Two Developments over the Weekend: Portugal and Italy

There have been two new developments over the weekend whose implications are worth considering ahead of the opening the markets.  In Portugal, after the markets closed on Friday, the Constitutional Court struck down part of the government's austerity measures. 

In Italy, the caretaker government, confirmed yesterday that it will pay down about half of the debt it owes largely to small and medium businesses for services rendered.  The payments may begin within days, according to some reports.

The court ruled that the Portuguese government violated that constitutional requirement for an equitable distribution of austerity and prevents the discrimination of state workers over the private sector.  Four of nine austerity measures were rendered unconstitutional.  

These include the suspension of civil servants holiday pay, the cut in pensions, the tax on unemployment and health benefits and the cuts salaries for teachers, researchers, and scholarship holders.  All told around 1.3 bln euros of savings (~1% of GDP) were disallowed and it is not just about what happens going forward, the court decision is retroactive to the start of the year and the government will have to compensate the state workers and pensioners.  

The government expressed shock at the decision and met on Saturday.  Last year the court blocked the intended reduction in state workers' pay in 2013 and 2014 (though allowed the cuts in 2012). The new measures were devised to replace those that had been struck down last year. 

The implications can be momentous.  It could jeopardize the next tranche of aid payment.  It could jeopardize the government's effort to return to the capital markets.  It could deter the euro group of finance ministers from agreeing to extend the maturities on Portugal's EFSF/ESM borrowings, which was possible toward the end of next week.  The court ruling could embolden the opposition and strengthen trade union pressure, after the government survived a vote of confidence in the middle of last week.  

The Wall Street Journal reports that the government was considering several measures in response. The one that was capturing the imagination of many was the possibility of paying civil servant workers and pensioners one month's salary in the form of T-bills.  The press report suggests that doing so would save the government as much as 1.1 bln euros in expenses.  

There are also far reaching implications for Italy's decision to begin repaying its debts to Italian businesses.  Many of the businesses that provide government goods and services are small and medium sized concerns, precisely those that have been squeezed so hard by the lack of credit.  The government arrears exacerbated this problem and, in turn, contributed to the banks' rising non-performing loans.   The vicious cycle can be arrested and reversed by the government's decision to make good not on its bonds, but its commercial obligations.

At the end of 2011, the most authoritative estimates put the government's obligations near 90 bln euros.  The decision on Saturday was to pay about half over the next 12 months.  There seems to be two ways Italy will get the funds.  First, it will likely boost its debt offerings.  Second, it will likely draw down some of the case reserve the Treasury has accumulated.  

The EU will likely be supportive and Treasury Minister Grilli reportedly will discuss this with EC Commissioner Rehn on Monday.  Even with the new borrowing and caretaker Monti's decision last month to increase the deficit target to 2.9% from 1.8%, it is likely that Italy exits from the excessive deficit procedures that it has been under.  

Monti has committed the next government to re-examine the fiscal trajectory at the end of Q3 and to take corrective measures, if necessary to ensure the deficit is below 3%.  The deficit in Q1 13 appears higher than deficit in Q1 12 (the deficit in 2012 has been estimated at 3% of GDP).  

The agenda of the next government may be clarified within a couple of days when President Napolitano commission will report on the measures that the main political parties can agree to.  In addition, a political agreement that can avoid an immediate return to the polls, may be enhanced by the weakening of the cohesion of the 5-Star Movement, which seemed inevitable to us, as the agenda shifted from criticism to concrete proposals.