Portugal reforms not gone far enough

Posted on September 7, 2016

As Portugal emerged in May 2014 from a three-year, €78bn EU-International Monetary Fund bailout, unsentimental central bankers in Lisbon had words of caution for the hard-pressed Portuguese people.

Despite having escaped the disaster of crashing out of the eurozone, Portugal had not reformed itself enough to ensure lasting economic and financial success, they said.

    Two years and four months later, the Portuguese central bank’s assessment appears to have been correct in every important respect. Portugal is at the centre of a perfect storm of meagre economic growth, falling investment, low competitiveness, persistent fiscal deficits and an undercapitalised banking sector that owns too much of the nation’s sky-high public debt.

    Grappling with these challenges is a minority Socialist government, propped up in parliament by the far left. In the eyes of Portuguese business, the government is inclined more to crowd-pleasing anti-austerity measures than to reforms aimed at improving public sector efficiency and encouraging investment. The question is whether Portugal’s troubles will make a second financial rescue unavoidable.

    For Portugal’s official and private sector creditors, it is a question of the utmost delicacy. Economists at Goldman Sachs estimate that about 46 per cent of Portugal’s debt is held by the eurozone’s central bank network, EU bailout funds and the International Monetary Fund. Another 14 per cent is held by financial and non-financial investors in Portugal.

    Investors outside Portugal own the remaining 40 per cent and would, understandably, be apprehensive about any second bailout that foresaw an extensive write-off of Portuguese debt. As happened when private sector holders of Greek debt were subjected to euphemistically termed “haircuts” in 2012, sovereign debt market contagion might spread into other parts of the 19-nation eurozone.

    Discussions about a second Portuguese bailout would surely be fraught. Germany will hold national parliamentary elections in 12 months’ time. Neither party in the Christian Democrat-Social Democrat “grand coalition” government would want to court public anger by arranging a German-led, eurozone rescue for Portugal without IMF participation.

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    Portugal's Prime Minister Antonio Costa reacts during an interview with Reuters in Lisbon, Portugal January 22, 2016. REUTERS/Rafael Marchante

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    However, the IMF, burnt by its experiences with Greece’s three bailouts, displays little enthusiasm for joining hands with the European Central Bank and European Commission in yet another “troika” programme for a weak eurozone state. If Portugal were to need help, the IMF would first demand a hard-headed analysis of whether the nation had any chance of repaying its debt.

    Portugal’s government debt totals about 130 per cent of gross domestic product, a clear risk for a country that in 17 years of eurozone membership has consistently struggled to produce healthy economic growth. As the IMF says, even moderate shocks to Portugal’s growth prospects and fiscal balance could “easily place the government debt-to-GDP ratio on an explosive path”.

    Such language indicates that the IMF might insist on some sort of debt write-off in exchange for joining Germany and its eurozone partners in a rescue of Portugal. Should this involve Portugal’s foreign private sector creditors, the threat of contagion would loom over the eurozone, as it did to such dangerous effect in the early years of the Greek debt crisis.

    In Portugal’s case, the risks involve banks that cannot recover loans from companies flattened by economic recession and are among the most thinly capitalised in the eurozone. These banks have loaded up on Portuguese sovereign debt, recreating the “doom loop” between weak lenders and financially fragile governments that almost destroyed the eurozone in 2010-2012.

    The question is whether Portugal’s troubles will make a second financial rescue unavoidable

    Moreover, only one of four ECB-recognised credit rating agencies gives Portugal the investment-grade rating that makes it eligible for ECB purchases of its government debt. Even this holdout, the Toronto-based agency DBRS, has aired concerns about Portugal’s slowing economic growth.

    If DBRS were to issue a downgrade next month, private investors may take fright at the lack of central bank backstop. Portugal would be one step closer to a second bailout. But financial markets would still be in the dark about what measures the ECB, eurozone governments and the IMF would take to save it.

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