Global financial markets continued to struggle overnight as investors fretted that the borrowings of debt-soaked eurozone countries won’t be permanently underwritten by Germany, and that bankers and bondholders will eventually be forced to take heavy losses.
As a result, the sell-off in eurozone bond markets continued, with Spanish bond yields reaching fresh euro-era highs of 5.45%. Portuguese bond yields bucked the trend, and fell 19 basis points to 6.65%, due to rumours sweeping through the market that the European Central Bank was actively buying Portuguese bonds in order to push yields lower.
The head of the ECB, Jean-Claude Trichet, overnight stressed Europe’s determination to control the mounting eurozone debt crisis, raising the possibility that the ECB may step up its bond-buying program.
There is a growing view that Portugal is about to become the next eurozone country to put its hand up for an emergency bailout. This view was reinforced by a warning from the Portuguese central bank that Portuguese banks could face an “intolerable risk” unless the country was able to reduce its budget deficits.
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In its semi-annual report, the Bank of Portugal also noted that Portuguese banks had a “permanent and large-scale” dependence on the European Central Bank for funding, and that this was unsustainable. Portuguese banks borrowed just over €40 billion from the ECB in October.
Although spared a banking crisis, the Portuguese economy has stagnated over the past decade. Portuguese companies have lost ground to competitors, and the country is grappling with unemployment rates above 10%.
In his latest strategy paper, Citibank’s highly respected chief economist Willem Buiter notes that Portugal managed to avoid the housing bubbles and bank excesses that have troubled Ireland and Spain, and that the country’s debt level — which is about 80% of GDP in 2010 — is close to the eurozone average.
But, he notes, “its government deficit remains stubbornly high and its growth prospects poor. Despite the fiscal austerity package implemented in May, the Portuguese central government budget deficit had not yet shown signs of improvement at the end of October 2010”.
Buiter points out the Portuguese government may only reach its target of reducing the budget deficit to 7.3% of GDP by relying on an accounting measure — moving the pension fund of a major Portuguese telecommunications company onto the government balance sheet. What’s more, he says, although the Portuguese government has announced plans to cut the budget deficit by about 3 percentage points of GDP next year, this may be hard to achieve. “This year’s experience shows that implementation risks are high.”
Buiter notes that Portugal’s growth prospects are bleak. “Growth in Portugal has been slow for many years. The high level of private debt (non-financial private sector debt is close to 250% of GDP), the funding difficulties of Portuguese banks and the additional fiscal austerity announced for the next years imply that growth is unlikely to pick up soon.”
As a result, he concludes that Portugal is likely to be the next country to put its hand up for a bailout from the European Union-IMF emergency rescue fund.
Buiter also takes a pessimistic view of Spain. He points out that worries about Spain have abated in recent months, after the Spanish government introduced austerity measures in May, and after the results of the European bank stress tests were published in July.
But, he says, there remains a huge question mark over Spanish banks.
“In our view, Spain is unjustifiably put in Italy’s risk class currently and should be closer to Ireland’s or Portugal’s risk class.”
He adds: “The stress tests have been discredited. The size of unrealised losses in the banking sector is highly uncertain, but probably large. Given the exposure of banks to the construction and real estate sectors and to overleveraged consumers, the size of capital injections into banks which the government has agreed to so far — around €10billion (1% of GDP) — seems woefully inadequate. By comparison, the Irish government is committing 30% of GDP and rising.”
In addition, he says, official Spanish growth estimates are far too optimistic, and the country will probably need to do more fiscal tightening in order to meet its deficit target for next year.
If the Spanish government does introduce new austerity measures, and if there are no big unexpected negative surprises emerging in the Spanish banking sector, he says, “Spain may yet muddle through without external help”.
But if Spain does need help, it would stretch the EU-IMF $US1 trillion rescue package to its limit, or even beyond. A short-term solution could be found if members of the eurozone agreed to inject more funding into the rescue package. Alternatively, the European Central Bank could help by buying more Spanish debt, and by providing funding to Spanish banks.
But, Buiter issues a somber warning. “In the longer term, there may be a need for large-scale restructuring of Spanish bank debt and possibly the sovereign.”