As Portugal Prepares to Exit Crisis, Will It Still Need a Safety Net?

Europe File: Country's Economy Recovers Better from Deep Recession than Has Often Seemed Likely

Simon Nixon

Portugal is the star pupil of the euro-zone crisis countries, its economy recovering better from its deep recession than has often seemed likely since it was forced to seek a bailout three years ago.

In the final quarter of last year, its economy grew at an annualized rate of 1.6%, the fastest in the euro zone; this year, the Bank of Portugal expects it will grow by 1.2%, having raised its forecast by 0.4 percentage points in three months. Privately, many in Lisbon believe the outcome could be even better.

Exports have grown by 24% since 2008, with the improvement spread across all sectors, boosted by almost 400 separate structural initiatives that have removed obstacles to growth. Exports now account for 41% of gross domestic product, up from 28% in 2008, and have helped turn a current-account deficit of close to 10% of gross domestic product in 2008 into a surplus last year, the first in two decades.

At the same time, unemployment has fallen by two percentage points from its peak to close to 15%, still far too high, but low enough to provide a boost to domestic demand. As a result, this year's budget-deficit target of 4% – the subject of a serious political crisis as recently as summer – now looks well within its grasp.

Net government debt – excluding cash reserves – is likely to have peaked last year at 120% of GDP. Partly in reflection of this success, yields on Portuguese government bonds have fallen sharply, with the 10-year bond yield last week falling below 4% for the first time since 2008.

This improvement in investors' sentiment couldn't have come at a better moment for the government of Prime Minister Pedro Passos Coelho. Portugal's three-year bailout program with its troika of international lenders – the European Commission, the European Central Bank and the International Monetary Fund – comes to an end in May.

Not so long ago, many troika officials feared that when this moment arrived, Portugal would need a second bailout. Now the discussion is how best to exit the program: with a precautionary credit line from the European Stability Mechanism; or, like Ireland, with no safety net at all?

The temptation to follow Ireland's example is inevitably strong. For many Portuguese, the involvement of the troika was seen as foreign servitude, at odds with the country's self-image as Europe's oldest sovereign state within stable frontiers.

Even so, there are crucial differences between the circumstances of Portugal and Ireland.

First, Ireland's government debt was rated investment grade by the credit-rating firms when it exited its program whereas Portugal's still has a junk rating. That didn't stop Portugal attracting strong demand from international investors when it issued its first five – and 10 – year bonds since the crisis in January and February, but it does mean that there is a smaller pool of eligible investors for Portugal's bonds than for Ireland's.

At the same time, Ireland had a €20 billion ($27.5 billion) cash buffer sufficient to cover its funding needs for a year when it exited its program. Portugal's cash cushion isn't yet so far advanced. That suggests that Portugal is more vulnerable to future market stress.

Second, Portugal's recovery also remains vulnerable to its very high levels of private-sector debt, which stood at 224% of GDP at the end of 2012, according to Eurostat. Corporate debt in particular remains stubbornly high, despite a wide-ranging overhaul of the insolvency rules and pressure from the Bank of Portugal on banks to fully write down the value of bad loans.

That indicates that viable companies are still struggling to restructure their balance sheets and find new capital for investment, thereby putting a cap on the country's long-term growth outlook.

Meanwhile, credit continues to contract, down 7.4% in the year to the end of February. Although the Bank of Portugal is confident that exporters have been able to secure finance, credit conditions for households and domestically focused companies remains tight.

One problem is that the banks are continuing to deleverage to strengthen their capital and liquidity positions. Although the banks meet minimum capital requirements, some are diverting profit that could be used to support new lending to repay expensive contingent convertible bonds provided by the government during the crisis, which still comprise a significant share of their capital base. Portuguese banks are still reliant on the ECB for a portion of their funding, creating further pressure to shrink.

Given this continued weakness, it is striking that no Portuguese bank has issued equity in the past year. In contrast, two Greek banks last week raised €3 billion in fresh capital at close to book value.

Finally, there is still concern in Frankfurt, Brussels and Berlin over the degree of political commitment in Portugal to maintain the momentum of its adjustment process after the formal program is ended.

Although the opposition Socialists say they will respect European Union fiscal rules, they have consistently opposed many of the government's fiscal measures. They have also referred a number to the Constitutional Court, which has adopted the broadest possible interpretation of its responsibilities to side with the opposition on politically contentious issues. This is making the adjustment process much harder.

With a general election due in 2015, will a future government continue to prioritize debt reduction and growth-friendly tax cuts over current spending? Would it continue to push ahead with further vital structural changes identified by the troika in areas such as further liberalization of the labor market and overhaul of the public sector?

Given this uncertainty, some officials in Lisbon and elsewhere counsel that Portugal should seek the security of a European Stability Mechanism safety net. The question is what conditions the euro zone may attach to its continued support. Much will depend on how far Portugal's three main political parties are able to reassure its partners that it will stick to the strategy that has already yielded positive results.

The greater the commitment, the lighter the conditions. Of course, if the commitment was truly credible, Portugal might not need a safety net at all.

Simon Nixon, The Wall Street Journal, March 30, 2014