Why Portugal won’t bring down Spain

March 24, 2011, 8:01 PM UTC

Portugal’s problems are bad, but they don’t have to rain bad news down on Spain.

Portugal’s prime minister resigned after his latest austerity plan was voted down, pushing the Continent’s simmering debt crisis to the front burner. A downgrade of Spanish banks – which have more than $100 billion of exposure to Portugal – added a pungent whiff of financial contagion.

This may pinch a little

The yield on Portuguese 10-year bonds surged near 8%. That makes it a matter of time till a new government asks for a bailout that could cost as much as $140 billion — and this just to stay upright so it can tighten its belt well beyond the pain point.

“Far-reaching structural reforms are needed,” Deutsche Bank economist Gilles Moec wrote Thursday. “No ‘adjustment-like’ approach would suffice.”

All this sounds depressingly like a replay of last spring’s Greek situation, which sent stock markets into free fall and threatened to derail the global recovery.

But this time, a market meltdown may not be in the cards. The euro, for instance, held above $1.40 in spite of the latest rumbles, and stock markets held their ground. Yields on Spanish bonds actually fell. 

For that you can credit the hawkishness of the European Central Bank and the liquid generosity of the Fed, among other things. But the muted reaction also suggests the Europeans have done more to defuse the sovereign debt time bomb than we have given them credit for.

“Believe it or not, we have come a long way,” said Jacob Funk Kirkegaard, a research fellow at the Peterson Institute for International Economics. “Last year we had people talking about the euro at parity and the euro zone breaking up. But now we can see there is a playbook to muddle through the next three or four years.”

It is a playbook that is still missing a few pages, to be sure.

European ministers have made progress in arranging for and funding bailout plans such as the European financial stability facility and its successor, the European stability mechanism. These vehicles ensure that troubled borrowers such as Portugal will be able to get funding in a crunch – at a price. The European summit today and Friday aims to lock in details on how those programs will be funded, among other things.

But Portugal isn’t likely to tap the bailout funds for another few months, till a new government is in place. That could put pressure on the European Central Bank to prop the country up during its lame duck period, by buying bonds in the secondary market. Portugal could need 15 billion euros of funding between now and June just to fund its deficit and scheduled bond payments, Deutsche Bank estimates.

Europe’s bigger weakness is its failure to confront the shortcomings of its banks. This is a concern even in stronger economies such as Germany, where the banks have hundreds of billions of euros of exposure to weaker countries including Spain.

There is no sign the Europeans have a plan for shoring up the banks much more involved than heading off sovereign defaults and instituting the pray and delay plan in effect here.

And then there is Spain, which remains something of a cipher. It had a huge housing bubble that collapsed, devastating the construction industry and leaving unemployment at 20%.

Yet Spain arguably is cause for hope. It hasn’t had a huge banking crisis, because strapped borrowers didn’t pig out on home equity loans as they did here. And the government has been trying to fix problems in its labor markets and with the local banks, which Kirkegaard says “have been used as piggy banks by the local politicians.”

The price of privatizing those banks, the cajas that are the target of the Moody’s downgrade Thursday, is a matter of some debate. The government said it will take 15 billion euros to recapitalize them, but private sector estimates run as much as seven times as high, in an unhappy echo of Ireland’s never-ending bank bailout.

Yet even if the worst-case scenario comes to pass with the cajas, the Spanish government appears strong enough to shoulder it. Debt is around 65% of gross domestic product and even a 100 billion-euro bailout amounts to just 10% of GDP.

Contrast this with Ireland, where the debt load is heavier and bank bailout costs are now estimated at a third of GDP.

“I just don’t see a solvency problem with Spain, no matter what happens with the banks,” said Kirkegaard. “With the reforms they are doing, they are on the road to bailing themselves out.”

Wouldn’t that be a welcome change.

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