Brussels has always been worried that a Greek default would spread to other countries. And its fears seem to have been justified. Markets now fear that Portugal will need a similar deal.
Mohamed El-Erian, of US bond fund giant PIMCO, thinks the European Union and the International Monetary Fund (IMF) will have to provide aid. Creditors will also have to take losses.
Professor Nouriel Roubini of New York University is even more bearish (admittedly, not an unusual position for Roubini). He has said the country will eventually have to leave the euro.
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However, the EU maintains that there will be no repeat of the Greek deal. The German finance minister has also said that Greece was "totally unique".
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Portugal is in a worse state than you might think
Superficially, Portugal seems to be in a better position than Greece. At 112% of GDP, the headline debt ratio is much lower. It also met its target for cutting the deficit in 2011.
Sadly, most of this is smoke and mirrors.The key reason why the deficit (the annual overspend as opposed to the overall national debt) fell to 4.5% of GDP was because it took over two big pension funds.
This meant that it got to book the cash as revenue. However, although the pension liabilities are off-book, they will still have to be paid in the future. In effect, the true deficit is much higher.
The nation has since promised not to repeat this trick. But it is unlikely that debt will peak below 120% of GDP, as the government still believes. Instead, experts suggest that by the end of this year, it will be more than 122%.
It could be even worse. Many Portuguese banks are in big trouble due to massive debts. While it would be best for Portugal to go Icelandic and limit any bail-out, this is unlikely. Therefore state debt may end up going a lot higher.
As with Greece, Portugal's growth prospects are poor. Figures released earlier this month show that GDP fell by 1.6% last year. Government spending cuts, low monetary growth and Portugal's inability to adjust its own exchange rate all mean that this year will be worse.
Even Lisbon accepts that GDP will fall by 3.3% this year. Capital Economics is even more bearish. It predicts that GDP will fall by 4% this year and another 8% next year.
If these predictions are true, then many firms could go bankrupt. That would be bad news for banks - many Portuguese companies took advantage of the low interest rates to borrow large amounts of money. This has led to combined public and private debt being 360% of GDP. To put this into perspective, the figure for Greece is only 260%.
This debt will act as a drag on growth for years to come: even when the Portuguese economy eventually starts to recover, firms will be paying off debt, rather than increasing output.
Bond markets will bring matters to a head
It's clear that the best solution is for Portugal to default and quit the euro entirely, using inflation to reduce the real value of wages and private debts. The only other option is debt 'haircuts' combined with a more relaxed stance on government spending. This would compensate for private sector deleveraging.
Either way, action will be needed sooner rather than later. Portugal will need to raise more money later this year in order to roll over its debts. With five-year bond yields now above 15%, it is clear that getting money from the markets is not an option.
This means that the government will have to go down the same route as Greece if it wants to get hold of any money. That in turn suggests that private sector bondholders will be facing big losses again.
The threat of a Portuguese bail-out is another reason to avoid banks
The best way to hedge your portfolio against a Portuguese default or bail-out is to avoid banks with exposure to the nation's public and private debt. Even if Portugal does not leave the euro, and there is no 'haircut' on public debt, many loans to private firms will default.
We're not keen on the banking sector,and Santander (LSE: BNC) seems to be particularly badly placed. As a Fitch report last year points out, not only does it have the largest amount of sovereign debt, it also runs a Portuguese subsidiary Santander Totter SGPS. A Portuguese default and/or 'haircut' is also likely to have a knock-on impact on its much larger holdings of Spanish sovereign bonds.
