The EU debt crisis: Is Portugal the final chapter?

The following information is based on market circumstances as of the date indicated.

On April 7, 2011, Portugal formally requested bailout funds from the European Union (EU) and the International Monetary Fund (IMF). The news didn't seem to unnerve investors, primarily because the bailout request had been expected for some weeks.

Less than 24 hours later, the European Central Bank (ECB) raised rates by 0.25 percentage points, an action that reflected its sole mandate: to maintain price stability within the euro zone. The tone expressed by the ECB at the time of the announcement (and in subsequent weeks) has apparently validated the market's current discounting of at least two more rate increases later this year.

Here are several points we're keeping in mind in light of Portugal's bailout bid:

  • A sovereign debt crisis is not a new phenomenon. What we feel is unique about today's situation, however, is that it's happening within the confines of a single currency. This straitjacket puts a limit on policy options, leaving governments with few avenues to pursue when resolving debt crises. Given that the euro has recovered to pre-Greek-crisis levels, certain sovereigns are being pressured even more — forcing them to impose massive fiscal austerity on their populations.
  • Portugal's case is different from Greece's and Ireland's. The bailout packages of Greece and Ireland have different dimensions, primarily because the two countries are dealing with different kinds of financial stress. Greece's package is based on the requirement that Greece reform its public sector and pension system while agreeing to additional fiscal measures to reduce its budget deficit dramatically by the end of 2014. Ireland's package, meanwhile, is primarily directed toward recapitalizing and restructuring the country's banking sector. Portugal's circumstance has its own particular variation; economic data suggest the country exhibits a less-competitive economic model, higher costs of production, a current account that is continuously in deficit, and a low savings rate compared with the core European countries.
  • We believe Portugal is not the final chapter of the sovereign debt crises. Spain, for instance, is another country that is under scrutiny. Analysts are concerned about weaknesses that include an undercapitalized banking sector, a rising budget deficit, high unemployment, and weak economic growth. The Spanish government began taking proactive steps last year, including steps to implement social reforms and apply austerity measures. Nonetheless, it would appear that the pressure on Spain is expected to persist in the second half of 2011, as more than 45 billion euros of government debt comes due.

Important update as of May 10, 2011 — The past week has witnessed another leg in the EU crisis, with official recognition that Greece's bailout package will probably not be enough. The massive austerity measures undertaken in Greece have caused public consumption to collapse. This, combined with the cost of financing a debt level that has reached 140% of gross domestic product, is resulting in painful consequences for the country.

Markets are expecting additional EU support of at least 30-60 billion euros to be announced in the very near term. More importantly, financial markets now expect some form of Greek debt restructuring during 2011. The euro has fallen and spreads have widened. A Greek restructuring event, while now largely expected, is likely to have negative implications for spread markets as concern will shift to the sustainability of the EU banking system and other sovereigns like Portugal and Ireland. We remain on alert.

    (Data: Bloomberg.)

The views expressed were current as of May 10, 2011, and are subject to change at any time.

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