Intervention variables

balance sheets that can be useful for other countries. There are three main ideas. First, we made a lot of mistakes, so if you can

avoid them, good for you; second, we had some success in correcting balance sheets and so if the measures that we have taken are useful for you, that’s also good; and third, we still have a lot of work to do.

As you can see, over-indebtedness is a serious situation in Portugal, not only in the public sector but also in the private sector. The figures we have are much higher than those presented by my neighbor Boris Vujčić, on Eastern Europe debt.

The household debt ratio was above 100 percent and the corporate debt ratio was above 140 percent of GDP in 2010. The private sector debt accumulation was reflected in a strong expansion of banks’ balance sheets that showed signs of unhealthy developments. Then, in 2010, we lost market access and, in the context of the sovereign debt crisis, we had to ask for an adjustment program, which started in 2011.

The program had three pillars. One of them was financial stability, which involved several work streams and several instruments. There is one instrument that I would like to highlight because it has proven to be very useful for us. This instrument is the Funding and Capital Plans. These are quarterly forward-looking reports that banks had to prepare and that have proven instrumental in enabling the central bank to gear the adjustment of banks’ balance sheets towards the capital and funding targets.

The main results overall have been very positive; by 2013, we had a much healthier financial situation. The borrowing needs or the lending capacity of every domestic sector has improved. The country achieved a net lending capacity, i.e., an external surplus, after several years with an external deficit close to 10 percent of GDP. And we are now seeing debt repayment flows from corporations to banks and from banks to the central bank and to the external sector. Debt ratios started to improve very clearly in the household sector. In the corporate sector, this improvement is more recent and more limited. The public sector debt ratio is expected to start declining this year, but I will leave the public sector out of this presentation.

Now, concerning the banks, results were broadly positive.

Solvency strengthened significantly, liquidity and funding structure became much more stable. We have been able to manage a more or less orderly process of balancing deleveraging needs with the financing of the economy. This was particularly challenging, because we needed to deleverage but at the same time we could not leave the economy without finance. Here I would like to make two points. Firstly, a large part of deleveraging was done by reducing external assets. This was the case in Portugal; maybe it is not possible in other countries.

Secondly, credit has declined, but we have evidence that some degree of discrimination has been achieved in favor of the most dynamic sectors. This is very positive, because, as the Governor of the Bank of Slovenia said, the allocation of credit is crucial when you are deleveraging. And then the inevitable weak point is the NPLs. NPLs have increased a lot because of two factors––

economic recession and stricter supervisory action by the Bank of Portugal. Because of that, banks have recorded losses for three years in a row and only in 2014 are they returning to profitability, if we exclude Banco Espírito Santo, which is an idiosyncratic case.

Let’s turn to households. The developments have also been very positive. Households have improved the capacity to service their debts and the incentives to engage in new borrowing have been reduced. What I would like to highlight is that these positive developments were the result of a combination of different policies and changes in behavior. There was a change in the savings behavior of households that adjusted consumption downwards and consequently increased their savings rate and net lending capacity. Monetary policy also made a contribution in this particular sector, namely because there was a pass-through of lower interest rates to existing mortgages that benefited existing mortgage borrowers. There was also a contribution from structural reforms, particularly through the development of the housing rental market that decreased the demand for housing credit. And there was also a contribution from fiscal policy—the tax deduction of mortgage interest payments was sharply reduced for old loans and actually eliminated for new loans; this

also reduced the demand for housing credit. Debt ratios benefited from these measures and started to decline consistently, and there were no major problems of debt restructuring or household over-indebtedness.

In regard to corporations, the story is more complex. There we had more mixed results because there were many more blocking factors that prevented a holistic approach from being fully pursued. And so this led us to launch a corporate debt restructuring program with the following key points:

discriminate between the viable and nonviable firms; restructure viable firms; and resolve or liquidate the nonviable firms. The major problems that we are trying to overcome are the risk of evergreening temptations by banks, the lack of coordination among creditors and with debtors, and the blocking power of debtors. There are multiple measures that were implemented or are in preparation under the program, including microprudential supervision actions, changes in insolvency regimes and other legal changes, the reinforcement of the role of the credit mediator, and different measures to promote the capitalization of firms.

Lessons learned. The first set of lessons has to do with monitoring and prevention; this is crucial. Monitoring market development is not enough; it may lead to complacency and delayed action, and we have been misled by that in a way. We also need to carefully monitor information on the behavior of economic agents, namely the savings evolutions and patterns, balance sheet structures, and all that; particular attention needs to be given to credit growth. Another lesson is that the financial sector is instrumental in the process of debt accumulation. So it is very important to have sound policies for banks. Now we have macroprudential policy instruments that we did not have at the time, and we hope that they will be very useful in the future.

A second set of lessons has to do with correction, once we are in a situation of excessive debt. One lesson is that the correction of over-indebtedness is very likely to have recessionary impacts, as economic agents’ attempts to restore or improve their

debt-servicing capacity in a stressful situation are likely to negatively affect consumption and investment. A second lesson is that bank deleveraging is important, but it is not enough. The central bank has a strong influence on the balance sheets of banks and can—

to some extent—gear the correction of these balance sheets. But this is not enough to correct balance sheets of households and corporates. And for those other balance sheets, we need what we call a holistic policy response––the combination of different policies, addressing both stock issues and flow issues. This response involves contributions from conventional monetary policy, non-conventional monetary policy, prudential measures, fiscal policy, and—last but not least—structural reforms. The latter vary from country to country; but in our case, they have proven to be very, very important—namely the change in the legal framework.

Panelist 4: Stanislava Zadravec Caprirolo, Vice Governor,