Risks Mount Ahead Of Bailout Exit

BMI View: In light of recent protests staged by Portugal's various divisions of its security forces, we see mounting risks to the country's political stability. We outline three scenarios for Portugal's scheduled exit from its bailout in mid-2014, with all scenarios entailing continuation of help from the troika (ECB/IMF/EU) of international lenders for the foreseeable future.

Recent developments in Portugal have prompted us to re-evaluate our fairly sanguine outlook on the prospects for political stability in 2014. Whereas previously we considered the conservative coalition comprising the Social Democratic Party (PSD) and the Popular Party (CDS-PP) to retain its stable position in power for the duration of its four-year term, we now see mounting risks to the government's stability. The reason is that the approval of the 2014 budget plan on November 26, which envisions harsh austerity cuts, has been accompanied by an unprecedented level of protests, which could seriously destabilise the government.

Although protests against the country's harsh troika-mandated (ECB/IMF/EU) bailout terms have been on the rise over the past two years, what makes this wave of protests different is that various divisions of the security forces joined the protestors - members of the police, prison officers, and the paramilitary National Republican Guard. Although the police forces dispersed voluntarily shortly after occupying the steps of the parliament building, a place which is usually off limits to protestors, a repetition of the police forces' demonstration might see tensions escalate. Moreover, protests by the security forces signal that the government's grip over the use of force in the state is weakening, which might lead to further delegitimisation of Prime Minister Pedro Passos Coelho's Cabinet. Given these risks to stability, we outline three scenarios for the country's prospects of exiting its financial support programme scheduled for mid-2014 and its return to private financial markets.

Low Growth = Grim Fiscal Sustainability Prospects
Portugal - Real GDP, Budget Balance, % chg y-o-y

Risks Mount Ahead Of Bailout Exit

BMI View: In light of recent protests staged by Portugal's various divisions of its security forces, we see mounting risks to the country's political stability. We outline three scenarios for Portugal's scheduled exit from its bailout in mid-2014, with all scenarios entailing continuation of help from the troika (ECB/IMF/EU) of international lenders for the foreseeable future.

Recent developments in Portugal have prompted us to re-evaluate our fairly sanguine outlook on the prospects for political stability in 2014. Whereas previously we considered the conservative coalition comprising the Social Democratic Party (PSD) and the Popular Party (CDS-PP) to retain its stable position in power for the duration of its four-year term, we now see mounting risks to the government's stability. The reason is that the approval of the 2014 budget plan on November 26, which envisions harsh austerity cuts, has been accompanied by an unprecedented level of protests, which could seriously destabilise the government.

Although protests against the country's harsh troika-mandated (ECB/IMF/EU) bailout terms have been on the rise over the past two years, what makes this wave of protests different is that various divisions of the security forces joined the protestors - members of the police, prison officers, and the paramilitary National Republican Guard. Although the police forces dispersed voluntarily shortly after occupying the steps of the parliament building, a place which is usually off limits to protestors, a repetition of the police forces' demonstration might see tensions escalate. Moreover, protests by the security forces signal that the government's grip over the use of force in the state is weakening, which might lead to further delegitimisation of Prime Minister Pedro Passos Coelho's Cabinet. Given these risks to stability, we outline three scenarios for the country's prospects of exiting its financial support programme scheduled for mid-2014 and its return to private financial markets.

Scenario 1 - Full-blown crisis (20% probability): This could result from an escalation of public discontent, especially if the security forces renew their demonstrations, which might lead to the resignation of the government. In another form of a full-blown crisis, the Constitutional Court might overrule the majority of measures included in the current 2014 budget. In either case, confidence in Portugal's ability to rein in its fiscal deficits, honour its borrowing commitments and return to private financial markets by mid-2014 would be seriously undermined. Although we do not rule out the possibility for partial default in this scenario (which would entail Private Sector Involvement (PSI)), the most likely outcome is the introduction of a new full-fledged financial rescue package from mid-2014 onwards. A new rescue programme would entail just as strict austerity measures as the current one, meaning that Portugal will remain at the mercy of the troika for the foreseeable future.

Scenario 2 - Stability (20% probability): In our second scenario, the government successfully passes the 2014 budget, assuring markets of its commitment to meeting its fiscal targets, and raising the probability of the country's successful return to private financial markets in mid-2014. The 2014 budget plan envisions wage cuts of 2.5% for those earning more than EUR675 per month, and 12.5% for those earning EUR2000; a 2% reduction in the number of public sector workers; an increase in the working week to 40 hours, up from 35 hours previously; and a reduction in annual holiday entitlements to 22 days, down from 25 days previously, among others. The planned austerity measures amount to EUR3.9bn, equal to 2.3% of the country's GDP, as the administration strives to achieve a budget deficit of 4% of GDP, down from 5.8% currently. Given Portugal's history of poor progress on implementing similar labour market reforms over the past three years, we remain sceptical that this attempt will be successful. This accounts for the low probability assigned to this scenario.

Low Growth = Grim Fiscal Sustainability Prospects
Portugal - Real GDP, Budget Balance, % chg y-o-y

Scenario 3 - Muddling Through (60% probability): In our third and most likely scenario, we expect Portugal's Constitutional Court to overrule some of the measures of the 2014 budget, implying that the country will continue to miss its fiscal target in 2014. Although it might be able to partially return to private markets, Portugal would continue to muddle through on some form of life support from the troika for the foreseeable future. This might take the form of a precautionary credit line from the EU's EUR500bn ESM fund (the European Stability Mechanism) and/or OMT (Outright Monetary Transactions) operations by the ECB to smooth its transition to markets. Although 10-year government bond yields, at 5.92% at the time of writing, have come down a long way from their 2013 high of 7.50% in July, implying improving investor confidence, they remain prohibitively high and bode ill for the country's fiscal consolidation prospects for 2014. As such, in this scenario, we anticipate a form of official (troika) help to lower the country's borrowing costs as the current bailout package draws to a close in mid-2014.

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