Now that the German elections are over, the euro zone needs to get back to crisis fighting. And top of the list of urgent problems is what to do about Portugal.
Uniquely among crisis countries, Portugal has seen no benefit from improving sentiment toward the euro zone. Despite second-quarter growth in gross domestic product of 1.1%—the strongest in the currency bloc—Portuguese 10-year government bond yields have soared well above 7% from 5.23% in May. Last week Lisbon was warned by Standard & Poor's that its credit rating faced a possible downgrade. Before the summer, Portugal was able to issue five- and 10-year bonds. Now it is shut out of markets again.
Blame that on June's political crisis when government squabbling over the budget triggered the resignation of highly regarded Finance Minister Vitor Gaspar. For two weeks, the survival of the coalition hung in the balance as minority party leader Paulo Portas announced his "irrevocable" resignation and President Aníbal Cavaco Silva tried to force a new cross-party government of national unity.
Ultimately, the administration led by Prime Minister Pedro Passos Coelho re-emerged at the head of an unchanged coalition, but the damage to investor confidence has been immense. Indeed, the timing couldn't have been worse. With Portugal's three-year bailout program coming to an end and with €14 billion ($18.93 billion) of bonds maturing next year, over the coming weeks the euro zone must find a way to put Portugal's funding back on a stable footing or risk seeing the crisis reignite.
There are two ways to think about Portugal's predicament. One is to look at it as a game of multidimensional chess involving the government, the markets and the so-called troika of official lenders that comprises the European Central Bank, the European Commission and the International Monetary Fund. The object is to restore Portugal's market access while avoiding at all costs any solution that involves forcing private-sector bondholders to take losses, given damage to Portuguese banks and wider euro zone contagion.
Success hinges on a series of delicate judgments. In Portugal, the focus is on whether the troika will relax the 2014 budget deficit target agreed to in June—the issue that triggered the summer political crisis. Is this target really achievable, particularly if the Constitutional Court continues to block public-sector pay and pension cuts? How would markets react to a decision to ease austerity? What signal would relaxing the target send to other euro-zone states such as Spain and Italy? What would be the political consequences in Portugal of not relaxing the target?
For investors and the troika and the markets, the more urgent question is whether Portugal's debt load—forecast to peak this year at 124% of GDP—is sustainable. The answer depends partly on how fast one assumes the economy can grow.
The Portuguese private sector may have regained some competitiveness via job cuts and structural reforms, but can an economy that managed average growth of just 1% a year between 2000 and 2010 really return to 1.8%-a-year growth by 2016 and deliver a primary budget surplus—before interest costs—of almost 2% that year and rising thereafter to bring debt down to safer levels?
But debt sustainability also hinges on what interest rate Portugal must pay. Getting 10-year bond yields back around 5% is crucial. But what would it take to persuade markets?
Would an official backstop be sufficient, such as access to the European Central Bank's Open Market Transactions bond-buying facility, or a precautionary credit line similar to the one under discussion with Ireland as its bailout program ends? Or will investors demand that official creditors first ease the debt burden by further extending the maturity and cutting the interest rates on their loans? Would the best solution be to keep Portugal out of the markets via a new bailout program?
Of course, these are urgent questions. But if the chess players focus too intensely on Portugal's next move, they risk losing sight of the endgame. The truth is that what really matters for Portugal—and Europe—in the long-term isn't whether the deficit target is 4% or 4.5% next year, but whether Portugal will ever succeed in turning itself into a dynamic economy capable of escaping its grim history of recurring debt crises and thereby removing all doubt about its place in the euro zone.
This challenge may be greater than official figures suggest. Sure, some export industries such as textiles have restructured and performed well during the recession, helping close a 10% current-account deficit in two years. But Portugal's second- quarter growth surprise was flattered by one-off factors, including the payment of public- sector bonuses reinstated by the Constitutional Court; unemployment would be well above 17% were it not for emigration. Total factor productivity growth remains among the worst in the euro zone.
Mr. Coelho has won international respect for his determined efforts to implement the troika program and address Portugal's long-term structural problems. But those problems remain considerable—and an obstacle to much-needed investment. The public sector is still too large, too well paid relative to the private sector, too inefficient and prone to cronyism.
Root and branch reform of processes and structures is needed. Currently 40,000 budget lines require parliamentary approval; the civil justice system is a mess. The government has made it easy to start a company, but it is still very hard to close one. The labor market remains too rigid, leading companies to shed jobs rather than cut wages. Meanwhile educational standards are among the lowest in the euro zone and university attendance has recently fallen.
But is the Portuguese political establishment capable of rising to these challenges? Mr. Portas's self-serving antics this summer may have secured him promotion to deputy prime minister, but only at massive cost to Portugal's credibility. The Socialist Party incites populist opposition to policies it must know it will have to adopt in government. The Constitutional Court's egregious rulings suggest it is more interested in protecting civil-service privileges than exercising responsibility to the wider economy or fairness toward younger generations.
The risk is that the crisis is causing Portugal's elites retreat to familiar comfort zones just when they need to be embracing radical change. Viewed this way, the multidimensional chess game is the least of Portugal's problems. No doubt a way will be found to finesse the immediate financing challenge, most likely involving some official-sector debt rescheduling and a precautionary credit line. But that will only buy Portugal some more time. The question is, for what?
By Simon Nyxon