In Portugal, it seems the compromise deal between the ruling party and its junior partner is back on track following the failure of all-party talks last week. As Citi notes, PM Coelho is on the wires saying he will once again reshuffle his cabinet, with Paulo Portas likely to become deputy PM in charge of negotiating with the Troika. Portas has made it clear he wants to discuss a softening of the terms of the country’s bailout program which obviously will make for a bumpy road ahead in terms of relations with the Troika, but is probably necessary if the ruling coalition is to hold on to power amid growing popular unrest. While debt restructuring remains a tough proposition (given the contagion and precedent - Portugal debt-to-GDP is lower than Italy's for instance), the likelihood of a further substantial bailout (up to EUR76bn) remains high.
Where Are We (via Goldman),
A Substantial Adjustment…
Portugal has undertaken significant measures to reduce its fiscal and external imbalances. The government deficit to GDP ratio has fallen from 9.9% (Eur 17.1bn) in 2010 to 6.4% (Eur 10.6bn) in 2012. Net of interest expense, the balance has improved from -7% (Eur 12bn) of GDP to -2% of GDP (Eur 3bn). In structural terms, the fiscal consolidation has been even greater. The current account deficit has declined from almost 13% of GDP to less than 2%. A series of important structural reforms to liberalize its economy (partly via privatisations), improve the efficiency of the justice system and reinforce the banking system have been implemented.
… Yet With Further Adjustment Required
However, the adjustment is far from complete. On the fiscal side, compared with the targets set when the program was negotiated in 2011, there has been a sizable relaxation in the pace of the required fiscal adjustment - the government deficit is about Eur 4.5bn (or 2% of GDP) higher than expected in May 2011. Despite that, the 2013 and 2014 deficit targets remain demanding: meeting them requires (i) the implementation of fiscal consolidation measures worth around 5% of GDP, (ii) some economic recovery, and (iii) government revenue to pick-up. (See the Economic Adjustment Programme for Portugal, Seventh Review, Occasional Paper 153, June 2013).
The economy is still contracting. The IMF assumes real GDP growth of -2.3% in 2013 and +0.6% in 2014 and unemployment reaching 18.5% next year. There have been clear signs of adjustment fatigue with Finance Minister Gaspar's resignation a reflection of that. The opposition Socialist Party, that withdrew its support for the adjustment programme, is now ahead in the polls.
A Substantial Fiscal Consolidation Has Been Undertaken, but Further Adjustment is Required
Portugal’s Eur 78bn financial assistance program ends in July 2014. So far about Eur 66bn (80% of the total available financial assistance) has been disbursed. The 8th Review was delayed and the IMF/ECB/EU will begin the next review at the end-August. Around 35% of the total stock of debt is already in the hands of the official sector.
Eur 76bn Would Fully Cover Portugal's Redemptions and Interest Payments Till the End of 2016
Political and Implementation Risks Are Likely to Require a New Program
Last week, President Cavaco Silva requested a broader coalition to be formed that included the Socialist Party (PS). Political negotiations over a broad-based coalition government have not borne fruit but the President stepped back from calling elections and accepted the proposal of the current ruling coalition, which is scheduled to remain in office until May 2015.
Even though the main political risk (fresh elections) has been avoided, given the additional political uncertainties, we expect a revised adjustment programme for Portugal to begin to be discussed in the fall.
The Risks to Our Baseline View
We see two main risks to our baseline view: (i) Political support for the current government erodes further and early elections are called before May 2015; (ii) The current productive relationship between Portugal and Europe deteriorates and the Troika questions the sustainability of Portuguese debt and the feasibility of the program. These risks have different implications for markets.
What if elections are called in Portugal in a few months?
The near-term risk to this baseline view stems from political parties’ inability to continue to support the government and to commit to the EU/ECB/IMF programme. In the event of early elections, Portuguese bond yields would likely rise. This would generate volatility in broader peripheral bond markets. We would not, however, expect significant contagion from political uncertainty in Portugal to other peripheral bond markets. The backstop provided by the ECB via its OMT transaction program is likely to reassure market participants against spillover risks in a similar way to that managed during the Cyprus bailout program negotiations and the Italian elections.
What if the current productive relationship between Portugal and Europe deteriorates and the Troika questions the sustainability of Portuguese Debt?
Any discussion of a restructuring of Portuguese government debt would, instead, lead to contagion to Italy and Spain in our view. If the current productive relationship between Portugal and Europe were to deteriorate, we would continue to see a low probability of haircuts applied to government debt. We believe an extension of the maturity bonds held by the private sector could occur with a higher probability than haircuts. Against this backdrop, 20 and 30 years Portuguese bonds are a more compelling investment opportunity from a risk-reward profile than bonds maturing between 2 and 10 years.
Critically, a debt restructuring exercise `a la Greece’, imposing severe losses on private investors would reduce the stock of Portuguese debt even if it would require a substantial recapitalization of Portuguese banks. However, it would expose the other Euro area countries to severe contagion. Recall that Portuguese debt to GDP is lower than that of Italy. It would become difficult for European policy makers to argue that Portugal is a special case too.
Will Portugal Restructure? (via SocGen),
Our central scenario is that euro area policymakers will stay away from PSI for Portugal and we would indeed strongly advise against given the risks of renewed contagion. Several considerations nonetheless deserve mention, and entail that PSI for Portugal cannot be considered a 0% risk.
1. Portugal will likely need another package: The Seventh Review on Portugal praised efforts, but also noted several risks. Under the current programme plans, Portugal is due to raise a modest €4.4bn of medium-long term market based funding in 2013, €15.8bn in 2014, €22.1bn in 2015, €24.9bn in 2016. Unless market conditions improve substantially, this will be challengingto say the least. Portugal suffers a problem of debt sustainability. The IMF expects general government debt to peak at 124% of GDP in 2014 (under our own weaker growth outlook, we see 137% in 2017). Moreover, Portugal also has a high level of private sector debt and a large external debt (just over €230bn). Funding buys time, but solvency needs growth!
2. Official sector debt share to peak at 40% in 2014: Under the current programme (final payment due 15 May 2014), Portugal’s debt to the EU and IMF will peak at a share of around 40% of total general government debt. Assuming Portugal fails to return to market based funding and requires an additional EUR60bn programme over the 2014-16 horizon, then the total share of official sector debt would increase to 60% of GDP. This is an argument that favours debt restructuring sooner rather than later to keep a smaller burden on the euro area taxpayer.
3. IMF takes new look at debt restructuring: Back in May, the IMF announced that it was taking a fresh look at debt restructuring. The paper outlines a benchmark for advanced economies at 85% of GDP for general government debt and 20% of GDP for gross general government financing needs. Portugal’s gross borrowing needs in 2013 are 23% of GDP in 2013, 22% in 2014, 21% in 2015 and 21% in 2016 on the IMF’s baseline. Moreover, the IMF has expressed concern that debt restructurings have often been too little too late.
4. Euro area policymakers appear less afraid of bail-in and restructuring: Recent developments (Greek PSI, Cyprus, banking union bail-in policy…) indicate that euro area policymakers have become less fearful of debt restructuring and bail-in. Significantly lower holdings of peripheral debt in core country banking systems may, nonetheless, be one element that has eased fears. The ECB’s ability to place a floor under the euro area debt crisis at critical times may be another factor. Finally, there is the political dimension of repeatedly asking for more taxpayer money for economic assistance programmes.
MARKET ISSUES: In the risk scenario that Portugal sees a debt restructuring, this could potentially undermine the credibility of the ESM/OMT. The debate on debt restructuring is set to continue in the absence of economic growth.