Portugal's government almost disintegrated last week but has now managed to shore up its support, bringing some calm to the country's bond market. But the political chaos could still have far-reaching implications.
Portugal's chances of regaining full market access now look much slimmer. That means the country will need more money from its troika of international lenders. But that could lead to a debt restructuring – potentially upsetting the tentative peace that the European Central Bank has brought to the continent's bond markets.
"It will be far more difficult for Portugal to fund itself in the market now," says Myles Bradshaw, a portfolio manager at Pimco. "The risks are that private debt rescheduling is used to lower the costs of any second troika program."
European leaders have promised that Greece's restructuring will remain unique, and the recent Portuguese turmoil was largely contained within its bond market. Germany will be loath to make any decisive moves that could destabilise the calm ahead of its September election and Lisbon is funded until May next year by the troika and recent debt sales.
However, one of Portugal's official lenders may prove wary. The International Monetary Fund usually requires a viable funding plan for the next 12 months for it to distribute its funds. A country's debts must also be considered sustainable. Portugal looks vulnerable on both accounts.
Combined with existing market jitters over the looming end of U.S. quantitative easing, the recent turmoil is a big setback for Portugal's plans to start regularly selling bonds. And a deeper-than-expected recession and stubborn budget deficit have increased the debt burden.
The IMF has estimated that Portugal's debts will peak at 124 per cent of gross domestic product next year. Many analysts and investors are more pessimistic. RBS estimates it will hit 134 per cent of GDP in 2015 – close to the bank's previous worst case scenario.
This is not nearly as bad as Greece's predicament before it restructured – a process euphemistically dubbed "private sector involvement," or PSI, by European officials leery of calling it a debt restructuring. Even now the IMF expects Greece's debt ratio to peak at 176 per cent in 2013 and only decline to 124 per cent by 2020.
"This would suggest that under the current scenario it would be incredibly difficult to justify a PSI in Portugal on the back of the Greece precedent," Deutsche Bank analyst Abhishek Singhania said in a note.
The IMF may see things differently. It has recently published a report criticising its own timidity on the Greek program. The Fund has separately published a broader report arguing that it should in the future engineer restructurings sooner when there are any doubts over a country's solvency.
The makeup of Portugal's lenders would make a restructuring tricky. Deutsche Bank estimates that the troika make up 43 per cent of the roughly €200-billion ($270.3-billion) government debt load. Domestic investors – mostly banks and insurers – hold 35 per cent, while foreign investors only hold roughly 22 per cent.
However, RBS reckons Portuguese banks are strong enough to weather a sovereign restructuring. That may well make one more likely. Mr. Bradshaw doubts creditors will suffer haircuts, but sees the most likely outcome being an extension of bond maturities though a "voluntary" bond exchange with local banks and investors that the government can lean on.
Many analysts and investors still think a restructuring is unlikely. The IMF might decline to join a new program, but Mr. Singhania estimates that Portugal needs roughly €30-billion to fund itself in 2014-15. This could be provided by the euro zone's bailout fund. Portugal's strict adherence to its program could also win it a euro zone debt reprieve.
"The end of the program is still a year away, and a lot can happen in that time," points out Nicholas Gartside, head of international fixed income at JPMorgan Asset Management.
He predicts any funding shortfall will be covered by "tweaking existing loans and programs, which is a lot easier and less emotive than outright restructurings or re-negotiating entire programs."
Nevertheless, a restructuring is still a risk. Germany will avoid any decisive moves ahead of elections, but is clearly becoming keener on creditors bearing the cost of bailouts. If a debt restructuring does occur, it could well escalate market tensions again and uncork the crisis genie the ECB managed to bottle up a year ago.