Against the tide: Debt crisis – Is Portugal the last domino?
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Against the tide: Debt crisis – Is Portugal the last domino?

Portugal’s debt crisis is as severe as Greece’s but can be resolved, painfully. The big upcoming sovereign debt risk is not from the eurozone but from the US and Japan.

Portugal has joined Greece and Ireland in Europe’s intensive care unit for sovereign debtors. It was long overdue.

Portugal’s debt crisis is not like Ireland’s: caused by an oversized banking sector that went belly up, forcing the sovereign to take the losses. It is like that of Greece: the result of uncontrolled state spending, weak growth and lack of competitiveness, leading to excessive sovereign leverage. So it is going to take a lot longer to turn around than a situation like Ireland’s.

There are two principal sources of the euro debt crisis. It is either caused by profligate state spending and a low tax base that lead to rising government deficits, a loss of competitiveness and excessive sovereign leverage (Greece). Or it is caused by an oversized banking sector inducing a credit bubble that bursts, forcing the sovereign to take bank losses onto its balance sheet (Ireland). Portugal fits the first category, so its solutions are similar to Greece’s: downsizing the state sector and increasing competitiveness and productivity.

Although both types of debt crisis involve the common denominator of budget austerity and pain, beyond that their characteristics dictate different resolutions. In a nutshell, the key to solving the Irish-type debt crisis lies in a recovery in asset markets. The key to solving a Portuguese-style crisis involves curbing the electorate’s entitlements – a more difficult process.

Portugal stands out for its weak contribution from productivity, its labour market rigidities and the lack of competition in its
non-tradeable sectors

The problem for Portugal and Greece is that a sovereign debt crisis caused by profligate budgets and accumulated debt is a longer and slower process to put right because government spending on health, welfare, and other entitlements must bear the whole burden of adjustment. In contrast, for Ireland there will be step-changes downward in sovereign debt as asset markets recover. Then state funding to banks can be withdrawn, bad loans and collateral can be liquidated and the state can receive some proceeds in return.

For Portugal, as for Greece, the problem of excessive sovereign leverage was a result of a lack of competitiveness. Portugal did not grow like the Celtic tiger, Ireland, and did not even participate in the credit-fuelled boom that southern Europe experienced between 2001 and 2007. Real GDP growth averaged only 1.1%, making it the slowest-growing country in the entire eurozone during this period. Growth per capita was even slower, at only 0.4% a year.

Portugal stands out for its weak contribution from productivity, its labour market rigidities and the lack of competition in its non-tradeable sectors. The competitiveness gap in tradeable markets is as much as 40%, exports have lost market share and Portugal runs one of the largest current account deficits and stocks of international liabilities in Europe. In contrast, Ireland now runs an external surplus, while exports, which have a value equivalent to 100% of GDP, are growing at 20% year on year. While Portugal’s sovereign debt level is not the highest in the eurozone, private-sector leverage (household and corporate) makes it one of the most indebted.

Required primary balance to stabilize debt  
Source: OECD

The government’s non-cyclical structural deficit was over 7% of GDP, entitlement spending on health was rising at 10% a year and the civil service wage bill was out of control. At the same time, tax revenues were falling, with gross financing needs reaching 40% of total tax revenue this year. So Portugal enters the eurozone’s emergency ward and is put on life support, but it will have to take some nasty medicine to get out of hospital. If there is no debt contagion to Spain, Belgium or Italy – and that seems likely – then managing the PIG-3 without a euro crisis is probable. There are enough bailout funds available. Even the much-talked-about restructuring, defaults or bond haircuts by all would be manageable once the European Stability Mechanism is established in 2013.

All this suggests to me that the real sovereign debt risk over the next few years will not be in Europe but in the profligate big economies of the US and Japan, which have gross debt levels larger than Spain or Portugal, budget deficits still near 10% of GDP and no effective plans to reduce them. And the monetization of debt there continues apace.

David Roche is president of Independent Strategy Ltd, a London-based research firm. 

See also

Banks tell Portugal to get its house in order 

THE MESSAGE OF the Portuguese bankers to their new government, elected on June 6, is blunt. Effectively: "We’re putting our house in order, now you do the same!"

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