Financials Watch. The Portuguese path to recovery. Group Economics Macro & Financial Markets. 27 September 2017

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Marketing Communication Financials Watch Group Economics Macro & Financial Markets DISCLAIMER: This report has not been prepared in accordance with the legal requirements designed to promote the

1 Marketing Communication Financials Watch Group Economics Macro & Financial Markets DISCLAIMER: This report has not been prepared in accordance with the legal requirements designed to promote the independence of investment research, and that it is not subject to any prohibition on dealing ahead. This report is marketing communication and not investment research and is intended for professional and eligible clients only. The Portuguese path to recovery 27 September 2017 Tom Kinmonth, CFA Fixed Income Strategist Tel: Portugal jumps to investment grade at S&P, Moody s and Fitch on BB+ Pos Fundamentals in the Portuguese economy shine through Foreign investors flock to Portuguese banks over the last twelve months they strengthened capital and increased stability in the sector Novo Banco reaching a final conclusion, to cement foreign control of banks NPL books are still elevated, and will significantly impact the already weak profitability outlook over the short-to-mid term Portugal suffered greatly in the crisis, most notably in 2011 when the nation requested a EUR 78bn IMF-EU bailout package. Since then, the country has seen a strong resurgence, especially as of late. The month started off well for the country, as S&P upgraded the Portuguese sovereign back to investment grade. The upgrade even occurred without the need for a Positive outlook on the previous rating. Other rating agencies could soon follow, as both Fitch and Moody s have the nation at BB+ with Positive outlooks. We therefore take a look at what the resurgence of the nation means for the banking sector, and the opportunities it presents. Improving fundamentals grace the Portuguese economy Developments have been quite favourable for the recovering Iberian nation from a macro point of view. Earlier this year, the outlook for the budget balance was the best in 40 years, and the European Commission (EC) has advised that the country should exit the monitoring procedure for excessive budget deficits. Indeed, thanks to the economic recovery as well as the implementation of austerity, government finances have improved during the past few years. The budget deficit has declined to 2% of GDP in 2016, a drop from 4.4% in 2015, and the government debt ratio is expected to edge lower this year and the next. That said we should not get too carried away, the 130% government debt-to-gdp ratio still does remain one of highest in the eurozone, only surpassed by Greece and Italy. Although, the key takeaway is that the trend does look positive. The constructive deficit numbers were driven by Portugal s robust economy growth both in H and H1 2017, both outperforming the eurozone average. Moreover, for the most recent quarter GDP grew by 3.0% y-o-y in Q2 2017, versus a eurozone average of 2.3%. We expect growth in Portugal to remain roughly above the eurozone average for the second half of this year and to continue this tendency into 2018, see graph on next page. 27 September 2017, 8:23 AM Insights.abnamro.nl/en Bloomberg: ABNM

2 2 Financials Watch - The Portuguese path to recovery 27 September 2017 GDP growth versus the eurozone Unemployment and house prices Mountain & Valley % year-on-year % labour force index E Portugal Eurozone Unemployment rate (lhs) House prices (rhs) Source: Thomson Reuters Datastream, ABN AMRO Group Economics Source: Thomson Reuters Datastream, ABN AMRO Group Economics Conditions of the labour market improve in line with the economy As the country witnessed growth return, the unemployment rate has fallen sharply and is now at its lowest level since the end of The drop in unemployment is fuelling consumer confidence and private consumption growth. Furthermore, house prices have bounced back after the price correction of the years , generating a positive wealth effect. Indeed, Eurostat s harmonized house price index has risen well above its pre-crisis level, see graph above right. Besides increased private consumption, fixed investment has also accelerated in recent quarters and should continue to grow solidly in the coming quarters on the back of increased profitability. Further upgrades, positive for nation, but QE reduction likely to spoil the party If indeed Portugal does gain an upgrade from Fitch or Moody s this will further improve the funding credentials for the sovereign. This could also be enhanced if one other rating agency follows suit with an upgrade. Particularly as for some benchmarks, such as the Markit iboxx Euro Sovereign Index, they take the average rating of the three largest rating agencies to incorporate a deal in the index. However, we should not be too quick to draw funding benefits from an upgrade of the sovereign. We believe that the removal of the ECB s quantity easing program (QE) would actually increase the costs of funding for the Portuguese government although a rating upgrade would limit the damage. We discuss these dynamics in more detail, here. In addition to the recent increases in capital, Portuguese banks are liquid and continue to make progress on shrinking their balance sheets. Nevertheless, they face numerous challenges, including low asset quality, weak profitability and limited capital buffers. Banking sector recovery takes large leaps in 2017, in part helped by the small size Like the nation, the banking sector is also in a state of repair and recovery. On the surface, it is a fate that has many traits similar to Italy. A high stock of non-performing loans, low profitability and inefficiencies are likewise present in the sector, see grey box left. Fortunately, the relatively small size of the Portuguese banking sector makes a solution more manageable and far less of a risk at European level. For illustration, the total number of outstanding loans in the Portuguese banking sector (roughly EUR 239bn) is actually smaller than just the number of non-performing loans in Italy (roughly EUR 349bn). In part due to the smaller size of the Portugal banking sector there has been large a number of leaps forward in 2017, with these leaps often supplemented by foreign direct capital. IMF, 15 September 2017

3 3 Financials Watch - The Portuguese path to recovery 27 September 2017 Foreign investors flock to Portuguese banks Indeed foreign investment has flourished in the banking sector this year. We have seen recent direct foreign involvement in deals of Banco BPI and Banco Comercial Português (BCP). Meanwhile, the Banco Santander purchase of Banco Popular in June this year, will also reinforce the footprint of the Spanish lender via their Santander Totta franchise, for further details see here. It was Chinese investors who were interested in a EUR 1.3bn private equity raise by Banco Comercial Portugues (BCP), that was performed at the start of the year. The Chinese conglomerate Fosun International, increased their share to 24% in the company. Meanwhile, Spain s CaixaBank SA increased their ownership to 85% of Banco BPI. The sale of the nation s third largest bank, Novo Banco, is currently also progressing; the state bank rose as the good bank from Banco Espírito Santo. On Monday this week, Portuguese press reports indicated that PIMCO Investment Management had finally agreed to accept a buyback offer. If this would be the case, this would seal the sale of the Portuguese lender to the US based Lone Star Funds. The investment is hoped to bring a 4.5% increase in regulatory capital for Novo Banco. The results of the actions, mean that four of the top five banks in Portugal could have significant foreign (and sometimes full) control from companies with significant capital. This will increase the strength, stability and safety of the Portuguese banking sector. Portuguese Bank Ownership total assets in EUR mn. GOLD: Foreign control, GREEN: Domestic control 120, ,000 80,000 60,000 40,000 20,000 0 CGD BCP Novo Banco Totta BPI Montepio Source: Financial Statements, Bloomberg, ABN AMRO Group Economics Capital strengthening occurs from foreign and domestic sources On top of these above foreign investments, the state-owned bank Caixa Geral de Depositos also increased their capital. It announced in December 2016 that it s capital positon would be enchanced via a EUR 2.7bn state recapitalisation. This was a significant event for the largest Portuguese bank, and the CET1 fully loaded of the institution has soared to 12.5%, from 5.5% at the end of All these capital events really demonstrate the impact a (relatively) small amount of capital can contribute to assist the domestic banking situation. The positive capital trend has changed the mood in the Portuguese banking sector, and these have significantly helped alleviate the short-term stress on the banks.

4 4 Financials Watch - The Portuguese path to recovery 27 September 2017 Financial stability has improved after recent capital augmentations, but the large stock of NPLs is likely to limit banks ability to finance future growth and leave them vulnerable to downside risks. Ambitious efforts are needed by banks to strengthen their balance sheets, which would improve the effective intermediation of savings by the banking sector to productive investment. IMF, 15 September 2017 now the Non-Performing Loan progress begins Arguably the capital of the institutions were the first item to address, and now the Non- Performing Loan (NPL) reduction can begin in earnest. Unfortunately, the positive capital story has not transcended to the bad loan situation. Indeed, coverage of non-performing assets is still below the guidance from regulators. Overall, NPLs still stood at 16 percent of total loans at end-march 2017, see here. Although there was a small trend indicating a slight increase in NPL provisions, but to a far lesser degree. For example, Net NPLs (Gross NPL minus provisions) to non-financial corporates saw a slight positive decline of 6% y-o-y to March Yet, the NPL situation is varied across all the banks. For instance, Novo Banco s current NPL ratio stands at 32% of loans, with provisions at 51%, something which the upcoming sale will aim to address. Just to put the NPL problem into perspective. In mid-2016, the cost to raise the major Portuguese banks provisions to a needed 80 percent of NPLs would be roughly EUR 3.2bn (2 percent of GDP), according to the IMF. If we review the large amount of external capital that has been raised in 2017, the NPL figure should be manageable long-term. Having said that, the necessity to reduce NPLs over the short-term will choke bank profitability. Unfortunately, the profitability is also still under pressure as restructuring at banks continue and negative interest rates continue to bite. The speed of the NPL reduction will depend mainly on profitability, which in turn is greatly dependent on the continued recovery of the nation. Overall, the situation will mean that NPL reduction will take a significant amount of time whereby disposals will likely be needed to achieve reductions. Capital positions dramatic strengthening CET1 Fully Loaded, as a % of RWAs Non-Performing Loan provision development as a %, Net NPL / Gross NPL CGD BCP Dec 2016 Jun Dec Sep Jun Mar-17 Portugal NPL Households Portugal NPL Non Financial Corporations Source: Financial Statements, Bloomberg, ABN AMRO Group Economics Source: ECB, ABN AMRO Group Economics Government participation an encouraging influence A positive for the sector is that the Portuguese finance ministry continues to work closely with the banks to solve both NPL and capital issues. Indeed, the most recent venture could be that three Portuguese banks (CGD, BCP and Novo Banco) will work together in unison to reduce their NPL stock. Additionally, Portugal s finance ministry recently announced that it is seeking to give more protection to institutional depositors by placing them above traditional senior liabilities in the case of resolution. This will lightly assist to avert liquidity runs the likes of which we saw at Banco Popular. All these developments are a positive for the sector.

5 5 Financials Watch - The Portuguese path to recovery 27 September 2017 The future is bright, although it will take time to arrive Performance of Portuguese debt has been relatively strong this year. Both bank debt and sovereign debt has seen strong performance, especially recently, please see below. Performance of debt Junior Subordinated (AT1) in bps, z-spread mid, capital type: CoCo 1150 Performance of debt Sovereign performance in bps, z-spread mid Mar May Jul-17 CXGD PERP Mar May Jul-17 PORTUG Source: Bloomberg, ABN AMRO Group Economics Source: Bloomberg, ABN AMRO Group Economics Looking forward, we expect Portuguese banks to continue to offer attractive returns, as the country moves towards normality again. Banks should see a reduction in NPLs, once restructuring and capitalisations are complete and they gradually return to profitability. The increased foreign ownership of the banks has reduced the underlying risks and boosted the recovery of the sector. The small size of the Portuguese banking sector will naturally still limit large scale issuance from the sector. Although hopefully the upgraded national outlook can assist in the gradual return of the banking sector in the mid-to-long term. This should also promote new instruments in the market. We also see the increased exposure by European banks to Portugal, such as CaixaBank SA and Banco Santander, as a positive for diversification within their bank models. Portugal Outstanding bank bond issues Selected instruments only Name C Cpn Priced To A/O Z-Bid Cls Rank Cntry Yrs to WO 1 Yr YTD Moodys BCPPL 8 1/2 PERP EUR 10 #VALUE! Jr Subordinated PT 148 #N/A N/A#N/A N/A - BESPL 7 1/8 11/28/23 EUR Nov #N/A N/A Subordinated PT 6 #N/A N/A#N/A N/A WR BPIPL 0 03/24/27 EUR Mar Subordinated PT 9 #N/A N/A#N/A N/A - CXGD 10 3/4 PERP EUR Mar Jr Subordinated PT Caa2u NOVBNC 0 04/16/46 EUR 0 Apr Sr Unsecured PT Caa2 /*- NOVBNC 0 03/27/47 EUR 0 Mar Sr Unsecured PT Caa2 /*- NOVBNC 0 04/03/48 EUR 0 Apr Sr Unsecured PT Caa2 /*- NOVBNC 0 10/02/48 EUR 0 Oct Sr Unsecured PT Caa2 /*- NOVBNC 0 02/05/49 EUR 0 Feb Sr Unsecured PT Caa2 /*- NOVBNC 0 03/25/50 EUR 0 Mar Sr Unsecured PT Caa2 /*- NOVBNC 0 02/27/51 EUR 0 Feb Sr Unsecured PT Caa2 /*- NOVBNC 0 03/06/51 EUR 0 Mar Sr Unsecured PT Caa2 /*- NOVBNC 0 04/09/52 EUR 0 Apr Sr Unsecured PT Caa2 /*- SANTAN 0 PERP EUR Dec Field Not Appl Jr Subordinated PT 149 #N/A N/A#N/A N/A - Source: Financial Statements, Bloomberg, ABN AMRO Group Economics

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Portuguese Banking System: latest developments. 2 nd quarter 2018

Portuguese Banking System: latest developments 2 nd quarter 218 Lisbon, 218 www.bportugal.pt Prepared with data available up to 26 th September of 218. Macroeconomic indicators and banking system data