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European Stability Mechanism Helps Push Portugal To The Brink

Interest-Rates / Euro-Zone Mar 30, 2011 - 03:02 AM GMT

By: Paul_L_Kasriel


Richard Thies writes: Just days after cutting the rating on Portuguese government bonds from A- to BBB, S&P took the unusual action of further reducing its rating to BBB- today. The explicit cause for the additional downgrade was the recently announced terms of the European Stability Mechanism (ESM), the structure that will permanently replace the temporary European Financial Stability Facility in 2013. Greece's rating was also cut further into junk territory from BB+ to BB-. There now exists a three-notch spread between Portugal's S&P and Moody's sovereign ratings, with the Moody's rating at A3 following a March 16th downgrade. 

The downgrade for Portugal complicates an already murky near-term financing picture for the sovereign, but more importantly provides some foreshadowing of the unintended consequences of the ESM. The salient points of the agreement are that all government debt, with the exception of IMF loans, will be subordinate to ESM debt. Further, the term sheet notes 'strict conditionality' will be a requirement of receiving ESM capital, one of the conditions explicitly noted is the involvement of the private sector. As part of this conditionality, investors will be consulted on debt restructuring and that "measures reducing the net present value of the debt will be considered only when other options are unlikely to deliver the expected results." Investors can be forgiven for not receiving great comfort from this given the success that 'other options' have had in Greece and Ireland.

It is not at all surprising that Portuguese yields are climbing to new records given that the ESM greatly reduces the attractiveness of holding Portuguese paper. Somewhat surprising, however, is that despite the fact that these new terms affect the Euro-zone as a whole, the bond market has only punished those obviously in trouble (Portugal, Ireland, Greece) while leaving other potential spillover markets (Spain) alone for the time being.  While Portugal has certainly been paying a premium at auctions in the past year, these auctions have always been met with high demand and healthy bid-to-cover ratios, reflecting the fact that investors were operating under the assumption that if a bailout was required, creditors would be protected. This clearly is no longer the case and the April rollover of €4.3 billion looms large. With only a caretaker government until June at the earliest, Portugal cannot negotiate with the EU and receiving non-conditional funding from the body seems extremely unlikely at the current juncture. Despite this, Lisbon continues to insist that it does not require a bailout.

There is much uncertainty about the cash position of the country and whether an outright default in the Euro-zone could be less than a month away. However, our belief is that the sovereign has enough flexibility to stay current on payments until June when a new government may have to negotiate a bailout. Notably, the country has $17.3 billion in gold reserves held by the Bank of Portugal. The laws governing the central bank currently prohibit transferring the proceeds from the sale of these gold reserves into the state treasury and the ECB has restrictions about how much gold member states may sell. However, one could easily see both of these restrictions being reviewed in the 11th hour.

The Northern Trust Company
Economic Research Department - Daily Global Commentary

Copyright © 2011 Paul Kasriel
Paul joined the economic research unit of The Northern Trust Company in 1986 as Vice President and Economist, being named Senior Vice President and Director of Economic Research in 2000. His economic and interest rate forecasts are used both internally and by clients. The accuracy of the Economic Research Department's forecasts has consistently been highly-ranked in the Blue Chip survey of about 50 forecasters over the years. To that point, Paul received the prestigious 2006 Lawrence R. Klein Award for having the most accurate economic forecast among the Blue Chip survey participants for the years 2002 through 2005.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.

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