Portugal’s PM exits after austerity plan rejected

Portuguese Prime Minister Jose Socrates has resigned and warned of grave consequences for the country after parliament rejected his government’s latest austerity measures aimed at avoiding a bailout.

The move has thrown Portugal into political uncertainty after months of battling against growing investor concerns over its ability to tame its public finances and avoid following Greece and Ireland by seeking international aid.

“This political crisis has very grave consequences for the confidence Portugal needs from institutions and the financial markets,” Socrates said.

Bailout still avoidable

The Organisation for Economic Co-operation and Development’s secretary general, Angel Gurria, said the political turmoil in Portugal makes a bailout look more likely.

But when asked whether a bailout was unavoidable, Gurria replied: “No, I would not say it is.”

Gurria expressed frustration that political turmoil in Portugal had led to what he called a partly “self-inflicted injury,” and said troubles there would pile pressure on other vulnerable euro zone countries.

“If you’re giving signs of distress, the markets pick those up immediately. The markets are like heat-seeking missiles – they’re weakness-seeking missiles – and wherever they see vulnerability, they focus,” Gurria said after giving a speech in Washington.

The Portuguese government will retain full powers for the duration of a European summit in Brussels on Thursday and Friday, during which EU leaders will sign up to a new, permanent, 700bn euro bailout facility for eurozone countries in trouble.

The main opposition Social Democrats has called for an election, hoping that its lead in opinion polls will bring it to power. Socrates said he would remain in power in a caretaker capacity.

The Portuguese government had hoped to obtain support for its plan before Thursday’s EU summit, to reduce market pressure on Portugal’s sovereign debt.

But the EU leaders, however, look set to disappoint investors by delaying any approval of a beefed-up euro zone rescue fund until June.

“The prospect of a bailout has risen drastically and is now enormous,” said Filipe Garcia, head of Informacao de Mercados Financeiros consultants in Porto, adding that Portugal has more than 9bn euros of maturing bonds through June.

Money markets had been wary of the outcome of the Portuguese vote all day on Wednesday and the news of the government’s defeat pushed the euro lower against the dollar, as did the announcement of a delay increasing a euro zone bailout fund.

Portuguese stocks fell and bond yields shot up.

At around 7.8 per cent, Portugal’s 10-year government bond yield is now at a level that many analysts think is unsustainable in the long term.
The five-year yield is even higher and similar levels were seen for Greece and Ireland before they sought bailouts last year.

After the rejection of the austerity measures, Portuguese yields could rise further unless a new government quickly comes up with a fresh austerity package – but forming a new government could take many weeks.

Silvio Peruzzo, an economist at RBS in London, said: “My worry is the period of inaction before a new government takes over.”

There are fears that opposition to austerity may increase as the Portuguese face lower wages and higher taxes, and the country returns to recession.

Large protests have been held on the past two weekends and train drivers have also been on on strike to demand higher wages, creating traffic chaos around Lisbon as commuters were forced to take their cars to work.

International bailout

Socrates and his Socialists have firmly opposed a bailout, but the main opposition Social Democrats have not ruled out seeking international aid.

Rich euro zone states such as Germany have been pressing Portugal to seriously consider a bailout, as a way of removing a major source of market instability in the euro zone. They could increase their pressure if Portuguese yields keep rising. An official euro zone source estimated in January that were Portugal to ask for international aid, it might need between 60 and 80 billion euros.

Impact on the wider EUUK

Britain may have to pledge more than £3bn towards an emergency EU bailout for Portugal, it has been claimed.

Prime Minister David Cameron cannot opt out if Portugal comes cap-in-hand, even though the UK is not a eurozone member state.

The UK is included in a current, temporary 440bn euro bailout fund set up to help Greece and which runs until mid-2013.

The temporary fund has also bailed out Ireland, and will be used again if Portugal needs support to prop up its economy and to try once more to restore the credibility of the euro.

The think tank Open Europe said the UK’s share in such a bail-out would range from 810mn to 3.7bn euros in the event of a 60bn euro bail-out, and 945mn to 4.26bn in the event of a 70bn euro rescue operation.

Open Europe’s economic analyst, Raoul Ruparel, said: “A bail-out of Portugal now looks virtually inevitable. But the cases of Ireland and Greece clearly illustrate that the EU’s strategy – to throw good money after bad – is failing.

“Rather than simply taking a bail-out, it would be better in the long run for Portugal to restructure its debt.”

“A Portuguese bail-out without a restructuring wouldn’t be in the UK’s interest, as it fails to tackle the long term problems of both Portugal and the eurozone.”

Spain

Spain has been under intense market scrutiny since Ireland was forced to accept a bailout at the end of last year, but spending cuts and reforms of the labour, pension and banking sector have stopped it from following suit.

Spain is considered the next weakest link in the euro zone and, with an economy more than twice the size of euro zone peripheral economies Greece, Ireland and Portugal combined, some economists predict that a bailout may stretch the EU/IMF rescue package to the limit.

Analysts have put the possible size of a bailout for Spain at above 300bn euros compared to estimates of 60-80bn euros for Portugal and the 85bn euros granted to Ireland.

The amount Spain pays for its borrowing compared with Germany – the country that sets the benchmark for the EU – reached a high of 300 basis points at the end of 2010.

But has since stabilised at around 200 bps, while Portugal’s spread against Germany has shot up to over 450.

Spain’s economy has been stagnant since emerging from 18 months in recession at the start of 2010, has an unemployment rate of more than double the euro zone average at 20.3 per cent and has one of the highest public deficits in the euro zone.

In response to the crisis, the Spanish government has passed labour market reforms, prompting a general strike, raised the retirement age to 67 from 65 and overhauled the banking sector.

Juergen Michels, an economist at Citi, said: “What they have done recently in Spain puts them in a better position than Portugal, but the shock waves coming out of Portugal will cause extra pain for Spain.”

Spain’s banks had total exposure of $108.6bn to Portugal at the end of the third quarter of 2010 according to the Bank of International Settlement. But economists have said that if a chunk of that went sour, it would not be an insurmountable blow.

Madrid has found no problems finding buyers for its debt so far, although the euro zone debt crisis has shown how quickly markets can turn.

Gary Jenkins, head of fixed income at Evolution Securities said the Spanish economy is in “good shape”. But he added: “I would have said exactly the same things about Ireland 12 months ago”.

Germany

Political considerations are influencing German Chancellor Angela Merkel who is pressing for further negotiations on an agreement struck by European finance ministers on the structure of the euro zone’s new bailout system.

Support for Merkel’s Christian Democrat Union has dropped sharply across Germany before an election on Sunday in the state of Baden-Wuerttemberg, according to an opinion poll. Voters are known to be unhappy about the need for Germany to fund bailouts of less economically prudent Eurozone neighours. The election in Baden-Wuerttemberg, the most important of seven regional votes this year, has contributed to a hardening of Germany’s stance on new measures to aid euro zone stragglers ahead of the summit.

Defeat in Baden-Wuerttemberg, an economic powerhouse where Mercedes-Benz and Porsche cars are produced and more than 10 million people live, could leave Merkel vulnerable to attack within her party, analysts say.

She is now said to believe that the direction of the agreement on the European Stability Mechanism – the bailout scheme for members of the euro zone coming into effect from 2013 – is right but details on capital injections should be changed.

“It’s in the right direction but the path will have still have to be altered,” one source quoted Merkel as saying.

Berlin wants to discuss both the timing and size of the capital injections into the ESM, the sources said, without giving further details.

Ireland

Ireland’s prime minister was expected make a plea for more time to tackle the country’s banking problems when he met other EU leaders at the summit.

The European Central Bank, which is supporting Irish banks by lending them money they would normally borrow from peers, wants to gradually withdraw this, but Irish Prime Minister Enda Kenny will seek support among EU leaders for more leeway.

Ireland’s economy shrank sharply in the fourth quarter and clocked up a third year of contraction, reinforcing concerns about its debt mountain and raising pressure on Europe to lend a hand.

EU leaders are not expected to offer Dublin any fresh initiatives at the EU summit but with its banking crisis deepening and borrowing costs soaring the Irish question will be a recurring theme in Brussels in coming weeks.

Gross Domestic Product dropped 1.6 per cent in the fourth quarter, the latest data showed, defying expectations for a 0.55 per cent increase and down sharply from a revised 0.6 per cent rise in the previous quarter after net exports came in below expectations.

Brian Devine, chief economist with NCB Stockbrokers, said: “There is nothing positive in terms of our negotiations with Europe. We still need the EU to help us big time.”

Overall, the Irish economy shrank by 1 per cent in 2010 missing a government forecast for a 0.3 per cent expansion and further undermining the view that Ireland can grow its way out of a financial crisis that could yet push the European debt crisis into overdrive.

Despite securing an 85bn euros bailout from the EU and the IMF late last year, Irish borrowing costs have hit euro-era highs this week based on concerns about mounting losses at domestic banks, which are set to be revealed in stress tests next week.