Portugal: The Price of Austerity

News of the collapse of the Portuguese coalition government is further evidence of adjustment fatigue in the periphery that threatens the European project.  The leader of the junior coalition partner CDS-PP resigned yesterday, complaining that the new Finance Minister (Maria Luís Albuquerque, replacing Vítor Gaspar who resigned Monday) represented a “mere continuity” of failed austerity policies.  While it’s possible the government may survive as a minority party, the odds are rising that there will be early elections this fall, a vote that is set to become a referendum on austerity.  It is both an opportunity and a serious challenge for Europe.

There is a lot of goodwill for Portugal.  While there has been speculation for some time that Portugal would need additional financing in 2014 when its current IMF program ends, it was assumed that the road to a new agreement would be far less bumpy than recent programs for Greece and Cyprus.  Policies have been seen as strong, even as the economy has performed worse than expected. The Troika has shown flexibility--an output gap of 5 percent and unemployment of 18 percent triggered an easing of fiscal targets in the last IMF review. Now, the IMF program looks to be heading off track.  In addition to fiscal slippage (the government recently promised 3 percent of GDP in spending cuts over the next few years that will now be in question), upcoming commitments to introduce legislation on labor and pension reform presumably will slip.  Following news of the resignations, Portuguese stocks fell more than 5 percent and 10-year bond yields have spiked to near 7 ½ percent, well above the level of interest rates seen as sustainable.  Market access looks increasingly distant.

The government cash position looks comfortable for now, so the risk isn’t really near-term funding.  But a spike in spreads, problems with the IMF program and a strong anti-austerity vote in the election all could spook markets.  In my most recent Global Economics Monthly, I discuss the lessons the Fund is drawing from recent programs and debt restructurings.  Importantly, the Fund seems more willing to take a tough line when programs are underfunded and debt is going in an unsustainable direction. We are seeing this in Greece, where the Fund is insisting on assurances that the program is well-funded for the next 12 months (it isn’t).  So it would not be surprising to see the Fund, which is reportedly heading out to Lisbon in a couple of weeks for the next review of the program, press European governments to commit to providing additional support if market access doesn’t return.  One way to do that would be through additional European Stability Mechanism (ESM) financing; another would be through the ECB’s Outright Monetary Transaction (OMT) program (which countries currently receiving bailouts are not eligible for).  Both require a government with a commitment to, and ability to deliver on, an adjustment program. Additional borrowing by the government will be hard to justify: with Portuguese government debt already at 124 percent of GDP at end 2012, the debt is not sustainable without growth, but at the same time there can’t be much scope for the government to take on new debt.  My view is that debt relief ultimately will be required.

Perhaps the near-term risk to watch is deposit flight.  Deposits, which are down 10 percent over a year earlier, have been falling in line with assets as Portuguese banks delever.  What happens next could be the first real test of whether the precedents set in the Cyprus restructuring will cause meaningful contagion when the risk of restructuring rises.

Europe has a lot at stake in the program succeeding. Leaders need to make the case forcefully here, as well as elsewhere, on the merits of deeper union and that the path forward is proceeding fast enough to restore growth.