Interview with Portuguese Secretary of State for Treasury and Finance Carlos Costa Pina:

As part of our ongoing series of interviews focused on the future of European economies, we talked to a senior figure in the Portuguese Finance Ministry about how his country plans to return to fiscal surplus and pay down debt.

Economic Observer: Given current market conditions, how does Portugal plan to handle the roll over of public debt this coming year? What are the risks involved in this roll over process, especially in terms of the impact of increased borrowing costs and recent ratings downgrades?

Portuguese Secretary of State for Treasury and Finance Carlos Costa Pina: Despite the more demanding market conditions, Portugal has managed to access the market without any major difficulties. In fact, by July this year, we have already covered more than 74% of the long term financing needs of the Republic. We have seen an increase in price, but other than that, the market has been there as the figures illustrate quite clearly. For example this year (to date) we have already placed more than double the average amount of medium/long term debt (average maturity of 8 years), than in the previous 3 years (full year). We have in fact even increased the weight of medium/long term debt.

Demand has, on average, been 2.4 times the amounts offered, which, again, compares favourably with an average below 2.2 in the past 3 years. Just this week we placed an
additional 1.28 bn Euro of debt maturing in 2013 and 2023.

Regarding next year we are absolutely confident and don't anticipate any problem. On the one hand redemption needs at less than 10 bn Euro are relatively small and we have already started reducing those needs by performing a buy-back program. In fact this year we have already bought back around 2bn Euro worth of debt due next year.

Regarding pricing and ratings we first of all feel that it is most a question of expectations–the wrong ones - rather than that of any relevant fundamental economic data, which in fact has been very positive, with Portugal growing in the first quarter at the fastest pace in the Euro Zone and exports of goods growing at over 15% and even more for the non euro countries. The downgrades by rating agencies seem to have had little impact on the market as it had already been anticipated and priced in.

It has to be kept in mind that despite the increase in the spreads demanded by investors to hold Portuguese debt, the total cost being paid by Portugal, which on this year's issuances averages 4.240%, still compares favourably with the average cost we paid for debt issued in 2007 and 2008, which was 4.458% and 4.608% respectively.

EO: In regard to the recent announcement of government plans to stabilize debt, how can the government start do reduce public debt (expressed in terms of % of GDP) while deficits, though shrinking, still persist? Will privatizations or other measures need to be taken to pay down the debt?

CCP: We are working fast on reducing deficit, as we have done in the past. In fact, this same government, while it was conducting very relevant structural reforms in
the public sector, in labour law, in social security system, education, etc, managed to reduce the deficit from 6.1% in 2005 to 2.7% in 2008, which was 1 year ahead of target.

We have done it in the past and we are now doing it again! This year we will reduce the general government deficit by at least 2 percentage points to no more than
7.3% and our primary balance deficit will be down to 4.1%. By next year, our primary balance deficit will be brought down to 0.8% and in 2012 we are already expecting a 0.8%
surplus. In this way we expect the public debt to peak at 85.9% of GDP in 2011/2012 and start to reduce in the following year. Privatization proceeds, expected at 6 billion Euro between 2010 and 1013, will be used to speed up the reduction of public debt.

EO: Portuguese banks escaped the worst of the subprime crisis due to lack of exposure to toxic assets and the absence of a real estate bubble. Despite this, Portuguese banks depend on external lenders for financing of their activities – given the virtual breakdown of the inter-bank market and the country's reliance on the ECB, what are the major risks to the solvency of the country's banking sector – do you have doubts that all Portuguese banks will "pass" the stress tests, the results of which will be published on July 23? (these questions were sent to the Secretary of State for Treasury and Finance before July 23)

CCP: As it has been dully recognized by the IMF, OECD and even the EU, Portugal has a strong financial system which has weathered the financial crisis relatively well. In the opinion of the IMF this can be attributed not only to the limited exposure to toxic assets and to the non-existence of a real state bubble in the Portuguese market but also to the fact that Portuguese banks follow a retail based business models, and that we have a solid regulatory and supervisory framework.

On the other hand we already knew that, on average, the Portuguese banks have a lower leverage ratio and less refinancing needs than the average in the Eurosystem. The results of the stress tests have but confirmed our trust and confidence in the Portuguese banking sector. Moreover, the feedback we have received from investors is that, at least in our case, the results clearly reflect the reality as the stress tests assumptions were correct.

EO: Why have no Portuguese banks made use of the 4 billion Euro recapitalization fund setup by the government?

CCP: They didn't need to use it. And this is a good news. They found their own ways, through their shareholder structure, to solve their capital needs. In the midst of the financial crisis in 2008 the Portuguese Government, as with all other European Governments, set up various instruments to help the banking sector. As part of this and well within the European competition laws we created the 4bn Euro recapitalization fund but also the 20bn Eur guarantee framework. As we already mentioned and as the results of the stress tests have shown, the Portuguese banks are well capitalized and so it is little surprise that the recapitalization fund hasn't been used.

We felt the crisis of 2008, much like the sovereign-debt crisis now, was mainly one of confidence – or lack of it. In this sense the fact that we provided the fund, even if it was not used, served its purpose – it restored confidence back to the market, that if need be, funds would be readily available to recapitalize the banks.

In the end the banks decided they could access the market by themselves and didn't use this fund. They did, however, use almost ? of the 20 billion Euro guarantees made available to them. Part of these guarantees have already been released back, underlying the fact that they were short term support measures.

EO: From your perspective, what are the most urgent reforms that need to be made to the system of financial regulation?

CCP: Create a more effective regulation and supervision system in Europe. In Portugal, just to improve current model, transforming it in a "twin peaks" model based in two authorities: one in charge of prudential regulation; the other one in charge of what we call "behavioural" supervision covering relations between financial institutions and consumers.

EO: In order for the European Monetary Union (EMU) to function better than it has up until now, what changes need to be made to the institutional structure of the Union? Is it inevitable that there'll be a shift in terms of power towards Europe away from the member states?

CCP: At an EU level a further integration of its political supra-national instruments onto to an increased fiscal federalism will be necessary. This will imply a clear leadership from the EU countries that are in the best position to do it, which are the ones that benefited the most from the introduction of the single European currency. Therefore, they are expected to take their responsibilities in the defence of the euro zone.

Furthermore, it will be necessary for the same purpose to develop institutional and legal instruments: (i) enlarge the dimension and role of the EU budget; (ii) create a EU treasury and debt agency; (iii) increase the accountability of rating agencies by regulating their activities and creating a EU rating agency.

EO: Portugal has already made serious reforms to in regard to pensions, labor markets and education system – from your perspective as Secretary of State for Treasury and Finance, what should be the next major issue on the reform agenda?

CCP: As you correctly pointed, and I think that is a major reason to distinguish Portugal from most other European countries, we have already started most of the needed structural reforms.

We now have one of the most sustainable social security systems in Europe. The European Commissioner for Employment, Social Affairs and Inclusion even recently recognized
Portugal as an example for the opportunity and extension of its social security system reform.

We are now below the European average in terms of risk for long term sustainability of public finances (next to Belgium, Austria and Germany) with an increase in age related
expenditures by 2060 of 2.9% against an EU average of 4.6% and Euro Area of 5.1%. The retirement age has already been set at 65 years of age – when some other countries are still discussing extending it to 62, and we even indexed it to changes in life expectancy. Pension payments are already linked to GDP and life expectancy growth. Regarding labour force we have on the one hand been working on the increasing qualification of the workforce – today already 35% of our youth attend universities and even school kids are using personal computers as soon as they start reading. On the other hand we have competing overhauled the labour legislation to reduce market force rigidity.

OECD recognizes Portugal as the faster mover in terms of the changes we have implemented. Currently we already compare well to France and are very close to Germany. But we have also taken extensive measures to reduce the weight of the public sector in the economy.

We have in the last 4 years reduced the number of civil servants by almost 10% while at the same time implementing some of the best online e-government features in the world. The result is less cost and increased public service and efficiency in the economy. For example, now it takes just an average of 35 minutes to incorporate a new company, when just a few years ago it could take a few months. In another example over 75% of all personal income tax returns were filled this year over the internet, reducing not only the number of people needed to received them, but most importantly reducing the amount of time wasted in line by workers. As another example, most export duties and declaration
forms are also submitted online, avoiding time consumption and costs and thus making the economy more competitive.

Another area were we have been working hard is in the energy sector and on our dependency on imported fossil fuels. By significantly increasing the production of electricity from renewable sources, from around 15% in 2005 to nearly 45% of all electricity consumption this year, we have reduced the share of energy on our current account deficit from over 50% in 2003 to less than 30% in the first quarter of this year. We are now the 5th country in Europe in terms of renewable and expect to reach a 60% share of clean sources in energy consumption by 2020.

Another very relevant area where we have been working hard is on the reshaping of Portugal manufacturing profile. In the last few years we have increased expenditure on research and development from just under 0.4% of GDP to more than 1.5%. We now compare favourable to countries like Spain and Italy and are ever closer to the EU average.

This has already yielded very interesting results with Portugal managing a complete u-turn in its export profile in less than two decade. The share of medium and high technology
intensity in our exports went from around 35% in 1990 to more than 60% in 2009. Over ? of our exports are no machinery, vehicles and equipment.

We have also been working hard to promote the diversification of export markets and this has been a huge success. In 1999 the share on non EU markets was only 15%, now it is
over 27%. It nearly doubled.

We are confident that we have already done an important part of the job, but we know we still have work to do. We are currently working on:
* Continued budget consolidation, including the frontloading the SGP to reduce debt ratio sooner
* Reinforce export led growth, specially to non EU and non Euro countries
* Continue domestic structural reforms, namely in labour force qualification and law,export promotion and diversification, and energy

EO: To what extent will growth in Portugal over the short to medium term, depend on the recovery of the country's European trade partners? To what extent has diversification of the country's trade markets reduced dependency on a European recovery?

CCP: We have already done much in this area. Today the share of non-EU markets has grown from around 15% to 27% and we are actively helping our companies diversify markets, through opening what we call countries export stores, export insurance and other support services. In the short term it is true that almost 70% of our exports depend on the growth of our EU partners, but we are working to continue changing this balance in the medium term. The export figures from the first months of this year are very encouraging with exports of goods growing at around 15% in general and at almost 18% for non EU countries.

EO: Spanish officials have made clear that any attempt to further integrate the EMU and require members to submit to stricter surveillance of their fiscal policy settings etc, should come at the price of Germany agreeing to take steps to address its large capital account imbalance with other members of the Union. How do you see these imbalances, should German policy makers take steps to increase domestic demand with in the country?

CCP: We prefer not to comment the other countries' internal economic policy options. Saying this, we have no doubts about the importance of German domestic demand for the EU
recovery.

EO: How do you see the risk to price stability in the EMU from rising commodity and energy prices?

CCP: If there is one area were the EMU has been successful is price stability. Even Germany has never benefited from such a long period or even such levels of price stability.
In such a scenario that you describe prices can surely increase, either from increases in commodity, energy prices or both, but we can remain certain that without a strong EMU, prices would increase even further.

EO: At a time when unemployment remains high, yet banks reap record profits on the back of the liquidity being pumped into the financial system by the ECB, is there a risk that voters may lose faith in the market system?

CCP: Banks play a fundamental role in helping liquidity reach the economy. It is this liquidity that will enable investment, which in turn will create jobs and foster development. It is the very nature of the market system. In the meantime the ECB is taking measures to reduce any excessive liquidity in the system.

EO: Encunbered with high debt, weak competitiveness, weak growth and a low savings rate, from a certain point of view, Portugal has more similarities to Greece rather than Spain. The market has serious doubts about Portugal's ability to pay back the debt and raise funds domestically, how do you responds to these doubts?

CCP: I cannot agree with that comment. Portugal's fundamentals are much closer to AAA countries than to non AAA countries of the Euro Zone. Just to give you a few examples and according to Eurostat Portugal's Public Debt costs at below 3% of GDP in 2009 are in-line with those of Germany, France and even lower than those of Austria. Belgium for example shows nearly 4%, while Greece and Italy are closer to the 5% threshold – a staggering difference.

If we look at the public debt trajectories in projections 2007-2011 made by Eurostat, again Portugal compares better with Spain, France and Germany and shows a total distinct path from Greece, Italy or Ireland.

On the other hand, it is curious that you should mention Portugal's so called lack of competitiveness when the facts show that not only did our economy contract less than the
rest of Europe during 2009, but we were also among the first countries to recover growth in 2010.

On top of that Portugal was the country of the Euro Zone which showed the fastest growth rate in the 1st quarter of this year. We grew at 5 times the average in the euro zone. And this happened while our exports – especially to non Euro countries were growing at 18%.

EO: Portuguese exporters have been losing market share to competitors. With consumption in your main export market - Spain – likely to fall due to the austerity measures adopted there, how can Portugal decrease its fiscal deficit from 9.4% of GDP to 5.1 % of GDP in 2011?

CCP: Again I have to say I cannot agree with your question. The comment certainly applies if you are only considering what used to be our traditional sectors – clothing and footwear, in which case we have been losing market share to China, India, Morocco and other countries.

But, as I have already mentioned, over the past few years, through for example investment in R&D, investment and education and changes in the labour laws, we have successfully
changed the profile of our exports. Today 27% of our exports are machinery, vehicles and equipment and nearly 2/3 of our exports (against only 1/3 20 years ago) have medium to high integration of technology.

On the other hand, and again as I have mentioned, Portugal has successfully diversified its export markets. Today 27% of total exports come from non EU countries. African, South and North American and even Asia countries have been growing. Today Angola is already our 4th export market.

EO: What's your forecast for economic growth in 2011 and 2012?

CCP: We don't want the markets to think we are placing the debt reduction burden on future expected economic growth and so we are being very conservative in our projections.
Just to give you an idea, this year we have grown 1.8% in the first quarter (and the preliminary figures for the 2nd quarter look good as well) but we are still keeping our end of year projection on 0.7%. Next year we are conservatively expecting 0.5% growth and only 1.1% in 2012

EO: How are your big-ticket infrustructrue projects progressing? How do see the role of investmnet in your economic recovery? Is there a possibility that by continuing to rely on investment to boost economic growth, you will make your debt unsustainable?

CCP: We are being more selective in the approval of investments and focusing on the ones that are most relevant for reshaping the country and fostering economic and social development. In this sense we are prioritizing key investments in transport and logistics such as the high speed train and the New Lisbon Airport, but also important investments in the energy systems (renewables and transport) and on education. In the case of the high speed train, we are focusing on connecting Portugal and Spain, which as you know is not only our largest export market but also our doorway to Europe. This rail connection will be used not only for passengers but also for freight, more than halving the time distance between the Portuguese Atlantic ports and Madrid – the main production and consumption region in the Iberian Peninsula.

Making sure of the affordability of any large investment is a necessary part of its approval process, so we don't see any risks there.

EO: In contrast to Greece and Spain, Portugal seems not to have experienced much of a housing bubble?. How do you see the relative gains and losses that the Portuguese economy experienced after joining the eurozone? And how do you see the future of the monetary union?

CCP: In fact, we did not experience a housing bubble. Real estate prices in Portugal increased in the last decade by around 12%, which is 10 times less than the situation in Spain and 5 times less than the situation in the EU.

It is a fact that the introduction of the Euro allowed Portugal's access to much cheaper credit and in the face of that both companies and individuals increased their borrowing. The interesting fact though is that when you see the evolution of families' net assets within the period of the latest 25 years, you see a clear increase (almost 5 times higher). This means that the increase in borrowing has been more than compensated by the increase in the assets that were acquired through it.

After joining the EU, Portugal is now undoubtedly a different country. In that sense, joining the euro zone has also been a great helping factor. In a more demanding and
competitive economic environment, we cannot have anymore our economic model based on traditional sectors and low salaries. And nowadays our economy has not indeed such
profile, as we explained before.

Tony Liu translated selections of this interview into Chinese, The Chinese-language translation of the transcript can be found here.

The above was conducted by e-mail and is part of a series of interviews with various officials, scholars and journalists throughout Europe on the topic of the future of the European economy in the wake of the sovereign-debt crisis. You can find a collection of the interviews in English here and in Chinese here.