Markets Insight
April 16, 2012 3:46 pm
Don’t let Spain detract from Portugal
The latest news from Spain makes for depressing reading. But despite the growing concerns about the eurozone’s fourth largest economy, Portugal poses a greater threat to the European Union.
Much has been written about Spain’s deteriorating economic situation. The economy is back in recession and expected to contract by 1.7 per cent this year, and unemployment is nearly 23 per cent. It took less than 100 days for the new government to face its first general strike on March 29, and with further austerity measures planned, more civil unrest is highly likely.
Spanish banks, which are heavily exposed to the deflating real estate bubble, are also likely to need more capital as the economy continues to struggle. Moreover, the poor PR effort surrounding the sequential adjustments of the Spanish deficit objective for 2012 and the disappointing increase in the European bailout facilities did not help calm down market worries over Spanish debt problems.
It is not surprising therefore that the yields on Spanish government 10-year bonds have climbed more than 100 basis points to more than 6 per cent since March 3, their highest levels since early December because investors are becoming increasingly sceptical about the Spanish government’s ability to reach the budget objectives and re-inject some vitality into its sluggish economy.
Despite all of this, we still don’t feel that Spain will need the sort of bailout that Ireland and Portugal required. Indeed, the possible contagion risk from Portugal is greater than that posed by Spain.
The needed adjustment to restore its competitiveness is even greater in Portugal and its long-term growth potential is lower. As a result, relative prices will need to fall more in Portugal than in Spain and the additional run-up in its debt-to-gross domestic product ratio also looks set to increase substantially in that process over the next decade.
In 2013, the country’s bailout runs out and it is expected to start borrowing in the free market again. However, it may struggle to convince investors of its creditworthiness. The economy is entering a second year of recession, and growth is expected to fall by 3.25 per cent this year, following a decline of 1.5 per cent last year. Unemployment continues to rise, hitting 15 per cent in February, and the cost of 10-year borrowing is still above 10 per cent. There is also considerable speculation that the country will need a second bailout. Once the market starts to anticipate this, a self-fulfilling dynamic might develop that pushes Portuguese yields towards Greek levels.
That should not take away from the fact that the country has been applauded for a good implementation programme concerning its fiscal and structural reform targets, and it has broad political and social consensus for this. However, this could be tested as further structural reforms in labour and product markets still seem necessary. Equally important, however, will be the “trust” that the rest of Europe will continue to have in the efforts of the Portuguese government to pursue this path of ongoing structural reform.
The Iberian republic may yet need a new support package from the EU and International Monetary Fund before the year is out. Even so, ongoing Troika support and constructive co-operation with other European stakeholders makes containment of the problems most likely. It would not only minimise the negative impact on the rest of the European economy and its treasury markets, but also create the higher probability that the needed long-term rebalancing objectives are actually achieved.
Looking more short term, the good news is that Portugal has actually become less influential on the Irish, Spanish and Italian treasury markets. Since the beginning of the year, the co-variance in 10-year yields in Portugal and the rest of the peripheral nations has been either negative or close to zero. For nearly all of the two years before that, the co-movement was clearly positive.
This offers some hope that a near-term escalation of the euro crisis and widespread contagion into treasury markets outside of Spain and Portugal is less likely than during stress periods last year. Especially if it continues to be coupled with a recovery in the global economy and much needed external demand for European economies.
Still, the ability of market sentiment to create its own reality in this crisis should never be underestimated, so cautious optimism that market stress will fade in the near term is all that can be offered at this stage.
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Valentijn van Nieuwenhuijzen is head of strategy at ING Investment Management
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Copyright The Financial Times Limited 2012.
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