23 de Fevereiro de 2000

Mr. Prime Minister
Mr. Minister of Finance and Economy
Messrs. Secretaries of State
Ladies and Gentlemen

In my name and in the name of my colleagues of the Board of Directors I would like to thank the Government for the confidence that it has placed on the team that is now going to govern the Banco de Portugal. In my personal case, I am returning to an institution where I have spent approximately 15 years of my professional life, holding different posts and different responsibilities. This is not my first day at the Banco de Portugal. I performed the functions of Governor in 1985-86 and therefore I think that it will be interesting to make a brief comparison between the country at that time and the country we live in today, when I take over again functions as Governor. At that time, Portugal had just finished its second IMF stabilisation programme, growth had been negative in 1984 (-1.9%) and inflation had reached 28.9%, following a 20% devaluation of the escudo effective exchange rate. 1985 was a more favourable year, with growth attaining 2.8%, but inflation still remaining at 20%; the unemployment rate stood at 8.7% and the public sector borrowing requirement at 10.5% of GDP. Lending rates stood at around 27% and deposit rates at 25%. The situation of the banking system was a source of major concern, since profitability was affected by the high implicit tax charged by the State under the form of a deficit financing below market rates, and the solvency situation was precarious with an 11% ratio of non-performing loans (NPL) to total credit and own funds plus provisions accounting approximately for only 80% of NPL.

It is not surprising thus that my speech when I took office in 1985 was focused on the introduction of the required reforms of State financing, of the money and foreign exchange market, the restructuring of the banking sector and the preparation for the switch to indirect methods of monetary control so that the former credit ceilings could be abandoned. During my term of office, I was able to carry out part of the programme announced. The issue of Treasury bills through tender procedures conducted by the Banco de Portugal, allowed for the creation of the first market-determined interest rates and laid the grounds for a true money market, a pre-requisite for the reform of the monetary control method according to market mechanisms. Interest rates started to be liberalised. The interbank money market was modernised and there was a shift from the physical presence in market sessions to continuous sessions throughout the day over the phone. Administered exchange rates were abandoned and a spot market with a daily fixing was set up. Rules were defined to accommodate in a profitable way, within the context of the credit ceilings system, the new private banks that in the meantime had been authorised.

In sum, the first steps were given towards financial liberalisation, which was a pre-requisite for accession to the EEC. It was an interesting period during which the Banco de Portugal was able to contribute again to the stabilisation and modernisation of the Portuguese financial system and economy.

In the meantime, the accession to the European Union galvanised and transformed the country much beyond our perception. Today, we have a developed country, which is a member of European Monetary Union, with full macroeconomic stability and conditions for development in the future. Harmonised inflation stands at 1.7%, virtually identical to the European average, the unemployment rate at 4.2%, the budget deficit at 1.9% and average interest rates are around 6%. This evolution was accompanied by deep structural transformations and a sizable rise in the standard of living of the population, whose real disposable income has increased by 50% since 1985.

Among the transformations made, I would like to highlight the changes introduced in the banking system, which today is globally profitable, modern, concentrated, well capitalised and expanding. In September, non-performing loans accounted for only 2.4% of total credit and own funds plus provisions were 600% higher. In the meantime in this period, banks placed in their own Pension Funds around 1,300 billion escudos to ensure their pension liabilities towards bank employees. On the other hand, increases in productivity gave rise to a 230% real growth of the system’s total assets, while the number of employees remained virtually unchanged. Although the system has a few problematic areas, the institutions’ modernisation capacity — through the introduction of state-of-the-art technologies in order to support the development achieved by the country — should be praised.

The voices that doubted of our capacity to profit favourably from the participation in the European Union were silenced. Portugal surprised even the most optimistic, by the way how it was able to achieve nominal convergence with its European partners and participate in the euro. The Banco de Portugal played a brilliant role in this process and in this perspective I am much honoured to congratulate Professor António de Sousa and his team on the way they conducted the Bank in the fulfilment of its functions.

I wouldn’t like the positive view that I have transmitted of the evolution of the country in this period to be misinterpreted. I am clearly conscious of the vulnerabilities and shortcomings that still characterise Portugal ¾ weak education indicators, insufficient infrastructures, low technological content of many productions, income inequalities. Besides, although the participation in the euro creates great opportunities, it entails some risks and imposes new competitive requirements. This is perhaps the reason why lately some doubts have been expressed on the sustainability of the recent development pattern of the Portuguese economy. Three aspects are usually highlighted:

• First, growth is excessively based on the buoyancy of domestic demand, particularly of consumption, giving rise to a high degree of indebtedness of households, mirrored in the external indebtedness of the banking system to accommodate the difference between the growth of credit and deposits.
• There are also concerns about the balance of payments and a somewhat confusing idea that it may disturb economic growth.
• Finally, there are concerns about the recent performance of exports and foreign direct investment.

As to the first point, I would like to stress that despite some projections to the contrary, Portugal did not experience an overheating of the economy: growth is moderately higher than that of the EU, inflation is similar to the European average and there is no inflation in the assets market. It is true, that the indebtedness of households reached almost 80% of the disposable income, but with the reduction over the past years in interest rates, the burden with interest charges recorded only a small rise. In fact, that percentage is rather lower than the one recorded in several countries when they experienced crises related to the real estate market. It is obvious that credit to households could not go on growing as in the past few years and prospects of some rise in interest rates led to some deceleration already towards the end of 1999. Banks in turn have to become more selective and above all keep their clients better informed about possible future increases in interest rates. The situation of their own accounts will also depend thereon as well as their capacity to go on borrowing normally from other euro area banks. Indeed, the strong external indebtedness of the banking system is normal between regions belonging to the same monetary area, where the transfer of savings is ensured without foreign exchange risks. The only limits relate to the credit capacity of each of the banking institutions, as assessed by the market and its kindred foreign institutions. This is not therefore a macroeconomic problem.

As a matter of fact this has to do with some confusion on the meaning of an external current account of a region belonging to a monetary union as is currently the case of Portugal. Without a currency of our own, we shall never again face the same balance of payments problems of the past. There is no macroeconomic monetary problem and no restrictive measures need to be taken for balance of payments reasons. No one analyses the macro size of the external account of the Mississipi or of any other region belonging to a large monetary union. This does not mean that there are no external restrictions on the economy. This restrictions result solely from the mere aggregation of the indebtedness capacity of the various economic agents. The limit depends on the indebtedness capacity of internal agents (including banks) vis-à-vis the Euroland financial system. If and when indebtedness is considered too high, expenditure will have to be cut, because the financial system will place limits on credit. The equilibrium will be spontaneously re-established, through a mechanism of expenditure deflation, and no adjustment policies will have to be implemented. The aftermath of a strong indebtedness situation may have recessive consequences, but it is not a balance of payments problem. The most adequate comparison would be with the new paradigm that sees the external current account as the result of an intertemporal optimisation of the consumption profile of an economy that faces a perfect capital market.

For a country with its own currency and assuming that the currency is traditionally weak, in general, the limits become apparent earlier on, since to pay for imports foreign currency is required, either by resorting to reserves or to credit, and both have obviously limits. That is, the suspicion that a country in this situation may have an external payments macroeconomic problem, due to the fact that it is running out of reserves, leads external restrictions to be felt before the economic indebtedness capacity of economic agents dries up. Thus in these cases, good companies or good investment projects may be subject to financing ceilings if the country does not hold foreign currencies. This does not happen in the context of a region that traditionally trades with other regions of the same monetary area. If the economy is growing soundly, with good projects, it means that its output is competitive and that there are no "balance of payments" problems hindering the process of real convergence with developed Europe. If, on the contrary, the economy is growing less than that of our trading partners and imports are far higher than exports, showing lack of competitiveness, the external current account can be indicative of problems, albeit not being itself a problem . It is therefore an indicator that has to be analysed together with other competitiveness indicators.

I have already mentioned that all this does not imply the absence of external restrictions on the economy, but from the point of view of public policies what matters is the existence of limits to the growth of domestic expenditure, due to the inflationary pressures that it can generate and to the consequences that it may have on the competitiveness of Portuguese output. Moreover, an excessive pressure of demand on the assets market (e.g. real estate prices) can give rise to a future crisis with recessive consequences.

The currently existing inflation differential is however of a reduced size and of a still recent nature. In addition, in the context of monetary union and of a process of real convergence of development levels, inflation in Portugal will be higher than the European average, but this will not necessarily imply a loss of competitiveness vis-à-vis the remaining Member States. The justification for this performance is peaceful and is related to the so-called Balassa-Samuelson effect.

This does not however imply that we may ignore the risks of inflation. Experience from the past decades in developed countries and the evolution of economic theory demonstrate that in addition to being counterproductive to try to fine-tune the conjuncture, the inflation rate is neutral in relation to the equilibrium path of output. That is, we do not have higher growth and more employment by creating more inflation and a decentralised market economy operates better in a low inflation environment. Therefore, if private expenditure remains unabated and growth continues to be strong, the State will have to maintain fiscal tightening. Considering that no interest rate cuts are foreseen in the short run, this implies that public consumer expenditure cannot go on increasing at the same pace of the past years. The degree of financial rigour will therefore increase and no illusions should be entertained, to quote the philosopher, because "an illusion is often worse than a mistake". I therefore congratulate the new Stability Programme presented by the Minister of Finance for being quite positive, committing the government to a rigorous path regarding the containment of the current expenditure of the State, by resuming the consolidation of Portuguese Public Finance. I can assure you, Minister, that the Banco de Portugal will support and stimulate this effort, including by being critical if required, so that the Programme can be fulfilled.

The latter point I mentioned regarding the Portuguese economic situation seems to be potentially more worrying. I am referring to the recent behaviour of exports and foreign investment. The loss, albeit negligible, of market quota over the past two years in the countries of destination of our exports, and the deceleration of direct investment may represent a loss of competitiveness caused by third country competition, with lower costs and more attractive conditions. It is too early to conclude whether we are facing a cyclical and brief phenomenon influenced by the 1998 Asian crisis, or whether it is of a structural nature. I have often claimed that our participation in the euro was something like a wager, and I have always trusted that we would win such wager. However, this process includes the introduction of structural changes in the productive structure, serving as a basis for new comparative advantages. In the present circumstances, this is more dependent on the entrepreneurial agents rather than on public policies. The only possible shortcoming of policies may be related to a lack of risk capital to stimulate investment in Portugal instead of abroad. Currently, however, public policies provide a framework of perfect macroeconomic stability and low financing and capital access costs. This promotes modernisation and expansionary productive investment. These are the largest advantages and the greatest opportunity created by the euro. Advantage ought to be taken of it, with a view to leading to an indispensable structural repositioning of Portuguese economy. Companies are now competing on the basis of a strong currency and cannot let themselves be misguided by short-term facilities. The Unions shall also be responsible for calibrating their claims in compliance with the new competitive context before us, if they are effectively trying to defend employment. There will be no devaluations or subsidies to support companies that have lost their competitive positions because they have not taken modernisation initiatives, or because they have not increased the technological contents of their production processes or the quality of their products. The path we are following is demanding and beyond the point of no return, but it is the best way to ensure our future progress.

The acuity of these statements will be even more significant, if the euro appreciates in the near future, increasing competitive pressures from third countries. No one should entertain any illusions that the recent weakness of the euro implies that we could classify it in the group of weak currencies. Conjuncture differences vis-à-vis the American economic stance lie behind its present depreciation. Over the 1990‘s, the Deutsche mark also experienced two depreciation cycles vis-à-vis the dollar and no conclusions were drawn that it was a weak currency.

Actually, what defines the quality of a currency can be summed up by the following aspects: It must be managed in an appropriate manner, thereby ensuring macroeconomic stability and low inflation; it must be adequately credible, in order to lead to low long-term interest rates; it must have liquidity available in all instruments and maturities. The euro does comply with all these criteria. Inflation is lower in Europe. Ten-year bond interest rates in European countries are lower than US interest rates for the same maturity. This means the markets are confident that, in the long run, inflation in Europe will tend to be lower than in the USA, thus reflecting their confidence in the way the euro will be managed. Finally, there is no lack of liquidity in the different financial instruments denominated in euro.

Evidence indicates that the euro is therefore destined to play an increasing role within the international monetary system and to appreciate in the future. The USA, unlike Europe, continues to reveal a rather negative balance of payments. This will eventually be reflected in the exchange rate of the dollar. Over time, the euro will grow in relevance and value. More important than that, however, is that the euro will be the instrument to maintain low inflation in the European economy, guaranteeing good conditions for steady economic growth.

The objectives of the European Central Bank do not include the «defence» of a given exchange rate for the euro. The purpose of European monetary is to for pursue internal objectives of stability and inflation control. As the Euro Area is a relatively closed economy the exchange rate does not have a decisive influence on domestic inflation. It would therefore be wrong to adopt the exchange rate as an intermediate objective of monetary policy. If monetary policy is able to maintain a low inflation trend, the euro will continue to be a strong currency, a position that will be fully reflected on its exchange rate. The attempt to create a «target zone» system for the major currencies would have led to higher interest rates in Europe to «protect» the euro. The result would have jeopardised the recovery of the European economy and the reduction of unemployment. The reason behind the creation of the euro by the European Union lies precisely in the possibility it opens of leading an autonomous monetary policy, chiefly concerned with the pursuit of its own objectives and detached from external situations. The indispensable efforts of international monetary cooperation in occasional situations of strong imbalances do not question that basic guideline.

The above is directly related with the change of functions experienced by the Banco de Portugal. Without its own monetary policy, but fully committed to the European System of Central Banks, the technical preparation requirements have increased, with a view to ensure our effective participation and to comply with the numerous requests for data and analysis submitted by the ECB. The responsibilities related with the supervision of payment systems and, chiefly, with the supervision of financial institutions have also increased, since the Banco de Portugal is the custodian of the financial system stability. The Minister of Finance has just announced the changes he intends to introduce in financial regulation. The guidelines he has outlined seem to be appropriate to our situation and are in line with the best international trends towards the introduction of further co-ordination, without the merger of specialised institutions that may even have conflicting perspectives on the different interests to be protected.

Other changes are imminent in the supervision area, especially the significant changes in the regulation about capital requirements of credit institutions, within the scope of the Basle Committee and of the European Commission. On the other hand, I believe that it is necessary to introduce some changes in the Deposit Guarantee Fund scheme as well as in the Legal Framework of Credit Institutions and Financial Companies.

The above tasks do not fully cover all of Banco de Portugal’s functions. Among these, there is a particular area where I even intend to widen the Bank’s mission - the provision of services to the community. I am referring to domains such as information, research and economic training, areas in which the Bank’s capacities should be more open to the requirements of the general public. The Bank has a duty to further support the informed debate of the country’s economic and social problems, even if these go beyond the strict domain of monetary policy. In particular, I intend to develop a new information service for the consumer, as it exists in the US Federal Reserve System s, with a view to inform the consumer about the utilisation of financial services and to promote the best system practices. This means, essentially, to inform and clarify, without promising any support that might lead to a sentiment of irresponsibility among consumers in their transactions with the banks, in particular those transactions increasing their level of indebtedness. In addition to the specific service it provides, this approach falls within the notion of a well-performed supervisory function, since it also contributes for the better protection of financial service users. A better knowledge and sophistication in the utilisation of financial products on the part of the users is essential to ensure that their choices do not distort the investment saving process. This also contributes to maintain confidence in the system and to ensure a better performance of its important task of allocating financial resources.

All aspects I have mentioned above mean that, despite the stability of the Portuguese situation, the tasks I will have to face in the Banco de Portugal are only apparently less demanding than those I had to face the first time I carried out these functions. I am considering this return to the public service with deep enthusiasm and with a deep sense of responsibility. To serve my country and the European project is a stimulating mission that I take with the highest degree of exigency. I am aware of the difficulties still confronting Portugal before it can fully assert itself as a developed and modern country, within the present competitive environment . . However, I face the future with the confidence of someone who has witnessed all the stages of the steady progress that, collectively and regardless of different governments and normal political conflicts, we were able to ensure and that democracy and the participation in the European Union have brought to Portugal.

Lisbon, 23 February 2000