Running (almost) on Empty

09/03/2011 Fabio Scacciavillani

While attention is focused on the domino effect in the Southern Shore of the Mediterranean Sea, another domino piece in a different game is about to fall on the Northern Shore. At yesterday's auction for 1 billion euro Portuguese 2 year bonds the average interest rate was almost 6%. Meanwhile the 5 year rate is above 7.6%. A simple spreadsheet shows that if the current interest rates do not fall substantially Portugal's situation is unsustainable, i.e. the debt to GDP ratio will keep climbing relentlessly.

The fiscal crisis in Portugal seems to have reached a critical juncture. As most observers have been warning, it is only a matter of time before Portugal defaults or, to be precise, is forced to request an IMF/EU bail out. That moment seems to be approaching fast, despite a stubborn refusal by the Portuguese government to resort to outside help (which, by the way, has already materialized in the form of purchases by the ECB of Portuguese bonds on secondary markets).

On March 2, S&P warned sternly that if Portugal's sources of external financing remain so feeble, the country will be forced to request a rescue package from the EU/IMF. The ratings agency was also adamant that a downgrade for Portugal is on the cards. With the Greek debt placed by Moody’s in “high speculative territory” three days ago, Spain's debt downgraded again this morning, Portugal’s debt credit review already announced by Moody’s (expected to be completed by March 21) will not be benign. Moreover all three major ratings agencies have Portugal on negative outlook.

EU officials have already drafted a rescue package, in the expectation that Portugal is unlikely to find enough funds on the market beyond April 2011 at rates that are compatible with long term solvency. Yields on 10-year Portuguese government bonds are above 7.5% despite the ECB intervention and its “moral suasion” exerted on major investment banks not to take short positions on peripheral countries' debt. Yesterday's auction of € 1 billion 2-year bonds by Portugal adds to concerns given the average rate was just short of 6%, up from 4.1% for a similar bond issue on Sep. 8^th. But this was just the appetizer for the next large redemptions of 10 year bonds in April and June (see the graph in Fig. 1 below).

The Portuguese government refuses to request an IMF/EU program. This is exactly the stubborn course of action already adopted in vain by Greece and Ireland (and countless countries before them). Waiting until the last second carries substantial risks of market disruption and imposes a higher cost to the domestic economy, which could be mitigated by an orderly approach. Besides, the 2011 budget does not provide any forecasts on key fiscal variables (nor the assumptions on debt service) beyond 2011, so the medium term framework is left to the imagination, rather than actual provisions. The most recent three-year forecast by the Portuguese authorities dates back to last spring when they presented to the EU authorities their Stability and Growth Program 2010-2013. The assumptions underlying that document are by now largely irrelevant.

What the Portuguese authorities do not seem to realize is that Portuguese bond prices are artificailly boosted by expectations that if the large redemptions due in April and June run into difficulties, the international organizations will step in with emergency funds. Paradoxically then, the Portuguese debt benefits from the fact that markets do not take seriously the government’s refusal to resort to the IMF/EU.

Simple Debt Arithmetic

The debt is sustainable if the sum of the primary government balance (i.e. net of interests) as a percentage of GDP plus the nominal GDP growth rate, is lower than the debt service i.e. in symbols,

i < pb + gdp

Current interest rates on medium term maturities are well above 7% and would be much higher if the ECB did not intervene heavily to sustain Portuguese government bond prices and if the markets were not confident that in case of default the IMF and the EU have already in the coffer enough money for an immediate bail out. As a matter of comparison the Greek 10-year debt yields more than 12% despite the IMF/EU support.

The spreadsheet depicts three scenarios: one, in the blue cells, is the combination of the Portuguese figures contained in the 2011 budget and the IMF World Economic Outlook projections (the interest rate assumptions for the WEO are not disclosed so I had to guess a profile that was consistent with the other series). The second, in the orange cells, is the scenario in which interest rates remain above 7% for the foreseeable future; by changing the assumptions on the relevant variables you can design your own scenario. The third scenario on the right hand side table refers to the Portuguese government's assumptions contained in the 2010-2013 Stability and Growth Pact program presented in March 2010 (which I just projected for an additional year). This graph summarizes the results with the green line representing the SPG forecast exercise.

Even assuming a primary deficit of 2%, interest rates slowly coming down (which is unlikely) and a gradual recovery despite the fiscal tightening, the debt to GDP ratio will not stabilize (orange and blue lines). The trajectory of the debt points upward. So at some point the investors will demand an interest rate so high that that it will de facto force Portugal into default. Hence the likely showdown on the markets will take place before April when a large stock of bonds is expiring (see graph below). So far the Portuguese debt rollover has involved mostly short term paper which investors have been willing to refinance because of the short term exposure to risk. and because the ECB accepts them as collateral in the weekly repo liquidity operations. For longer maturities (which extend beyond the expiration of the ESFS (the EU guarantee scheme) in 2013, investors will be much less eager, given that the German government, which will be the main contributor to any EU funding facility, has been explicitly envisaging that bondholders share the pain of any bailout.

Fig. 1 - Maturity of the Portuguese bank and government debt

_{Source: Bloomberg}

The significance of a Portuguese downfall goes beyond the size of the country and has systemic implications. Support for Portugal will more or less absorb most of the residual ESFS funds so that there will be no significant line of defense left for other emergencies.

So the Portuguese woes are likely to re-ignite the political squabble within the EU between Germany and its close partners (Austria, Netherlands, Luxembourg, etc.) which demand draconian fiscal austerity and the peripheral countries which are pushing for the creation of some form of Federal European Debt Agency.

Over the next few weeks bond markets are bracing themselves for another storm over Euroland especially in view of the next European Council on March 24-25 where the decision on the EU fiscal arrangement and crisis management framework must be taken. The euro might come under renewed strain and the ECB will be compelled to intervene to support the banking system with liquidity injections and government bonds purchases on the secondary market. It is doubtful that the interest rate hike (ventilated by Trichet in his press conference and confirmed forcefully by Weber) will take place in April. In an environment already nervous for the oil market pressures and the political uncertainty in the Arab world, the impending crisis in Europe is developing at the worst possible moment. That's why it should be pre-empted.