FROM THE ECONOMIST INTELLIGENCE UNIT
Portuguese leaders declared a closely watched bond auction a success yesterday, after the sovereign managed to raise €1.25bn in four-year and ten-year notes. Although there was considerable demand for the debt, Portugal still had to pay an expensive interest rate on its borrowing, with the four-year unit costing 5.4% and the ten-year charging 6.7%. The fact that Portugal managed to raise debt at all in the market was well received across the euro area, but it does nothing to mask the underlying obstacles to Portugal’s fiscal and economic health in the coming years. Unfavourable debt dynamics mean it remains a question of when, rather than if, the country will have to access the joint EU/IMF emergency credit facilities. It is unlikely to be able to delay the process beyond the middle of 2011.
The minority Socialist Party (PS) government faces an immense task to reduce the budget deficit from 9.4% of GDP in 2009 to 3% of GDP by 2013, as agreed with the European Commission. With the support of the main opposition Social Democratic Party (PSD), two fiscal packages have already been agreed, which raise a range of taxes, especially value-added tax (VAT) by 3 percentage points in total, and cut public-sector wages and capital expenditure, along with a range of other measures. However, the government is struggling to rein in expenditure growth and had to resort to one-off measures to meet the 2010 deficit target of 7.3% of GDP, damaging the credibility of its fiscal consolidation efforts. As these moves serve to mask the (worse) underlying budget position, the Economist Intelligence Unit forecasts that Portugal will miss by some distance its budget deficit target in 2011 (of 4.6% of GDP) because its starting point will hardly be better than in 2010. Fiscal consolidation efforts in 2011-12 are likely to be hampered by the economy returning to recession, which in turn will reduce fiscal revenue and raise transfer payments.
With these difficulties in mind, the case for Portugal trying to remain outside the EU/IMF emergency credit facilities, the cornerstone of which is the €440bn European Financial Stability Facility (EFSF), is becoming more and more difficult to justify. The interest rate from the facility being charged to Ireland—believed to be around 5.5%—is effectively what Portugal had to pay for borrowing for four years from the markets at yesterday’s auction. Yet, by accessing the EFSF, Portugal would be provided with sufficient funding at a pre-defined interest rate until at least 2013 (the country will require, and be provided with, funding for longer than this). Official funding would provide some much-needed stability to Portuguese external financing, and allow the government to pursue its fiscal consolidation programme without the distractions of worrying whether the next chunk of funding will be forthcoming.
EU/IMF intervention is certainly no panacea. It would come with strict conditions attached, such as structural reform demands and fiscal targets. However, it would also make fiscal consolidation efforts more credible and transparent. The external intervention would also be likely to push the government towards more serious action to reduce the size of the wider public sector, which is outside the general government accounts but receives large transfers from the public purse.
Neither this nor the rest of the budgetary cuts are politically palatable, of course, and Portuguese leaders continue to work hard to avoid accessing the emergency credit facility. For the next few months—with ongoing intervention by the European Central Bank (ECB) in the secondary debt market helping to keep a lid on yields—Portugal may well experience more “successful” debt auctions. However, we still expect the country to succumb to the financial pressures of sovereign debt markets and eventually have to access the EU/IMF facilities. Indeed, German, French and wider EU pressure may see Portugal reach that point more quickly, because European leaders are likely to become more and more worried about the contagion risk of the Portuguese funding crisis on other wobbling euro area countries.
In a bid to reduce uncertainty and instability in financial markets, we expect Portugal to have to take a bailout sometime in the first half of 2011. This will mark the end of the beginning in terms of fiscal consolidation, for once this occurs, many more hard decisions on fiscal retrenchment will become necessary. Debt interest payments will continue to rise, as the EU has insisted on a high bailout interest rate to avoid accusations of fostering moral hazard. The process will play out against a background of weak GDP growth. The private sector (households and companies) holds extremely high levels of debt, lowering their capacity to absorb fiscal cuts and worsening their own financial situations. This has the potential for negative knock-on effects to banks’ balance sheets. Portuguese public debt is expected to continue to rise at a sharp pace for some years yet and is unlikely to stabilise before reaching 100% of GDP.
There is a high risk that Portugal will not be able to service fully its public debt in the medium to long term. If other peripheral euro area countries restructure their public debt in coming years, Portugal may be tempted to do the same. Given these enormous obstacles, setting aside the challenges of raising money on capital markets may soon become a more attractive proposition to Portuguese policymakers.