Portugal in the bailout trap

March 29, 2011, 7:20 PM UTC

Europe’s bailout trap ensnared Portugal Tuesday, as S&P downgraded its debt.

The rating agency cut its rating on Portugal to triple-B-minus from triple-B, citing last week’s decision by European ministers to impose strict terms on nations that tap a new bailout fund taking effect in 2013.

Periphery problems remain

The downgrade wasn’t unexpected, S&P having recently warned it was headed in this direction. S&P also downgraded Greece to double-B-minus from double-B-plus, citing the same bailout rules.

But the downgrade shows the pickle European policymakers find themselves in. They are trying to head off a sovereign default that could make the collapse of Lehman Brothers look like a walk in the park, while at the same time trying to force private investors to pick up some of the costs of what looks like an inevitable restructuring – without scaring them out of the bonds of weak European economies altogether.

Good luck with that. The result is that private money is pulling back from the worst hit states in Europe. Portuguese bond yields have spiked, rising above 8% this week for the first time since the creation of the euro more than a decade ago and ensuring the government can’t afford to fund its upcoming obligations in the market.

All this makes another bailout likely – without offering a hint at how the politically divided euro zone might muddle through the next two years.

“Bailout fatigue is on the rise,” writes Graham Turner of GFC Economics in London. “The failure of the ECB’s intervention yesterday to stem the rise in Portuguese yields speaks volumes.”

S&P blamed two decisions at the European summit for its downgrade: Ministers’ decision to make sovereign debt restructuring “a potential precondition to borrowing” from the European Stability Mechanism, and the move to rank bailout loans above senior unsecured government debt in a liquidation.

Both those moves are “detrimental to the commercial creditors of EU sovereign ESM borrowers,” S&P wrote. The tougher terms “represent a major departure” from the existing bailout regime, known as the European Financial Stability Facility, in which sovereign loans rank would be treated the same as commercial borrowings.

The downgrade comes as investors have been pulling back from Portuguese debt, on the fear that shocks to a weak economic recovery could force the country to seek a bailout that would eventually lead to bondholder haircuts. The government fell last week after parliament rejected the latest plans to cut government spending, leaving a leadership vacuum that could last two months.

S&P’s move makes Portugal the latest victim of the European Union’s struggle to come to grips with its fiscal and economic imbalances. The Germans have resisted steps toward a fiscal union in Europe that, they argue, would stick them with the tab for the supposed profligacy of weaker countries like Ireland, Greece and Portugal. Losses in local elections this month have limited the flexibility of Germany’s Angela Merkel and France’s Nicolas Sarkozy to support plans to prop up weaker economies.

By the same token, all the EU countries have missed debt and deficit targets over the past decade, and many observers say leaders in France and Germany have invested too much in the common economy project to give up now.

That, along with the threats of the European Central Bank to raise interest rates at a time when the Fed remains on hold, explains why the euro continues to trade near its 52-week high at a recent $1.41. How long that calm might hold isn’t clear, however.

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