Yesterday the Portuguese Government issued EUR3bn worth of 10-year bonds with an interest rate of 5.11%. Demand was just over three times that amount. This successful operation comes after a 5-year operation in January 2012, a 10-year operation in May 2013 at a rate of 5.67%, and a five-year operation in January this year. These operations were all supported by a syndicate of banks that assessed potential demand for these instruments beforehand.
This week’s issuance brings the Government’s extra cash to close to EUR20bn, which is costly because the Government pays interest on it, but also provides a safety net for the next few months in case market conditions deteriorate. This strategy is a copycat of Ireland’s, which allowed the Irish to leave the Economic and Financial Assistance programme in December without the support of a precautionary programme.
As the Portuguese programme is due to end on 17th May, the focus is on whether the Government is ready to go it alone to international financial markets. Leaving aside any political questions, the “economics” test is whether, in absence of further support, Portuguese Government debt will start declining towards more sustainable levels which should reassure investors that Portugal will pay back its debt.
The sustainability of debt depends on three crucial factors: the Government’s primary balance, (i.e., the balance excluding interest), interest paid on debt and growth. An oversimplified example might be, in a country where the primary surplus is zero, debt to GDP will fall if nominal interest rates on debt are lower than nominal GDP growth. We take each of these elements in turn.
- The Government expects the primary surplus to be positive in the coming years. However, the improvement in the Government balance so far has been mostly due to rising taxes one-off factors. In the longer run, the size and the functions of the Government need to be adjusted to Portugal’s capacity to generate tax revenue, which probably demands some downsizing.
- Interest rates (in both the primary and secondary markets) have been on a downward trend since the political reshuffle last summer, reflecting Portugal’s sovereign debt attractiveness to foreign investors . This renewed interest may be related, not only to Portugal’s improved performance, but also to the crisis in emerging markets as investors look for lower risk and an attractive yield. However, rates remain well above the rates that are being demanded under the programme and well above trend, nominal growth.
- Finally, on growth, Portuguese GDP has surprised on the upside over the last few months, which means that the capacity to pay debt in the future is better than what was expected only a few months ago. However, in absence of achieving a sustainable primary surplus, for growth to compensate interest payments and for the debt ratio to fall, nominal GDP would have to rise by about 5% a year in the medium to long term, which is probably wishful thinking at this stage.
Therefore, though these trends are mostly positive news, they may not be enough to make debt sustainable without any further support, and a precautionary programme may be the Government’s best option.