After a lull over the Christmas and New Year period, the euro zone is back to where it was for much of 2010: buffeted by markets and staggering from one crisis to another. The markets have picked up where they left off, circling Portugal whose shaky public finances and low growth prospects make it seem a dead cert for a bailout. The question for the 17 euro zone countries up one since Estonia joined on Jan. 1 is whether they can contain the damage before it infects everyone else.
Portugal, naturally, insists it is doing swimmingly. Indeed, the country passed a key test Wednesday, when it raised $1.62 billion (€1.25 billion) in an auction of four and 10-year bonds, suggesting it can still borrow money from the global markets despite its debt and deficit problems. And, in a routine recalling the strenuous denials of Irish and Greek ministers just before they took their own bailouts, Lisbon has dismissed claims that it would seek a rescue package. "Faced with this result, there is no need for outside help," Finance Minister Fernando Teixeira dos Santos said after the auction. "The success of today's issue shows that Portugal has the necessary conditions to finance itself."
But this cheery interpretation is not shared by economists, who say Portugal has merely bought itself some time before dipping into the $980 billion (€750 billion) bailout fund set up last year by the European Union and the International Monetary Fund (IMF). "Portugal will have to access the stability fund," says Colin McLean of U.K.-based SVM Asset Management.
Closer inspection of the bond sale suggests as much: the yield, or interest rate Portugal must pay to borrow funds, on the 10-year bond was an average 6.72%, a figure that woefully exacerbates debt in a country whose nominal GDP growth last year was just 1.4%. Portugal's government needs to borrow around $26 billion (€20 billion) from the markets this year; a 6-7% interest rate for this sum would probably bankrupt the country. Indeed, the suspicion amongst market analysts is that the main buyer of these bonds was none other than the European Central Bank, which has an obvious interest in ensuring Portugal's stability.
Lisbon insists its situation is different from those of Greece and Ireland, which respectively agreed to $145 billion and $110 billion bailouts from the E.U. and IMF last year. It says its deficit and debt are lower than those nations', its banks are sound, and Portugal has not experienced a property bubble. Like many E.U. countries, it has introduced a raft of austerity measures aimed at nursing public finances back to health, even if Portugal's mix of tax hikes and pay cuts also risks further dampening down consumer demand.
But as with Greece and Ireland, there are profound questions about where Portugal will find its growth to pare down its debt. After a meager recovery in 2010, Portugal's economy is now forecast to shrink slightly in 2011. Without the option of devaluing its currency, Portugal's combination of debt and poor competitiveness puts it in a tenuous position.
This, more than the official denials, best explains why markets seem convinced a bailout is in the offing. And why according to German magazine Der Spiegel France and Germany are both pressing Portugal to tap into the E.U.'s rescue fund. Compounding the problem, Portugal has a presidential election on Jan. 23, which is likely to freeze government decision-making until the vote.
But if Portugal cannot escape a bailout, will the euro zone at least be able to limit the contagion? This week, Belgium and Italy both felt a chill from the markets over their own debts, but E.U. policy-makers appear most anxious about ring-fencing Spain. It's the fourth-largest economy in the euro zone and, like Portugal, it needs to rollover tens of billions of euros in government debt in the first quarter of this year. And the E.U. and IMF rescue fund, massive though it is, is unlikely to cover any Spanish bailout.
Which is why E.U. officials have begun whispering about raising the bailout fund. No figures have yet been mentioned, but it would have to be significantly larger to head off market anxieties, and offer an interest rate that could reasonably allow users to pay back the loans. This is perhaps the real significance of Portugal's bond sale, according to Carsten Brzeski, Senior Economist at ING Bank in Brussels. "It has bought the E.U. time for another rescue mechanism or bazooka to prevent any contagion," he says. "Could it solve the crisis? No, because these countries are currently in an economic mess as well as a financial mess. But it gives them room to breathe."