During the first decade of the twenty-first century, in the happy days preceding the Global Financial Crisis, Portugal had been spending beyond its means. It had been accumulating a high stock of debt vis-Ă -vis external borrowers. Foreign banks, insurance companies, asset managers and multilateral institutions like the European Investment Bank (âEIBâ) had been accumulating Portuguese private and public debt. The Portuguese economy was depending on external credit to guarantee a certain level of domestic economic growth. Portuguese households were buying their houses with recourse to foreign money. Home ownership increased at a rapid pace. Local banks would aggressively finance mortgages, repackaging them into securitization vehicles; the vehicles would then issue bonds and those bonds were then placed with international investors. The banks were also active in financing corporations, a good share of which either were developers or offered real estate as collateral for their borrowings. The banks were financing the gap between credit and deposits by issuing bonds they would then sell in the international markets. Portugalâs economic growth was meek when compared with other Eurozone countries but even these modest levels of growth were being sustained by external investors in Portuguese bonds and loans. These bonds took different names: mortgage-backed securities, SME securitization bonds, senior bank bonds, subordinated bank bonds, Portuguese government bonds. A good share of these bonds were originated by the domestic banking sector and then placed abroad with the assistance of global investment banks. The Portuguese banks had the highest share of credit not financed by deposits in Europe. To finance the difference they came regularly to the international markets with bond offerings; some of these bond programs took specific domestic names, like the name of a Portuguese horse breed or the name of Portuguese navigators like Magellan. As in Hollywood blockbusters, they were issued in series, I, II, III, IV and so on.
In parallel, public sector corporations were financing a good share of their capital expenditures with recourse to external lenders that were banking on the Portuguese Stateâs implicit guarantee. The railways, the subway companies, counted on loans from the EIB but also from some foreign banks specialized in public sector loans, like Dexia and Depfa, to keep their investment levels. Roads were being built with borrowed money originating in the same sources. By 2016, and following the building program preceding 2011, Portugalâs quality of road infrastructure was classified by the World Economic Forum as the ninth best in the world, just ahead of Denmark, Taiwan and Finland.
Portugal had been accumulating external deficits since the second half of the 1990s but these accelerated with the turn of the century. This, of course, came in tandem with the accumulation of private credit financed by foreign investors. As a consequence, external debt kept accumulating. The economy was addicted to these private external sources of funds. Households needed them to keep consuming, corporations to finance their new projects, and in some cases to cover their persistent losses, and public sector companies to keep investing and building more roads.
In 2003, the government tried to engineer a slowdown but with growth already quite fragile, it did not persist in its effort. So when the 2008 financial crisis (âthe Global Financial Crisisâ) closed some of the private bond and loan markets that the Portuguese banks were using, Portugal ran the risk of being forced into an uncontrolled adjustment that could derail the economy very sharply. Without the availability of external financing sources, imports would have to contract markedly causing a possibly catastrophic adjustment in domestic consumption and investment.
Luckily for the government of the time, the government bond market remained open and the European Central Bank (âECBâ) started to play a bigger role in the European financial markets. As the financing of domestic banks by external private investors decreased sharply, the financing of the Portuguese external deficits started to rely on the Target 2 balances at the ECB, central bank credits that replaced private flows from surplus countries toward deficit countries. These funds from the ECB counterbalanced the reduction in external private financing of the domestic banking sector. They kept the external financing flowing: as a measure of external dependence, the Portuguese current account deficit reached its peak in 2008. This allowed the Portuguese economy just to muddle through in 2008, with an almost flat economic growth as the access to foreign funds was maintained. As we have seen, these flows were now different in their composition. In 2009 the Portuguese economy was contracting almost by 3% but by 2010 it was already experiencing 1.9% growth. How was this recovery possible given the circumstances?
Given the importance of the role that the Target 2 system played in keeping external funding to the Portuguese economy after the Global Financial Crisis, I will try to explain how the system works in a simple way. Consider a Portuguese corporate that wants to acquire a new fleet of Volkswagens from Germany. The corporate will ask its bank in Portugal to make a transfer to Volkswagenâs bank in Germany to process the payment implied by this transaction. Both banks have accounts in their respective central banks. The Portuguese bank submits the payment instructions to Target 2. The Portuguese bank account will show a debit in the system and the German bank account will show, symmetrically, a credit. As a result of this transaction, the Bank of Portugal will generate a liability to the ECB and the Bundesbank a credit to the ECB. Target 2 balances represent the aggregate difference of these debits and credits between national central banks all over Europe. A country like Portugal that continued to accumulate external deficits, exporting less than it imports, and given these deficits were no longer financed by private flows, would accumulate negative balances in the Target 2 system. After 2008, external deficits of European peripheral countries like Portugal were financed by central bank funding. The National Central Bank was financed through Target 2 by the central banks of countries that had external surpluses like Germany and the Netherlands. After 2009, private flows toward deficit countries had dried out and were actually flowing to safe havens like Germany. Anyway, this system allowed Portugal to continue to accumulate external deficits after the Global Financial Crisis. These were only corrected after the country followed the economic and financial adjustment measures prescribed by the Troika.1 As you may expect, in case you do not remember the public debate at the time, Target 2 balances created some discomfort for the authorities in the surplus countries, even if the matter was too technical to be understood by the majority of the public opinion. The system allowed deficit countries to avoid a deep adjustment in their domestic consumption and investment patterns.
To keep the economy from contracting further following the 2009 crisis and to stabilize it in 2010, the Portuguese government decided, at the time, to increase expenditures and embark in record budget deficits; 2009 saw a big increase in government expenditures as a percentage of GDP after a few years of contraction and a small increase in 2008. These policies culminated in record government deficits in 2009 and 2010. They were intended to compensate for the impact in the contraction of private credit growth coming from the higher prudence on the part of the banks, for which their usual financing sources had dried. This kept the economy going, surviving the threat of a sharp contraction, as the government and the public sector companies engineered more spending, with the corresponding external deficits financed by the Target 2 system.
As a consequence of these policies, direct government debt increased during the period due to the accumulation of deficits. In addition, the State accumulated debt outside of the direct public debt perimeter through public sector companies, as a good share of them were loss making. During this period, the government embarked on a massive school building program and continued to build roads and tunnels. From 2007, before the financial crisis, to 2010, the public debt in percentage of GDP increased by more than 35 percentage points.
As expected, the market conditions in which this debt was placed were getting worse and worse, in a process that mimicked what happened with other peripheral Europe sovereigns following the Global Financial Crisis. After the disclosure of a massive budget deficit in 2009, Greece had requested support from the Troika in April 2010. In the meantime, Ireland, suffering from the aftershocks of the Global Financial Crisis and its impact on the banks, saw a massive accumulation in public debt and had to ask for external support from the Troika in November 2010. The yields on Portuguese government bonds, or the interest the State had to pay annually to investors on freshly issued bonds, started 2010 close to 4% but ended the year close to 7%. The fact that rating agencies started to reduce the rating attached to these sovereign bonds did not help.
In early January 2009, Portugal was considered a AA quality by the three most widely used rating agencies, Moodyâs, Fitch and S&P, close to the current rating notation for France. During that month, S&P downgraded Portugal to A+ and in March 2011 to BBBâ, just above investment grade. Below investment grade, the rating is considered speculative grade, and a proportion of buy and hold institutional investors in government bonds, like insurance companies, pension funds and more conservative mutual funds, become constrained by their own investment rules, in their capacity to hold the bonds in the portfolios. Potentially, there will be a lot of forced sellers of the bonds at that point. Some of these constraints on investorsâ capacity to hold speculative grade bonds depend on at least two rating agencies. In consequence, most investors become forced sellers when two agencies downgrade the sovereign from investment grade to speculative grade, although they may start selling in anticipation.
Moodyâs downgraded Portugal to A1 in July 2010 and then closer to speculative grade in April 2011, Baa1 (Baa3 is the last rating in investment grade). And Fitch downgraded Portugal to A+ in December 2010, just before Christmas, and then to BBBâ on 1 April 2011.2 So, from 2009 to 2011, when Portugal had to request for assistance from the Troika, a gradual but sustained process of rating downgrades was taking place. It became clear that the rating agenciesâ perception of the Portuguese governmentâs credit quality was decreasing.
During the previous decade, Portuguese government bonds had been sold to investors located in Europe, to French, German and UK institutions including banks, asset managers and insurance companies. The latter would buy these bonds and hold them in their books. The Portuguese investors represented, generally, only around 10â20% of investment in new Portuguese government bonds.
This started to change in 2010. In February 2011, the Treasury and Debt Management Office for Portugal (âIGCPâ), which had the responsibility to execute the issuance of new bonds, came to the market with a new five-year bond. This bond offered a coupon of 6.4%. As it was sold at a discount, the yield on the bond was even a bit higher (6.46% in reality). This level of annual interest, paid to investors by a country with a level of debt expected to cross 100% of GDP during that same year and with a clear positive public debt trend, worried most investors. The fact that Portugal was willing to pay a yield of that magnitude to investors was perceived as a sign of despair given the circumstances. It showed that the need was there to keep going to the market whatever the conditions. And as we will see later, it is never good to make it clear to investors that you really need market support to survive. This effect was re-enforced given the sovereign was on a negative path in terms of debt accumulation and given adverse external market circumstances. Keep in mind that by the beginning of 2011 investors had already seen a similar process unfolding in Greece and Ireland. Both countries had been through a process of increasing public debt and deteriorating market conditions and both processes culminated with the need for external public support.
In addition to the issuance of Portuguese government bonds with a remaining life of more than one year, the Portuguese Treasury issues Treasury Bills that mature in less than one year. At the beginning of 2011, these bills were placed mostly with Portuguese banks. Domestic banks would bring the bills to the ECB as collateral for funding. Even so, the cost of these very short term instruments increased substantially: from an average of 1.6% in 2010 to 4.9% in 2011 for three-month Treasury Bills. It became clear that the banks had less and less capacity to absorb the needs of the Portuguese Treasury.
Market closure, which meant that international investors were no longer willing to buy new issuances of Portuguese government bonds whatever their maturities,3 was hovering on the horizon. In these circumstances, Portugal would only be able to issue very short bonds (three months, six months) and only to domestic investors. These bonds are normally kept for liquidity reasons, a way to invest balances that need to be easily converted into cash to honor short-term commitments besides being used as collateral for funding from the ECB. Domestic banks, at the time, would take these bonds and finance them at the ECB and keep the difference between the cost of funds and the yield on the bonds. When that was the case, the ECB would be indirectly financing the Portuguese government. As expected, the ECB was not willing to do that indefinitely. If that was going to be the case, they preferred to contact the authorities and advise them to ask for a formal support program like the Irish and the Greeks had done before. As a consequence, the incapacity to issue bonds with maturities higher than one year was pushing the Portuguese government into a corner. The government, to refinance the exist...