Portugal Bites the Bullet?

Portugal's caretake Prime Minister bowed to international and domestic pressure and announced he was going to make a formal request for aid within the existing framework. This would seem to suggest a package, like Greece and Ireland, that covers the anticipated financing needs for three years. However, it is not clear that he has the authority to do so. Instead there has been much speculation about a bridge loan until the early June elections.

The pressure has mounted in recent days following sovereign, local government and bank downgrades. Portuguese banks reportedly threatened a capital strike, ie, they would not purchase any more government debt and urged the government to seek assistance before the election. On Wed, the government dared to sell bills and although it was not a failed auction, this is they sold the full amount. It reportedly was helped by demand from state directed entities. Moreover, the rate was prohibitively high. Consider that the 5.9% it paid on 1 year bills. It is roughly what Spain pays for 30-year borrowing. It is twice Germany's 5-year yield. It matched the Irish 1-year rate after Wed's 33 bp decline in yield.

It is too simple and self-serving (for the government) to blame the market. Socrates headed up a minority government and did not try to bring opposition into the government to make extremely critical decision on how to distribute the pain/adjustment. It initially said its budget deficit was 7.3% of GDP and now acknowledges it was really 8.6%.

Each country that has sought aid is a bit different and only Greece really fits into the narrative that European officials typically tell of profligate countries lacking fiscal discipline. That was not Ireland's problem. Ireland's fiscal problems only materialized when it, at the urging of European officials, socialized (made public) the private debt of banks. Portugal's problem is not excessive public debt. In fact Portugal's federal debt to GDP is lower than Germany. Nor was the problem a housing market bubble as in Ireland. Portugal's problem was a chronic loss of competitiveness and growth. It has expanded at a rate of less than 1% since the advent of the euro. The lack of competitiveness is reflected in the Portugal's current account deficit which has averaged more around 10% a year for the past decade.

That Portugal needs international assistance is no surprise. The market has been convinced this was going to happen. Only Portuguese officials were in denial, or at least in public. At the same time, as we have seen in Greece and Ireland's experience, international assistance has not capped interest rates or renewed their ability (yet) to return to the market. There may be a bit of relief on the notion that Portugal is getting a package and will not default.

I remain hesitant, though, to regard this as a bail out of Portugal. Portugal, like Greece and Ireland, is not being bailed out. Their debt burden is rising and they borrow more money. Their creditors are the ones being made whole. European officials do seem to be gradually preparing for an eventual restructuring where it is possible that the creditors are not made whole. But that is not until after the EFSF expires and the ESM is in place and even then it is not completely clear. In the best light, European officials seem to be saying that a default would trigger a new financial crisis. But the crisis would not be in Greece, Ireland or Portugal; after all they are already in crisis. Rather the crisis would be in the creditor countries. Precisely why Greece, Ireland and Portugal are willing to take on even more debt to support foreign banking systems remains a bit of a mystery and no doubt will be the subject of future Phd dissertations.

The next likely candidate for attention is Spain. We continue to monitor the correlation between Portugal and Spanish bonds to see if the latter is catching the virus of the former. Our work shows only a small increase in the correlation in recent days and, however we measure it, it is still below the peaks seen earlier this year.

A serious erosion of confidence in Spain would require, it would seem, a precipitating cause. There are several that we will be monitoring. These include the bank stress test, political developments now that the PM said he will not stand for re-election next year, global risk appetite. In some ways, Portugal's aid could be cathartic and prompt a bit of relief for Spain.

On the other hand, European official dithering means that the funding to support Spain, if needed, is not currently available (EFSF) and this may prevent the return to normalcy (whatever that means these days). The premium Spain pays over Germany for 10-year money stands at 180 bp on Wed. This was the lowest since before the Irish crisis came to a head last Nov and presents a little more than a 100 bp decline since late Nov.

Euro reaction to the news was minimal. It was late in the NY session and the euro has been relatively immune to the deterioration of the situation in Portugal in recent days/weeks.