Via email, Barclays Capital offered thoughts on “Potential Fiscal Slippage” in Portugal.

The Central Bank of Portugal warned the economy might fail to meet budget deficit targets set for this year and next under the EU/IMF programme (5.9% and 4.5% of GDP, respectively), unless it takes “significant additional measures”.

Contraction Two More Years

According to the report, lower-than-previously projected GDP growth and lack of implementation of structural reforms (as opposed to one-off actions) would be responsible for the anticipated fiscal slippage in 2012. The Central Bank expects GDP growth to contract 1.9% this year (BarCap: -2.0%, EU/IMF: -2.0%) and 2.2% next (previous forecast: 1.9%, BarCap: -1.7%, EU/IMF: -1.8%).

FM Cavaco Silva had also warned that Portugal needs “tough and relentless budget discipline” adding that a failure to control public spending and introduce reforms might trigger the request of additional support, the FT reports this morning.

In September, the ‘troika’ (EU, ECB, IMF) identified a potential fiscal slippage of 1.3pp of GDP due in part to to the electoral cycle. Later, hidden debt in the Madeira region (worth 0.3% of GDP) was also disclosed.

In a note published earlier this week, we had flagged the risk of potential fiscal slippage in Portugal. According to our own seasonal adjustment, general government budget deficit data for H1 were off-track, suggesting a tracking budget deficit of 9.8% of GDP for this year (for more please see: Portugal: H1 national accounts fall behind 2011 budget deficit targets). We expect Portugal to reach a budget deficit of 6.3% and 5.0% of GDP this year and next.

Weak Domestic and External Demand

While we share the view that the main risk faced by public finances is related to potential weak GDP performance this year and next, we think that it refers more to 2012 than 2011. In fact, the government has already announced additional measures to tap the potential fiscal gap this year such as bringing forward the VAT rate increase on petrol prices and the re-direction of bank pension funds to the state social security system. For next year instead, the clouds of weak domestic and external demand are likely to cast a shadow on the Portuguese economy.

In fact, net exports have been the main contributor to real GDP growth over the past few years. A slowdown of growth in the economies of key trade partners could make it difficult for Portugal to contain the magnitude of the recession next year, implying significant downside risks to its public finances.

Portugal 10-Year Government Bond Yield

Italy 10-Year Government Bond Yield

Greece 1-Year Government Bond Yield

The bond market does not think anything has been fixed in Europe and neither do I.

More Sovereign Credit Rating Downgrades – When It Rains It Pours

Pater Tenebraum has plenty of comments on Spain and Portugal in The ECB’s ‘QE Lite’ and New Downgrades of Euro Area Sovereigns and Banks

Late on Friday, Fitch piled on more pressure, by further downgrading Spain and Italy. Spain was taken down two notches to AA minus, while Italy was downgraded by one notch to A plus. In its downgrade of Spain, Fitch specifically mentioned the financial troubles of Spain’s regions, which are responsible for a large portion of government spending.

With this, Fitch has basically cut through the veil of creative accounting used by Spain’s central government, which propped up its own budget deficit by simply cutting payments to the regions by 16%. In essence, this means that the hole in the budget has been moved from the center to the regions, but it has not gone away.

In addition to the rating action by Fitch, Moody’s downgraded nine Portuguese banks, citing specifically their holdings of Portuguese government debt. It also downgraded a number of UK banks, due to rule changes that allegedly make government support for these banks less likely in the future (in our opinion that’s wishful thinking). Moody’s also intimated it may soon lower Belgium’s credit rating due to the Dexia collapse, which has morphed into a full-scale bailout, namely the failed bank’s nationalization over the weekend.

As we have mentioned previously, we think that both Portugal and Spain represent the most immediate new threat to the euro area after Greece, in spite of the fact that the markets have lately become more sanguine about Spain. Spain is one of the euro-area’s economic wastelands. It is undergoing a 1930’s style depression, with the recent weak cyclical recovery already giving way to contraction again. The burst housing bubble has brought the banking system to the brink, which has so far kept the true extent of the damage under wraps by means of creative accounting. Occasionally a caja or two will blow up and admit to sudden vast losses en lieu of the previously reported meager profits, prompting the Bank of Spain’s intercession. Since the government has so far been activist with regards to keeping the banking system afloat, the ultimate cost remains undetermined but is almost certainly far higher than the blue-eyed estimates that have been circulated by officialdom up until recently. What we wrote in April about Spain (scroll down to ‘Spain, A Case of Crisis Fatigue – Is It Justified?’) is still applicable, only the situation has since then deteriorated. While the government has met its official deficit reduction targets, the markets have repriced both Spain’s debt and CDS on its debt markedly in the meantime. Lately Italy has been the market’s main focus, but we think Spain’s economy is far more suspect, not least due to high indebtedness of the country’s households and its vast external debt.

The downturn has practically paralyzed what was one of the domestic economy’s biggest sectors, the construction industry and industries related to it. The hitherto successful Spanish export sector is too small to matter, and is currently faced with falling demand as well. Construction is fairly labor-intensive and its downfall has contributed to an extremely high unemployment rate above 21%. Regional governments from the central down to the municipal level are all struggling financially, taking down the businesses that cater(ed) to them.

Mike “Mish” Shedlock
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