Portugal (2013): Caught Between Court and Troika

Government Taking Refuge in Saving Promises

Constitutional Court Stops Part of the Austerity Package
Within the scope of the EUR 78bn rescue package granted by the troika [made up of the European Central Bank (ECB), the European Commission (EC), and the International Monetary Fund (IMF)] in 2011, the Portuguese government was obliged to adopt an extensive savings package with the aim of reducing new borrowing to less than 3% of GDP this year already. This savings target was later eased to 5.5% of GDP. Key components of the savings plan were tax increases, reductions in the pensions and salaries of public-sector workers, as well as the privatisation of state-owned companies. The savings package amounts to around EUR 5bn, which represents roughly 3% of Portugal’s gross domestic product.

On Friday, April 5, Portugal’s constitutional court declared that four of the nine austerity measures were unconstitutional. Specifically, this refers to the scrapping of the 14th month salary for public-sector workers and pensioners, as well as cuts in unemployment and sickness benefits. The financial scope of the measures rejected by the court amounts to EUR 1.3-1.5bn or at least 0.8% of GDP.

Following publication of the constitutional court’s judgement on Friday after the close of trading, Portuguese government bonds reacted at the start of the Monday, April 8, trading session with spread widening of between 20 and 30 basis points. Ten-year yields reached a high of 6.5%, which is the highest level seen since mid-February. Yields have therefore departed again somewhat from their annual lows of 5.70% – these also equated to the lowest levels since the end of 2010, during which Portuguese bonds meanwhile traded intermittently well above the 10 per cent mark. However, the situation settled down considerably in the course of the following days, after some investors viewed the lower prices as a buying opportunity. Overall, the impact of the ruling is limited for now. In addition, there was no evidence of the classic risk-off pattern: we saw no major bund purchases after the negative reports from Portugal. Neither was there any sign of broad-based selling of periphery bonds. Quite the contrary, spreads of European Monetary Union (EMU) government bonds fell against bunds across the board.

Portugal’s centre-right government finds itself under significant pressure after the ruling. Having tabled a no confidence vote last Wednesday that was, however, defeated, the opposition is now calling for the resignation of prime minister Coelho, while public sentiment is already aimed against the austerity measures. The stability of the coalition government between the liberals and conservatives also remains to be seen. Although the government has a strong majority in parliament, the junior coalition party CDS-PP could emerge as an uncertain candidate, having already expressed significant reservations about the reform policy in the past. Coelho is supported on the other hand by the Portuguese president Silva and Coehlo’s fellow party member who, of all people, supported the opposition’s claim of constitutionality.

Reacting to concerns about the market reaction, the Portuguese government announced April 14, that it would undertake new austerity measures to meet the conditions set by the troika and not threaten the disbursement of the EUR 2bn tranche pending in Q2. A total of EUR 7.7bn from the rescue package still remains to be paid out this year. The programme will end next year after another EUR 8.1bn is disbursed. The new measures were only vaguely outlined to date and should include spending cuts in social benefits, education, health insurance and state-owned companies. Tax increases have been ruled out up to now.

Portugal’s Austerity Efforts Are Taking Effect
Portugal has distinguished itself with its consistent austerity policy since the rescue package was launched, thus succeeding in improving the country’s competitiveness. Portugal’s unit labour costs fell by 3.7% in 2012 – Greece is the only other euro zone country to have posted a greater reduction. The current account deficit is expected to amount to only 1.4% of GDP, after 3% in 2012. Portugal’s real effective exchange rate (REER) has fallen significantly since its high in 2008 and traded at 98.75 in February, which was close to its previous low on April 8, and therefore almost at the level from the end of 2002.

Chart 1: Portugal’s Reform Policy is Taking Effect

Source: Bloomberg

The downside of the austerity measures is the ongoing recession and the sharp increase in unemployment, which is already over 17%. After the 3.1% decline in economic output in 2012, we anticipate another contraction of 2% this year, which is fuelling discontent among the general public and criticism of the government.

Portugal currently finds itself in a dilemma, where it has to make savings in order to meet the requirements of the troika and improve its competitive situation. However, it is still lacking an industrial basis that could benefit from improved competitiveness. One of the most important economic sectors is automobile production, which is suffering from the decline in European demand and exposure to strong competition from central and eastern Europe. More than 70% of exports are to European Union countries, where crisis-ridden Spain is the most important trading partner by far (22%). On the other hand, Portugal enjoys comparative advantages through its close links to Brazil and even Angola, which accounts for more than 6.5% of Portuguese exports and is already the country’s fourth most important trading partner.

After the judgement by the constitutional court, the government now finds itself caught between the political pressure from the general public on the one hand and the financial constraints on the other. From an economic perspective, it looks as though the hurdle of the new austerity measures amounting to at least 0.8% of GDP can be overcome. The country’s total revenue relative to economic output was 40.6% in 2012 and is expected to rise to 42.6%. In comparison, Germany has a ratio of 45.3% and France even 51.9% (both figures for 2012). However, Portugal’s interest expenditure already stands at 4.2% of GDP and could rise to 4.4% this year, which is almost double that of Germany and close to the European highs. In addition, Portugal still has to deal with a primary deficit – unlike, for example, Italy. Portugal has lived beyond its means for many decades. It last succeeded in reaching a primary budget surplus in 1992 (!).

However, it is doubtful whether the government can really succeed in plugging the gap through spending cuts alone and therefore reach the targeted deficit of 5.5% of GDP in 2013 and 4.0% in 2014. Resistance in the country is likely to be dogged. Rather, the government could aim for a mix of spending cuts, tax increases and even extend the timeframe once more for the austerity measures.

Although the government has publicly insisted that the payment of the next tranches depends on the success of implementing the new austerity measures, it is doubtful the troika would really cut off funding. For one, Portugal has already reduced its primary deficit from 7.3% of GDP in 2009 to 0.8% last year. Only Greece and Ireland have made even greater savings. On the other hand, Europe’s adamant willingness to save is crumbling on other fronts too. Italy has kept its budget deficit low – albeit artificially – by not settling outstanding accounts with the private sector for man years. Although these payments are now being made in the interest of the economy, the budget deficit could rise in the absence of further austerity measures. The government in Rome is also planning to shore up the domestic economy with a EUR 40bn spending package. France also faces new budget deficits after the government had to drastically amend its growth forecast for this year.

The troika thus found it very difficult not to reward Portugal’s savings efforts and granted the expected extension of the maximum average maturity by seven years of the EFSF/ESM-bailout-loans at the Eurogroup’s meeting on April 12. This measure provides at least some relief, especially for 2016, when almost EUR7bn of EFSF/ESM loans (excluding interest) would have matured. However, the approval is still conditional on the approval of several EMU parliaments (including the German Bundestag, which put its weight behind a rescue package for Cyprus on 18 April) and the final go of the Ecofin as soon as the Coelho government has presented a plan of how to cut its budget by the previously mentioned EUR1.3-1.5bn – the measures rejected by the constitutional court on April 5.

Portuguese Government Bonds Benefit from OMT Option
After an exceptional performance in 2012, Portuguese government bonds changed tack to a sideways phase in the first quarter of 2013 and yields fluctuated at a relatively low level. As we outlined in a previous news flash, one of the reasons for this could be that Portugal meets the ECB’s requirements for using its Outright Monetary Transactions (OMT) programme, having successfully returned to the capital market on 23 January with a syndicated bond auction: the EUR 2.5bn 4.35 PGB 10/17 tap at 4.891% drew bids of more than EUR 12bn at issuance, which represent a bid-cover ratio of a good 4.8. In addition, the share of real money investors (including 24% of hedge fund investors, however) amounted to 90%, so that Portugal’s syndicated auction can undoubtedly be considered the most successful to date this year on the basis of these indicators.

This was the first bond placement since Portugal applied for financial assistance in April 2011, having raised finance since then through loans from the European Financial Stability Facility (EFSF), the European Financial Stabilisation Mechanism (EFSM) and the International Monetary Fund (IMF) (EUR 26bn from each). The progress of the reform is reviewed on a quarterly basis and further loans are granted (ranging between EUR two and three per quarter – the volume was considerably higher when the programme started), provided the agreed targets are met. The aid programme is expected to expire in July 2014 and Portugal should already be returning gradually to independent refinancing on the capital market. Which will also be necessary, since we have calculated a funding gap of at least EUR 4bn for the current year, even taking into account the emergency loans. Bearing in mind that the planning of the sixth review by the Commission in autumn 2012 had still not assumed Portugal could tap the capital market independently, the country has already taken a major step towards reaching its funding target for 2013 by placing the aforementioned bond. At least one more auction can be expected during the year. A potential focal point could be September, when a bond totalling almost EUR six billion will mature.


Chart 2: Maturity Profile PGBs (EUR bn, Excluding Emergency Loans):
High Maturities in 2014/15 as a Prerequisite

Source: Bloomberg

Chart 3: Portugal Yield Curve (in %):
What a Difference a Year Makes

Source: Bloomberg


With redemptions and interest payments of around EUR 17bn (already taking into account the EFSF/EFSM maturity extension) pending in both 2014 and 2015 and budget deficits of around EUR 5bn each, the Republic of Portugal is likely to be a regular issuer on the capital market. In historical terms, the issuance volume is very high for Portugal and the status as (still) sub-investment grade creditor should not be demand supportive – higher yields are looming. However, the potential use of the OMT programme by the ECB should prevent this from happening. Another rescue package for Portugal cannot be ruled out – especially if the development of the economic framework in Europe is worse than expected.

Portugal has undertaken enormous fiscal efforts in recent years, which are already reflected in a high degree of competitiveness. Following the ruling by the constitutional court to reject parts of the austerity package, the government is now under pressure to act and find other means of plugging the budget deficit, which is the precondition for getting the maturity extension. Even though additional political risks remain in the short-term (pending approval of the changed bail-out package by national parliaments and final support by Ecofin), we don’t expect major obstacles for the Portuguese bailout from that side.

Given that Portugal can be seen as a more successful example of tackling the crisis, the troika will endeavour to support the Portuguese government. Although it cannot be ruled out that the government will fail, none of the participating lenders would be agreeable to another flashpoint, in view of the crisis in Cyprus and Italy. Given that the markets have been satisfied with vague promises up to now, we can expect that soft rhetoric will be used everywhere in relation to Portugal so as to keep the situation under control. Nevertheless, the government does not have that much time before it has to announce specific austerity measures. Another positive factor is that Portugal’s programme status and OMT eligibility continues to impress the market. Our “marketperformer” recommendation therefore remains unchanged for the time being. In the event of the less likely scenario to date of the government collapsing, thus threatening the austerity drive as a whole, we would, however, have to revise our assessment.