Portuguese bond yields surged by 100 basis points on Wednesday to 7.2% – up from 5.25% in mid-May – as fractures within the ruling PSD/CSD coalition raised expectations of an early election in September, imperiling the implementation of the austerity agenda.
The catalyst was the resignation of the Paulo Portas, head of the junior coalition CDS party, over the replacement of finance minister Vitor Gaspar. Political crisis talks are ongoing.
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| Paulo Portas, the head of CDS and foreign minister |
After a bailout two years ago, Portugal has been hailed as a poster-child for fiscal prudence and policy obedience by the troika, with the sale of 10-year bonds in April marking the sovereign’s partial rehabilitation in the eyes of international markets. However, deep budget cuts – equating to around two-thirds of the 10% of GDP target – have sparked political tensions after the inevitable domestic backlash.
The May 2014 termination target for the first EU/IMF programme is now complicated by the political crisis. As a result, a second full programme is likely, says Credit Suisse, compared with expectations earlier this year that the sovereign could fully finance itself in the markets next year or embark on a programme light on fiscal conditionality through the enhanced conditions credit line of the ESM.
Some analysts are sounding the alarm. Says Torben Kaaber, CEO of Saxo Capital Markets: “Portugal’s plunge has come at the worst possible time for Angela Merkel ahead of a German election. She will almost certainly try to kick this issue into the post-election long grass but, let us make no mistake, it will come to a head.
“Germany’s actions will be the key but, if the economic outlook for Germany and the UK recedes over the next quarter, when it comes to the real decision-making time, Europe’s big economies are unlikely to be in a forgiving mood.”
He adds: “There will be blood on the eurozone floor before the end of the year.”
Though Cyprus highlighted the dangers of requesting a bailout in a German election year – given the punitive losses on the private sector and modest fiscal transfers – this sounds melodramatic.
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| Vitor Gaspar, the former Portuguese finance minister |
Portugal’s yield curve remains steep, suggesting markets are relatively sanguine over the short-term to medium-term prospect of default, while most analysts think the crisis is not comparable with Greece in 2012. For good reasons. 1. Irrespective of the political funk, Portugal is fully funded for the 2013 calendar, with enough cash to cover €5.8 billion-worth of government bonds coming due in September. In fact, the Treasury has begun to pre-finance 2014, though a €9 billion funding gap is pending.
Non-resident buyers hold a surprisingly large amount of the country’s debt stock, at just under a half, suggesting volatility ahead, given the sensitivity of foreign buyers to economic and political news, compared with a faithful domestic investor base.
However, the country’s banks – crucial marginal sovereign debt buyers – have beefed up their liquidity buffers while reducing their dependence on borrowing from the ECB, suggesting wholesale funding access has improved.
Says Christel Aranda-Hassel, an economist at Credit Suisse: “If worse comes to worst, the ECB won’t allow domestic banks to go to the wall”, and will help facilitate their purchases of sovereign debt.
Martin Baccardax, deputy managing director of the Deutsche Börse Group, told Euromoney in a tweet that Portuguese banks are sufficiently liquid and could stomach more government paper if the sovereign chose to pre-finance 2014 funding requirements this year: “As long as they can repo it to the ECB ... and the expectation is that collateral rules are going to be further relaxed.”
What’s more, there is €6.4 billion left in the country’s bank-recapitalization fund, adding another fiscal buffer in the extremis.
2. There is a political consensus largely in favour of the EU/IMF bailout, unlike the situation in Greece last year. In Credit Suisse’s words: “The main opposition (Socialist) party – currently leading in the polls – mostly asks for a re-modulation of the programme, while it signed the original memorandum of understanding with the EU/IMF.
“The most likely outcome of an election would be, according to recent polls, a ‘grand coalition’ led by the Socialist Party. The economic strategy would change only marginally if that were to happen, we believe. That is different from the distribution of risks in the Greek elections, with the main opposition party vehemently against the EU/IMF plans. Portugal’s euro membership is not at risk, in our view.”
3. If a second programme materializes, at around €40 billion to €50 billion, compared with the first at €80 billion, and the Greece bailout at close to €250 billion, a PSI is unlikely, given the negative impact on domestic banks and the fact it would undermine the credibility of EU officials that have hitherto feted Portugal’s fiscal adjustment and rejected the prospect of a PSI.
Given the likely contagion on the eurozone and Portugal’s healthier debt metrics, a PSI is unlikely, analysts conclude. Says Credit Suisse’s Aranda-Hassel: “Like Ireland, Portugal has been seen as a good student. There is a lot of EU sympathy for the country.”
4. Portugal runs a current-account surplus at near 2%, which means it is not subject to the risk of an external financing shortfall and the domestic economy can finance public sector borrowing needs at around 6% of GDP.
5. The ECB is ready to firefight in the periphery. In the words of Barclays Capital: “The ECB is not likely to use the OMT as a tool to steer yields whenever there is some volatility and rise in yields. The bar for it to be used is pretty high and the ECB prefers to keep its ‘bazooka’ virtual and untested.
“However, this does not change the fact that the eurozone has a much stronger, open commitment to the EUR than a year ago, which should make it very difficult for the extreme cases to be tested again (unlike in H2 11 and H1 12).”
6. Structural reforms have gathered pace in Portugal. The government has increased labour-market flexibility, reduced regulation, simplified taxes and strengthened the competition framework while the privatization programme is running ahead of target.
Though reforms are unlikely to reap economic benefits in the near-term, they boost Portugal’s credibility and leverage with the troika and, in theory, its medium-term growth potential, say analysts.
7. The sovereign bond market boasts some positive technicals, aside from the ECB’s loose stance.
Firstly, there is a growing healthy and captive investor base for yieldy sovereign paper in the eurozone with, for example, non-domestic ownership of the Italian and Spanish debt stock growing, during the past year, from lows of 22% and 35% to 28% and 36%, respectively – though that’s still short of pre-crisis levels of 45% to 50%.
What’s more, core eurozone sovereigns are reducing their supply, freeing up financing power of institutional investors to invest in the periphery.
As BarCap analysts note: “This is one of the main reasons, in our view, why most of the political noise so far this year related to Italian elections, Cyprus, Greece, etc, was taken relatively well by the market.”
The analysts add: “With the Fed structurally closer to exit than the ECB, some heavily US Treasury-exposed foreign money might see relatively better value in EGB [European government bonds] paper from a portfolio allocation perspective, which should help EGB yields in general (core and core periphery paper).”
In sum, relative value concerns – along with a benign supply/demand outlook – suggest peripheral sovereign yields are less vulnerable to contagion from neighbouring political noise, BarCap analysts conclude.
In the words of BCA Research: “Portugal is an unlikely source of systemic risk to Europe and turbulence in nearby peripheral debt markets should abate ... Portugal is a ‘red herring’ [while] Greece is not.”
