Portugal: strike three for the eurozone?

An EU bailout of Portugal now seems inevitable.But at some point, EU taxpayers are likely to tire of bailing out nations like Portugal, which seem unwilling to curb their spendthrift ways.

Yves Logghe/AP
From left, Portugal's caretaker Prime Minister Jose Socrates, Bulgarian Prime Minister Boyko Borissov, German Chancellor Angela Merkel, European Commission President Jose Manuel Barroso, and French President Nicolas Sarkozy share a word during a group photo at an EU summit in Brussels March 24, 2011. Portugal's political crisis and uncertainty over the true scale of problems at Irish banks dominated a summit of European Union leaders that was designed to finally put an end to the region's crippling debt crisis.

Overshadowed for weeks by violence in the Middle East and the tragic earthquake and tsunami in Japan, the European debt crisis is again front and center. It now appears inevitable that Portugal will become the third European country to require emergency funding to bail out its national economy.

The strongest signal of Portugal’s insolvency came Wednesday, when the country’s prime minister unexpectedly resigned. Jose Socrates stepped down after failing to convince the Portuguese parliament to approve an austerity plan aimed at preventing default on its debt.

By refusing to address these fundamental issues, Portugal’s legislators have set the country on a course with only one possible outcome: European Union intervention. In order to protect the integrity of the eurozone and the value of the euro, the European Union (EU) has no choice but to provide Portugal with emergency funding. However, as Greece and Ireland can attest, this largesse comes with hefty strings attached – not the least of which is the loss of sovereignty and control of the nation’s finances.

Portugal’s situation will surely become even more precarious in April, when the next round of its government bonds matures. At a time when the nation is broke and the government is effectively suspended, Portugal faces €9 billion ($12.7 billion) in redemptions due in April and June.

Below the iceberg

In 2010, the EU and the International Monetary Fund (IMF) provided a total of €180 billion to prop up Greece and Ireland. Early estimates place the total amount needed to rescue Portugal at €70 billion. Unfortunately, this may not mark the end of the debt crisis as several other European countries remain at risk.

Spain – to put it bluntly – is a financial basket case. Unemployment exceeds 20 percent, buoyed by a generous system that pays unemployed workers 65 percent of the average national earnings for up to two years if they’ve worked for six years. The country’s unsold housing inventory is six times worse than in the United States, with some 1.6 million unsold properties. Spain’s deficit equals 11.4 percent of gross domestic product (GDP) and its government debt alone equals nearly 60 percent of total GDP. With several credit downgrades by Fitch and Standard & Poor’s, it has become even more expensive for Spain to finance its debt at a time when it simply cannot afford to pay more interest.

With Spain’s economy making up roughly one-tenth of the eurozone, its insolvency could cause immense damage to the entire region. By way of comparison, the combined economies of Greece, Ireland, and Portugal equal barely half of Spain’s total value. Using the earlier rescue packages as a guide, it is not out of line to estimate that should Spain require emergency funds, the amount could easily be a quarter of a trillion.

EU close to breaking point

At some point, the EU will be forced to accept that by continuing to bail out foundering economies, it is inadvertently promoting moral hazard by absolving sovereign governments from making difficult but necessary fiscal decisions. Such a policy is too costly to be sustainable and does more harm than good in the long term.

Last year’s general strike protests in Greece, and Portugal’s recent political deadlock, show that some eurozone members are less inclined to take responsibility than others. It is little wonder that taxpayer resentment is on the rise in countries like Germany. Being forced to pay for the folly of irresponsible, spendthrift nations is unfair.

The real problem these insolvent countries face is their inability to raise sufficient funds to meet their debt obligations. Soon, however, circumstances may force them to shut up and put up. The eurozone is only as strong as its weakest link and the escalating debt crisis may prove to be its undoing.

At this point, even if Portugal does adopt a responsible and proactive approach to its budget problems by implementing severe spending cuts and raising taxes, it will still be forced to issue debt securities. However, now that it is identified as a “risk,” it becomes more difficult and much more expensive to entice investors to buy its debt.

Currently, the yield on Portuguese bonds is about 450 basis points higher than the benchmark German 10-year bund (bond). This means that investors demand a premium of 4.5 percent to buy Portugal’s debt compared to Germany. The inability to raise funds in a cost-effective manner adds to the country’s financial woes and the whole thing becomes a vicious circle that keeps getting worse.

To counter this, Eurogroup Chair Jean-Claude Juncker proposed the creation of a common “euro bond” backed by the entire region rather than an individual country. The idea is that rather than sell its own questionable debt directly, Portugal could acquire cash by selling euro bonds, which should be able to find buyers at a lower cost.

"It's an intelligent way to keep economically weaker euro countries attractive for investors in the future," Mr. Juncker explained in an interview with a German news outlet.

Intelligent or not, there is some opposition to the scheme and many details must yet be ironed out. But it could offer an alternative to the issuing of “loans”.

The other obvious option is for the eurozone to dissolve, leaving the former member countries to fend for themselves. This is a long shot, but it is interesting to note that the late Milton Friedman, winner of the Nobel Prize in Economics, declared the eurozone an unworkable arrangement doomed to collapse upon facing its first economic crisis.

Scott Boyd is a currency analyst with OANDA and contributes to the company’s MarketPulse FX blog.

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