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Western EuropeOctober 2 2005

Buoyancy in a weak economy

Banks are displaying considerable resilience, with their profits growing, in an economy that is climbing out of recession.By Peter Wise.Portuguese banks are nothing if not resilient. This will be the fifth year in which the economy has underperformed average EU growth. Recovery since a deep recession in 2003, when GDP growth contracted by 1.1%, has been weak and the outlook for the coming two years is less than buoyant.
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Banks, however, are weathering the protracted slump with remarkable composure.

Between 2000 and 2004, net profit for the top four listed financial groups grew by an average of 5.3% and return on equity by 15.3%. Net profit as a percentage of total assets rose from 0.73% to 0.99% over the same period.

“Portuguese banks have shown themselves to be considerably more sophisticated and mature than the Portuguese economy in general,” says Paulo Teixeira Pinto, chief executive of Millennium BCP, the country’s biggest bank. “This has enabled them to continue increasing their profits during a particularly difficult period of stagnant economic growth.”

Central bank officials describe the financial sector as “an oasis” in an otherwise arid economy where no immediate improvement in the barren business climate is expected. In July, the Bank of Portugal cut its forecast for economic growth in 2005 to 0.5%, sharply down from the estimate of 1.6% it had made last December. The forecast for 2006 was lowered from 2% to 1.2%.

Brighter prospects

Some light is beginning to shine through the gloom, though. The general election in February produced a Socialist government with a solid majority in parliament, ending a period of damaging instability in which the government changed four times in four years. Prime Minister José Sócrates has begun implementing forceful measures to tackle a spiralling budget deficit, including gradually increasing the retirement age for state employees from 60 years old to 65 years old and cutting sickness pay from 100% to 65%.

He has also announced a partial lifting of bank secrecy laws as part of a crackdown on tax evasion and fraud. The measure, which marks a break with southern European traditions, has met with strong criticism from some bankers but has also been praised as courageous by opposition parties.

Important measures

Fernando Ulrich, chief executive of Banco BPI, one of Portugal’s top five banks, says the budgetary restrictions needed to control the deficit will dampen economic growth in the near future. But he believes that disciplining public finances is a prerequisite of sustained growth and has been encouraged by the new government’s approach to reform.

“Important measures have been taken to control government spending on public administration, particularly in regard to pensions, the freezing of automatic promotions and eliminating unfair benefits in relation to the private sector,” he says. “This has short-term costs in terms of economic growth. But failing to implement reforms would be a much bigger blow to confidence than the loss of one or two points of GDP growth.”

Mr Sócrates has not been immune from political troubles. He has already had to appoint his second finance minister – Portugal’s fourth in little more than a year – after Luís Campos e Cunha, the architect of the tough spending cuts, quit unexpectedly after four months in office, citing family reasons and fatigue.

His successor, Fernando Teixeira dos Santos, formerly the head of Portugal’s capital markets watchdog, the CMVM, has already intervened directly in the banking sector. He appointed Carlos Santos Ferreira, a respected administrator, as the new chief executive of state-owned Caixa Geral de Depósitos (CGD), the country’s second biggest financial group.

He said the position of the previous CEO, Vítor Martins, had been weakened since the previous centre-right government hurriedly determined last December to transfer the bank’s pension fund to a state body as an emergency measure aimed at keeping the budget deficit within the limits set by the eurozone’s growth and stability pact.

Under new EU rules, Portugal has exceptionally been granted three years to take its deficit to less than 3% of GDP. A special central bank commission said in May that, without tough measures to tackle the crisis, the deficit would soar well above 6% of GDP this year – the most serious breach of the pact by any country since the euro was introduced in 1999. Following his initial package of spending cuts, Mr Sócrates is expected to introduce more austerity measures in his 2006 budget, due to be presented to parliament in October.

Impact of stagnation

Although Portuguese banks have been able to increase net profit during the past five difficult years, the impact of economic stagnation is reflected more negatively in earnings before tax (EBT). For the five biggest banks, these fell by an average of 3.5% from 2000 to 2004, with CGD suffering a fall of 8.7% and Millennium BCP down 6.5%. Santander Totta, owned by Santander Central Hispano, Spain’s biggest bank, was by far the strongest performer with its EBT growing by 15.7% over the same period. BPI showed a gain of 4.7% and Banco Espírito Santo was up 0.8%.

Asset quality has held up remarkably well in depressed economic conditions that have resulted in unemployment practically doubling in the past five years to about 7.5%. The total stock of non-performing loans (NPLs) rose markedly from €535m in early 2001 to €3.6bn in March this year. However, the ratio of NPLs to total credit fell 20 basis points to just 2% over the same period, thanks to a 9% increase in the total loan stock.

Despite the economic slowdown, credit growth has remained surprisingly buoyant, particularly mortgage loans, which account for more than half of the €40.8bn increase in total lending by Portuguese banks since March 2001. Mortgage loans continue to represent about 80% of all private loans.

The boom in lending has been fuelled by a plunge in interest rates to historic lows since Portugal qualified to join the eurozone in the late 1990s. “Individuals suddenly found themselves being offered rates of about 5% for mortgages that at the start of the decade were running four times higher,” says Bruno Duarte, a London-based analyst at Fox-Pitt, Kelton. “As a result, the overall lending stock of Portuguese banks doubled every five years between 1990 and 2000.”

Unlike Spain, where strong economic expansion has helped to keep lending growth relatively stable at 10%-15% a year since the launch of the euro, Portugal has gone through a “classic boom/bust cycle”, says Mr Duarte, with credit growth reaching a peak of about 30% a year in 1998 before falling to about 5% last year. “Nevertheless, this trend has allowed Portugal to catch up and surpass average European lending rates with a household indebtedness level of about 120% compared with an EU average of about 115%,” he says.

Spanner in the works

In the climate of high indebtedness, rising unemployment and historically low interest rates – which many Portuguese borrowers appear to have deluded themselves is permanent – a decision by the European Central Bank to increase interest rates could significantly increase the number of loan defaults and would almost inevitably lead to a sharp slowdown in lending growth. “An increase of 1 percentage point would hurt,” says Miguel Namorado Rosa, chief economist at Millennium BCP. “Two points would be critical.”

Portuguese banks lay great faith in their rigorous risk control policies, to which they attribute the resilience of their asset quality. Analysts see BPI as the most defensive, with the lowest credit loss and cost of risk. But all of the top five banks are focusing on meticulous controls.

“We succeeded in cutting our NPL ratio from 2.4% in 2000 to 1.3% last year by the careful application of a group risk control policy,” says Luís Bento dos Santos, a Santander Totta board member. “Our risk premium as a percentage of total loans has fallen 85% over the same period as a result of strict credit and recovery policies.”

According to Fox-Pitt, Kelton: “The true extent to which Portuguese banks have been able to price risk appropriately will become evident over the coming quarters.”

Asset quality optimism

Bankers remain confident of maintaining a high level of asset quality, however. “We are not prepared to sacrifice our financial margin or incur greater risks for the sake of market share,” says Mr Teixeira Pinto. At the same time, Portuguese borrowers, for whom becoming a homeowner is a big emotional investment, show a marked determination to keep up their mortgage payments, only defaulting in extremis.

Mr Teixeira Pinto acknowledges that a rise in interest rates would increase loan defaults. But he says this would be offset by the increased profitability of financial operations and the relief that higher rates would provide in financing the bank’s pension costs. Most Portuguese banks run their own pension funds independently of the state social security system. Millennium BCP, for example, pays pensions from a fund valued at €4.25bn to 15,000 retired workers, compared with an active workforce of about 12,000.

Millennium BCP will be retiring more workers shortly as it pursues its drive to cut the highest cost/income ratio among the top four listed banks. The average ratio for the four, excluding trading operations, increased from 64% in 2000 to 66.1% in 2004. BCP’s ratio was the highest at 74.2% in 2004 and Santander Totta’s was the lowest, having cut its ratio from 63.4% to 51.4% over the same period.

Despite significant improvements in the first half of 2005, reducing the cost/income ratio is Millennium BCP’s strategic priority, says Mr Teixeira Pinto. This involves restructuring the bank’s workflow processes, stripping out administrative layers and integrating back offices with new technology platforms. At the same, the group plans a further reduction of its workforce, about10%, before the end of the year, Mr Teixeira Pinto told The Banker.

“Our aim is to make a substantial reduction in staff costs,” he says. “The focus will be on central services rather than at the branch network level. This is because we don’t want the cutbacks to affect our commercial capacity and because it is at the central level that we can most effectively reduce costs. Reducing the workforce by 10% doesn’t mean cutting wage costs by 10% if most of those people are on relatively low salaries. Our aim is to make the hierarchy of the bank more agile and cut personnel costs significantly by staff reductions at the central level.”

Raising income

BPI, with a cost/income ratio of 66.3% in 2004, the highest after BCP, is focusing on raising income more than cutting costs. “Since 1999, we have lowered the ratio by 10 percentage points, which is a substantial accomplishment,” says Mr Ulrich. “We have achieved further improvements this year, mainly by increasing income. Our costs are under control at about the same level as inflation and our income is growing.”

BPI has made a famous recruit in its drive to increase income, contracting the Portuguese football coach José Mourinho, the highly successful manager of London’s Chelsea soccer club, to head an advertising campaign for its fund management products. If, despite the difficult economic climate, the financial sector can equal the success Mr Mourinho has achieved on the football pitch, banks will continue to reign as champions of the Portuguese economy.

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