For Portugal, Moment of Truth Nears

The Wall Street Journal

By CHARLES FORELLE in London and PATRICIA KOWSMANN in Lisbon

Politicians in Lisbon and policy makers in Brussels insist that Portugal isn't like Greece. This spring, the country will have to prove it.

The European Central Bank's injection of money into the Continent's banking system has, for now, pulled Italy and Spain away from the edge of the sovereign-debt crisis. But that medicine hasn't soothed Portugal. Though its government-bond yields have improved this week, they remain at elevated levels that suggest distress.

In part that is because investors take a dim view of the government's struggle to close its budget gap amid a prolonged economic downturn. Portugal beat its 2011 deficit target of 5.9% of gross domestic product only after booking a gain from the transfer of pension assets from banks. It used a similar accounting maneuver in 2010, that time with telecom pension assets.

Portugal's banks also haven't stepped in heavily to buy government debt, an important ingredient of the revival in Spanish and Italian sentiment. Portugal is thus in a sort of public-finance purgatory. Its fiscal woes aren't Greek in stature, but nor has it delivered the steady improvements that fellow bailout recipient Ireland has.

Portugal's 10-year bond on Wednesday yielded above 11%, according to Tradeweb, down from 13.5% at the beginning of the year. Volume is thin and prices volatile. The comparable Irish bond yielded less than 7%.

"Even though the yield is very attractive, the risk return for holding that position is not," said Rebecca Patterson, chief markets strategist for J.P. Morgan Asset Management in New York. "There are plenty of places you can get return and not take a Greek-like risk."

The weak demand and low volumes suggest Portugal may have trouble raising money. Under its €78 billion ($104 billion) bailout from euro-zone countries and the International Monetary Fund, Portugal must borrow €10 billion from private markets in 2013; if it doesn't, it can't make a €9.7 billion bond repayment that September.

Unless bond yields fall substantially, to a level suggesting Portugal has a chance at tapping markets, the issue could arise as soon as late spring; the IMF requires that such "funding gaps" be resolved a year ahead of time.

There are reasons to believe some investors won't return. As credit-rating firms downgraded Portugal, its bonds lost favor with the pension funds and other big buyers of government debt who follow indexes of investment-grade securities.

"Foreign investors have largely disinvested from Portugal simply because it has fallen out of the indexes," said Justin Knight, head of European interest-rate strategy at UBS in London.

And Portuguese financial institutions aren't buying in sustained amounts. Their holdings stood at €23 billion at the end of January, after the first of the ECB's two big cash injections, unchanged from two months earlier. By contrast, Spanish banks' holdings of their own government's debt jumped 70% in the same period, and Italian banks' holdings of Italy's debt rose more than 15%, central-bank data show.

Portuguese banks rely heavily on the ECB for funding, and they are under regulatory pressure to reduce exposure to risky countries like their own. Some Portuguese banks were burned by holdings of Greek debt. Late Wednesday, Moody's Investors Service downgraded its ratings on four Portuguese banks and the Portuguese subsidiary of Spain's Banco Santander SA, STD -2.29% pointing to mounting pressure from the country's weakening economy.

For buyers of bonds, the chief question is whether Portugal will restructure its debt and impose losses on creditors, as Greece did. UBS's Mr. Knight said the euro zone will try to avoid it, if Portugal shows it is serious about budget discipline. "As long as Portugal has played ball all the way through, we think the [European Union] will be flexible," he said.

The EU and the IMF have signaled they are willing to do more. But there is a risk that public backlash in Germany and other countries makes it harder for them to open their wallets again if Portugal fails to raise money from markets. Moody's Analytics pegs the likelihood of a Portuguese default within the next five years at about 17%, far higher than Ireland, Italy or Spain.

Portuguese leaders have said they are committed to fiscal targets, even if it means more painful cuts. On Tuesday, Prime Minister Pedro Passos Coelho said that day's drop in bond yields reflected Portugal's "strong commitment" to the bailout program. And the head of Portugal's biggest bank has said it is "slowly" buying Portuguese government debt.

Still, the challenge is daunting. Mr. Passos Coelho's government made cuts in public spending after it took office last June and imposed more taxes. But hidden debt of the regional government in the island of Madeira, plus shortfalls in the education and defense budgets, upset the plans.

In response, Portugal enacted the pension maneuver, whereby it received an upfront payment in exchange for assuming future liabilities. That narrowed the deficit to beneath the target.

For this year, Portugal's goal is a deficit of 4.5% of gross domestic product. It drew up a budget in October aimed at meeting that target, but the economic outlook already has darkened.

Finance Minister Vitor Gaspar said in October that the jobless rate should be 13.4% for 2012, while the economy should shrink 2.8%. The contraction since has been revised to 3.3%, and many economists expect worse. Unemployment reached 14.8% in January.

The effects already are clear: The government raised less money from taxes and spent more on unemployment benefits in the first two months of 2012 than it did a year ago.

Write to Charles Forelle at charles.forelle@wsj.com and Patricia Kowsmann at patricia.kowsmann@dowjones.com