A graph showing Portugal’s government borrowing costs over the past decade provides a telling snapshot of the country’s recent history. From about 4% between 2006 and 2010, the yield on benchmark 10-year debt soared to a record high of more than 15% in early 2012, months after Lisbon was forced to negotiate a €78bn bailout package with the EU and the International Monetary Fund (IMF).
By March last year, the yield had fallen to an all-time low of just over 1.5%, a level seen as reflecting the success of the gruelling three-year adjust programme that Portugal had exited less than a year earlier. By February this year, however, the rate had climbed back above 4.5%, as the new Socialist Party government argued in Brussels over a draft budget that the European Commission challenged as putting the country’s deficit-reduction commitments at risk. In February, Lisbon paid its highest rate since 2014 in an issue of 10-year government bonds.
The good news
In this volatile climate, government officials could be forgiven for breathing a collective sigh of relief when the 10-year yield fell back below the 3% threshold in March, following parliament’s final approval of a revised budget endorsed by the European Commission at the same time as the European Central Bank (ECB) added more heft to its quantitative easing programme, with Portugal set to be a leading beneficiary.
Mário Centeno, the new finance minister and chief economic strategist for the governing Socialist Party, believes the austerity measures of the previous centre-right government can be rolled back without undermining fiscal discipline. “We will continue bringing down the budget deficit and public debt, but at a slower place,” he says. “This will create the economic space needed to alleviate the serious financial restraints families and companies face. It’s not the direction we challenge, but the speed of travel.”
Economists and rating agencies have welcomed the government’s willingness to revise the budget in response to EU pressure. The changes included additional fiscal savings equivalent to almost half a percentage point of gross domestic product (GDP). But they remain sceptical over Lisbon’s ability to meet the ambitious deficit reduction and growth targets it has set out. In March, Fitch revised the outlook on Portugal’s BB+ rating from 'positive' to 'stable', saying the government’s target of cutting the deficit to 2.2% of GDP this year, down from 4.2% in 2015, was based on an overly optimistic growth forecast of 1.8%, up from 1.5% last year. Moody’s said the deficit was likely to be nearer 3% of GDP.
Averting any further downgrade of its credit ratings is crucial to Portugal’s economic recovery. Canada’s DBRS is the only leading agency to maintain an investment-grade rating for Portugal’s sovereign debt. If Lisbon were to lose this when the DBRS rating comes up for review in April, it would be automatically excluded from the ECB’s bond-buying programme, with damaging implications for investor confidence and government borrowing costs.
Fixed-income concerns
Perceptions of increased risk for fixed-income investors in Portugal have also been fuelled by the central bank’s controversial decision in December to impose losses on almost €2bn of senior bonds in Novo Banco, the 'good bank' salvaged from the ruins of Banco Espírito Santo. Bondholders (BES), including some of the world’s biggest fixed-income fund managers, have threatened to take legal action over what they see as an unfairly discriminatory measure in which five out of 52 senior bonds were moved to the 'bad bank' holding BES’s toxic assets as a means of plugging a €1.4bn capital gap at Novo Banco.
Philippe Bodereau, managing director and global head of financial research at investment management company Pimco, has condemned the measure as amounting to “asset confiscation and populist expediency”, saying it called into question the rule of law in Portugal. The ECB and the Lisbon government have both distanced themselves from the move, while DBRS warned that it could “impact investor sentiment and confidence in Portuguese banks”. However, the Bank of Portugal has defended its decision as “in accordance with Portuguese law and the principles underlying BRRD [the EU’s Bank Resolution and Recovery Directive, which came into effect on January 1]”.
The Novo Banco 'bail-in' has hit the value of bank debt across peripheral EU countries and, according to Lisbon bankers, effectively closed down the senior debt market for Portuguese lenders, although they currently have no great need for this instrument. However, the stabilisation of 10-year debt yields below 3% following final approval of the budget suggests fears that the fall out from Novo Banco bond controversy could also have a negative impact on government borrowing costs are unlikely to materialise.
In fact, although Portugal faces potential sanctions under the EU’s excessive deficit rules if it fails to achieve the reduction targeted for this year, deficit consolidation has reached a significant turning point. Before the global financial crisis, Portugal was running a high primary budget deficit, that is, excluding debt-servicing costs, which alone amounted to about 4% to 5% of GDP a year.
A better balance
After more than a decade of policy targeted at correcting fiscal imbalances, however, Portugal now benefits from a primary surplus. As government borrowing costs come down, Lisbon is substituting debt at rates of about 4.5% for bonds with a coupon closer to 3%. It is also paying off IMF loans early – a total of €10.4bn so far – and replacing it with debt that is less costly to service.
This has important implications for one of the heaviest constraints on the economy – a public debt-to-GDP ratio estimated to have reached 129% in 2015. “Steadily increasing the primary budget is an essential pre-requisite for lowering the debt-to-GDP ratio and lifting growth,” says Rui Constantino, chief economist at Banco Santander Totta. Fitch sees public debt falling to 115.5% of national output by 2024.
Growth in new mortgage lending is one of the signs of Portugal’s emergent economic recovery. Production of new loans has doubled since the country began moving out of recession in 2014, but volumes remain far below pre-crisis levels. At the end of 2015, mortgages represented 82% of lending to individuals and 49% of total loans to families and companies. Historically low interest rates mean that of the average monthly mortgage payment of about €300, €200 is paying off capital, with the remainder representing interest payments. As a result, families are paying off more mortgage loans than new ones being taken out, one strand of a steady deleveraging process by the state, companies and families that has been under way since the financial crisis.
Filomena Raquel de Oliveira, chief executive of Caixa Gestão de Activos, the asset management arm of state-owned Caixa Geral de Depósitos, Portugal’s largest bank by deposits, believes growth in mortgage lending will see a revival of the covered bond market. “Currently, there is so much liquidity in the banking system that there is no great need for covered bonds," she says. "But I think that will change as they provide very safe, low cost instrument for savers.”
Ms de Oliveira believes Portuguese covered bonds are particularly attractive because, as a late starter that issued its first covered bond in 2006, Portugal benefited from the experience of other markets to introduce legislation that is “very robust and that provides a high level of protection for investors”.
Seeking alternatives
Banks are also responding to growing demand for asset management products from retail customers seeking a better return from bank deposits. The overall level of deposits has held up strongly through the crisis, with the average loan-to-deposit ratio for the Portuguese financial sector falling from 158% at the end of 2010 to 104% in September 2015. Over the same period, however, the average interest rate on new household deposits has dropped from about 4% to 0.5%. “In a context where even a zero-interest deposit account costs banks money, lenders are focusing more and more on selling funds and providing wealth management services,” says Ms de Oliveira.
Customers are also increasingly demanding alternatives to low-interest deposits. “The Portuguese are traditionally very conservative with their savings,” says Ms Oliveira. “But we are seeing a significant flow of funds out of deposits into asset management products as even people who have never had anything more than a savings account ask for more sophisticated products with a better return.”
She expects compliance, auditing and risk management costs to rise as tougher EU legislation expands from banking to cover asset management as well, saying: “Until last year we were able to use the risk department of our parent bank, but now we need our [own] service.” The other big challenge for Portuguese asset managers is expected to be competition from international internet-based players with no need for a physical presence in the country. As Ms de Oliveira says: “The future is digital.”
