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Caveat emptor: Portugal’s recovery is not all it seems

portuguese euroAhead of launching new legal proceedings against Banco de Portugal, the Novo Note Group’s coordinators – Attestor, BlackRock, CQS and PIMCO – have written the below article that outlines the negative impact the retransfer has had on Portugal and the need for urgent action:

Portugal’s return to the capital markets in September was widely heralded as a sign of the country’s recovery coming of age – it has now won back its investment-grade credit rating from S&P and Fitch, with sovereign bond yields falling to their lowest level in almost three years as a result.

But investors in Portugal’s revival should be on their guard, for the country’s institutions remain weak and prone to governance failures. A house built on poor foundations is likely to show its cracks again, even if they have been papered over and presented for sale as new to the market.

Portugal had long been regarded as one of the weakest eurozone economies – behind only Greece – and its journey since the 2011 bailout has been arduous. However, Portugal has the dubious honour of doing something that even Greece never did by imposing discriminatory losses on specific senior bondholders and breaking pari passu, the well-established principle that creditors in equally ranked securities must be treated equally.

On 29th December 2015 (just three days before Europe took over from national resolution authorities) Portugal’s central bank, Banco de Portugal, took the unlawful decision to move five of 52 then outstanding series of senior bonds from Novo Banco, the ‘good bank’ created in 2014 as a result of the resolution of Banco Espírito Santo, back to the remaining ‘bad bank’.

The end result was that investors representing pensions and savers, as well as retail investors, found their fundamentally good assets investments had suffered huge losses overnight, in an attempt by Portugal’s central bank to ‘cheaply’ plug the hole in Novo Banco’s balance sheet.

Banco de Portugal’s stated justification for breaching the sacrosanct rule of pari passu was that the five series selected were issued to international institutional investors, rather than to retail investors.

While it is a breach of resolution law to discriminate against investors on the basis that they are institutional rather than retail, it was also a flawed justification, as Banco de Portugal undertook no due diligence to determine who actually held the retransferred notes. Some were in fact held by a group of Portuguese retail investors.

However, the most important, and unstated, criteria behind Banco de Portugal’s selection was much more opportunistic: the retransferred notes were all governed by Portuguese law, with all other series (bar one) subject to English law, thereby conveniently avoiding the prospect of litigation in an international forum.

It is now two years since this remarkable failure of capital markets governance, and yet since that time, Banco de Portugal has failed to meaningfully engage with the bondholders upon whom it imposed such significant losses in breach of fundamental legal principles.

Yet the problem is not going away for Portugal. Legal challenges that were launched by the Novo Note Group and others are still ongoing, and new legal action is set to be launched to seek action over the unlawful decisions taken by Portugal’s central bank.

The consequences of the Novo Banco retransfer for Portugal are not just legal, however. The retransfer has led to an inherent distrust of Portugal amongst the international investment community – whose help it badly needs if the country’s recovery is to be sustained, especially in its banking sector.

Actions taken by the Portuguese authorities have undermined the legal certainty and level playing field that the eurozone has sought to create via the Bank Recovery and Resolution Directive (BRRD), making it even harder and more expensive for peripheral banks to raise capital.

Action to address this is urgent – Portugal’s banking system remains frail and, despite recent good news on the economic front, is in dire need of help if it is to survive.

Portuguese banks must raise new capital to cover Non-Performing Loans (NPL) sales, which still account for 17.6% of the banking system, with only 44.9% cash coverage, and a catalogue of nearterm regulatory challenges like Total Loss Absorbing Capacity and Minimum Requirement for Eligible Liabilities requirements.

Portugal can ill afford to ignore this poor investment climate for its banks, for which the Banco de Portugal bears significant responsibility. If investors are to take risks to help shore up Portugal’s banks, then their price for doing so will be high, if indeed they decide to take the risk at all.

The reality is that the retransfer has turned out to be anything but ‘cheap’ for Portugal.

If Portugal is to rely on the support it needs for its recovery to succeed, Banco de Portugal must correct its mistaken past actions and look to rebuild trust with the international investment community.

The continued failure of Portugal to take action regarding the illegal and unfair retransfer would only suggest the foundations of the country’s recovery remain weak. Investors need to be mindful that unless things change, the cracks will re-appear.