Is time running out for Portugal?

On the weekend, Portuguese officials reacted frostily to press reports that Germany and France were pushing the country to seek an emergency bail-out. Portugal, they insisted, faced no such pressure.

But investors were far from convinced by their protestations. The previous bail-outs of Greece and Ireland have taught them that there’s a familiar pattern at play. Leaders of debt-laden countries typically insist that they’re more than capable of managing their financial problems — up until the very day when a formal bail-out request is submitted.

And markets have also learnt that it’s usually a matter of weeks between the time when a country’s 10-year bond yields rise above the critical 7% level — as Portugal’s did at the end of last week — and the formal request for an emergency bail-out, as debt-laden countries buckle under the higher interest costs.

In Portugal’s case, the time frame may be cut even further.

Overnight, the European Central Bank threw debt-laden Portugal a temporary lifeline by stepping into the market and buying up Portuguese bonds in order to stop the sell-off in the bonds gaining momentum.

As reports of the ECB’s buying spread through the market, yields on Portuguese 10-year bonds dropped 26 points to 7.13%. But there are limits to the ECB’s willingness to continue loading up its balance sheet with dubious bonds.

What’s more, the bank is also becoming an important source of liquidity for Portuguese banks, which are finding it increasingly difficult to borrow in global capital markets. The latest ECB data shows that Portuguese banks used €40 billion ($US51.8 billion) in ECB liquidity facilities in November, but this has likely increased as Portugal’s debt strains have risen.

As a result, Portugal faces a key test this Wednesday when it plans to sell up to €1.25 billion in 5- and 10-year bonds. If investors demonstrate an unwillingness to buy these bonds, it will put massive pressure on Portugal to seek to access the $1 trillion emergency rescue fund set up by the European Union and the IMF last May.

If Portugal takes this step, its likely to receive a bailout of between €50 billion and €100 billion — which would be sufficient to cover its budget deficits and interest bills for the next three years, as well as providing a financial buffer for its banks.

Germany and France are reportedly putting pressure on Portugal to move quickly to request a bail-out, in order to stop the debt crisis spreading to other debt-laden eurozone countries such as Spain and Belgium.

German and French officials are also worried about the European banking system, which is coming under intense pressure now that the eurozone debt crisis is again flaring.

Investors are concerned that European banks could face hefty losses as a result of their huge portfolios of eurozone bonds, and this is making it more difficult for European banks to refinance their debt.

But so far, Portugal is showing a deep reluctance to call for an emergency bail-out. The country still has painful memories of humiliation of two IMF rescues since its 1974 return to democracy.

Portugal argues that its debt levels are lower than Greece, and that its banks are in far better shape than those of Ireland. It also points out that it is likely to beat its target of reducing its 2010 deficit to 7.3% of GDP (although this was partly helped by a one-time transfer to the state of Portugal Telecom’s pension fund).

At the same time, Germany is anxious to dispel suggestions that Berlin is dictating the Portuguese bail-out.

German Chancellor Angela Merkel has strenuously denied suggestions that Germany is forcing Portugal’s hand. “There’s an offer on the table to help,” she told reporters overnight. But, she added, requesting aid was “a free decision for each country.”

All the same, markets believe it could be a matter of days before Portugal exerts its free decision to ask for a bail-out.

*This article was originally published on Business Spectator.

Peter Fray

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