On Tuesday, Brussels and Berlin got what amounted to the worst news possible out of Portugal. In what sounds like the plot of a McCarthy-era propaganda spy novel, the Socialists and Communists have overthrown the government.
More specifically, Antonio Costa and the Socialists cemented their coalition with the Communists and The Left Bloc on the way to ousting Portuguese PM Pedro Passos Coelho's government. This came just days after President Anibal Cavaco Silva reappointed the premier on the heels of largely inconclusive elections. That reappointment represented a slap in the face for the leftists and all but guaranteed they’d move to take control.
That’s just about the last outcome Jean Claude-Juncker, Angela Merkel, and Christine Lagarde wanted to see on the heels of the summer’s fraught and protracted negotiations with Greece.
As we’ve discussed extensively, the whole point of putting Alexis Tsipras through round after round of “mental waterboarding” was to dissuade any and all Syriza sympathizers from attempting to negotiate for debt relief and/or a rolling back of austerity. If things should go south in Lisbon, it would mean that the advocates of fiscal rectitude in the EMU will be forced to watch as one of their prized bailout “success” stories turns the corner and decides “austerity” isn’t worth the trouble.
That sets the stage for more debt drama just as the EU splinters over the migrant crisis.
Needless to say, none of the above is credit positive for Portugal (although arguably, a prolonged period of political discord may have been worse) and as Bloomberg reports, the country may be about to lose its last investment grade rating and with it, its eligibility for PSPP. Here’s more:
Portugal’s government bonds, the worst performers in the euro zone over the past month, face another hurdle with a potential credit-rating downgrade that may see them excluded from the European Central Bank’s asset-buying program.
For Portugal’s bonds to be eligible for purchase, the nation must be rated investment grade by at least one major ratings company. It has already been junked by Moody’s Investors Service, Standard & Poor’s and Fitch Ratings.
But the country still holds that crucial investment-grade status by DBRS Ltd. The Toronto-based company is scheduled to review its position on Friday, raising the possibility Portugal could lose a crucial source of support.
“The fear is that if DBRS downgraded them, it would trigger Portugal falling out of the eligibility,” said David Schnautz, a London-based interest-rates strategist at Commerzbank AG. “It’s obviously something that investors have to brace for. It’s a low-probability but high-impact event.”
If Portugal is downgraded, a waiver allowing the ECB to keep buying their bonds may be possible, Commerzbank analysts wrote in a research note.
So essentially, this is just the start of the very same kind of tactics the troika used to bully Greece; that is, they'll use the fear of financial armageddon to get the political outcomes that you want. Here's Reuters explaining why Portugal may need some "tough love" now that the Socialists and in charge:
A compromise could be messy, tough love might actually help.
Cutting Portugal off could be dramatic. In 2013, Italy was gripped with similar instability and its 10-year bond spreads rose over a 100 basis points higher than Portugal's today. Cyprus was late to gain access to the programme in 2015 and it spread over German bunds was over 5 percent. Beyond Portugal, the move would highlight the limits of the ECB's ability to move markets.
So let's get this straight, cutting Portugal off would be "dramatic" and it could have a huge effect on spreads, but somehow cutting them off "highlights the limits of the ECB's ability to move markets"? That seems contradictory. It seems like cutting them off and seeing Portuguese yields soar would show just how much the ECB matters when it comes to influencing borrowing costs.
Of course all of this is farcical to a certain extent. As the chart below shows, the definition of "austerity" is apparently soaring debt-to-GDP and when it comes to driving down borrowing costs, Draghi's jawboning ("whatever it takes") is clearly more effective than the ECB's bazooka:
Still, if the ECB does cut Portugal off we'll be on the same slippery slope as we were with Greece. As we noted last month, "the ATM lines, empty shelves, and gas station queues Greece witnessed over the summer have not had their intended psychological effect in Portugal as Socialist leader Antonio Costa announced earlier in the week that he’s prepared to align with the Communists and with Left Bloc to form a government in defiance of the Right-wing coalition." But seeing another country forced into third world status and watching it happen in yours are two entirely different things and it could very well be that cutting Lisbon off from PSPP is a warning shot from the ECB which, if not heeded, could very well lead to further punitive "measures."
Incidentally, it's also worth noting that Portugal's fiscal deficit just ballooned to 7.2% (just "slightly" above target) after the country admitted that the Novo Banco bailout would likely have to remain on the government's books for the time being and make no mistake, there's nothing about a 7.2% budget deficit that Wolfgang Schaueble is going to like.
Finally, we wonder if the ECB is cutting its nose off to spite its face given the lack of PSPP eligible bonds. Of course Draghi could always just go and grab a few GGBs to fill the govie void - Greece is "fixed" after all.
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Bonus color from Barclays
The elevated costs of political and policy uncertainty
Political uncertainty is having already significant costs. Portugal 10y sovereign spreads have increased to over 215bp versus Bunds and more than 90bp versus 10y Spanish Bonos. The political uncertainty takes place against a background of still elevated private and public debt. Public debt stands at c.125% of GDP, and it continues to be rated below investment grade by three of the major credit rating agencies.
Key to where Portugal’s funding costs and future ratings are heading will be the macroeconomic policies of the new government. A fundamental difference of the Socialist Party and its allies has been their proposal of less austerity. While Mr Costa has expressed his full commitment to take Portugal out of the Excessive Deficit Procedure as soon as possible by reducing the public deficit below 3% of GDP, it is not yet clear how this target squares with his proposals (and his allies’): to roll back some of the public sector wage cuts, unfreeze of pensions, reverse some privatizations (including the transport systems of Lisbon and Oporto), and cut the VAT on some goods and services. At the same time, the parties have pledged to boost public investment. In sum, the markets await the content of the economic and fiscal plans of the new government in order to assess whether they square with its overall fiscal objectives.
Will markets settle after the appointment of the Socialist Party?
Even if the Socialist Party is appointed to form a government (as we expect), we do not think that the Communist Party or the Left Bloc will enter Mr Costa’s cabinet in a full-fledged coalition. The support of these radical-left parties is likely to be on an “as need” basis and will depend on how close the Socialist’s proposals are aligned with their own parties’ agendas. These parties have already dropped some of their previous, more radical proposals, including a euro area exit and an upfront restructuring of Portugal’s public debt. However, we remain concerned about the strength of the alliance between these parties, given the traditional moderation of the Socialist Party and the much more radical stance of the other two. Minority governments in Portugal tend not to last their full term, and we do not rule out the possibility that Portugal may need to hold elections again within a year. Political uncertainty is likely to continue to weigh on Portugal’s funding costs, despite the very accommodative monetary policy of the ECB (Portuguese debt is part of ECB's PSPP programme) and the more benign macroeconomic conditions in Portugal and the euro area.
Bonus Bonus: a snapshot of the country's vulnerabilities