Downgrade puts Portugal at debt's door

With the euro under siege once more, there's a sense of desperation in Brussels, writes Phillip Inman.

With the euro under siege once more, there's a sense of desperation in Brussels, writes Phillip Inman.

THERE is a growing sense of despair in Brussels. Unlike previous attacks on the euro project, the latest downgrade of Portugal's debt by Moody's feels like the beginning of the end. Those economists and fund managers who argued that a second bailout for Greece with private sector involvement would mean something similar for Portugal and most likely Ireland are hitting the target.

Like a 19th-century battalion holding the line against oncoming hordes with depleted firepower and an officer class at war with itself, the euro's supporters are in a desperate situation.

Since last year's Greek debacle, European leaders have tried to provide lifelines to the worst-hit countries by replacing the private debt markets with the European Central Bank. The bank now holds almost #100 billion ($A150 billion) of Greek debt. Portugal was in much the same position, but hoped to muddle through its crisis with just one bailout from Brussels.

Moody's says Portugal is likely to join Greece in a second bailout because, as with Greece, private lenders are going to stay away for longer than expected.

Investors ask why they should buy the bonds issued by a country that will be forced to change the terms for the worse midway through the life of the loan. That is what Brussels is contemplating for Greece. Moody's naturally assumes the same will be imposed on Lisbon.

Just as we found in the worst period of the banking crisis, attempts by politicians to save money and preserve asset values only make the situation worse.

The British government was urged to nationalise the worst-hit banks almost as soon as the bank Northern Rock collapsed, but did everything it could to avoid recognising the problem and when it did, it tried mergers and loans coupled with austerity to minimise the effect on the state.

Lloyds was encouraged to merge with Halifax Bank, and when that failed it was told to use an injection of government cash, to be repaid, as a way to slim down. Now Lloyds, like most British banks, is a zombie institution unable to help the economy get back on its feet. The same recipe is being lined up for Greece and soon for Portugal as well.

Moody's recognises this unpalatable fact and says it fears "Portugal will not achieve the deficit reduction target to 3 per cent by 2013 from 9.1 per cent last year as projected in the EU-IMF program. This is due to the formidable challenges the country is facing in reducing spending, increasing tax compliance, achieving economic growth and supporting the banking system."

It then lists four main areas of concern. The first centres on the ability of Lisbon's new government to make promised cutbacks in sectors such as healthcare, state-owned enterprises and regional and local governments.

Delays in tackling tax avoidance, the possibility of a further bailout of local banks and limits on economic growth also sow the seeds of doubt that Portugal can make it through the next few years without extra loans. Like the worst-hit banks, Portugal, Ireland and Greece are bust. To get them back on their feet there is a moral case for including private investors in further bailouts. Why should governments bear all the burden? It's a fair question, but that road leads to disaster. Even though many private investors in euro-zone sovereign debt are EU banks and pension funds, and you might think a force for good, they have no other motive than to maximise returns. They will listen to Moody's fears and scram at the first sign of trouble.

This contagion effect is real and economically ruinous. In Japan, businesses, politicians and academics are permanently worried about Greece. US policymakers likewise. Stocks fell in New York in the hours after the Portugal downgrade because the possibility of another Lehman Brothers felt real. The only answer is for the EU's richer nations to admit that they made bad decisions when they bought peripheral sovereign debt. It was not a risk-free bet. It turned bad and their assets are only worth 20 or 30? in the euro. The French and Germans, in particular, have rather smugly portrayed themselves as wiser than everyone else, that somehow their adherence to a regime of "conservative" bond purchases allowed them to avoid the problems visited on the US, Britain and most other European nations.

If anything, it is the opposite. They are up to their necks in bad debts, just as much as Britain it's just that their debts relate to bad loans made to Greece, Portugal, Ireland and Spain, and not housing developers or buying exotic financial derivatives.

Spain is often talked about as the next domino. On Tuesday ugly economic figures for Italy appeared to put Rome higher up the scale of walking disasters.

Unless Brussels admits the full extent of the problems blighting Greece and Portugal, the panic will spread, hurting us all.

As Bank of England governor Sir Mervyn King keeps insisting, the European crisis is not one of liquidity. It is a full-blown debt crisis.

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