Why Portugal is Important Even If You have No Direct Exposure

Portugal's 10-year bond yield has risen almost 120 bp this year.  It is one of the few eurozone members that still pay to borrow two-year money.   There are two set of drivers.  One set is country specific.  These may matter only to current or prospective investors.  The other set of considerations may have broader applicability.  This means that even those without direct exposure may want to take note of developments in Portugal.

There are a few country-specific considerations that are worrisome.  First, three of the four rating agencies that the ECB relies on rate Portugal just below investment grade.  If the fourth rating agency, DBRS were to match the other rating agencies, it would have serious implications.  Portuguese bonds would not longer qualify to be purchased under the ECB's asset purchase program.  In addition, it would also mean that Portugal banks could not use government bonds for collateral to borrow from the ECB as they currently do.

Prior to last year's election, there were expectations that Portugal could regain its investment grade status.  However, the election results and the center-left success in pushing out the center-right government makes this less likely.    Fitch has warned that any fiscal relaxation would be seen as credit-negative.  DBRS is set to review Portugal's debt rate at the end of April.

Second, after much negotiating with the EC, Portugal's 2016 budget was approved.  The outgoing government had agreed to the EC's demand for a 1.8% budget deficit.  The new government submitted a budget that originally projected a deficit of 2.6%.  There the negotiating process this was reduced to 2.2%, through extra taxes on fuels, tobacco, auto, and a special levy on banks.

An often used ploy to project a smaller deficit-to-GDP ratio is to inflate growth estimates.  The EC pressured the Portuguese government to reduce its 2016 growth forecast to 1.8% from 2.1%.   There is some risk that this is still too high.  The Bloomberg consensus, for example, is 1.5%, and this was probably predicated on lower interest rates.  There is little room for maneuvering.     Slower growth in H1 could prompt the EC to seek a midterm correction--, i.e., additional savings measures.

Third, the new government is reversing the previous decision to sell controlling interest in TAP, the national airline.  The Portuguese government is raising its stake to 50%.  The rationale is on nationalist grounds.  The government wants to "guarantee that TAP's strategic vision is respected and that TAP will always ensure the connection of Portugal and of the Portuguese to the world."  In 2011, Portugal had agreed to sell TAP as a condition of receiving assistance from the EU and IMF.

In some ways, Portugal is an extreme expression of that is happening elsewhere in the European periphery.  They cannot keep pace with the demand for German bunds, which means spreads are widening.  The 10-year yield ins Italy is also higher in the year.    At the two-year tenor, the Italy, Spain and Portugal have experienced rising yields this year, while Germany, France and other core countries have seen their yields fall.    Despite the ongoing asset purchase program, there is a risk of new fragmentation of the European credit.

Portugal's recent experience is a reminder of the political limits of the EU's strategy. Despite some modifications, many are austerity-weary.  Opposition to the EU may be expressed as a form of nationalism, and this inhibits forms of union and privatization.

There is also an understandable discomfort from investors and creditors of Europe's new Bank Recovery and Resolution Directive.  This was meant to protect taxpayers and make creditors, as well as shareholders, bear the initial burden of a bank failure.  Portugal was among the first to implement and it bailed-in some senior creditors, which shocked many observers and journalists (see here).

Lastly, we note that Europe is being pulled apart in more complex ways that in 2010-2011.  The South (Greece, Italy, Portugal and probably Spain) have left of center governments compared to center-right governments among most of the creditors.  The immigration burden also falls on the South disproportionately given geography and ideological posture.  In addition, a block in central Europe (including Hungary and Poland) are critical of the EU from a different but just as fundamental of grounds.