Why the Markets Are Against Portugal

Since the start of the Greek crisis, bond investors have been eyeing Portugal as next in line for a bailout—if not default. As the Lisbon stock index sank (down more than 14 percent so far this year) and the credit default swaps market ranked Portuguese debt alongside that of Lebanon, Portuguese Prime Minister José Sócrates and his colleagues fought back, swearing that their country, one of the euro zone's poorest, would not go begging to Brussels. Finance Minister Fernando Teixeira dos Santos put it this way after Standard & Poor's Apr. 27 downgrade of Portuguese debt: "There are no reasons for markets to look at Portugal as they have been doing with Greece."

The markets have roundly repudiated that view. Many bondholders are now convinced that only a much larger program of fiscal austerity for the euro zone's vulnerable southern tier will reassure them. So just days after the Greek bailout, investors drove Portuguese stocks down almost 4 percent in one session: Yields on Portuguese two-year bonds topped 5 percent, way above the 1.3 percent they were yielding in January. The Portuguese reacted with dismay, blaming the excesses of naked capitalism. One politician, Francisco Louça, thundered about "attacks by international gangs."

Sócrates does not have a lot of cards to play. He points out, rightly, that Portugal did not fiddle its numbers the way the Greeks did and that Portugal's public debt, at 77 percent of gross domestic product, is lower than that of Greece and on a par with France. He and his ministers also successfully lowered the budget deficit in 2007 after spending spun out of control.

Investors, though, are not in a generous mood. Portugal's economy has grown less than 1 percent a year on average for the last decade. Its main advantage, cheap labor, gradually disappeared when it joined the pricey euro zone and wages kept rising. "We have seen a lot of multinational activity move away, and we have not been able to compensate," says Miguel Athayde Marques, chairman of Euronext Lisbon, the country's bourse. Labor costs have surged 3.4 percent a year, compared with 1.7 percent in Germany, and Portugal's productivity is the lowest in the euro region, according to the EU's statistics office.

As for Portuguese debt, throw in corporate and household obligations and you reach 236 percent of GDP, worse than Greece and Italy. The prospect of economic growth paying all that off is remote. "The reason we're concerned about Portugal is not because its public debts are especially high, it's more that the economy doesn't really grow," says Kenneth Wattret, chief euro region economist at BNP Paribas in London.

Portugal plans to raise as much as 25 billion euros this year to pay off earlier obligations. Luring buyers will be expensive. Yields of almost 6 percent on Portuguese 10-year bonds are nearly three percentage points higher than German bonds. Investors are trying to avoid being ambushed by the "next Greece," says Olaf Penninga, who helps manage $187 billion at Robeco Group, a Rotterdam-based asset manager.

Portugal's savings rate, at 10 percent, is the fourth-lowest among 27 members of the Organization for Economic Cooperation & Development, according to the Paris-based group's data. Low savings have fostered a dangerous dependence on foreigners to fund the deficit.

Sócrates, a Socialist, has been running a government without a parliamentary majority since his reelection in September, making it harder to push through unpopular legislation. We face tough times, says Filipe de Botton, co-chief executive officer of Logoplaste, a maker of plastic packaging headquartered near Lisbon. The government will have to lower salaries in the public sector. We will probably have to increase taxes.

Before adopting the euro, Portugal could devalue its currency to boost competitiveness. That option no longer exists. Instead, it has to restructure its debt, says Stuart Thomson, who helps oversee $100 billion at Ignis Asset Management in Glasgow. Debt restructuring, explains Thomson, "is the new currency devaluation in the euro zone."

The bottom line: The real issue is competitiveness. Portugal needs better-educated workers and looser labor rules to attract multinationals.

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