Portugal’s downward spiral

Portuguese bond yields have hit euro-era highs following a downgrade to junk status by ratings agency Standard & Poor's. How big a hit will bondholders have to take to avoid a default?

Fears of defaults in southern Europe have eased of late, with one exception Portugal. There, yields have hit new euro-era highs as investors have sold off government debt. The ten-year yield is more than 17%, up 4% this year alone. Prices of credit default swaps imply a 70% chance of default over the next five years. Yet Portugal received a €78bn bail-out from the eurozone only last year.

The immediate concern is a recent downgrade of Portuguese debt to junk levels by Standard & Poor's. This pushed the country out of benchmark bond indices, forcing funds to ditch its debt. The basic problem is that investors "clearly believe that, like Greece, Portugal will soon need to impose a significant haircut on bondholders", says FxPro.com.

Portugal suffered a gradual erosion of competitiveness in the years leading up to the crisis as wages rose and Asian export prices fell. This hampered growth and tax revenues, while government spending increased. Inflexible labour markets and a high private debt load (around three times GDP) have militated against a pick-up in growth in recent years.

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Now the worry is that the public debt load, already above 105% of GDP, is becoming unsustainable as the economy shrinks rapidly by 2% last year and an estimated 3% this year. In this environment, Portugal looks unlikely to lower its budget deficit much further, despite tough austerity measures. Last year's 5.9% target was only met thanks to a one-off measure: bank pension funds were transferred to the social security system.

The economy is "already in the downward debt spiral" seen in Greece, reckons Kasia Zatorska of Lombard Street Research. Austerity is merely making the economy, and hence the deficit and overall debt pile, worse. Fewer and fewer investors believe that Portugal can grow its way out of its problems and finance itself in the markets next year.

The government is "likely to default before too long", says Capital Economics. Some analysts have pencilled in a haircut for bondholders of at least a third. With Portugal set to follow Greece into debt restructuring, fears over a possible eventual default by Italy and Spain, and hence a break-up of the eurozone, will return.