleveraging is ongoing; and
The banking sector is more robust, with a stronger liquidity position, higher solvency ratios
and improved asset quality.
The adjustment programme has widely been regarded as a success. In my view, this success
was due to three factors:
1. First, programme ownership. Portugal was committed to the implementation of the
programme, which was accepted by the population. A constructive dialogue with social
partners was possible and this was key to ensuring the success of the quarterly reviews.
2. Secondly, the speed and intensity of the response from the tradable sector, in particular
exports, was key to the rapid rebalancing of external accounts and mitigation of the impact of
lower domestic demand on the non-tradable sector.
3. Third, the maintenance of confidence in the banking sector, as evidenced by the behaviour
of deposits. This was crucial to preventing the economy from collapsing with a credit crunch
and avoiding the imposition of capital controls.
It is important to remember that an adjustment programme is always a short-term programme
whose effects are only sustainable if there are structural and institutional adjustments that
prevent repetition of the conditions that led to the need for adjustment.
As such, notwithstanding the undisputable progress, there is no room for complacency.
A lasting trajectory of growth and convergence towards our European partners depends on our
capacity to generate and maintain high levels of employment and productivity. This is a
necessary condition to (i) bring our workers' wage levels closer to European standards; and (ii)
finance the welfare state in a context of unfavourable demographic developments.
The challenge is thus one of activating the 'levers' of employment and productivity. I will briefly
highlight the four most critical ones.
1. First, investment. It is vital to increase both the stock of capital and investment in intangibles,
learning from past mistakes, particularly by scrutinising investment projects in a far more
demanding way. Of course, we cannot ignore the fact that the recovery in investment is
constrained by the (still) high indebtedness level and low savings rate of the Portuguese
economy. This means that higher investment will have to be financed through an increase in
equity, either from existing shareholders, or the entry of new domestic or foreign
shareholders.
2. Second, skills. In Portugal, employees' skills have improved considerably in recent years but
important gaps remain in relation to European averages, which we need to continue to
close.
3. Third, management. We need management frameworks that encourage openness to risk
and favour decentralised decision-making. It is well documented that firms with a more
decentralised management and higher educated managers are more open to disruptions
and thus more innovative.
4. Fourth, innovation policies. Public policies that are innovation-friendly are also critical to
stimulate productivity and employment.
Let me conclude.
The challenge we are confronted with is that of generating and maintaining high levels of
employment and productivity to ensure a lasting trajectory of growth and convergence with our
European partners.
We're talking about the deep institutional and structural foundations of the economy. The task is
hard and will take time to complete before it bears fruit. This means we need to be determined
and tenacious and focus on what really matters from a long-run perspective.
I will of course be happy to take questions, or listen to any comments you may have.
Thank you for your attention.