The challenges of adjustment and growth

AMERICAN CHAMBER OF COMERCE IN PORTUGAL 

I would first like to say thank you for the invitation, and say how honoured I am to speak at this luncheon of the American Chamber of Commerce in Portugal.

In the first part, I will make some comments about the current circumstances.

As we all know, Portugal is undergoing an Economic Adjustment Programme as a result of over-borrowing and accumulation of a high external deficit, which left us dependent on foreign funding, which in turn dried up.

Until very recently, the way the programme was being executed enabled us to substantially improve our image abroad, both in political centres and in the markets' perception of the Portuguese economy's prospects. The progress made in fiscal consolidation, stability of the financial system and some structural reforms is undeniable.

Indeed, we have had some resounding successes:

• Our primary balance went down from -7% of GDP in 2010 to -0.4% in 2011 (and 0.5% in 2012).
• Public spending fell 4.6% in 2011 to 84.393 billion euros. This reduction could have been even more substantial (-7.2%) if interest rates had not risen 39.4% in the same period. We expect an 8% reduction in spending in 2012 (9.5% if we exclude interest, which is expected to grow by 9%).
• The balance of payments went down from -9.7% of GDP in 2012 to -6.6% in 2011 and -2.6% in 2012 (-1.1% if we consider the balance of payments and capital account).
• The performance of Portuguese exports exceeded all expectations in terms of growth and diversification of destinations. In 2011 exports of goods and services increased 13.3%, with goods growing 15.3%. There was a year-on-year growth of 9.6% in the first eight months of 2012. 
• Emigrants' remittances also performed very well, growing 6.3% in 2010 and 0.2% in 2011
• The markets appreciated these performances and are giving our adjustment programme a positive interpretation (and that in Ireland). This is demonstrated by the fall in interest rate differentials on one-year and 10-year public debt against Germany. Renewed access by the largest companies (EDP, BRISA, PT, SONAE, etc) to the bond markets occurred on very reasonable conditions. Last week, BES was also highly successful in issuing a three-year senior debt of 750 million euros, in which demand was five times greater than supply, bringing forward entry into the medium- and long-term market by one year.

But in addition to all these good results, there is another factor that the markets appreciate and emphasise and that it is important to highlight as a differentiating factor.

In fact, this strict, tough austerity programme, which requires extreme sacrifices from the population, has been implemented in an environment dominated by:

- civic awareness that the country needed external assistance, that it would meet its commitments and that temporary impoverishment was inevitable

- consensus, cohesion and social peace, which were not jeopardised by expressions of dissatisfaction, apprehension and protest, where the Portuguese showed a high sense of responsibility reflected in the entry into a collective bargaining agreement, now in effect

- consensus and a political commitment between the government coalition and the Socialist Party in opposition to execute the adjustment programme, which was negotiated and signed while the socialists were still in power

But as was always accepted, as the austerity affected people, it was natural for the atmosphere to get heavier. It is the so-called “adjustment fatigue”.

Nonetheless, the idea that the programme was being successfully implemented fuelled the flame of hope, as austerity and sacrifices were inevitable. We were not only going to manage to achieve the goals but might also introduce a new, more dynamic, open growth model.

But first came the bad news that, as a result of a poor tax revenue result, the adjustment of public accounts was going to fall short of the goals and require additional austerity measures. Furthermore, the recession was expected to continue into 2013.

Then, the way in which a corrective measure (single social contribution) was announced sparked a wave of discontent that mainly revealed feelings of anxiety and concern. How are we going to overcome the difficulties? Are we going to manage?

We all know that we're going through extraordinarily complex, difficult times in which people have to change their “way of life”. We are all called upon to cooperate in responding to the serious problems that we are facing. The elites have an even greater responsibility because they are better prepared, more able to understand the size of the issues and help overcome them and motivate everyone to take on this complicated task.

More than in other crises that we have been through, we need considerable lucidity, clear-sightedness, common sense, realism and creativity, along with a demand for emotional intelligence aimed more at restoring hope than creating a climate of despair or indignation, often fuelled by pure contestation and speculation with no arguments or credible proposals for feasible alternatives.

We cannot ignore the serious situations of many people in Portugal and the sacrifices that they are making or the concern of many others for their future. This accentuates even further the duty of Portuguese institutions to serve the people and our country. And this begins with the obligation to provide accurate, transparent, comprehensive timely information as the only way to clarify matters and avoid destructive speculation that the so-called far left favours so much.

I can't see any alternative more favourable to Portugal than the execution of an adjustment programme involving fiscal consolidation and therefore austerity, and restoration of competitiveness to speed up the transition to growth and employment. The country needs institutional funding to buy us the time we need to return to the markets.

Dropping out of the euro would involve insupportable costs and would take us off any track that would allow us to converge within a reasonable period of time.

Breaking off international commitments, i.e. failing to meet them, would not only mean shame and dishonour but would also deprive us of normal use of the markets for decades. It is out of the question.

It therefore falls to us to execute the Economic Adjustment Programme and try to achieve as much flexibility and adjustments and/or complements to current agreements. Indeed, this is what has already happened during execution.

It is worth recalling that in 1995 the total public debt represented 60% of GDP, while today it is more than 120%. Our net external debt was 8% of GDP, while today it is over 100%. The savings rate was 22% of GDP; today it is less than half. The country cannot begin to grow again without first making the adjustment.

The Adjustment Programme covers three basic aspects – fiscal consolidation and the rebalance of public finances and structural and economic reforms - and a fourth that involves strengthening the financial system in order to guarantee funding of the economy.

Fiscal consolidation can be done by cutting down public spending and increasing normal and extraordinary revenue.

Total public spending comprises current primary expenditure, capital expenditure and interest.

The effort to reduce spending set out in the 2013 State Budget is 4.9 billion euros.

Current primary expenditure focuses on four main areas: social security, health, education and so-called security, which comprises defence, police and justice.

As no major cuts can be expected in social security (though the increase in workers' single social contribution may contribute to its sustainability) or in security, with the possible exception of reducing or limiting the acquisition of equipment), the main part will be health and education.

In addition to measures to improve efficiency in these two fields while not forfeiting quality of service, the possible forms of further action will involve optimising human resources, while may entail downsizing, increases in health service user charges and the reintroduction of school fees based on household income in both cases.

Any of these actions will be accompanied by contestation and protests that the welfare state is being placed in jeopardy, but the truth is that there are no miracle solutions and we have to be realistic and show common sense. It is better to have solutions of this nature using the user/payer model to a certain extent or increase the tax burden.

If there is anything wrong with the project called Refundação, which involves reducing public spending and speeding up structural reforms, especially in the public administration, it is perhaps that it should have started earlier …

There is another weighty component in total public spending, where margin for manoeuvre will depend basically on the willingness of the European Union, IMF and investors, and that is interest rates and a possible increase in funding.

Unfortunately, interest rates will go up: from 4.9 billion euros in 2010 and 6.9 billion in 2011 to 7.5 billion in 2013. Only the renegotiation of rates and/or repayment times, possible acceleration of the process to mutualisation of the sovereign debt in the European Union and a good performance in the secondary markets will be able to reduce the interest component.

An extremely pertinent observation arises when we are talking about the interest component of public debt: external funding is the active restriction that conditions economic policy.

“Any postponement of adjustment entails new funding needs (which are not guaranteed) and exacerbation of the problem of unsustainability of the public debt and the resulting additional loss of credibility.”

When many people talk of the advantage of slowing down and extending the fiscal consolidation period because of the risk of a negative spiral between fiscal consolidation and recession or of requesting more funding to cover further needs, the effects will have to be properly assessed.

Where increasing revenue is concerned, it is very likely that we have reached the socially and economically acceptable and sustainable limit, as shown by the poor performance of tax revenue.

The central issue of the crisis that our country is undergoing is economic growth, in itself and also because GDP is the denominator of all ratios. The more it grows the less reinforcement it requires for the numerator, and the more it decreases, the more efforts and measures are necessary for the functions represented in the numerator.

As Carlos Costa said last Friday (his work as Governor of Banco de Portugal deserves the highest praise), “The importance of economic growth to the trajectory of the public debt ratio can be illustrated with some simple calculations. Starting from plausible figures for Portugal in 2015 and keeping the other relevant variables constant, between 2016 and 2020 a 1 p.p. increase in variation in GDP would achieve a debt ratio 15 p.p. lower than the base scenario at the end of the period.”

Fiscal consolidation requires strict, painful austerity measures and everyone knows that austerity and growth don't go well together. In the initial phase of an adjustment process, recession and impoverishment are therefore inevitable. In this phase, it is common for there to be a significant transfer of assets to other stakeholders and often the loss of decision centres.

The transition from recession to economic growth is powered by the structural reforms made in the meantime to reduce context costs and generate gains in competitiveness, which also include reducing personnel costs, improving efficiency and the impact of innovation.

The central issue in Portugal is how to speed up the creation of wealth in order to move on to sustainable growth. This is because growth in GDP is essential for balancing public finances, creating jobs, increasing people's and companies' earnings and boosting consumption and savings.

In order to do this, we need business and investment capacity and initiative, the funding of the economy and companies and the ability to take advantage of market opportunities. Taxation policy may be an essential tool in attracting national and foreign investment and encouraging the internationalisation of our companies.

There are different ways of funding companies. It depends on the quantity and quality of investment and adequate equity, the ability to obtain loans on reasonable terms, recourse to the capital market especially for bond issues and the standardisation of payment times between companies and between the state and companies.

In Europe, 2/3 of companies' funding comes from bank loans (in the United States, 70% is from the capital market). Everyone knows the importance of obtaining loans to the funding of Portuguese companies.

We know that Portuguese companies' debt accounted for as much as 137% of GDP in 2010, one of the highest figures in the European Union (in Germany it was only 50% of GDP).

Companies and the state, individuals and banks have therefore needed to reduce their borrowing. On the other hand, in the present situation many of them are facing problems that reflect negatively on their balance sheets and affect their access to credit. Companies must increase their levels of self-financing. Recapitalisation is therefore an essential factor for economic growth.

There are a number of alternatives when the shareholders are unable to do it:

• New shareholders 
• Partnerships with other companies that may be able to consolidate them (merger, association or an increase in their ability to attract resources)
• Different types of venture capital (it is hard to explain the low use of this tool)
• Use of innovative instruments and unusual forms of capital increase, such as recapitalisation funds, favouring good export companies
• Restructuring of loans with the possible conversion of part of the debt into capital, also reinforcing their governance
• Greater use of the capital market 
• Inclusion in restructuring funds

In my opinion, the implementation of economic adjustment programme models in an EU Member State and a member of Economic and Monetary Union should be complemented by an extraordinary package of measures to stimulate investment, economic growth and employment, as is fitting in a union whose pillars are cohesion, convergence and solidarity.

We can clearly see the extreme difficulty experienced by countries receiving financial assistance and implementing serious austerity measures in preventing deep recessions caused by a fall in public and private spending.

We know that economic growth is the programmes' ultimate goal but the corrective measures are supposed to improve economies' competitiveness.

Meanwhile the recessive spiral distances these countries more and more from their goals of cohesion and convergence with their European peers.

Their situation brings extreme competitive disadvantages in relation to the other Member States: closed financial and capital markets, higher tax burdens, a shortage of capital and depressed domestic markets. All this tends to create an unattractive scenario for investment.

I think it would be fully justified to set up a temporary, extraordinary growth and employment programme possibly using cohesion funds, structural funds, project bonds or EIB funding to assist and fund companies, with more flexible rules for using the funds. Some people will call it a kind of Marshall Plan, Merkel Plano or Durão Barroso Plan, as they prefer.

We know how difficult the discussion of the Commission's financial framework and budget for 2014-2020 is, with several Member States alleging domestic problems and seeking to limit their contribution. We also know that the distribution of the cake now covers many more Member States and so it will be harder. But it would make sense to create a mechanism.

The fact is that solutions today are not national; they are European.

There is an urgent need for a growth agenda and I draw attention to the measures just announced by the Minister of the Economy.

In spite of the present difficulties, Portugal has made remarkable progress in the last 20 years. Today we have much higher scientific and management capacity, a much more qualified workforce, excellent infrastructures and several cases of great success in the field of innovation and technology. Our entrepreneurs have been able to react and show an excellent response to adversity by turning more and more to external markets.

It would be advisable to find solutions to the competitive disadvantages that the crisis has caused and eliminate obvious contradiction. For example, a framework of tax benefits could be developed to attract investments and create employment.

It is essential to attract foreign and Portuguese investment and take advantage of the improved competitiveness resulting from structural reforms at medium and long term and improvements in companies' efficiency and reductions in real exchange rates at short term.

Note that, as we belong to the euro area, we do not have room for manoeuvre when it comes to the nominal exchange rate, though there has been an internal devaluation by means of pay cuts and consumer tax increases (not yet a reduction in taxation on work, which could be used).

Another important factor in attractiveness of investment has to do with competitive disadvantages resulting from interest rates on loans that are higher than in Member States less affected by the sovereign debt crisis. I will return to this issue at the end.

Still talking about growth, I would just like to add that a growth strategy for the Portuguese economy must focus on the tradable sector of the economy, on exports in their broad sense. In 2010, they accounted for 30% of GDP and should be around 35% this year, when in countries similar to ours they are almost always higher than 50%.

The state, which must act as a catalyst in a structural transformation, must above all foster an institutional framework and macroeconomic conditions favourable to investment.

Today I don't have time to go further into a point of view that I upheld many years ago and continue to believe matches Portugal's profile. In Europe, we should be something like Florida is in the United States, a central cluster that I would call a wellbeing cluster (health, leisure, residential tourism, the culture industry, food distribution, etc), a sea industry cluster, another aimed at new technology and agro-industry including wines, while nurturing the motor sector, high-quality, value-added traditional industries and a centre open to innovative business enterprise.

In conclusion, I would like to say a few words about the banking sector. About two hours ago at the Banking Forum, I gave a presentation about the current situation and the main challenges faced by Portuguese banks in their essential missions of steadfastly defending their depositors and funding the economy.

It will be at your disposal on the APB website. This is just an excerpt.

THE BANKING SYSTEM'S MAIN CHALLENGES  

The financial crisis put the brakes on the financial integration process in Europe and there are risks of additional fragmentation with the deepening of the sovereign debt crisis

Where financial integration is concerned, it should be noted that the interest rates charged by the banks went down by an average of around 70% in Europe compared to 1990.

Although it is hard to quantify, the low interest rates charged to companies helped to increase investment, employment and growth, thereby benefiting all European economic agents.

In Monetary Union there are supposed to be homogeneous, uniform monetary conditions in all members. But reality has shown that MU is fragmented and each Member State is subject to its own monetary conditions – liquidity, interest rates, credit conditions, which are much tougher in the countries most affected by the sovereign debt crisis.

There has also been a decline or even reversal of cross-border credit flows. The banks have focused more on their domestic markets and sought to meet domestic funding needs.

There are growing differences in wholesale funding costs and retail interest rates between Member States.

This process is exacerbated to an extent by some supervisors' focus on the financial stability of their own countries.

We are aware that there is a risk of an increased inclination to reduce the banks' exposure in other Member States, to encourage the banks to invest their liquidity in domestic debt and for their regulators to increase their discretionary intervention at national level.

The financial crisis showed up the insufficiencies of EMU and there are more and more political, legislative, regulatory and structural initiatives to try to correct the obstacles to the proper functioning and goals that dictated its creation. Banking union, tax union, political union and a central bank that is lender of last resort are essential in standardising the situation.

But the interests at stake are often not the same either from a political or a business point of view.

The process is complex and difficult and has been slower than needs require.

In this framework, the European financial system is experiencing a time of profound changes leading to a new paradigm for the sector.

This is characterised by a true regulatory, technological and behavioural “revolution” and significant changes in business models.

In spite of the adverse context, the Portuguese banks are sounder, better provisioned and doing their essential job of intermediation. The banks' primary responsibility is to manage their customers' deposits well, pay them proper interest and use the resources obtained efficiently to fund households, companies and institutions in the service of the economy, growth and the population's wellbeing.

The Portuguese banks have fulfilled their responsibilities scrupulously. In recent decades they have showed a remarkable capacity for modernisation and outstanding resilience in the face of very difficult circumstances moving into their fifth consecutive year.

The Portuguese banks are now in a more comfortable liquidity situation with the highest ever levels of solvency and soundness and will continue to be the fundamental instruments in a strong financial system, where they fulfil their irreplaceable mission of funding the economy.

Fernando Faria de Oliveira

President of the Portuguese Banking Association

Lisbon, 6 November 2012