As Portugal’s Pain Deepens, Investors Reward Nation

on August 16 2012 10:37 AM

Finally, some good news coming out of Portugal.

But first some background. The country's economy shrank for a seventh quarter in the three months through June and unemployment rate shot up to a record high, suggesting Portugal's austerity measures are actually working.

Portuguese Prime Minister Pedro Passos Coelho told his party in July that he would rather lose at the ballot box than abandon his policy of strict adherence to the terms of a bailout from the European Union and the International Monetary Fund.

"If one day we have to lose elections in Portugal in order to save the country, then, as they say, the hell with elections," Coelho said at the party meeting, which was broadcast by Portuguese television.

Portugal -- the third euro zone country to seek a bailout after Greece and Ireland -- is trying to fulfill the terms of the 78 billion-euro ($122 million) bailout and return to bond markets next year.

Investors rewarded Portugal's efforts to trim its budget gap by sending the credit-default swaps, essentially insurance policies for investors against a sovereign default, on Portugal down to 725 basis points on Thursday, from 1,515 in January and 1,237 in May, according to Bloomberg. The implied probability in that CDS number of Portugal defaulting on its debt fell to 46 percent from 73 percent.

The CDS contracts have fallen by the most of any government this year. A drop signals improving perceptions of creditworthiness, while an increase suggests the opposite.

Portugal is also seeing its bond yields falling sharply from euro-era highs hit in January as the government soothed antsy investors by introducing sweeping austerity measures that steered the country farther away from following the footsteps of Greece in restructuring its debt.

That said, many are still skeptical of Portugal's ability to meet this year's fiscal targets as set out under the EU/IMF package.

These concerns have kept five and 10-year yields at unsustainable levels, according to Reuters.

While Portugal's five-year borrowing cost stands at 8.6 percent, down from a euro-era high above 20 percent in January, it remains above bailed-out Ireland's 4.8 percent, Spain's 5.7 percent and Italy's 4.9 percent.

Ten-year yields are below euro-era peaks above 17 percent hit earlier this year and Greece's 24 percent, but above Ireland's 6 percent.

Moreover, Portuguese debt markets are currently very illiquid. The gap between the prices at which a bank is will to buy and sell 10-year bonds is at 72 basis points, compared with just 14 basis points for Spain, according to Reuters.

Portugal's gross domestic product declined 1.2 percent from the first quarter, when it fell 0.1 percent.

The unemployment rate moved up to 15 percent in the second quarter from 14.9 percent in the first quarter, hitting the highest level since Portugal became a part of the single-currency bloc. The latest figure was sharply higher than the 12.1 percent recorded in the second quarter of 2011.

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