Portugal debt worries to stem euro rally
The euro continues to defy gravity, enjoying a New Year rally as optimism over abundant ECB liquidity eases some debt concerns, but building pressure in Portugal is set to undermine the single currency.
While most of Europe has enjoyed some respite after the implementation of the ECB’s long-term refinancing operation and hopes for a deal over private sector involvement for a rescue deal for Greece, Portugal has suffered on rising concerns that Lisbon might need another bailout from its eurozone partners. Concerns over Portugal rest not on its public debt – which at 113% of GDP is relatively modest compared with Greece – but on the country’s total debt burden, much of which is owed to overseas lenders and stands at a whopping 360% of GDP.
Those worries were exacerbated by Standard & Poor’s decision – after moves from Moody’s and Fitch last year – to downgrade Portugal’s sovereign credit rating to junk status on January 13.
Since the downgrade, Portuguese government borrowing costs have soared, with the yield on two-year bonds rising from below 13% to 21% and 10-year yields rising from 12.5% to above 17%.
Both moves match closely with the increase in yields seen at the start of the second Greek crisis at the end of the first quarter last year.
Furthermore, the five-year credit default swap on Portuguese government paper has risen from 1,173 basis points to 1,548bp, a record high. This is roughly where Greek CDS stood in late April 2011 and well above the levels reached by Icelandic CDS in 2008.
Greece, Portugal 5-year CDS versus EURUSD
Simon Derrick, head of FX research at Bank of New York Mellon, says that the bank’s custodial data flow, unsurprisingly, has seen renewed outflows from Portuguese debt since mid-January. He says for all the talk of creating a firewall around Greece, it seems clear that eurozone officials have so far failed to build one.
“As a result, the Portuguese debt markets are following a very similar trajectory to that taken by the markets in Athens during the second quarter of last year as the second Greek crisis took hold,” says Derrick.
“In the absence of a more meaningful response from the eurozone authorities, the danger must therefore be that Lisbon experiences a similar collapse in confidence.”
Chris Turner, head of FX strategy at ING, says these contagion risks, left unattended, could again weigh on the euro.
He says the principle concern for Portugal is that there is no natural buyer for its debt now that the downgrade to junk status has caused its paper to fall out of key bond fund indices.
This raises the question of whether Portugal will comply and move to undertake more austerity measures to improve investor confidence in its debt, or point to the precedent of Greece having written off 50% of its debt.
If the problem is left unchecked, contagion could again spread through the Spanish banking sector, which, according to data from the Bank for International Settlements, owns 43% of foreign claims on Portugal.
Foreign claims on Portugal by nationality
“Admittedly, most of these claims are on the Portuguese corporate sector rather than Portuguese government debt, yet, as in Greece, the fear will be that all assets could be hit hard,” says Turner.
“Thus, while EURUSD seems quite bid short term, it is far too early to sound the all-clear on Europe, and we look for a move back to $1.25 by the end of this quarter.”