After the Greek rescue package: will Portugal be the next to fall?



Greece is rescued, for now…maybe. Perhaps it’s time to move on to the next basket case. So, which of the PIIGS is the next Greece?

For the moment, Portugal looks to be the front-runner. The country’s public-debt-to-GDP ratio is above 100%, and with a forecasted growth rate of -3.3%, its economy is shrinking at a faster rate than every other European country except Greece. Exacerbating the problem is the fact that financial markets are still jittery about the repayment of Portuguese sovereign debt. We continue to see stubbornly high spreads on Portuguese government bonds over German bond rates, which – contrary to those of Spain and Italy – failed to go down after the ECB changed its policy stance in late 2011.

Whatever one might think about the most recent Greek rescue package, Greece is not a role model for the other troubled Eurozone countries in general, and for Portugal in particular. It never was.

Greece may fit the German-favoured interpretation of the crisis: profligate southerners unwilling or unable to undertake reforms, thus requiring strict fiscal austerity measures to be imposed, eventually coupled with strict EU (read German) supervision. The same can’t be said for the other troubled Eurozone countries, where more often than not, fiscal deficits have been the consequence rather than the cause of the crisis.

It’s safe to say that Portugal is probably the most vulnerable Eurozone economy at the moment. But how did it get there? Portugal has suffered neither Spanish-type real estate bubbles or Irish-style bank rescues in recent years. Nor has it endured a Greek-style fiscal tragedy that can be blamed for the sad situation the country is in. Rather, it is the combination of a number of small sins conducted within an ill-designed Eurozone governance structure that has ultimately led to its punishment.

In particular, wages and prices in Portugal increased at a much faster rate than in the European core, leaving the country with a loss in competitiveness and an increasing current account deficit. In 1996, Portugal’s previously balanced current account deficit started to increase and reached almost 9% of GDP when Portugal entered the Eurozone in 1999. With limits in fiscal deficits at this time, the public sector current account deficit mirrored private sector excesses of spending over saving.

European banks helped to finance these deficits. To illustrate the point: according to BIS statistics, by the end of the third quarter of 2010, Eurozone banks had an exposure to Portugal of about $233 billion, of which only $42 billion was to the public sector. These exposures were concentrated on Spanish ($108.6 billion), German ($48.5 billion) and French ($45.6 billion) banks. When the crisis came, Portugal found itself trapped with both a fiscal and a current account deficit, and external investors became increasingly unwilling to finance both its public and private sector deficits.

Since 20 May 2011, Portugal has been operating under a €78 billion EU finance package to which the IMF contributes approximately €26 billion. The success of this program depends crucially on four factors.

Firstly, as it is now widely known and accepted, the market for sovereign debt is prone to self-fulfilling prophecies. Doubts about full repayments can reduce the demand for such bonds even when the prices of these bonds fall. Without a lender of last resort or or a big enough European rescue fund, bond prices can fall steeply at any time when investors get sufficiently pessimistic, thus raising public funding costs to unbearable levels. Both IMF and US officials have suggested that the current €500 billion rescue fund should be doubled or even tripled.

In other words, the first condition is that Europe and the ECB demonstrate convincingly their willingness to make strong moves to protect the Euro project with a large enough firewall.

Secondly, to overcome the crisis Portugal will need strong export markets. This will be difficult to achieve, since the Eurozone as a whole is projected to shrink by 0.3% in 2012 and additional risks remain in the global economy. Europe and the Eurozone will therefore need to overcome the austerity bias of their policy responses.

More inflation (through looser monetary and fiscal policies) in the hypercompetitive core countries like Germany could help countries such as Portugal to regain competitiveness, with less pain. Such policies could also help to avoid a recession in the core. However, the concept of reflation has not been looked upon favourably by Germany and other core countries.

Thirdly, and as a consequence, if Portugal has only an internal devaluation left as an alternative to regain competitiveness, it is clear that improvements will take a long time. Portugal will need to significantly lower its unit labour costs relative to the Euro core countries in order to increase its competitiveness. The IMF is projecting a drop in unit labour costs by only 1.1% in 2012, with no decrease projected thereafter. This is not good news for the country, as its social consensus is already extremely fragile.

If the pain that has to be shouldered by the Portuguese people is too high in relation to uncertain gains in a far-off distant future, there will be political resistance against the adjustment program and a reconsideration of the Euro exit option. Thus, Portugal needs more financial support to initiate programs to revive economic growth.

Finally, to survive as an attractive future option, Europe needs to provide a convincing solution on how to fix the current flaws of the common currency area. Adjustments will need to be made so that it is both crisis-free and welfare-enhancing to its members. If members stay in only because the exit option would be too devastating, then the Eurozone will be dead before too long.