You started as an economist at Bank of Portugal, then transitioned to become finance minister in 2015 and president of the Eurogroup in 2018. Last year, you returned to monetary policy as governor. What have you learned about monetary-fiscal interaction in the eurozone from the sovereign-debt crisis and Covid-19?

We have different instruments for fiscal and monetary policy. But our common goal is not that different. I was trained at Harvard as a microeconomist, and I always see economics through the lens of the microeconomy. What connects all the dots in my career is the special attention to the behaviour of economic agents. In the US, most of my professors had experienced public service in the administration and or at the Federal Reserve System. So, I came to believe there is nothing special about this engagement across policy areas.

The monetary and fiscal interaction achieved in the Covid-19 crisis is a major leap of integration that many requested for quite some time, including myself as president of the Eurogroup. But unfortunately, it was not possible before March 2020. A time at which there were no moral hazard concerns or fiscal dominance worries. Monetary policy is no longer ‘the only game in town’ in Europe, and we should not fear a lack of ECB [European Central Bank] independence because of it. The build-up of confidence during the last three to four years in Europe was the main factor that made this increased co-ordination possible. Of course, the magnitude of the crisis also played an important role. But, over time, we learned that building trust in the eurozone is the best way to speed up integration and smooth policy interactions.

I want to stress that on the fiscal side, 14 eurozone countries met their medium-term fiscal objectives in 2019. This was highly relevant in the debates about how to respond to the pandemic. In the financial system, non-performing loans [NPLs] and debt-to-GDP ratios were reduced in all countries. And finally, right before the pandemic, governments agreed on the first euro area budgetary capacity, in December 2019. This was a game-changer that paved the way for the very high level of commitment and the rapid agreement in March 2020.

 

Although fundamentals were better before the pandemic, to what extent was fiscal policy deployed because monetary policy had been partially exhausted and its efficiency had declined?

We have been very innovative on both sides. The Eurogroup’s April 2020 statement called for an innovative financial solution to address the difficulties and challenges ahead, and governments have responded. If you look at the ECB response to the crisis through [the] PEPP [Pandemic Emergency Purchase Programme] and TLTROs [Targeted Longer-Term Refinancing Operations], it is clear that monetary policy is not exhausted. In fact, it has been a key pillar in addressing the pandemic.

 

In December 2020, the Governing Council again increased the PEPP’s portfolio, targeting an ever-wider set of indicators including sovereign yields, corporate yields, lending rates to households, etc. Some fear this is leading to mission creep, binding the ECB to unlimited market interventions. What is your view?

This decision reflects the evaluation we had on the pandemic and the evolution of the economy at that time. Now that two months have passed, and there is some perspective to assess it, we are not disappointed about the decision. The increase in the number of Covid-19 cases, the new lockdowns imposed on the continent and the consequences we know this is having on the economy prove that it was a suitable recalibration of our instruments. In every policy meeting, we make similar assessments. We always look at a very large set of indicators to evaluate the economic situation. We feel the recalibration was absolutely necessary to fulfil our price stability objective. 

You also have to factor in that the treaty on the functioning of the European Union also states that, without prejudice to price stability, the ECB should support the union’s economic policies. We think that’s exactly what we have been doing. The PEPP is not an open-ended purchase programme. We have defined the size of its envelope and the period of net purchases. These elements are important to understand the role of this programme. The PEPP is intended to preserve favourable financing conditions to all sectors of the economy. This crisis has not been caused by structural weaknesses, but by the nature of the pandemic. That is why we need to monitor a wide set of financing conditions to shield all sectors from an exogenous shock.

 

The December decision also ignited a debate among observers about whether the ECB has in practice adopted yield curve control. Bank of Spain governor Pablo Hernández de Cos has said it is “an option worth exploring”, noting the possible tailoring of asset purchases to prevent sovereign yield curves from departing from the euro overnight index swap curve. What do you think about yield curve control?

I think our current instruments are working very well, preserving favourable financing conditions. The PEPP has been particularly effective and efficient, ensuring that the middle- and long-end segments of the yield curve component of overall financing conditions remain appropriate. Indeed, the entire euro area GDP-weighted sovereign yield curve is significantly below the pre-pandemic level. The dispersion across the euro area of 10-year sovereign yields has reached a new post-2008 low. Additionally, all eurozone countries can now fund long-term borrowing at or below the rates of bonds of non-eurozone advanced economies. This highlights the extent of the monetary stimulus that the Eurosystem is currently providing and is expected to provide in the future to mitigate the social and economic costs of the pandemic.

Adopting yield curve control implies announcing the target price for government bonds at different maturities. My opinion is that a central bank can only promise simultaneously specific nominal rates and inflation rates for an extended period of time as long as they are compatible with the long-run real interest rate that clears the market. And that will not be the easiest way forward.

 

Some observers warn the link between asset purchase programmes and sharply higher public debt levels are blurring the lines between fiscal and monetary authorities. Are you concerned about fiscal dominance as a legacy of the pandemic?

I’m not concerned about fiscal dominance. This crisis confirms the power of monetary and fiscal policy when acting together. There is an interaction effect that we must explore within our independence and instruments. This is a lesson learned that should guide our forthcoming decisions. Both former [ECB] president [Mario] Draghi and president [Christine] Lagarde have stressed for years that we need both fiscal and monetary policies acting co-ordinately.

The set of unconventional measures from our side has proved to be very effective in the crisis, when supporting growth and inflation was key. They were also crucial in stabilising markets and easing financial conditions. There are always costs and side effects associated with these decisions. If you consider a possible counterfactual: a scenario without these measures, it is very likely that we would have experienced a much larger economic shock.

 

The number of former finance ministers on the ECB’s Governing Council appears to be growing, and includes president Lagarde, vice-president Luis de Guindos, Bank of Finland governor Olli Rehn as well as yourself. Some are concerned that it indicates a stronger political will to influence an increasingly powerful institution. Are you worried about the ECB’s independence?

All these members of the Governing Council you mentioned have had several high-profile positions throughout their professional careers. They all have a very relevant experience in the government and or the private sector, in national and international institutions. The presence of former ministers in the Governing Council should be seen as a natural phenomenon. It happened frequently in the past. If you go back 10 years and count the number of former ministers, it will not substantially differ from the current situation. I want to make completely clear this situation did not imperil central banking independence in the past, neither will it do so today. In the Governing Council, we work as a team.

 

In December, in an op-ed article in Portuguese newspaper Diário de Notícias, you stressed that the ECB’s asset purchases have contributed to lower Portugal’s risk premium against Germany to the lowest level since 2010. In fact, 10-year bond yields dropped below 0% for the first time in November 2020. Now that the public deficit is expected to rise over 8% of GDP in 2020, do you worry protracted asset purchases might weaken market discipline, hampering the rebuilding of fiscal buffers?

I don’t think this will happen. For example, Moody’s Investors Service has recently indicated that there is scope for an upgrade of Portugal’s rating. I think there’s a solid connection between what monetary policy is facilitating and what the market evaluates as appropriate. In 2020, the reaction of fiscal authorities around the globe was co-ordinated. This intervention was proportional to the challenges the eurozone faced. And it was also possible due to the lack of market fragmentation in the eurozone, contrary to what happened during the sovereign debt crisis.

Governments implemented temporary policies. They were able to target them towards the sectors more in need, something not possible for macro-oriented monetary policy. As a result, the public deficit in Portugal has jumped in 2020 vis-à-vis 2019, when it recorded a surplus [0.2% of GDP]. As of the actual outcome, the most recent estimates point to much lower deficit than the government projected in October. The budget deficit will most likely stay clearly below 7% of GDP. Portugal is set to continue outperforming market expectations and to act according to market discipline. The government is quite focused on that, without jeopardising much-needed support to the economy. We can expect a debate in Europe on fiscal rules. That will start as soon as the crisis is under control. Since the Finnish presidency of the European Council, in the second half of 2019, this debate has gathered steam. I do not expect changes to the commitments that brought us to the most co-ordinated fiscal response ever among eurozone countries. On the contrary, I expect the efforts to be focused on simplifying the methodology behind fiscal guidelines, so that they can be made clearer to citizens and other stakeholders.

 

The ECB is due to publish the result of its ongoing strategy review after the summer. Some Governing Council members seem to agree the inflation target should be higher, and the preferred alternative would be a 2% symmetric target. Do you agree with this goal?

A common sentiment in the Governing Council is that there is room for improvement in the way we specify our aim. The current definition of price stability clearly establishes an upper bound for inflation, but the identification of the lower bound is softened. This clearly creates ambiguity, and it may have led to a perception that the ECB is more tolerant of low inflation than of high inflation. This perception may have led to a less successful anchoring of inflation expectations. The wording used in defining our target is very important – it ultimately affects the effectiveness of our actions – and we must be very careful with that.

It is also true that the Governing Council frequently reaffirmed its commitment to symmetry. A simpler symmetric definition of the price-stability objective – for example, inflation at 2% over the medium term – will be easier to communicate and contribute to a better understanding of the ECB’s symmetric reaction function. And if we are successful, we could contribute to a better anchoring of inflation expectations. We can also consider that this change accommodates, to some extent, the fact that the natural rate of interest has gradually declined, which entails smaller room for monetary accommodation because we repeatedly risk reaching the zero lower bound. This is an interaction affecting our policy framework that we must take care of in the future.

 

The Fed’s adoption of average inflation target last year has raised concerns among some academics and former officials. Some say it is problematic that the Fed has not specified for how long it would allow inflation to overshoot the 2% target, and by how much. If the ECB was to adopt symmetry, would you favour the Fed’s approach or would you add more information for markets to anticipate future policy moves?

I want to stress the ECB has already adopted a symmetric approach to its target. The Governing Council has made that abundantly clear in the introductory statements of its monetary policy decisions at least since July 2019. That means that we are intolerant of inflation above our aim, but also that we are intolerant of inflation below it. The deployment of unconventional measures over the last decade illustrates it.

Approaches such as the average inflation target adopted by the Federal Reserve has been indeed proposed as a possible way to overcome the limitations of our interest rate policy facing the lower bound constraint. The success of such approaches strongly depends on expectations, acting almost as automatic stabilisers. For this to happen, and the economic literature is very clear on this, these approaches must be credible and well understood by the public. This raises challenges. On the one hand, it requires more clarity about the length of the make-up window, which is not the case yet, and the horizon over which to reabsorb past deviations of inflation from the target. On the other hand, having more information comes at the cost of a lower degree of flexibility in future policy decisions. The trade-off is very clear. And if this can be an important drawback, especially in the face of uncertain situations in which the central bank may need to follow a different course of action, we must be careful.

In my opinion, it is key to achieve the right balance between clarity and flexibility, which is quite hard. Another key condition is that long-run inflation expectations must remain firmly anchored. 

 

Last July, the European Council approved the €750 billion (€910 billion) NextGenerationEU Fund. As Eurogroup president just prior to its creation, you were directly involved in the negotiations leading up to the deal. With a few months of perspective, and bearing in mind its implementation is still pending, how significant do you think it is within the historic context of the construction of the European Union?

This is a big step in the construction of the Union – of an integrated and especially close-to-its-citizens Union. Sometimes, it is hard to understand what’s going on at the Union level, but what we’ve seen in the last few years is a big improvement. Statistics coming from the ‘euro barometer’ show the euro has never been more popular.

The importance of the NextGenerationEU package requires a faster adoption of all regulations, both at the EU and national levels. NextGenerationEU inherits the spirit of previous eurozone budget instruments. We really need an instrument to address these kinds of events in Europe. We had very lively discussions in the Eurogroup. The integration of the governance framework of the European Union and the modalities for eurozone members were part of the debate, and have definitely had a great impact on the design of these funds. Now, we need to make a success of it.

 

President Lagarde and other Governing Council members – although not all – have said the fund should not just be a temporary measure to fight the pandemic. They argue instead it should be the first step towards a common fiscal mechanism. Do you think eurozone member states are ready for the level of external scrutiny, fiscal discipline and co-ordination required to go in that direction? 

We have been preparing for this for many years. In my opinion, the spirit behind the Next Generation EU fund will stay with us for quite some time. I find it difficult to call it temporary. Of course, it is aimed at fostering a more resilient post-Covid-19 Europe; there is no doubt about it. But its goals are long-term, such as developing a greener economy or a digital economy. Having said that, there is no way a European policy will stay if it is not successful.

Financially, though, the fund is set to stay for decades. To finance the €750 billion, the European Union will borrow on the market, which is one of the most important and promising features of the instrument. This is certainly a sign of European solidarity, as the EU can raise funds at more favourable rates than many of its Member States. And it is also a commitment, a willingness to pursue the economic integration of the EU. The maturity of the instruments can go up to 30 years, so this is far from temporary. The reinforced ability of the EU to successfully fund the programme, and manage it over the following 30 years, will set the ground for new ambitious commitments.

You need to bear in mind that over the next three decades, we will be discussing how to finance the fund. It will become part of our future discussions. I am certain this step will have long-lasting positive repercussions. For instance, the articulation between the public debt issuance offices of EU countries will be strengthened, and better funding practices will emerge. The ongoing project of the capital markets union will also strongly benefit from this. Ultimately, our economic and monetary union will be reinforced at the international level. I say this because I am sure that different instruments with different maturities will be used, building a new reference yield curve. This will offer global investors new high-quality instruments, a Europe-wide safe asset.

 

Portugal’s GDP contracted by 7.6% in 2020, and the European Commission forecasts it will grow by 4.1% in 2021. However, Bank of Portugal has forecast unemployment to increase to 8.8% in 2021. How do you assess the resilience of Portugal’s economy to the pandemic? To what extent have the fiscal consolidation efforts implemented over the previous decade served the country?

Data available for the fourth quarter reveals a better performance of the Portuguese economy than expected. The size of the upward revision has a very significant carry-over effect. This is one of the reasons why the European Commission now forecasts Portugal will grow by 4.1% in 2021 – an even higher performance than what the Bank of Portugal was expecting back in December.

Of course, there is a great degree of uncertainty for the short-run because we don’t know the duration of the lockdowns, neither in Portugal nor in Europe. What we know is that this lockdown is less severe than the one in the second quarter of 2020, but, still, it will raise some concerns. We finished 2020 with a less severe recession than previously thought. The contraction is assessed to have been 7.6%, less than in previous estimates. The same thing is true for the unemployment rate, at 6.8% in 2020– a much lower figure than in our forecast. This is partly explained by the reduction in the number of hours worked, but still there was quite a bit of resilience in the labour market.

Looking at 2021, we can expect to have a rebound, although probably not as strong as previously thought. As a positive development, economic agents are learning how to deal with lockdowns. We are much better at dealing with the effects of the pandemic. And vaccines are a key factor, and they will make a difference in the coming months, while health authorities keep an eye on all variants of the virus. But for the first quarter of the year, the GDP contraction will depend on the duration of the lockdown and can be severe. All in all, we continue to see a gradual recovery, even if asymmetric and uneven across sectors. We continue also to expect that GDP will go back to its pre-crisis level at the end of 2022.

 

In 2021–22, Portugal will receive grants worth over €9.1 billion through the NextGenerationEU fund’s Recovery and Resiliency Facility, in 2021, €1.5 billion more through the fund’s React-EU, and €204 million through the Just Transition Fund. When investing these funds across Portugal, what do you think should be the priorities to better serve the national economy over the long term?

These funds are crucial. High-quality investment in the green and digital economies are expected. These should translate into higher productivity levels, supporting the supply side of the economy in the medium and long run. The real challenge is the need to allocate the funds correctly, preserving competition between firms. The broad priorities that have been established at the European level also include reinforcing social expenditure as a way to mitigate inequality. These priorities are growth-oriented. If they are correctly implemented by all member states, we will also deepen economic integration, reinforcing the single market. It’s very important for us to keep that in mind. We need to make the most of this opportunity to take on projects that are already mature enough to speed up implementation.

 

In September 2020, the government extended the suspension of loan repayments. In December 2020, you told the Portuguese parliament the value of suspended loan repayments for businesses and households had become very high, and a reassessment was overdue. You also stressed the need to resume payments as soon as possible. Do you think this scheme has become too lenient? How would you change the focus of these moratoriums over the coming months? 

These moratoria proved quite effective in mitigating liquidity shortages. Activity came to a halt, and this was unexpected. No-one really had the opportunity to prepare for these conditions. We did our homework, over the previous three to four years, financing conditions improved for most companies due to lower debt, and better solvency and liquidity indicators. This was especially the case for small and medium-sized companies in Portugal.

The Covid-19 economic shock was unavoidable: we needed to act on the helthcare front, and the moratoria have been effective. In implementing it, we followed EBA [European Banking Authority] guidelines, safeguarding the harmonisation across European countries. The moratoria take-up was quite high in Portugal, and it worked as a complement to other support measures that were enacted. Now, we need to start thinking about future steps. The extension of the programme until September 2021 was justified due to the new waves of infections. However, the crisis is having asymmetric consequences across economic sectors, and a more targeted approach to moratoria may be required. All of this must be implemented in accordance with the prevailing economic conditions after the summer.

 

The Portuguese financial system made major progress reducing the ratio of NPLs from 17.9% in June 2016 to 5.5% in June 2020. Nonetheless, this is higher than the 2.9% EU average. Are you worried this could sharply rise once the loan moratoriums expire later this year? To what extent is the banking sector better equipped to deal with the effects of the pandemic than it was in the aftermath of the sovereign-debt crisis?

This is certainly a real risk we have identified in our assessments, including the Financial Stability Report published in December. We experienced a very positive evolution since 2016, with the NPL ratio, in net terms, decreasing to just one percentage [point] above the eurozone average.

The banking sector, this time around, is better prepared to deal with the negative consequences of the pandemic. 

In particular, we must underline a few facts. First, we have seen an increase in liquidity buffers, as a structural adjustment of bank financing. This reduced the vulnerability and risk perception of international investors in our banking sector. The second fact is the reduction in operating costs, a result of the restructuring programmes in Portuguese banks implemented in the aftermath of the sovereign debt crisis. The third is the gradual recovery of profitability, at least up until the beginning of the pandemic. And finally, the significant strengthening of capital ratios. If we look at measures of solvency, for example, the ratio of total own funds increased by 7.4 percentage points since the end of 2008, reaching 16.9% at the end of 2019. 

These improvements allow banks to better accommodate losses resulting from the materialisation of private risk during the pandemic. However, this does not mean that we should not remain attentive and to carefully monitor these developments.

On the moratoria side, connecting the fragility of firms and spillovers to the financial sector, we have data indicating that borrowers benefiting from moratoria added substantial precautionary margins in the form of savings. Additionally, around 20% of the overall amount of credit to small and medium enterprises under the moratoria is covered by bank deposits. It is a quite important factor to mitigate concerns over the size of the moratoria. But, of course, it’s up to the banks to monitor their borrowers and manage these risks adequately, and to Government policies to be active as long as they are needed. I am confident that each part will perform according to expectations until we are out of the woods with this crisis.

 

The Bank of Portugal joined the Network for Greening the Financial System in December 2018. To what extent has this membership shaped the institution’s approach to climate change, especially regarding financial stability? 

The participation of the Bank of Portugal in this group boosted discussions around climate change, accelerated risk analysis, and has had a very substantial contribution to develop new initiatives. Climate change is a global risk, deserving a global approach. That’s why the topic is a focus of attention in publications, conferences and various meetings with associations and large companies that play an important role in this area. In 2021, we plan to conclude an evaluation of the exposure of the Portuguese banking system to non-financial corporates sensitive to climate transition risks.

Nonetheless, in spite of the progress made so far, there are important pending challenges. We still lack information, especially harmonised information, regarding the exposure of institutions to the climatic phenomena. In addition, we still have some drawbacks that persist on methodologies concerning the quantification of the impacts of these phenomena on the economy – and, of course, on the financial sector. This is a matter that deserves close attention. At the Governing Council level, we pay close attention to these issues, and we will continue to work in order to close these gaps both on data and methodologies.

 

In 2019, the Bank of Portugal became a seed investor in the Bank for International Settlements’ green bond fund, and it is also considering developing a responsible investment charter. What are the main takeaways from the process? What have been the main challenges and next steps developing the charter?

We are adopting a stepwise approach on integrating sustainable and responsible investment considerations on asset management. The investment in the BIS green bond funds, both in the first dollar-denominated [fund] and in the euro-denominated fund that was launched in January, is part of this process. I should note, however, that the Bank of Portugal has also been investing directly in the green bond market through its trading portfolio. We have implemented environmental sustainability considerations that are an integral part of our investment guidelines. As part of this process, we aim to conclude our socially responsible investment [SRI] charter defining the main features of our SRI approach.

The main takeaway from these experiences is that there is still a lot to be done – namely, in terms of common standards, data availability and harmonised reporting. 

Also, the Governing Council of the ECB has a task force on this issue, and we’re actively participating in this task force, so that we can make progress in the future and be one of the institutions at the cutting edge of these policies. We are collecting information on this type of information available in the market, identifying private-sector sources of information that we can use. The goal is to have all central banks use a common dataset. This does not mean relying only on one, but rather on several datasets. Then, we can all operate on a level playing field. When information is noisy, all your actions get blurred very easily, and it is a quite sensitive market, so we need to be ready to act together.

 

What are your longer-term institutional objectives for the Bank of Portugal at the national and European levels?

It’s important to me to increase the Bank of Portugal’s institutional capacity at both the national and the European levels. I have the experience of being a past president of the Eurogroup and I want to bring that experience in. But the Bank as a tradition to keep, in 2021, the Bank of Portugal will reach 175 years as an institution, a remarkable figure. 

It has a central role in Portugal and in Europe. Over the last few years, Portugal achieved important milestones in terms of credibility of its economic policy – namely, fiscal and financial. The country’s outperformed its targets, surprising many analysts, market participants and our European partners.

I want to reinforce this kind of ambition internally. It is quite important for us to be part of the group of economies that pushes the euro to overcome its challenges. Additionally, I aim to be able to communicate better institutionally, to share our decisions with stakeholders, and to be clear about their rationale. It is not always easy. But if you are not an open institution, that is always communicating, when things go wrong, you feel totally isolated. That wouldn’t be good for the Bank or for Portugal. We need to be present at all times.

Once, I described the euro as a rugby ball, because both are difficult to handle. In rugby, teammates must work and play together. When a team plays with one person down, it is hard to make progress on the pitch. This is pretty much how our currency union works. This is also how I see our institution. I want Portugal and the Bank of Portugal to be very active participants in this ‘euro’ rugby game, which is the Euro.