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Address by Governor, Carlos da Silva Costa, at Delphi Economic Forum IV: "The Challenge of Inclusive Growth"

01 Mar. 2019

Address¹

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 ¾ 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:

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.
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.
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.

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.
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.
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.
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.

¹As prepared for delivery.

Related documents

Supporting slide

Interviews to local media as part of the preparations of the Delphi Forum:

Proto Thema (published on 10 February 2019)

1. Mr. Governor, you are about to visit Greece for the Delphi Forum a few months after Greece’s exit from the adjustment programs and a few weeks after the issuance of a new 5-year Greek bond. Do you think that Greece can now stand on its feet again, like Portugal? Is Greece a “success story”, despite being under enhanced surveillance from the European institutions?

Greece needs to continue to build on all the efforts made over the last few years for a successful convergence towards the other EU Member States. The recent 5-year issuance reflects improving investor confidence that should continue to grow, just as has been the case for Portugal since its exit from its own adjustment programme. Markets’ trust in countries with high levels of public debt such as Portugal and Greece are the ‘acid test’ of the sustainability of policies. That depends on the continued adjustment of public finances and domestic savings’ capacity to cover financial needs.

2. Shortly after exiting its adjustment program, Portugal was characterized as an “economic miracle”, since some austerity measures were cancelled, exports grew and investments increased. How did you make this? How could Greece take advantage of Portugal’s example?

The key to Portugal’s economic performance was the adjustment of the existing sizeable imbalances: a turnaround in the external accounts, a strong and unprecedented fiscal consolidation effort, the deleveraging of the private sector and a strengthening of the financial sector. There was also a significant restructuring of the economy, with resources increasingly being reallocated to the tradable sectors and the most productive firms.
Export performance was one of the main drivers of the recovery during and after the adjustment programme. Portuguese exporters have been gaining market share in external markets since 2008, with tourism playing a bigger role in recent years. This reflects the improvement in non-price competitiveness (though price competitiveness also improved during the adjustment period), associated with a restructuring of export businesses, an upgrade of product quality and innovation which led to exports’ higher added value, and a diversification of geographical destinations.
The economic recovery has also been supported by strong investment growth, in particular business investment driven by favourable developments in overall demand, the need to rebuild capital stock after the strong reduction in investment during the crisis years and favourable financing conditions.
Finally it is also worth noting that throughout the adjustment programme there was strong domestic ownership of the measures. In particular, social partners understood the need to adjust the economy, which fuelled credibility and created a solid background for the ensuing recovery, anchored on compliance with European rules.

3. Since February 1st, the subminimum wage for young employees was abolished and the minimum wage increased by 11% in Greece, reaching 650 euros/month. Was this a correct decision in your opinion, judging from Portugal’s relative experience?

I have no comment on this specific topic. What I can say is that the minimum wage should be set to reflect the productivity of each economy in order to safeguard its external competitiveness.

4. The NPEs and the new household insolvency framework are two of the biggest problems for the Greek economy. Are there any lessons that we can draw from the Portuguese experience?

Since the peak observed in June 2016, Portuguese banks have reduced their NPLs in gross terms by about EUR 19.2bn or 38% (from EUR 50.4bn in June 2016 to EUR 31.2bn in September 2018). In net terms, NPLs stood at around EUR 14.6bn as of September 2018. Importantly, NPLs in Portugal are fairly concentrated in the corporate sector.
Notwithstanding the persistently high NPL ratio compared to Portugal’s European peers, the measures taken have led to upgrades from the rating agencies, enabling a reduction of costs when banks tap the markets to issue MREL-eligible instruments.

5. One of the common problems in Portugal and Greece was the inefficiency of the public sector. Portugal has done a lot of progress in this field. Taking advantage of this experience, what do you suggest to Greece?

Increasing the efficiency of public administration depends on the historical and cultural context of each country. Problems tend to be idiosyncratic. The impetus is the same but the answers vary from country to country.
In the case of Portugal, I would highlight the increased efficiency of tax administration, the cumulative reduction of civil servants and the increase in qualifications among new hires, the introduction of the budgetary framework law, the reform of the judicial system, and improvements and simplification of the administrative burden, benefiting from new IT infrastructures.

6. In 2011 you had said that Grexit is inconceivable. However, later on we got really close to Grexit twice and the Greek drama reached its peak in 2015. Why was that? Why did things get worse? Was it only Greece’s mistake?

I was not directly involved in the discussions assessing what went wrong exactly. What I can say is that all relevant stakeholders need to look back at past events and take stock of the lessons learned. Participation in the European Monetary Union is a plus that needs to be preserved in the interest of each individual country and of the whole group.

7. Klaus Regling has stated that the negotiations between the Greek government and the European creditors during the first semester of 2015 cost 86 billion euros to Greece. Do you share this view?

I cannot comment as I have no detailed information to assess potential costs.

8. Many analysts, as well as the Governor of the Bank of Greece Yiannis Stournaras, were in favour of a precautionary credit line after the end of the 3rd program, but the government rejected this solution and even accused Mr. Stournaras for expressing this view. What is your opinion?

It was up to the Greek authorities to decide on the course of action to follow. I trust the decision was taken considering all the relevant information and circumstances as well as the pros and cons.

9. Greece has not taken advantage of the QE, even though it was the country that mostly needed it. Wasn’t this unfair? Could the ECB have done more to help Greece?

The Eurosystem defined a set of eligibility requirements for the purposes of the Public Sector Purchase Programme (PSPP). Greece has thus far not been able to meet the necessary requirements. It should nevertheless be recalled that Greek sovereign bonds (GGBs) were purchased in the Securities Markets Programme (SMP) in 2011/12 and that Greek (as well as other euro area) banks benefited from very substantial liquidity support from the Eurosystem at the peak of the crisis.

10. The economic crisis in the Eurozone challenged the competence of the politicians and the institutional framework. In addition to this, it increased tensions and inequality between the North and the South, while populism and nationalism also increased. Are you worried about all this, in view of the European elections? Has the Eurozone become more resilient?

One should not underestimate how much has been achieved in recent years, but the foundations of Europe’s financial architecture need to be reinforced further to withstand the impact of a future crisis. This should be a priority for policy-makers and relevant institutions. Decisive political will to move forward with the completion of the banking union is required. In the absence of this will, Europe must revisit its existing rules to safeguard financial stability. This is in the best interest of its people as few things can be more destructive to citizens’ trust in European institutions than threats to financial stability.

Ta Nea (published on 23 February 2019)

1. Uncertainty is becoming increasingly prevalent in the public debate about the state of the global, but also the Euro economy? What risks do you see and what is needed to tackle the situation?

The economic outlook of the euro area is currently subject to high uncertainty and downside risks, which mainly relate to the possibility of: (i) a rise in tensions in European financial markets, (ii) a disruptive withdrawal of the UK from the EU, (iii) persistent global protectionist tensions and related uncertainty, and (iv) a broader deterioration of financial market sentiment. If some or all of these risks materialise at the same time, the probability of a more severe downward scenario would increase.
In a setting where the euro area economy is decelerating faster than anticipated and risks to growth remain skewed to the downside, policy priorities should focus on: (i) adopting structural measures that enhance productivity and potential growth and raise resilience to shocks, (ii) creating fiscal policy space and reducing financial risks where needed, given the still high debt levels and tighter financial conditions, and (iii) strengthening multilateral cooperation on trade policy.

2. Taking also into account uncertainties related to Italy, what risks to you see on the European south and especially in countries such as Portugal and Greece?

A stable macroeconomic environment requires long-term commitments to be honoured, helping anchor agents’ incentives. Uncertainty regarding the ownership and fulfillment of European commitments is clearly undesirable. We know that, under extreme volatility, markets may segment those countries which have stronger latent vulnerabilities. Addressing existing uncertainties must therefore be a goal of all European partners, in order to promote economic stability and long-term growth.

3. The monetary union hasn't yet been made crisis-proof, while the banking union is still missing key elements. Recent Eurogroup meetings failed to make progress on the deposit guarantee scheme. What are your concerns? How would you like to see efforts developing?

One should not underestimate how much has been achieved in recent years, but the foundations of Europe’s financial architecture need to be reinforced further to withstand the impact of a future crisis. This should be a priority for policy-makers and relevant institutions. Decisive political will to move forward with the completion of the banking union is required. In the absence of this will, Europe must revisit its existing rules to safeguard financial stability. This is in the best interest of its people as few things can be more destructive of citizens’ trust in European institutions than threats to financial stability.

4. Greece exited the bailout programme and is now on track of regaining confidence and market access. Portugal has recently gone through a similar process. How do you see Greece’s efforts and what risks do you see?

Greece needs to continue to build on all the efforts made over the last few years for a successful convergence towards the other EU Member States. The recent 5-year issuance reflects improving investor confidence, which is expected to continue, just as has been the case for Portugal since it exited from its own adjustment programme. Markets’ trust in countries with high levels of public debt such as Portugal and Greece are the ‘acid test’ of the sustainability of policies. That depends on the continued adjustment of public finances and domestic savings’ capacity to cover financial needs.

5. The rapid resolution of "bad loans" has been recognised as a matter of paramount importance for restarting the economy and restoring significant and sustainable growth rates in Greece. Proposals are on the table, while NPL reduction targets are quite high. How do you assess this situation?

From recent reports I understand that proposals have been presented and are being discussed with the relevant stakeholders. I do not have visibility into the ongoing discussions. However, what I can say is that it is important that all proposals are explored to find suitable and feasible solutions to reduce the stock of NPLs. This will strengthen depositors and market participants’ trust in the banking sector, enabling it to play an important role in the continued recovery of the Greek economy.

6. You will participate at the Delphi Forum. What messages you would like to convey?

The main messages I want to convey relate to the importance of learning the lessons from the crisis, preventing imbalances from accumulating and ensuring ownership of an adjustment programme when it is required.
Authorities need to create long-term competitiveness conditions and increase potential output and employment in order to absorb both headline and hidden unemployment.
When investors’ concerns about the sovereign’s capacity to pay back debts intensify and the country is unable to fund itself on the international markets an adjustment programme must be negotiated. Authorities need to ensure ownership of the programme and a fair distribution of costs across society to create a collective sense of purpose. The reaction of the tradable sector, in particular exports, is crucial for rebalancing the external accounts and mitigating the impact of lower domestic demand on the non-tradable sector. Maintenance of confidence in the banking sector is also key to preserving regular financing of the economy and avoiding a deeper credit crunch.
Adjustment programmes are always short-term, 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.