Saturday, July 13, 2013

Portugal Crisis: Will Contagion Make a Comeback?

by Pater Tenebrarum

Crisis Conditions Return

The political crisis in Portugal has received fresh impetus when the country's president Anibal Cavaco Silva decided to reject the government's plan to 'heal its internal rift'. By calling for early elections next year, he is now accused by critics to have ignited a 'time bomb'. As is well known by now, too much democracy isn't  good for EU bailout regimes tied to austerity.

“Portugal's president has thrown the bailed-out eurozone country into disarray after rejecting a plan to heal a government rift, igniting what critics called a "time bomb" by calling for early elections next year.

President Anibal Cavaco Silva proposed a cross-party agreement between the ruling coalition and opposition Socialists to guarantee wide support for austerity measures needed for Portugal to exit its bailout next year, followed by elections.

The surprise move came just when conservative prime minister Paolo Passos Coelho thought he had overcome a cabinet crisis by reaching a deal to keep his centre-right coalition together. The decision was a warning shot to all mainstream parties indicating the conservative president does not think any of them is capable of ruling effectively until the EU-IMF bailout is due to expire in June.”

(emphasis added)

This has promptly emboldened the socialist opposition to demand a 'renegotiation of the bailout terms'. It seems the former austerity 'model student' Portugal is going to throw a spanner into the works – just prior to elections in Germany to boot, which will make any changes to the bailout conditions a hard sell indeed.

“The opposition Socialists demanded a renegotiation of Portugal's bailout terms on Friday, raising a hurdle to a cross-party pact the president says is needed to end the euro zone country's dependence on international funding next year.

Prime Minister Pedro Passos Coelho and Socialist leader Antonio Jose Seguro said they are ready to discuss a deal, but analysts say their divergence on painful austerity policies linked to the bailout could make it hard to resolve the crisis.

"We have to abandon austerity politics. We have to renegotiate the terms of our adjustment program," Seguro told parliament. "The prime minister has to recognize publicly that his austerity policies have failed."

The political turmoil has already forced Lisbon to request a delay in the eighth review of the bailout by its creditors, initially due to start on Monday, until the end of August or early September. The delay drove up yields on Portuguese government bonds, which move inversely with prices, with 10-year yields surging 90 basis points on Friday to 7.87 percent.”

(emphasis added)

As always, the main problem is what the alternative to 'austerity' is supposed to consist of. To state that 'austerity has failed' is not enough. After all, the government is definitely insolvent. It cannot resume deficit spending on a grand scale. The problem with EU style austerity in fact isn't that governments are cutting their spending. It is the failure to implement truly wide-ranging economic reform and the failure to actually shrink government. Instead of giving the market room to breathe, governments have raised taxes so as to keep their 'share of the pie' unchanged. Spain's government is incidentally currently well on its way to intensifying precisely this mistake.

Portugal, 10 year yield, 30 min10 year government bond yield of Portugal, 30 minute chart: back to recent highs – click to enlarge.

Portugal, 10 year yield, daily

10 year government bond yield of Portugal, daily chart. This does not inspire much confidence at present – click to enlarge.

It should be remembered here that the former socialist government originally applied for a bailout from the EU when 10 year Portuguese government bond yields first reached 8.4%. Current yields are not very far away from this level and are definitely too high to allow the government to finance itself in the markets. At current yields, it would immediately enter into an unstoppable debt spiral.  Not surprisingly, Portugal's stock market is under pressure again as well:

PSI-20After a brief bounce, the PSI 20 in Lisbon has turned down again – click to enlarge.

The Danger Beyond Portugal

We haven't seen this discussed anywhere in the mainstream financial media yet, but we suspect that sooner or later, the question will come into focus: namely what a renewed crisis in Portugal could mean to Spain and specifically Spain's floundering banks.

Below is a (slightly dated) overview of the exposure of various banking systems in Europe to Portugal. Spain's banks have exposure amounting to nearly € 70 billion, which is by far the largest in all of Europe.

In short, it is the danger of contagion that should actually be the biggest worry here. Spain's banks have already so many problems that they really don't need yet another headache.

Spain's exposure to Portugal

Bank exposure to Portugal by country and type of debt, via Scott Barber of Reuters.

Among the crisis-stricken euro area countries, Portugal is in the top three in terms of official unemployment rates and its economy continues to be under great pressure. A return of outright crisis conditions could conceivably push numerous marginal borrowers over the edge.


Unemployment in Portugal is at almost 18%, mirroring the weakness of its economy.

As Ambrose Evans-Pritchard writes, the 'wheels are coming off' again in the euro area periphery:

“The Portuguese press is already reporting that the European Commission is working secretly on a second bail-out, an admission that the wheels are coming off the original €78bn EU-IMF troika rescue.

This is a political minefield. Any fresh rescue would require a vote in the German Bundestag, certain to demand ferocious conditions if this occurs before the elections.

Europe’s leaders have given a solemn pledge that they will never repeat the error made in Greece of forcing an EMU state into default, with haircuts for banks and pension funds. If Portugal needs debt relief, these leaders will face an ugly choice.

Do they violate this pledge, and shatter market confidence? Or do they admit for the first time that taxpayers will have to foot the bill for holding EMU together? All rescue packages have been loans so far. German, Dutch, Finnish and other creditor parliaments have never yet had to crystallize a single euro in losses.”

(emphasis added)

We would add that there is yet another danger waiting in the wings that hasn't received much attention yet: what if the EU's new bank resolution process is put to the test? We suspect that even the slightest whiff that Cyprus style 'haircuts' could be in store for bank depositors anywhere else in the euro area periphery would immediately reignite capital flight from the periphery to the center. The Euro-Stoxx bank index is already poised rather precariously just above an important lateral support level. If it breaks below it, it will probably signal that a full-scale crisis is about to be reignited.

Euro-Stoxx banksEuro-Stoxx Banks, weekly: poised precariously just above a support level – click to enlarge.


As always, it is not just about the isolated case of a relatively small country getting into trouble. The interdependence of banks in the euro area almost ensures that contagion will spread unless the flare-up of crisis conditions in Portugal is quickly brought under control again. Keep in mind that the ECB's 'OMT' promise does not extend to countries like Portugal that have already lost market access. It seems that the times are about to become 'interesting' again, possibly in a hurry.

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