Forget Greece; it’s Portugal that’ll destroy euro

(http://www.marketwatch.com/Story/story/print?guid=0D71E072-474F-11E1-8F6F-002128040CF6)


Forget Greece; it’s Portugal that’ll destroy euro

Commentary: One default is an accident; two is a systemic crisis

By Matthew Lynn

LONDON (MarketWatch) — It is a long-time since Portugal played a decisive role in world history. The Treaty of Tordesillas, which divided the non-European world up between Spain and Portugal in 1494, was probably its last major contribution, and even that did not end very happily.

But 2012 could be the year Portugal explodes onto the world stage again. How? By blowing up the euro (ICAPC:EURUSD) .

Greece is already bust — and its default is already priced into the market. But Portugal is in precisely the same position, just on a longer fuse. It too is sliding toward an inevitable default on its debts — and when it does so, it will deliver a terminal political blow to the single currency, and inflict damage on the European banking system that may well prove catastrophic.

We have known for some time of course that Portugal was in trouble. Back in May last year it became the third euro-zone country that had to be rescued. After bond yields soared up past the crucial 7% level it was forced to ask for a bailout package worth 79 billion euros. The International Monetary Fund and the European Union moved in with the formula they had honed to such perfection in Greece — big tax raises, spending cuts, wage cuts, and a little bit of structural reform. The country — one of the poorest members of the European Union, with a gross domestic product per capita of only $21,000, significantly less than Greece‘s $26,000 — was set a target of reducing its deficit to 4.5% in 2012 and 3% in 2013.

So how’s it going? About as well as it did in Greece — which is to say, not very well at all. The Greek economy is forecast to shrink by 6% this year, and Portugal is not very far behind — Citigroup is predicting the economy will contract by 5.7% in 2012 and another 3% in 2013.

Rising taxes are pushing more and more of the economy off the books. A study for Porto University found that the shadow economy, which doesn’t pay any tax, grew by 2.5% last year, and now accounts for a quarter of Portuguese economic activity. There is no point in expecting that to change any time soon. Portuguese companies simply can’t survive paying the tax rates now imposed on them.

The result? Deficit reduction targets are being missed. Earlier this month, the government revised the deficit forecast up from 4.5% to 5.9% of GDP for this year. If the Greek experience is anything to go by, the target will continually be revised upwards. The economy shrinks, taxes fall, more and more people switch into the black economy simply to survive, and the deficit keeps on growing.

In response, the European Union demands more and more austerity — which simply means the economy shrinks even faster. It is a vicious circle. If anyone knows how to get out of it then they are keeping it to themselves.

Standard & Poor’s has already downgraded Portuguese debt to below investment grade, and more downgrades are on the way. Bond yields are spiking up. Last week, yields went up past 14%. They are set to go a lot higher. Greek 10-year bonds now yield 33%. Is there any reason why Portuguese yields shouldn’t reach those levels? None at all.

That matters. The Greek crisis could be spun as a special case. Not Portugal. There was no fiddling of the figures. It didn’t run massive deficits — indeed in the run up to the crisis of 2008, Portugal was running deficits of less than 3% of GDP, well within the euro-zone rules. It wasn’t irresponsible. The problem was simply that it couldn’t compete within a single currency with much stronger economies. Now the country is being plunged into a full-scale depression — as bad as anything witnessed in the 1930s — by monetary union.

It will be every bit as serious as Greece. And perhaps more so.

While the Greek government borrowed a lot of money, and mostly wasted it, Greek consumers and companies were relatively restrained. Not the Portuguese. According to figures from the Bank of International Settlements, total Portuguese debt amounts to 479% of GDP (compared with 296% for Greece). That comes to 783 billion euros, compared with 703 billion euros for Greece.

Europe’s banks are even more exposed to Portugal than they are to Greece. In total, the banks have $244 billion exposure to Portugal, compared to just $204 billion to Greece, again according to BIS data.

So how is this going to play out? Greece looks certain to default in the first half of this year. The pressure will then move straight on to Portugal. It has precisely the same problems, only worse. If one country can’t pay its debts then neither can the other.

That will have two big effects.

First, there will be a huge hit to the euro-zone banking system. The bulk of Portuguese debt is owed to Germany and France. But those are the official figures. It seems likely a lot of the private debt, which is far more substantial than government debt, will be owed to Spanish banks. They are already fragile. Can they take the losses? Perhaps, but you wouldn’t want to bet your last bottle of port on it.

Next, it will deal a huge blow to the currency. For one country to default within a monetary union can be written off as an unfortunate accident. Every family has a black sheep. When the second one goes down, it looks a lot more serious. The line that this is all the fault of a few irresponsible governments will be unsustainable. The alternative explanation — that the euro is a dysfunctional currency, wreaking havoc across the continent — will gain a lot more traction.

A Portuguese default will trigger a whole-scale retreat from the euro-zone — and right now looks like the trigger for the collapse of the system. It’s been a five-century wait. But Portugal could be about to play a key role in the global economy again.