Carlos da Silva Costa • Governor of the Banco de Portugal28 May 2018

Economic development, financing, credit cycles and financial crisesThe Portuguese case

30th Aniversary of Afi

2 • 28 May 2018

Outline

1. 1995-2007

Capital inflows from euro adoption misallocated, leading to macroeconomic

imbalances

2. 2008-2010

Global crisis tackled through fiscal expansion disregarding accumulated imbalances

3. 2011 onwards

Macroeconomic rebalancing and financial deleveraging: notable progress, but no

room for complacency

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1. 1995-2007 – Capital inflows and macro imbalances

Euro brought increased access to capital since mid-90’s.

Interest rates plummeted…

10,5

2,6

4,7

11,9

3,93,2

4,5

4 • 28 May 2018* In the case of Households, interest revenues and expenses are taken into account, producing an estimate of the impact onnet losses from interests.

1. 1995-2007 – Capital inflows and macro imbalances

… providing significant reductions in interest expenses…

Estimated impact of implicit interest rate evolution on interest expenses* As a percentage of GDP

Cumulative impactover the periodAs a percentage of GDP

-2,3

-1,6

-1,4

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1. 1995-2007 – Capital inflows and macro imbalances

… and generating a credit boom.

52

2824

131

73

58

59

30

105

90

6 • 28 May 2018

1. 1995-2007 – Capital inflows and macro imbalances

The banking system channeled foreign funds to domestic residents.

(Short-term) loans used to finance (long-term) domestic credit.

156

89

7 • 28 May 2018

1. 1995-2007 – Capital inflows and macro imbalances

Credit expansion was used to strongly increase consumption and investment, which, in

turn, accelerated imports…

Imports

Public consumptionInvestmentPrivate consumptionGDP

Index 2007

193

139138135133

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1. 1995-2007 – Capital inflows and macro imbalances

…with a consequent deterioration in the current account…

-2,5

-3,6

-8,6

100

90

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1. 1995-2007 – Capital inflows and macro imbalances

… and increasing exposure to foreign markets / dependence on foreign savings

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Investment surge financed through the credit expansion mainly channeled towards

non-tradable sectors, typically associated to relatively low returns…

1. 1995-2007 – Capital inflows and macro imbalances

8

16

10

12

11 • 28 May 2018

1. 1995-2007 – Capital inflows and macro imbalances

… hampering productivity and potential GDP growth, cornerstones of debt

sustainability.

Average95-00

0,64

Average01-07

0,18

Average95-00

3,03

Average01-07

1,49

0,9

0,2

3,3

0,8

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1. 1995-2007 – Capital inflows and macro imbalances

The public sector exacerbated the leveraging dynamics, adopting fiscal expansion as

private savings contracted.

-3,6

13 • 28 May 2018

1. 1995-2007 – Capital inflows and macro imbalances

In the early 00’s, as interest rates stabilized and growth slowed, general government

deficit and debt increased.

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2. 2008-2010 – A crisis leading to financial stress

Expansionary fiscal policy adopted in response to the 2008 global crisis disregarded

indebtedness levels, competitiveness vulnerability and investors’ fears.

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2. 2008-2010 – A crisis leading to financial stress

GDP responded in the short-term, but potential growth kept downward trend.

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2. 2008-2010 – A crisis leading to financial stress

As investors’ concerns grew, public debt marginal interest rates increased, up until the

sudden stop in foreign lending and subsequent financial assistance program (April 2011).

10Y30.12.2011

13,4

10Y18.08.1997

6,4

17 • 28 May 2018

• In the context of a monetary union, a sizeable credit boom, coupled with such an imbalance

between savings and investment, immediately translates into indebtedness and external

imbalance, putting macroeconomic stability and debt sustainability at risk.

• By priorly channeling available capital to non-productive – instead of productive – and

indirectly productive – instead of directly productive – investment, economic agents limit and

delay return.

• By privileging non-tradable sectors – instead of tradable –, investors hinder the economy’s

ability to generate long-term sustainable growth, the major guarantee of debt sustainability.

• On top of such a set of choices, two economic policy stances become indispensable:

macroprudential and fiscal countercyclical action. In their absence, vulnerability mounts.

Lessons to take away

18 • 28 May 2018

3. 2011 onwards – Rebalancingremains a challenge

The Economic and Financial Assistance Program (EFAP) with the European

Commission, ECB and IMF targeted three major adjustment needs:

A. Fiscal consolidation

B. Financial stability

C. Structural macroeconomic reform

19 • 28 May 2018

3. 2011 onwards – Rebalancingremains a challenge

A. Significant progress in Fiscal consolidation, but debt and external exposure remain

high. Further progress is needed in order to fit (i) public provision of goods and

services to (ii) social needs and (iii) accepted tax burden.

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3. 2011 onwards – Rebalancingremains a challenge

B. Financial stability conditions also improved markedly…

7,6

14,5

89

93

21 • 28 May 2018

3. 2011 onwards – Rebalancingremains a challenge

B. … but risks still loom.

2,9

11,8

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3. 2011 onwards – Rebalancingremains a challenge

C. Structural macroeconomic reform poses continuous challenges. Further

resource reallocation towards tradable sectors remains urgent…

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3. 2011 onwards – Rebalancingremains a challenge

C. … and although competitiveness has improved…

24 • 28 May 2018

C. … both productivity and potential GDP growth must raise.

3. 2011 onwards – Rebalancingremains a challenge

25 • 28 May 2018

Challenges for the coming future

Ensuring potential GDP growth is

• sustainable, providing real convergence

• and inclusive, promoting structural employment.

Attract investment Spur productivity

• Proceed with banking-sector balance sheet

cleanup

• Reinforce firm capitalization

• Promote new financing channels

• Minimize uncertainty

• Proceed with fiscal consolidation

• Promote tax and regulatory stability

• Promote resource reallocation towards

tradables

• Fight red tape

• Ensure private sector extracts full benefits

from public infrastructure

• Spur innovation and its translation into

market value

• Promote human capital (re)qualification