Portugal Calls for Bail-out

(07.04.2011) Portugal became yesterday the third EU-country to ask the European Union for financial assistance in less than one year. The Euro did not react on the news, but the bail-out was most likely prices in by the markets.

By Kyrre Aamdal, Senior Economist at DNB Markets

illustration euroIn an auction yesterday Portugal sold 1bn Euros in six-month and one-year bills, paying 5.11 per cent and 5.9 per cent respectively compared with just less than 3 per cent and 4.3 per cent in previous similar auctions. The bond issue was seen as a crucial test of market sentiment as the country struggles to finance its debt following the resignation of José Sócrates as prime minister on March 23.

Yesterday evening Sócrates announced that the government had decided to ask the European Commission for financial assistance. The request was welcomed by EU officials. “It is a responsible move by the Portuguese government,” Olli Rehn, the EU’s top economic official, told the Financial Times.

Portugal is aiming for a package that may be worth as much as 75 billion euros ($107 billion), two European officials with knowledge of the situation told Bloomberg, but such details have not been officially announced. Critical voices have said Portugal should have asked for a bail-out at an earlier stage, because that would have given Portugal a better negotiating position versus the European Commission. But after the parliament rejected proposed budget cuts March 23, Sócrates has just been in charge of a caretaker government with limited powers until a June 5 election.

Now the focus may turn to Spain, by many seen as the next country on the list to seek financial assistance. But Spain has already undertaken several measures to control the budget deficit. The banking sector, which is less than in Ireland relative to GDP, is being restructured. It looks like the Spanish central bank has tighter control on the Spanish banks compared to the situation in Germany. And the debt level is less than in several other EU countries. But if markets loose confidence to Spain, the government may be forced to seek a bail-out. At the moment we believe this is way off.

Today ECB's council meets to discuss interest rates. At the March meeting the signals were clear. Trichet said that "strong vigilance is warranted" and did not repeat that the key policy rate was appropriate. He also stated that "An increase in interest rates at the next meeting is possible". Thus the expectation for a rate hike today has increased substantially, and 75 out of 80 surveyed by Reuters expect a 25 bps rate hike today. The economic reason for a rate hike is the strong increase in over all inflation. The main factor for this increase has been the raise in energy and commodity prices.

In the U.S., the Fed believe these effects are transitory. ECB however, believe the rise in energy and commodity prices may contaminate the general price level. Two channels may transform this contagion. The first is through increased inflation expectations. The other is through inflation indexed wage systems. Stronger economic growth figures also open for the central bank to start normalization of the key policy rate. Unemployment has been stabilized at just below 10 per cent. Such high unemployment level should normally lead to low wage growth. But wages are to some extent are indexed to inflation, as is the case in Spain (20 per cent unemployment and rising wage growth). High unemployment will thus not be sufficient to keep wage inflation low. This is different in the U.S.