FOREIGNERS SHUN EUROPE´S BONDS, AND DEBT PILES UP / THE NEW YORK TIMES NEWS ANALYSIS ( A MUST READ )

January 11, 2011

Foreigners Shun Europe’s Bonds, and Debt Piles Up

By LANDON THOMAS Jr.

ATHENS —  Greece. Ireland. And now, it seems, Portugal.


While the circumstances that have driven these debt-ridden members of the euro zone to the brink differ, they share one common characteristic: all three countries aggressively tapped their domestic banking systems for more debt long after they had been shut out of international bond markets.


With its 10-year debt trading near the record high of 7 percent reached last week, Portugal will try on Wednesday to sustain what many have come to see as nothing more than a form of bond market charades. It will try to raise up to 1.25 billion euros ($1.62 billion) in long-term financing — debt that is expected to come largely from the country’s already depleted banking system.


For Portugal, as it was for Greece and Ireland before their bailouts, borrowing at such high rates from lower-quality lenders may demonstrate its economic sovereignty. But to an increasingly skeptical marketplace, borrowing on such terms reflects nothing more than the country’s unwillingness to accept the harsh reality of its fiscal condition.


As a result, the Portuguese banking system takes on more debt, making it harder to restructure and thus requiring the government in Lisbon to impose more pain on its citizens, a dynamic that is now playing out in Greece.


“Eighty percent of Portugal’s debt stock is held by foreigners,” said Jonathan Tepper, an analyst at Variant Perception, a research firm in London. “But the flow, now, is being financed domestically.”


As its interest rates moved above 6 percent, Greece bowed out of the markets and soon after had to accept a bailout.


Portugal has so far insisted that its financing needs for this year — about 20 billion euros — or 11 percent of its gross domestic product — are manageable, and compared with what Greece owed last year, they are.


But with its gaping current-account and budget deficits, combined with a negligible growth rate, the market consensus is that Portugal must soon accept a bailout from Europe and the International Monetary Fund. Analysts say they believe it will involve a package of 50 billion to 70 billion euros, smaller than the Irish or Greek bailouts.


All sides emphasize, however, that nothing can happen until Portugal feels it has no other choice and formally requests aid.


To date, Portugal has vigorously denied that a rescue package is imminent, and Prime Minister José Sócrates reiterated that stance Tuesday. But the view in the marketplace is that it is just a matter of time before the country throws in the towel.


In fact, some may ask what took so long.


A year ago, the I.M.F. published the following in its annual assessment of Portugal’s economy. “The outlook: bleak.”


The fund’s economists added, “The staff’s baseline scenario envisages modest adjustment, weak growth and continuing unsustainable imbalances.”


Like Greece and Ireland before it, Portugal’s financing needs have become all the more dire as the foreign investors that once bought its securities stay away. They have been scared off as Europe moves closer to formalizing a new mechanism that could require the holders of bank and sovereign debt to take losses on their positions in the event of a future crisis.


But regardless of what happens to Portugal in the short term, the increased amounts of sovereign debt it is taking on compounds a recurring theme: domestic banking systems are absorbing higher levels of dubious debt, which not only infects their balance sheets but could well end up being restructured.


Consider the situation in Greece.

According to research from Goldman Sachs, Greek banks, not those in Germany and France, are the largest holders of risky European debt. Indeed, the bank with the largest single exposure to Greek, Irish or Portuguese sovereign debt is the National Bank of Greece, which owns nearly 20 billion euros of Greek government obligations.


All together, Greek banks hold 62 billion euros in sovereign Greek debt.


Such a buildup within a country’s own banking system makes it all the more difficult for a government to propose a debt restructuring, given that the country’s local banks and its many unionized employees will suffer, not just faceless hedge funds abroad.


In Greece, the government is in the middle of a tough restructuring program that focuses on cutting public sector wages and pensions. The only major line item of the budget that is increasing is debt interest, which, according to the European Commission, will exceed government proceeds from direct taxes by 2014.

Still, government officials and bankers are resolute in insisting that Greece will not restructure its sovereign debt, and that to do so would be unacceptable after having accepted so much money from Europe and the I.M.F.


“A large part of the Greek debt is hidden on the balance sheets of the Greek banks,” said Theodore Pelagidis, an economist at the University of Piraeus and the co-author of “Understanding the Crisis in Greece,” a scathing account of Greece’s economic implosion. “So you cannot just say ‘Let’s restructure.’ It is not so easy.”


Goldman estimates that requiring a lender to give up 40 percent on holdings of Greek sovereign debt would result in a loss of 5.3 billion euros for the National Bank of Greece, the country’s largest bank. While that bank, which is in the process of raising fresh cash, probably has the capital to survive such a loss, Greece’s other banks may not be so lucky.


As for Portugal, its domestic debt burden is divided more proportionally among foreign and domestic banks, compared with Greece. Still, two out of the three largest holders of its debt are Portuguese, Caixa Geral de Depósitos and Banco BPI, with 11 billion euros combined.


The No. 2 holder, behind Caixa Geral de Depósitos, is the Spanish giant, Santander, according to Goldman, with 4.9 billion euros.


But, with foreign banks increasingly reluctant to take on more risky debt from Europe’s periphery, debt loads of local banks are expected to grow — that is, until Portugal calls it quits.