Portugal: Peripheral Nerves

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Portugal: Peripheral nerves

By Victor Mallet and Peter Wise Published: November 7 2010 19:24 | Last updated: November 7 2010 19:24

On sale in Lisbon: eurozone membership brought a decade of plenty but the Portuguese are now suffering a painful hangover from the credit binge and seeking to bring order to public finances

For young, mobile Portuguese such as Daniel Rebelo and Bárbara Faria, the idea of life without the euro that they and most other west Europeans have known for more than a decade is almost inconceivable. “I don’t think going back to a situation without the euro is possible,” says the 32-year-old Mr Rebelo, formerly a financial manager at a local motor parts subsidiary of Germany’s Continental. “I don’t see an environment where you could live without the euro.”

Neither he nor Ms Faria, both studying in Lisbon for MBAs, has any qualms about Brussels or northern Europe imposing budgetary discipline on Portugal if that is what it takes to calm financial markets, which fear a sovereign crisis like the one that engulfed Greece earlier this year. “Having Brussels around is good news for sure,” says Ms Faria, 26.

Mr Rebelo concludes that “the only thing I could see that would be unfair, is for Portugal to be seen as the next target after Greece”.

Yet that is exactly what seems to be happening. Portugal – because of its worse-than-expected budget outcome for the first nine months of this year and a bruising political struggle to approve the latest set of austerity measures – now stands alongside Ireland in the front line of the battle for the euro’s survival. The notion that the eurozone could fragment – with its weaker members being forced to re-adopt the drachma, the escudo or the punt so that they could devalue and remain competitive – was once seen by economists as absurd. Now it is merely unlikely.

Last week, both Portugal and Ireland notched up uncomfortable records in the bond markets. Portugal’s 10-year government bond yields reached a new euro-era high of almost 6.8 per cent on Thursday, while the spread on Irish debt over German bunds hit a record 532 basis points.

For investors, the good news of a political accord in Lisbon to allow the passage of a harsh economic austerity plan has been overshadowed by the bad news. European Union leaders have agreed to design a mechanism to resolve future sovereign debt crises that could penalise bondholders. They would have to take “haircuts”, or discounts on the value of the debt they hold, in the event of a restructuring. Holders of Portuguese and Irish bonds have taken fright.

Amid the gloom, however, some welcome support came from Chinese president Hu Jintao during a state visit to Portugal on Sunday, when he promised “concrete measures” to help the country cope with the financial crisis.

Chinese officials said this could include purchases of Portuguese government bonds.

“The markets tend to perceive the small economies as vulnerable,” says Vitor Bento, chief executive of Sibs, the Lisbon-based bank payments group, and a former senior Treasury official. “I think we’re going to have a rough

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2011.”

José Sócrates (left), the Socialist prime minister, insists that the economy and the plans to reform it are in much better shape than the financial markets believe. The problem, he says, is that Portugal is trapped inside a “Danger Zone” where it has no reason to be. “This is the most demanding budget exercise of the last 25 years,” he says, minutes after parliament has voted in favour of the latest plan. “We decided to take all the tough measures in order to give full confidence, in order to take Portugal out of this ‘Danger Zone’ movie.”

The so-called “peripheral” economies of south and west Europe – Spain, Portugal, Ireland and Greece – have all been at the mercy of the international markets since the start of the financial crisis, although the relative standings of different countries are constantly changing. As recently as May, Spain, with an economy six times the size of Portugal’s, was seen as teetering on the brink of default. But after successive austerity plans it has graduated from its association with Portugal and Ireland, and is now usually bracketed with Italy in terms of risk. Ireland was lauded for the harshness of its austerity measures until investors decided those were crushing prospects for growth – and until the full gravity of the country’s banking losses came to light.

One common feature, after the euro was launched in 1999, is that all four enjoyed years of plenty in the form of easy foreign credit to finance transport infrastructure, home construction and the consumption of imports. The single currency, however, turned out to be what one Lisbon-based diplomat calls “a deadly painkiller”. All four are now suffering a painful hangover from the credit binge and seeking to bring order to public finances after their fragility was brutally exposed by the global financial crisis. ...

Portugal, which unlike Spain has failed to rein in its current account deficit, has for weeks been a concern for economists. In September, Deutsche Bank identified the country – western Europe’s poorest by per capita gross domestic product – as the main concern, pointing to “a combination of fiscal drift, elevated stress in banks and current account relapse”.

Broadly, there are two directions in which the Portuguese and eurozone sovereign debt crises could go. The first and worst path would be a continued deterioration of market confidence in the ability of peripheral European economies to control their deficits, restore their competitiveness and return to sustained growth. Portugal’s banks are already shut out of the international wholesale finance markets and depend on the European Central Bank for liquidity.

If bond yields rise beyond the ability or willingness of Lisbon or Dublin to pay, the country concerned would be forced to call for emergency assistance in the manner of Greece. That in turn could infect other weaker economies in the eurozone and lead to another full-scale crisis. As one Portuguese policymaker points out, with the economy dependent on external finance and the goodwill of the market, “we are in a fragile situation”.

But there is an alternative path. If Mr Sócrates and other eurozone leaders can convince the markets that their austerity plans will be implemented and produce the desired result of lower deficits, confidence will gradually return – as it did for a time during the summer after the hurried unveiling in May of a €750bn bailout fund for Spain and other relatively weak eurozone economies.

For Portugal at least, this is not an impossible task. Mr Sócrates has a record of reform, even if he was this year slow to recognise the need to appease the bond markets with visibly drastic austerity measures. The package approved last week was the third in seven months.

A 2008 overhaul of the pension system, an issue with which many European governments are still grappling, was characteristic of his pragmatic approach.

He also faced down strikes and protests from judges, doctors, teachers, civil servants and even the armed forces to tackle inefficiencies in education, the public administration and business practices, and was duly re-elected in 2009, albeit without an overall majority.

By then, in the depths of the global crisis, the budget deficit had reached 9.3 per cent of GDP. An initial austerity plan unveiled this March froze public sector pay,

José Sócrates in view of the current situation of our public finances and the need to cut government spending, the light at the end of the tunnel will be switched off until further notice.

This spoof communiqué, currently a much-forwarded email in Portugal, will be keenly felt by José Sócrates, the prime minister from whose office it pretends to originate.

Confidence, optimism and selfbelief are qualities the 53-yearold has unfailingly championed during five years in office marked by successive battles to cut the budget deficit, lift weak economic growth and tackle long-delayed structural reforms.

“I often feel I’m trying to rouse the nation’s energies on my own,” he said earlier this year, as the threat of a sovereign debt crisis soured the mood of a country already facing prolonged austerity and likely return to recession.

A keen jogger and marathon runner described by a fashion designer as the country’s bestdressed politician, the prime minister exudes a pugnacious energy that sat better with voters during his first term.

Then, his centre-left Socialists enjoyed a solid majority in parliament and prospects for an economic recovery remained credible.

Since the global economic crisis and his re-election in 2009 at the head of a minority government dependent on opposition parties to pass legislation, his continuing buoyancy has been increasingly criticised as a symptom of “being in denial” of the serious risks facing the Portuguese economy.

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increased the tax rate for top earners and reduced military spending. After the Greek debt crisis in May, he cut politicians’ pay, increased value added tax and postponed big infrastructure projects.

The latest round of cuts includes a 5 per cent cut in public sector pay, a state pension freeze and another VAT increase. But the centre-right Social Democrats, the main opposition party, insisted on a say in that 2011 austerity budget in return for not using their votes to defeat the government and force Mr Sócrates to resign. ...

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But Mr Sócrates, son of an architect from a northern village, refuses to be browbeaten by political setbacks, dire economic forecasts or financial markets.

“We have to respond confidently to every challenge,” he says. “If we just sit back and complain we’re lost.” For him, he makes clear, the light at the end of the tunnel will never go out.

Now the markets want to see results. “If we bring the deficit to where it should be over the next couple of years and take additional measures to improve competitiveness, I think we will recover our credibility in the markets,” says Fernando Ulrich, chief executive of Banco BPI, one of Portugal’s top five banks. “We cannot afford to invest any more money in cement for the next 10 years. We have to spend all our available funds on improving the competitiveness of the export sector.”

Unfortunately, no one has worked out a magic formula that reconciles harsh austerity with government-financed economic growth. Like José Luis Rodríguez Zapatero, his friend and fellow Socialist prime minister in Spain, Mr Sócrates instinctively favours a Keynesian spending solution but has been obliged by the markets to make ever deeper cuts.

Some analysts and business leaders, including Mr Bento of Sibs, say the answer to this conundrum is for Europe to use its multibillion euro bail-out funds pre-emptively rather than at the last minute in response to the next Greece. That would mean International Monetary Fund-style bridging loans in exchange for closely monitored reform plans.

“At the moment, all the forces lead towards contraction of the economy without any compensating elements,” Mr Bento says. “This can bring Europe into a recessionary spiral.” Europe is failing to deal with a problem that clearly affects several countries, he argues. “A systemic problem needs a systemic solution,” he says.

Inevitably, governments balk at talk of rescue, since the mere mention of the idea would be enough to spread panic in the markets about the country concerned. “Portugal doesn’t need any help,” declares Mr Sócrates, almost leaping out of his chair at the suggestion. “We can solve our problems by ourselves and we want to do it this way, with the markets. We don’t need any special help. We only need the understanding of the markets that we are doing our job.”

The latest phase of Europe’s sovereign debt crisis shows that the fundamental contradiction at the heart of the euro – the lack of a common economic policy to go with the common currency – remains unresolved.

But the inhabitants of Portugal, from Mr Sócrates to students such as Mr Rebelo and Ms Faria, hope that this most peripheral of European economies can convince the bond markets of its viability within the euro even without a coherent EU road map to follow.

It is a sign of the times that Mr Sócrates, who learnt in 2008 how to look up oil prices on his mobile telephone as energy costs soared, has just worked out how to use it for checking the latest European bond yields.

‘The risk of yields spiking to unsustainable levels is very real indeed’ It all seemed so different a year ago, David Oakley reports.

Then, investors in the eurozone bond markets were relatively sanguine about the problems of mounting debt in the so-called peripheral economies of Portugal, Ireland, Spain and Greece.

Yet in the past 12 months, the investment world has been turned on its head. Greece has been forced to seek multilateral help to avoid default and a €750bn “shock and awe” rescue plan was launched in May to avert a meltdown in the bond markets.

For a time, it then looked like the markets were settling down. Growing confidence in Spain, considered by some to be the key economy in the fortunes of the eurozone, raised hopes that the worst was over.

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But the mood has recently changed for the worse again. The pivotal moment came at the European Union summit on October 29, when EU policymakers announced that they wanted investors to foot a greater share of the bill for future bail-outs.

Portugal, Ireland and Greece came under pressure again as worries rose that one of them would have to default on their bonds as Germany showed it was not willing to write a blank cheque for other eurozone members.

Bill Blain of Matrix Corporate Capital says: “It is difficult to see how Ireland and Portugal can turn sentiment in their favour. To me, the risks of their yields spiking higher, to unsustainable levels, are very real indeed.”

In short, in the eyes of many investors, Portugal and Ireland are now more likely than ever to run into funding difficulties and follow Greece into the emergency room.

Germany was always going to insist at some point that investors would have to share some of the burden in the event of future sovereign defaults. But Jean-Claude Trichet, the European Central Bank president, and many strategists question the timing of the EU’s latest announcement.

Just as sentiment had started to improve once more and many investors believed the market was witnessing a turning point, Europe’s politicians have again shaken confidence in the troubled peripheral economies.

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