The Portuguese government has struggled to convince the international finance markets of its commitment to fiscal discipline, and this has prevented any easing of the country's funding problems and delayed economic recovery. However, deposits are bouncing back and industry is managing to maintain investment. Writer Peter Wise

Talking to Portuguese bankers and corporate leaders is a little like listening to the chorus in an ancient play. They all sound an identical note of warning aimed at preventing the country's sovereign debt crisis from turning into a Greek-style tragedy.

Fernando Ulrich, chief executive of Banco BPI, says it is "absolutely fundamental" that the country's centre-left government meets its commitment to cut the budget deficit from a record 9.3% of gross domestic product (GDP) in 2009 to 7.3% this year, and approves a "credible budget" to achieve next year's ambitious deficit target of 4.6% of GDP.

To achieve this, says Vasco de Mello, chairman of Brisa, Portugal's main motorway operator, prime minister José Sócrates needs to make cutting public expenditure his overriding priority, sacrificing short-term economic growth if necessary. "Portugal has to base growth on exports and investment rather than consumption," he says.

The international markets have not been encouraged by the government's budget performance for January to July, which saw total spending increase by 4% compared with the same period in 2009. Tax revenue rose 5.6%, thanks to an increase in indirect tax rates, but the overall deficit was up €300m. Spain, on the other hand, almost halved its deficit in the first half of the year.

Slow progress

This lack of progress has seen the Portuguese government's borrowing penalised, with spreads over 10-year German bunds reaching 330 basis points (bps) in September, up from 67bps in January and compared with 190bps for Spanish debt. Funding markets have begun to reopen for Spanish banks, including some senior debt and covered bond issues, albeit at a high cost. But they have remained closed to Portuguese banks, which are left dependent on European Central Bank (ECB) funding to finance loan-to-deposit ratios.

"The pool of liquidity available to Portuguese banks has been reduced since the country's sovereign debt rating was downgraded in April and this has led to a much greater need for ECB financing, leaving banks more vulnerable to any alteration in European monetary policy," says Amílcar Morais Pires, chief financial officer (CFO) of Banco Espírito Santo.

For this to change, says Paulo Macedo, vice-chairman and CFO at Millennium BCP, "the markets need to see clear and consistent signs that the government is effectively implementing its deficit-reduction programme and maintaining budget discipline".

He adds: "The economy also needs to prove that it can grow in a more balanced way, continuing the recent trend of export-led growth." After a decade of low economic growth, the Portuguese economy is expected to grow about 1.1% this year and 0.5% in 2011.

The main funding restraint on banks relates to maturities rather than cost, says Nuno Amado, chief executive officer of Santander Totta.

"The interbank market is providing funds at maturities of one to four weeks, but three- and five-year financing is not currently available," he says, explaining that this makes it difficult to fund investment projects and mortgage lending. "A significant improvement is unlikely without evidence of successful deficit reduction this year and credible measures for 2011." When medium- to long-term financing does become available again, he says, costs will be significantly higher than they used to be.

Lending stalls

The funding scarcity has resulted in a marked slowdown in lending rates in Portugal after a decade in which household and corporate lending grew at annual averages of 11% to 12%, respectively. Credit to the Portuguese economy grew by only about 3% in the 12 months to September, says Mr Amado, and was restrained by lack of demand rather than price. In the second half of 2010, Mr Morais Pires expects lending growth to fall to about 1% or 2%, compared with 7% previously. However, he sees deposits growing at double-digit levels.

Ignacio Ulargui and Miguel Ángel Alcalá, analysts with Spain's BBVA Research, forecast average growth of 2.5% to 4% in Portuguese mortgage lending, which accounts for 80% of all household credit in the country, over the next three years. They expect average corporate lending to show negative growth in 2010 before picking up to levels of about 2% next year and 3.5% in 2012.

Although competition for deposits has intensified over the past year, Portugal is not experiencing a deposit war on a par with Spain. Contrary to trends in Spain, sight deposits (which can be withdrawn any time) have grown at a rate of about 5% to 7% over the past 10 months, while time deposits (which cannot be withdrawn until a specified time) have remained almost flat. Analysts expect deposits to grow faster than lending over the next three years.

Bankers see this rebalancing of lending and deposit rates as part of an overall deleveraging of the Portuguese economy. The key issue, says Mr Amado, is to ensure a "soft landing" through a gradual increase in credit spreads, rather than an abrupt increase in costs or a drying up of credit that could have a damaging impact on the country's fragile economic recovery.

A gradual increase in the savings rate is also welcomed as a positive trend towards a less indebted economy. "Portugal needs to save," says Jorge Tomé, chairman of Caixa - Banco de Investimento and a board member of state-owned Caixa Geral de Depósitos (CGD), its parent group. "We have a savings rate of about 8%, but we need to reach about 15% to deleverage the economy and support bank funding." Banks are seeing "a shift away from growth in credit volumes towards a stronger focus on savings", adds Mr Macedo of BCP.

The retraction in lending has had a predictable impact on profitability, with the average income of banks falling at double-digit rates from pre-crisis levels. In the first half of 2010, the average return on equity for Portugal's five big banks was 9.5%. With large contributions coming from overseas operations, particularly in Angola and Brazil, the figures reflect a sharp reduction in the profitability of domestic assets. Santander Totta was the exception to the rule, with a first-half return on equity of 17.8% based solely on Portuguese operations. The fall in earnings appears to have bottomed out in 2008 for most banks, with modest recoveries in the succeeding years. But Mr Amado expects average revenues for the sector to remain relatively flat in 2010 and 2011.

Growth in time and sight deposits in Portugal

Growth in time and sight deposits in Portugal

Margins under pressure

Financial margins have come under pressure as banks have been unable to reflect the full extent of higher funding costs in increased spreads. "The cost of funding has approximately doubled since April," says Mr Morais Pires. "The spread on covered bonds, although not currently available to Portuguese banks, has risen from about 120bps to 270bps. European Medium Term Note spreads have increased from 240bps to 430bps. But we have only increased the cost to customers by 50bps to 60bps."

A 400bps drop in the Euribor interest rate in less than two years has had a negative impact of about €600m on the before-tax earnings at CGD, says Mr Tomé. "Most lending by Portuguese banks, especially mortgage loans, is indexed to Euribor, but most deposits are not. This means that any change in the rate has a significant impact on financial margins. We calculate that every variation of 100bps in Euribor affects our earnings by about €150m either positively or negatively."

While Portugal's sovereign debt crisis has restricted funding, with no institution issuing covered bonds or senior debt over the past four months, banks are not facing capital difficulties and they all comfortably passed the recent EU stress tests. However, BBVA Research says that the potential impact on solvency of the proposed Basel III banking regulations and effects relating to pension funds "needs to be closely monitored".

Despite the global downturn and credit crunch, leading Portuguese companies have succeeded, with the support of local banks, in undertaking large-scale investment programmes and business restructuring while maintaining buoyant cash flows. Galp Energia, the country's leading oil and gas utility, has gone ahead with planned investments totalling more than €3.5bn over three years, succeeding at the same time in more than doubling its market capitalisation to €10.5bn to become Portugal's largest listed company.

"We made a commitment to the debt and equity markets to uphold extremely simple balance-sheet criteria when we began these transformational investments," says Manuel Ferreira de Oliveira, Galp's CEO. "We said we would not allow the level of debt to capital employed to rise above 50%. We have taken this extremely seriously, to the point where we are now in the process of selling about 40% of our regulated gas infrastructures in Portugal to infrastructure funds, just in case we need the additional capital to ensure that debt does not rise above equity."

Since 2008, Galp has invested €650m in integrating its gas marketing and oil distribution assets in Spain, where it has a 10% market share; €2bn in upgrading its two refineries in Portugal, where it has a 50% share of the total oil market; and approximately €500m a year in successful oil exploration and production in Angola and Brazil - investment decisions made before 2008, which had to be implemented in a significantly more restricted post-credit crunch environment than initially envisaged.

"When we saw markets being squeezed, we made sure that we had sufficient liquidity from the outset to see the projects through," says Mr Ferreira de Oliveira. "We started with a low debt position of about €1.6bn and told the markets that we would allow this to grow to about €3.6bn. We issued €1.7bn of long- and short-term [debt] through a consortium of banks, which, together with our cash-flow, would enable us to complete the investments. We focused only on what needed to be done, maintained a continuous focus on our balance sheet, made rigorous cost cuts and have always been prepared to alter the pace of transformation to keep debt under control."


Vasco de Mello, chairman of Brisa

Investment roadmap

Brisa, Portugal's leading toll road operator, is also undergoing a major transformation, separating its main motorway concession, representing 90% of the group's total income, from its holding company to gain flexibility and improve its credit rating.

"Our main operation, which generates strong free cash-flow, will now become the rated entity of the group," says Brisa chairman Vasco de Mello. "Instead of the main concession carrying the risk of all our other concessions, it will be ring-fenced as a stand-alone operation. Our other concessions will be moved under the holding company, so that each individual operation supports its own debt."

Mr de Mello says the reorganisation will relieve pressure on the group's credit rating, providing Brisa with "a strong BBB rating with a stable outlook". It will also ensure greater protection for creditors, he says, because the model requires creditors to be paid from cash-flow before dividends. "Dividing our different performance areas into separate business divisions in this way will optimise our financial structure and improve operational efficiency," he says.

Brisa has seen its financing costs decrease during the credit crunch, as underlying interest rates have fallen by more than the increase in spreads. The total cost of the group's €3.5bn debt is now below 4%. Project finance accounts for €1bn of the total, the remainder being corporate debt in the form of bonds and European Investment Bank loans.

"Our main concession is generating positive free cash-flow and has no medium-term refinancing needs," says Mr de Mello. "Our other concessions are financed through non-recourse project finance and debt with long-term maturities and a smooth amortisation profile." The group cut operating costs by 7% on a like-for-like basis in 2009 and is committed to a further 3% reduction this year.

Brisa is also in the process of selling its 16.35% stake in CCR, Brazil's leading motorway operator, for about €1.2bn, representing a before-tax capital gain of approximately €1bn within eight years. "The sale will enable Brisa to crystallise significant value," says Mr de Mello. "The proceeds will have a significant impact on our liquidity. We will use them partly to reduce net debt and partly to fund future expansion, possibly in India or Turkey, using the same successful model that we have applied in Brazil."


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