Portugal's Government Collapses — Will a Bailout Follow?

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Rafael Marchante / Reuters

Portuguese Prime Minister Jose Socrates announces his resignation to journalists during a news conference at his official residence in Sao Bento in Lisbon March 23, 2011.

As European Union leaders meet on Thursday for a two-day summit to hammer out a euro-zone debt crisis plan, they may be wishing they had a few extra days. Late Wednesday night, the Portuguese government led by Prime Minister Jose Socrates collapsed following a vote in parliament against the austerity package designed to curb the country's deficit. Socrates resigned and President Aníbal Cavaco Silva called for snap elections, no earlier than two months from now.

Politics aside, the nay vote will also likely lead to a financial bailout from the EU and International Monetary Fund. Markets have been predicting this since Greece and Ireland sought rescue lines last year. Now that Portugal appears to be on the same path, Spain will be next on the watch-list of indebted euro-zone countries.

Earlier this week, Socrates warned he would resign if his Socialist government's cost-cutting package, the fourth of its kind in the past year, was not approved. The measures involved raising taxes and introducing the deepest spending cuts in three decades, an unpopular combination for the Portuguese but something Lisbon said was necessary to decrease debt and avoid a European rescue.

During the parliamentary debate on Wednesday, Finance Minister Fernando Teixeira dos Santos stressed that righting the economy was no easy task. "This [deficit] reduction is not going to fall from the sky," he said. "You cannot justify the argument that more sacrifices cannot be asked for... it's a deceitful and irresponsible argument."

On March 11, Teixeira dos Santos cut pensions by more than €1,500 ($2,000) a month and made additional reductions in tax benefits. The government had earlier also imposed an average 5% decrease in public workers' salaries and called on state companies to cut expenses by 15%.

Lisbon estimates that debt will reach 87.9% of GDP this year, and 88.1% in 2012 — last year, it was 82.4%. "The bottom line is that countries such as Portugal and Spain and Greece need to pass strong austerity measures," says Gayle Allard, an economics professor at the IE Business School in Madrid. "If they did, the markets would likely leave them alone."

Socrates has governed Portugal since 2005, but his victory in 2009 did not garner him a majority in parliament. The opposition Social Democratic (PSD) and Communist parties, and the Left Bloc group, had said on Tuesday they would vote against the Socialist Party's cost-cutting plan. The PSD, Portugal's largest opposition group — whose head, Pedro Passos Coelho, is leading opinion polls as the next prime minister — allowed the government's 2011 budget proposal to pass through parliament in October only by abstaining.

Portugal had intended to sell around €20 billion ($28 billion) of bonds this year, but analysts predicted that the bonds' high yields would likely force Lisbon to accept a bailout, the country's first since 1983 — when external debt grew too large for Portugal to pay back and the IMF had to step in to help. To make matters worse, on March 16 ratings agency Moody's cut Portugal's credit rating to A3, just four steps from junk status, and gave the country a "negative" outlook.

Despite the setback for the European economy, the Portuguese crisis has not taken the markets by surprise. A much bigger question mark resides next door in Spain, Europe's fifth-largest economy. Spanish banks, especially the embattled savings banks, are being closely monitored as part of a recent consolidation of the financial sector. According to the Bank of Spain, the banking sector needs around €15 billion ($20 billion) to meet minimum capital levels imposed by the government. Analysts, however, have said the investment needed may reach €50 billion ($70 billion) to offset future losses. On Thursday, Moody's downgraded the debt and deposit ratings of 30 Spanish banks, not including the three largest: Santander, BBVA and La Caixa.

Any further economic turmoil for Spain, already mired in a deep recession after its property bubble burst in 2008, will likely capsize the increasingly unpopular government of Prime Minister José Luis Rodríguez Zapatero. With unemployment in Spain topping 20% and a €98-billion ($138-billion) budget deficit, the Spanish Socialists cannot afford another economic setback.

But the pessimism that surrounded Portugal hasn't infected its larger neighbor — yet. "It wouldn't be rational for the markets to go after Spain," says economist Allard. "Its deficit isn't too bad and it has no trouble covering its bonds. But who said the markets are rational?"