Inflationary pressures have consolidated, leading major central banks to start raising official interest rates. While interest rates are still at contained levels, the abrupt nature of the monetary policy normalisation process coincides with a deterioration in the outlook for economic activity.

The external environment is conditioned by developments in energy markets, with looming expectations of a technical recession emerging in both the euro area and other major advanced economies. 

The more unfavourable external and financial environment, with an adverse effect on real disposable income, will tend to curb economic developments in Portugal in the coming quarters. 

These developments are set against a background in which some major vulnerabilities in resident sectors still persist: (i) debt levels; (ii) the sensitivity of debt service to rising official interest rates, especially as regards firms and households, given the prevalence of credit with variable interest rates; and (iii) in the case of the banking sector, exposure to certain asset classes, such as fixed-rate debt securities, namely sovereign debt, and real estate assets, most notably residential property.

Given this environment and such vulnerabilities, the main risks to financial stability are:

• a further reassessment of risk premia, leading to a devaluation of asset portfolios and increasing market financing costs for new issuances;
• a decline in residential real estate prices, which could also affect the value of asset portfolios, for households or financial entities, either directly or via collateral in credit transactions;
• greater difficulty in ensuring the expected reduction in the public sector debt ratio in view of the real and nominal slowdown of the economy and a potentially more significant increase in interest expenditure;
• the deterioration in the financial situation of households in a context of low saving rates, particularly among those already most vulnerable, and the preponderance of borrowing at variable interest rates;
• the deterioration in the financial situation of non-financial corporations, in particular those most exposed to the effects of the pandemic and/or rising energy and commodity costs, characterised by lower market power and a weaker balance sheet structure;
• in the banking sector, further materialisation of market and credit risks. This will depend to a large extent on developments in the economy and the unemployment rate, the pace of increase in interest rates and the support measures taken. This environment brings to light the importance for the sector: (i) to take a proactive approach in assessing its customers’ ability to pay and to adjust loan conditions to possible difficulties, and (ii) to follow appropriate provisioning and capital conservation practices, thereby promoting the ability to absorb potential losses and finance the economy.

Alongside these risks, some more structural, albeit topical challenges should also be considered and increasingly internalised in the assessment and decision-making processes of financial and non-financial institutions: (i) the climate transition, (ii) digital transformation, including operational resilience and cyber risk mitigation, and (iii) the change in the economic and financial globalisation process.

The complexity of the current situation and the materiality of the associated risks were enough to warrant a warning from the European Systemic Risk Board (ESRB) in September, calling for the need to preserve or strengthen the resilience of the financial system – a message echoed by the ECB in early November. The Banco de Portugal will continue to monitor the resilience of the financial system and borrowers in view of the deterioration in real and nominal conditions in the economy, including monetary and financial conditions resulting from monetary policy normalisation.