Pressure on Portugal Increases, What Will Socrates Do ?

The reprieve on Greek bonds after the successful placement of 5-year bonds (at a hefty premium to existing 5-year bonds) was short-lived. Benchmark 10-year yields are up 23 bp today, while 2-year yields are up 32 bp, bring the total increase over the past five sessions to 71 bp and 62 bp respectively.

In contrast, the pressure on Portugal is considerably more modest but rising. Today Portugal's 10-year yield is up 6 bp (to 4.17% compared with 6.48% in Greece) and the 2-year yield is up 0 bp (to 1.49% compared with 4.93% in Greece). Over the past five days, the 10-year yield has fallen 6 bp, while the 2-year yield has risen 14 bp. Yesterday Portugal reported a larger budget deficit of 9.3% of GDP last year (the EC had expected something closer to 8%), but promises to reduce the deficit to 8.3% this year and back to the mandated 3% level in 2013. Judging from the developments in the debt market today, including the sovereign CDS markets, many doubt measures are sufficient.

The debt to GDP ratio is set to continue to deteriorate. It is expected to surpass 85% this year and may be the highest in 20 years form about 76.6% last year. But here is the rub, even if Portugal can reduce its deficit to 3% of GDP as the Stability and Growth Pact mandates, it will still not be able to stabilize its debt to GDP ratio because growth is so anemic. The last quarter that Portugal posted year-over-year growth in excess of 3% was Q2 2001.

The fiscal headwind suggested by a 6 percentage point cut in the deficit in 3-years will likely mean slower growth rather than more. Moreover, as we noted about Greece, so too with Portugal: efforts to reduce the structural deficit serves to exacerbate on the margins the cyclical deficit.

But at this rate Prime Minister Socrates deficit cutting plans are concentrated the civil servants--wage freeze and attrition (one replacement for every two workers than leave). No new taxes are projected (outside of a 50% tax on bonus on top executive of financial firms and spending is projected to rise slightly. Socrates appears to be pinning his hopes on increased revenue (+2.7%) as the economy returns to growth (0.7%) and restarting the privatization program that was disrupted by the financial crisis.

Socrates leads a minority government and the Social Democrats (biggest opposition party) are pushing for more cuts in public works spending. Leaders of the Social Democrats indicate they will abstain on the budget vote, which is a passive objection as such a parliamentary maneuver ensures the budget will pass.

Any deterioration of growth or significant increase in interest rates, a la Greece, and Portugal's ratings, already on negative watch, risk being downgraded. On the other hand, Socrates may be convinced, by investors, if no one else, that stronger efforts need to be made. Given the poor growth profile, even during expansion phases, means that fiscal reform needs to be embraced as part of a larger restructuring effort, not simply as a goal in and of itself.

While the optics and fundamentals in Greece are significantly worse than Portugal, it is mainly a difference of degree not kind. Some noted observers have highlight greater concern over Spain to be sure Spanish debt has also traded heavier. The larger point that should not be lost is that the debt/deficit challenges in the euro zone are not confined to Greece. These issues, as we have argued, go to the very core of the great experiment in Europe--is monetary union without political union sustainable?