After Greece and Ireland, it seems increasingly likely that Portugal may become the third euro-area country to be bailed out by an EU/IMF rescue package. In the past week, the yields on Portuguese (as well as Spanish) public debt bonds were driven lower through massive European Central Bank (ECB) purchases, but this type of intervention is unlikely to be sustainable. The fully fledged monetisation of public debt by the ECB would generate grave moral hazard problems and – perhaps more importantly from a German perspective – also compromise monetary stability in the euro-area. It is therefore unlikely that the Portuguese debt crisis will be solved through ECB intervention.
In this context, the prognosis for Portugal seems to be quite dire. Since my previous post, an austerity programme has indeed been agreed by the two main Portuguese political parties (the ruling Socialist Party and the opposition Social Democratic Party) but the announced cuts may be too little, too late after years of reckless growth in public expenditure and public debt. Furthermore, there are mounting doubts about whether there is the political will to carry out the approved measures. For example, there is increasing talk of public hospitals being exempted from some of the budget cuts, while the regional government of the autonomous Portuguese region of Azores announced that some public servants there would receive a special subsidy to offset the nationally approved pay cuts. Worse still, even though the country is on the verge of bankruptcy, plans to conduct major new public works projects have not been abandoned and seem to be constrained only by the current lack of financing capability.
With economic growth likely to be weak, the Portuguese state simply will not be able to keep borrowing money at high interest rates without putting itself in an unsustainable situation – which lenders will no doubt quickly recognise as such. Perhaps the only slightly encouraging piece of news from Portugal is that – so far – there have not been any major problems with the biggest Portuguese banks (the worst case until now has been that of the relatively small Banco Portugues de Negocios, which has been bailed out by state-owned Caixa Geral de Depositos). But even this can quickly change given the relatively high financing needs of Portuguese banks and the extent to which they are dependent on international lenders.
In this scenario, unless the Portuguese government can provide an internationally credible commitment to wide reaching and immediate cuts in public expenditure – which seems unlikely at this point – the remaining options appear to be a bailout package and/or some form of default on existing debt. If a bailout does materialise, it would be important for creditors to take a substantial haircut on their claims. Assuming Portugal retains fiscal sovereignty (which is not a given under present circumstances in the EU), linking any bailout with a haircut on creditors will be essential to limit moral hazard in the actions of international lenders and also to ensure Portuguese politicians undertake much needed structural reform.