Journal Issue

From Crisis to Convergence: Charting a Course for Portugal

Dmitry Gershenson, Albert Jaeger, and Subir Lall
Published Date:
March 2016
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5. Dealing with Private Debt Overhang: Corporate Debt Restructuring1

In the years preceding the economic crisis, the corporate sector experienced rapid debt accumulation. The stock of nonfinancial corporation (NFC) debt stands at 112.7 percent of gross domestic product (GDP) on a consolidated basis as of 2015:Q2, one of the largest in the EU. Excessive corporate leverage constrains profitability, resulting in higher nonperforming loans (NPLs) and lower business investment. Yet both banks and NFCs face disincentives to speed up the deleveraging process. The authorities have taken some important steps to facilitate corporate debt restructuring, including enhancing the legal and institutional framework. The current economic and financial environment affords an opportunity to tackle the corporate debt overhang more ambitiously with a standardized bank-led, time-bound framework.


The global financial crisis prompted a renewed focus on financial stability and how it should be defined. As the importance of macro-financial linkages came into stark relief, narrow definitions of financial stability proved inadequate to capture the underlying complexities of financial stress and its impact on the economy.2 This paper takes a broad view of financial stability as “a condition in which the financial system—intermediaries, markets and market infrastructures—can withstand shocks without major disruption in financial intermediation and in the effective allocation of savings to productive investment” (ECB 2014). It argues that reducing corporate debt is a necessary, albeit not a sufficient, condition for restoring financial intermediation and resuming investment. The authorities have taken steps to enhance the legal and institutional framework for corporate debt restructuring. Banks and nonfinancial corporations in Portugal, however, face incentives that prolong the deleveraging process. Therefore, in the absence of decisive policy action to reduce NPLs and the level of corporate debt, the economic recovery will remain subdued.

Portugal’s Leveraging-Up Process

In the years preceding the economic crisis, the corporate sector experienced rapid debt accumulation. Following the adoption of the euro, large capital inflows and low funding costs unlocked the flow of credit to NFCs. By April 2008, credit to NFCs was growing at 14½ percent, and long-term borrowing (over five years) was growing even faster, at 21 percent.

The accumulation of debt continued well after the start of the global crisis. By June 2013, the stock of debt of NFCs—defined as loans, debt securities, and trade credits, on a consolidated basis—had peaked at more than €214 billion (126.9 percent of GDP; see Box 5.1 for statistical issues). The small and medium enterprise (SME) segment accounted for the largest share, with about half of outstanding debt. Following a gradual decline beginning in mid-2013, the stock of NFC debt stands at €201 billion (112.7 percent of projected 2015 GDP) as of June 2015. However, the level of NFC debt is still high by EU standards.

Portugal’s firms remain highly leveraged; the leverage ratio was 200 percent as of June 2015.3 High corporate leverage also continued to weigh on firms’ capacity to repay their debt, as approximated by the low interest coverage ratio, just 3.5 as of end-March 2015.

The stock of corporate NPLs in Portugal is at its historical peak and still rising, further weighing down bank balance sheets. Nonperforming loans comprised 21.1 percent of loans to corporations in 2015:Q2, up from 3½ percent in 2008:Q4. High and still rising NPLs reflect the weak profitability and excessive indebtedness of a large segment of Portuguese firms. They are also reflective of lower lending standards by banks in the run-up to the crisis.

The Impact of Excessive Corporate Debt on the Real Economy

Excessive corporate leverage constrains profitability, resulting in higher NPLs and lower business investment (Figure 5.1). A declining interest rate coverage ratio and the high number of firms with overdue loans (31 percent as of January 2015) are indicative of the impact of the debt overhang on the corporate side. On the bank side, the continued rise of nonperforming loans impacts profitability and, in turn, new lending (see Bergthaler and others 2015).

Portugal: NFC Debt

(Percent of GDP; consolidated basis)

Source: Bank of Portugal.

NFC Debt to GDP, 2014:Q3

(Percent of GDP; consolidated basis)

Source: Eurostat.

1Luxembourg, 400 percent.

Portugal: Nonperforming Loans to NFCs

(Percent of gross loans to NFCs)

Source: Bank of Portugal.

As the economic crisis unfolded, the interest coverage ratio declined (from 6.7 at end-2010 to 2.6 at end-2012), reflecting the impact of the corporate debt overhang on NFCs. Servicing high debt levels became an insurmountable challenge to many firms also confronting an unfavorable economic environment, and as a result NPLs rose sharply.

The growing stock of NPLs exacted a heavy toll on bank profitability. The deteriorating quality of banks’ portfolios necessitated additional provisions and credit impairments, which in turn eroded banks’ capital. Banks also increased their reliance on financial operations (such as trading of sovereign bonds) as a source of income. As done by banks with these characteristics elsewhere in Europe (Gambacorta and Marques-Ibanez 2011), Portuguese banks restricted the loan supply more strongly during the crisis period and credit growth turned negative.

Portugal: Key Indicators of Corporate Indebtedness, 2008–2015:Q1

Sources: Bank of Portugal; European Central Bank; and IMF staff estimates.

1 NPLs are in percent of total loans.

2 Interest coverage ratio is measured by earnings before interest, taxes, depreciation and amortization (EBITDA)/interest expenses.

3 RoA are EBITDA/total assets.

In addition to being constrained, credit was misallocated. Despite its low profitability, the construction sector remains the largest recipient sector of bank loans, at about €14.6 billion as of end-June 2015 (17 percent of bank loans), while one-third of the loans to this sector are nonperforming.

The debt overhang also discourages investment, because (1) debt impacts the profitability of firms and hence their ability to obtain funding (supply side), and (2) firms with a high level of debt might refrain from investing. Indeed, Jaeger (2003) provides evidence of substantial and persistent leverage effects on corporate investment in the United States and Germany, especially when leverage is measured by the debt-to-internal funds ratio. Goretti and Souto (2013), using firm-level data for eight euro area countries (including Portugal), find that higher debt overhang, proxied by debt-to-equity or interest coverage ratio, is found to significantly reduce the firms’ investment to capital ratio. In a broader context, Cecchetti, Mohanty, and Zampolli (2010) show that corporate debt becomes a drag on growth for levels beyond 90 percent of GDP. More recently, the European Investment Bank documents a negative relationship between NFC credit growth and the share of NPLs (EIB 2015). Bergthaler and others (2015) find that high corporate debt and NPLs represent a significant drag on investment, as credit-constrained firms cut back on spending to repay debt.

Disincentives for Nonfinancial Corporations and Banks to Restructure Corporate Debt

Both banks and NFCs face disincentives to speed up the deleveraging process. On the bank side, the reliance on collateralized lending and the difficulty of marking-to-market collateral create an incentive to postpone provisions and debt write-offs until the economic recovery takes hold, despite eroding profitability. The corporate sector is dominated by small and medium enterprises (SMEs) where, due to weak corporate governance and personal guarantees, firm owners typically distribute (rather than retain) earnings, shifting the risk from firms to banks.

From the perspective of NFCs, there are important deterrents to restructuring their debt:

  • The legal and institutional framework, though recently strengthened, is still a burden (Box 5.2). The introduction of streamlined and strengthened in- and out-of-court workouts was an important step toward putting in place an enhanced framework. However, many firms access the framework when it is too late and, when they do, they face institutional hurdles that slow down the process. In essence, other mechanisms may need to be developed to provide a systemic solution for processing large numbers of distressed firms quickly and equitably.
  • Weak corporate governance. The Portuguese corporate sector is dominated by small and medium enterprises, mostly operating in the nontradables sector. In contrast to their Spanish peers, Portuguese firm owners typically distribute more earnings. This reduces the equity ratio of those businesses, shifting the risk from the firm’s owners to the bank. Until firm owners leave more earnings in their firms and/or inject additional equity, the deleveraging contribution from this channel will be limited.
  • The pledging of personal guarantees as business collateral. For the large segment of SMEs that is family owned and operated, restructuring business debts can have devastating personal consequences. Personal guarantees are frequently used as collateral. If personal assets have been used to secure business loans, the incentive of business owners in highly indebted companies may be against retaining earnings.

On the bank side, there are additional hurdles. Portuguese banks continue to operate in a difficult environment, with low profit margins and little incentive or ability to incur the cost of large-scale write-offs. There are several reasons why this is likely the case:4

  • Insufficient capital buffers and modest provisioning levels. While banks may have sufficient capital to meet the minimum regulatory requirement, writing off NPLs erodes capital. Capital buffers remain too thin to absorb the substantial losses that would be required to achieve meaningful deleveraging (average Common Equity Tier 1 ratio was 11.6 percent as of June 2015, which is below the euro area average). At the same time, provisioning levels, although found adequate during the Asset Quality Review, are not high enough to avert a material reduction in capital should banks begin to accelerate the write-offs. Further, by holding on to their provisioned loans, banks can avoid the negative impact on their provisioning coverage ratios that would result from writing off or selling the bad debt.
  • Low profitability and collateral dependency. In many cases, Portuguese banks have relied on collateralized lending, which in its most common form entails the use of real estate collateral. With the decline of the real estate market in Portugal, it became very difficult to price real estate and when an estimate was completed it typically fell far short of the price the bank had on its books. This created an incentive for banks to postpone foreclosure and liquidation until the economic recovery took hold, and banks continue to wait even as their profitability continues to erode.

The Outlines of a Way Forward—Using the Toolkit at Hand

The authorities have taken some important steps to facilitate corporate debt restructuring (Boxes 5.2 and 5.4). The institutional and legal framework was enhanced, including (1) introducing a less favorable tax treatment of debt financing, (2) lowering the threshold for creditor approval in restructuring plans, (3) streamlining and strengthening in- and out-of-court workouts (PER and SIREVE, respectively), (4) providing a fresh start for entrepreneurs declaring bankruptcy, and (5) developing an early warning system.

The current economic and financial environment affords an opportunity to tackle the corporate debt overhang more ambitiously. Waiting for growth to restore profitability will likely not be enough, given the size and complexity of the problem. A systemic approach, led by a body with sufficient resources and sway over banks, could move the restructuring process forward, but would also likely impose costs on both corporations and banks. A standardized bank-led, time-bound framework that calls on banks to raise more capital, increase provisioning, and accelerate the pace of write-offs to deal with debt restructuring would pave the way for restoring the flow of private credit to viable firms, and supporting economic growth. Although the pace of such a framework would need to be carefully calibrated to preserve financial stability, this approach would ultimately help lower risks to financial stability by improving the overall asset quality of the banking system.

For Portugal, the policy toolkit should be aimed at:

  • Activating the stock channel, which would require incentivizing firm owners to accept debt-equity swaps and encouraging banks to resolve NPLs, namely through write-offs; whereas activating the flow channel would require firm owners to retain more earnings or inject additional equity.
  • Further tightening supervisory policies on provisioning and write-offs to speed NPL resolution. This could include (1) introducing new guidelines on provisioning to increase provisions for restructured loans (as in Spain or Malta); (2) tightening supervisory requirements to speed up write-offs, such as imposing higher capital charges or time limits on NPL write-offs; (3) facilitating the liquidation of nonviable firms by imposing stricter impairment triggers and discounted cash flow analysis to distinguish between viable and nonviable borrowers; and (4) a swifter recognition and exit of nonviable borrowers (such as in Sweden, where borrowers with a low interest coverage ratio and high leverage are quickly ushered into bankruptcy or liquidation).
  • Strengthening supervisory guidance on the use of personal guarantees as collateral for business lending.
  • Removing tax impediments to loan restructuring by introducing the tax deductibility of write-offs,5 and allowing public creditors with claims against distressed debtors to agree to similar restructuring treatment as other creditors (Box 5.3).6
  • Legal reforms to improve in- and out-of-court restructuring. To this end, systemic workouts—offering standardized solutions, particularly for small and medium enterprises overseen by a body with sufficient sway over banks to reach efficient and equitable terms for revaluation and write-offs—would help.

Corporate Debt: Data and Statistical Issues

The statistical analysis of corporate debt in Portugal is made more challenging by discrepancies across data sources and statistical definitions and coverage.

Information on debt held by corporations is gathered by the National Statistics Office, INE, as part of the national accounts data. These data have in turn recently migrated to European System of National and Regional Accounts (ESA) 2010, causing some material changes. Changes to the breakdown of the economy by sector are due to an amended delineation between the financial and the nonfinancial corporate sectors, a more detailed breakdown of the financial sector and the new requirement for a breakdown between households and nonprofit institutions in the financial accounts. For example, on an ESA 2010 basis, corporate holding companies are no longer classified as NFCs.

In addition, information on the debt owed by corporations to monetary financial institutions is gathered and disseminated by the Bank of Portugal and also by the European Central Bank (ECB), and these data may differ in coverage or definition from data published by INE. For the purposes of this paper, we rely mainly on data published by the Bank of Portugal through September 2015.

In this paper, corporate debt is measured using consolidated data on loans, debt securities, and trade credits to the nonfinancial corporate sector. Unlike nonconsolidated data, consolidated data nets out intragroup financing and financing between NFCs belonging to different groups, that is, the sector is viewed as a single entity. This is more relevant as it reflects trends that could impact economic activity. Regarding nonconsolidated data, intragroup and intrasector financing have very different implications in terms of monitoring but unfortunately, due to the lack of available data, it is not possible to distinguish between the two. Indeed, nonconsolidated data is subject to statistical measurement issues regarding different coverage of inter-NFC debt and different concepts of statistical units for NFCs (see EC 2013 and ECB 2014b for further details). Overall, the use of consolidated data appears to be analytically sounder and statistically more robust.

However, sometimes more granular information on corporate debt is available only on a nonconsolidated basis (for example, for debt by sector or size of the firm).

The Legal and Institutional Framework

The introduction of streamlined and strengthened in- (that is, pre-pack1) and out-of-court workouts (PER, SIREVE, and out-of-court guidelines) was an important step toward putting in place an enhanced framework for rehabilitation and insolvency. However, a few issues continue to hamper the use to the full potential of the revised framework:

Portugal: In-Court Workouts

(Number of pre-pack cases)

Source: Ministry of Justice.

First, firms attempt restructuring too late. For instance, the prohibition for directors for trading insolvent is not enforced.2

Second, due to the significant increase in insolvency cases, there are important institutional constraints (for example, lack of enough specialized judges, lack of capacity of the Institute of Support to Small and Medium Enterprises and Innovation, and small number of qualified insolvency administrators).

Portugal: Insolvency Cases

(Number of cases filed)

Sources: Ministry of Justice.

Third, due to legal constraints (for example, no principal write-off, ceiling of 150 installments), public creditors continue not to be able to participate meaningfully in the debtor’s restructuring.

While the authorities have tackled these issues decisively in the course of the IMF-supported program (for example, with new restructuring tools, new judicial organization that increases specialization and concentration of judges and courts, and a new statute for insolvency administrators in terms of qualification, supervision, and remuneration that opened the profession to new entrants), the reforms need to be sustained.

Finally, the revised legal and institutional framework cannot provide a systemic solution for processing the large numbers of SMEs quickly and equitably, and other mechanisms would need to be designed, such as systemic workouts offering standardized solutions.

1 Pre-packs refer to procedures under which the court expeditiously approves a debt restructuring plan negotiated between the debtor and its creditors in a consensual manner before the initiation of an insolvency proceeding. This technique draws on the most significant advantage of a court-approved restructuring plan—the ability to make the plan binding on dissenting creditors or cram-down (that is, involuntary imposition by a court of a reorganization plan over the objection of some classes of creditors)—while leveraging a speedy out-of-court negotiation process.2 In other words, there is no enforcement against directors who do not file for insolvency protection of the company even though the threshold for insolvency for such company is met.

How Can Tax Policy Contribute to Corporate Deleveraging?

Tax systems typically favor corporate debt over equity, because interest payments are deductible for corporate income tax (CIT) purposes while equity returns are not (IMF 2011). CIT generally allows a deduction of interest payments when determining taxable profits. The return on equity—whether dividends paid to shareholders or capital gains on shares—is typically not deductible. For domestic investors who are subject to personal income tax (PIT) on their capital income, taxes on interest mitigate this tax advantage of debt. Taxes on capital gains and dividends magnify debt bias. Mitigating debt bias calls for either reducing the tax deductibility of interest, or introducing similar deductions for equity returns.

Portugal has progressively reduced tax debt bias by limiting the tax deductibility of interest (IMF 2013b). Until recently, there was no limitation on tax deductibility of interest in Portugal. In 2013, the government restricted the deductibility of interest for companies whose net interest payments exceeded €3 million and limited interest deductibility to 70 percent of EBITDA in 2013. This will be further reduced to 30 percent in 2017, yielding an estimated €115 million additional revenue in 2017 according to an IMF Fiscal Affairs Department (FAD) estimate (from €24 million in 2014). The 2014 CIT reform has further reduced the threshold to €1 million, in line with the FAD recommendation. In addition, the CIT rate cut adopted in 2014 (from 25 to 23 percent) will contribute to limit the debt bias as less tax is saved at lower rates. These reforms are consistent with tax measures adopted in the EU, particularly in Germany (2008) and France (2013).

In 2014, Portugal increased its capital injection tax relief scheme for individual investors and venture capital companies by capping the deduction to 5 percent of the taxable income (from 3 percent). Addressing the debt bias across the board would require introducing a more ambitious deduction for corporate equity, in line with FAD recommendations. This allowance for corporate equity (ACE) involves granting firms a deduction for the normal return on equity, equivalent to the rate of government bonds (a proxy for risk-free rate of return on capital).3 It thus neutralizes the preferential tax treatment of debt finance, and avoids tax incentives for artificially high leverage, especially for financial institutions. With the ACE, normal equity returns are fully CIT-deductible and taxed only at an individual level, while returns above that are still taxed at both the corporate and the individual levels. The base to which this rate would apply is the book value of equity, minus equity participations in other firms (to avoid duplication of tax relief).

3 For example, for the first three fiscal years (2011–13) of ACE implementation in Italy, the notional interest rate was set at 3 percent.

2014 Action Plan for Corporate Debt Restructuring

Recognizing the complexity of reducing corporate debt levels, the authorities implemented a wide-ranging action plan for corporate debt restructuring during 2014. The action plan centered on four pillars of intervention:

  • Assessment/warning. As an incentive for companies to restructure earlier, debtors receive a credit rating each year issued by the National Mutual Guarantee System. An early warning system for distressed corporate debt implemented by the Banco de Portugal allows banks and their supervisor to identify overindebted firms in their loan book. A special assessment program of banks’ policies and procedures to deal with distressed loans is also being overseen by the Banco de Portugal.
  • Formal procedures. The legal and institutional framework has been significantly strengthened through improvement to PER and SIREVE during the implementation of the action plan (Box 5.2). The authorities are considering extending the framework to begin in the pre-restructuring phase, to reduce the stigma of restructuring.
  • Recapitalization instruments and incentives. Recapitalization instruments, alternatives to bank debt financing, and incentives for companies to maintain a more prudent and balanced capital structure are also integral to the action plan. The authorities introduced fiscal incentives in the context of the 2014 budget (to be phased in through 2017), including measures to favor preferred shares and convertible debt and thin capitalization rules to discourage corporations from becoming highly leveraged. The authorities are also studying ways to increase access to financing for viable restructured companies, notably SMEs, and potential Pillar 1 and Pillar 2 regulatory measures to promote corporate debt restructuring or sale/transfer of the underlying exposures.
  • Stakeholder involvement. Reforms in this area aim to reduce the debt bias of firms by introducing changes to the legal framework for preferred equity and dividends, as early as next year. In addition, a more dynamic role for the credit mediator is envisaged.

Looking forward, the authorities are completing the implementation of the action plan, and considering additional policy actions taking into account the scale and complexity of the issue, as well as the need to preserve financial stability and debt sustainability.

The Ministry of Economy and the Ministry of Justice continue to work on improvements to the PER and SIREVE systems aimed at removing the associated stigma and increasing capacity. However, the capacity of the framework remains limited and the number of SMEs that are in need of debt restructuring is very high.

Also, pending an assessment of the effect of fiscal incentives in 2015, the authorities are analyzing options for reducing the debt bias of firms through changes to the legal framework for preferred equity and dividends.

The Bank of Portugal has set up several work streams to promote and incentivize banks to restructure distressed debt, to collect more granular data and statistics, and to better focus the Bank of Portugal’s role as an independent advisor of the government on matters pertaining to corporate debt restructuring. More recently, the Bank of Portugal published a revised macroprudential toolkit.

Appendix I. Data Sources

The main data sources for this chapter are Banco de Portugal Statistical Bulletin and the Quarterly Report on the Portuguese Banking System. All the data sources are listed in the table below.

Appendix Table 5.1.1.Data Sources
Nonfinancial corporation debt: loans, debt securities and trade credit, consolidated dataBank of Portugal, financial accounts for Portugal, Eurostat for other European countries
GDPINE, National Accounts
Growth rate of corporate loansBank of Portugal, Monetary and Financial Statistics
Investment rate of NFCEuropean Central Bank, National Accounts
Nonfinancial corporate debt: Debt outstanding to GDP, nonconsolidated dataEuropean Central Bank, National Accounts
Nonperforming loansBank of Portugal, Statistical Bulletin
Interest rate coverage ratioBank of Portugal, Statistical Bulletin
Interest rate on NFC loansBank of Portugal, Monetary and Financial Statistics
Return on assets of NFCBank of Portugal, Statistical Bulletin
Return on assets of banksBank of Portugal, Portuguese Banking System: Latest Developments

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Prepared by Antoine Bouveret, Irene Yackovlev, Wolfgang Bergthaler, and Maximilien Queyranne. The authors would like to thank Maria Ines Drummond and the staff at the Bank of Portugal, as well as Bernardo Maya Afonso and staff at the Ministry of Economy for sharing key data and providing helpful suggestions.


The European Central Bank’s current definition is 306 words long.


Leverage is defined as the ratio of debt to shareholder equity.


For a discussion of similar factors affecting Italian banks, see Jassaud and Kang 2015.


In particular, creditors reported that, unlike provisions, write-offs were not tax-deductible unless the insolvency of the debtor was certified by a judge, which further disincentivized creditors to write off NPLs.


There is recognition that employee withholding taxes such as PAYE and sales taxes such as VAT should be excluded since the former represent amounts withheld from employees’ salaries to cover their tax obligation, while the latter are presumed to have been recovered from the debtor’s clients.

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