More Bailouts: Citi Says Portugal To Need Debt Restructuring

Aug.21.12 | About: SPDR EURO (FEZ)

While everyone focuses on Spain, Italy and Greece, Portugal could well be on its way to needing another bailout package according to a new report from Citi. A review of Eurostat's report on Q2 eurozone GDP shows that Portugal's economy contracted by 1.2% sequentially in the second quarter, the most of any EU27 country. Furthermore, Portugal's economy contract 3.3% YOY during the same period, the most of any country in the EU27 except Greece. Additionally, unemployment is hovering near 15%.

Surprisingly, Portugal has had little difficulty implementing austerity measures. In fact, the country has cut its budget deficit from 10.2% to just 4.2% since 2009 with little in the way of protests from the citizenry. According to the NY Times, that could change next year if the government fails to lead the country out of recession. For its part, Citi does not believe the Portuguese economy will expand in 2013. In fact, Citi doesn't even believe the country can hit this year's deficit target of 4.5%. If Eurostat's figures on how poorly the country's economy is performing are any indication, Citi may well be correct.

It isn't all bad news in Portugal however. As noted above, the country has largely complied with the Troika-mandated austerity measures attached to the country's 78 billion euro bailout. As a result, Portugal's debt has seen some measure of relief in terms of yields lately. In mid-July yields on Portuguese 12 month bills actually fell below those for Spanish notes of the same maturity (Portugal remains shut-out of the long-term debt market and hopes to return in 2013). Yields on Portuguese 10-year notes fell below 10% in the secondary market for the first time in over 12 months in June and currently sit at around 9.61%.

Interestingly, Portuguese banks have been reluctant to buy the bonds of their sovereign in the past, even when ECB funds were available post-LTRO. Apparently, Portuguese financial institutions actually listened - imagine that - when the IMF said that, as part of the conditions for the bailout, they needed to set aside cash to guard against nonperforming loans which stood at around 12 billion euros in 2011. This reluctance of Portuguese banks to participate in the eurozone's circular funding scheme by funneling borrowed cash to their governments forced the ECB to purchase Portuguese debt in February. The banks are still short on cash though. Portuguese banks' ECB borrowings hit an all time record of 60.5 billion euros in June as the country's financial sector is still shut out of the bond market - the total fell to 56.8 billion euros in July.

Ultimately though, there are serious questions as to whether the country can continue to hit deficit targets while maintaining political stability. Citi believes the task will prove too daunting and the country will be forced into a debt restructuring:

"... we expect that, in the next 1 to 3 years [that] debt restructuring, including private-sector involvement (PSI) and official sector involvement (OSI), will take place as the Troika program likely fails to return Portugal to fiscal sustainability."

As I have said on numerous occasions however, a PSI similar to that which took place with Greek debt in March will only be feasible if the ECB (the official sector) agrees to write down its Portuguese debt along with the private sector. Private creditors have remained skeptical regarding ECB plans to shore-up struggling countries since the Greek bond swap because the central bank failed to take similar haircuts to private creditors. Since then, the issues of seniority and subordination have been front and center in discussions of debt forgiveness.

In any case, investors shouldn't forget about Portgual - any country which cuts its deficit so dramatically in such a short period of time is bound to experience a backlash in terms of pressure from the populace asking to stop the pain sooner or later. If Portugal strays from the austerity path, it could again take center stage in the unfolding eurozone drama. This is just one more reason to stay short European equities (NYSEARCA:FEZ) for the foreseeable future. As soon as one problem is addressed, another arises and this pattern is likely to continue indefinitely.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.