Small European country. Glorious history; rather less illustrious present. Nice place to go for a beach holiday. And about to go bust within the euro. It's a good description of Greece. But actually, we're talking about Portugal.
Earlier this week, Mohamed El-Erian, chief executive of the massive Pimco bond fund, ruffled eurozone feathers by arguing that Portugal would be the next country to need a fresh bail-out. Nonsense, proclaimed German finance minister Wolfgang Schuble, along with other senior officials. Greece is a special case. No other country is in the same trouble.
Unfortunately, they're wrong and El-Erian is right. Portugal is just Greece with a longer fuse. It is falling into exactly the same economic abyss. The difference is that Portugal has even higher debts than Greece did. And, because it didn't fiddle any of its figures, it will be impossible to blame its looming bankruptcy on anything other than the structural flaws built into the single currency. If anything, El-Erian was not pessimistic enough. Not only is Portugal sliding into a Greek-style crisis, but it could inflict far worse damage on the euro than Greece has done.
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Portugal never had a particularly strong economy to start with. But after joining the euro in 1999, it steadily lost competitiveness with the rest of the continent. From 1996 to 2010, unit labour costs in Germany rose by just 8%, and by 13% in France. But in Portugal they rose by 24%. It wasn't quite as bad as in Greece, where labour costs rose by 59% over the same period, but it was the same basic problem. Portuguese factories steadily became ever-more expensive compared with more productive rivals.
The result was pretty much the same too. The trade deficit ballooned and all those imports were paid for with borrowed money. Eventually, confidence in the bond markets collapsed and it had to be bailed out by the European Union and the International Monetary Fund (IMF).
The trouble is, the eurozone and IMF are imposing the same policies on Portugal that they imposed on Greece with the same ugly results. The government, under the terms of its bail-out, is imposing big tax raises, spending cuts, wage cuts, and a little bit of structural reform. The country one of the EU's poorest members, with GDP per head of only $21,000, well below Greece's $26,000 has been set a target of cutting its deficit to 4.5% in 2012 and 3% in 2013.
The result, as anyone who has watched what has happened to Greece could have figured out, is a huge recession. The Greek economy is expected to shrink by 6% this year, and Portugal is not far behind Citigroup reckons the economy will shrink by 5.7% in 2012 and another 3% in 2013. That's probably an under-estimate. Portugal's main export market is Spain and that too is heading into recession. A slump of more than 6% of GDP this year is possible.
The deficit-cutting targets are being missed. Earlier this year, the government revised the deficit forecast up from 4.5% to 5.9% of GDP for this year. If the Greek experience is anything to go by, it will keep being revised up. The economy will shrink, taxes fall, more people will switch into the black economy simply to survive, and the deficit will keep growing. In response, the EU will demand more austerity, and the economy will merely shrink even faster. It is a vicious circle.
That means a fresh Portuguese bond crisis seems as inevitable as an early England exit from the Euro 2012 championship. When it happens, it will be every bit as serious as Greece perhaps more so. While the Greek government borrowed a lot of money, and mostly wasted it, Greek consumers and companies were relatively restrained.
Not the Portuguese. According to figures from the Bank of International Settlements (BIS), total Portuguese debt amounts to 479% of GDP (compared with 296% for Greece). That comes to €783bn, compared with €703bn for Greece. Europe's banks are even more exposed to Portugal than they are to Greece. In total, the banks have $244bn exposure to Portugal, compared to just $204bn to Greece, says the BIS.
Greece has already defaulted on much of its debt. There isn't much incentive for Portugal not to follow. That will have two big effects. First, there will be a huge hit to the eurozone banking system. The bulk of Portuguese debt is owed to Germany and France. But those are the official figures. It seems likely a lot of the private debt, which is far more substantial, will be owed to Spanish banks. They are already fragile. Can they take the losses?
Next, it will deal a huge blow to the euro. For one country to default within a monetary union can be written off as an accident. When the second one goes down, it's more serious. The line that this is all down to one irresponsible government will be unsustainable. The alternative view that the euro is a dysfunctional currency, wreaking havoc across Europe will be far more plausible.
A Portuguese default will be the next, and potentially far more dramatic, leg of the crisis. The single currency may have stabilised for now, but once Portugal blows up, it will dominate the headlines again and rock the markets as well.
Matthew Lynn is a columnist for Bloomberg, and writes weekly commentary syndicated in papers such as the Daily Telegraph, Die Welt, the Sydney Morning Herald, the South China Morning Post and the Miami Herald. He is also an associate editor of Spectator Business, and a regular contributor to The Spectator. Before that, he worked for the business section of the Sunday Times for ten years.
He has written books on finance and financial topics, including Bust: Greece, The Euro and The Sovereign Debt Crisis and The Long Depression: The Slump of 2008 to 2031. Matthew is also the author of the Death Force series of military thrillers and the founder of Lume Books, an independent publisher.
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