Portugal's Step Forward

This is an important day for Portugal. It is selling 10-year bonds for the first time in more than two years. Demand is reportedly strong. Today's 10-year sale follows the 5-year bond sale in January and heralds to full return of Portugal to the capital markets. Portugal's success in returning to the capital markets is a success for European officials more broadly.

When Portugal last sold a 10-year bond in January 2011, it paid about a 6.7% yield. The yield on the Oct 2023 existing issue yields about 5.43%. While yields are at the lowest level since October 2010, the new offering looks richly priced at around 400 bp above mid-swap rates and this has helped ensure healthy demand for paper that is still rated below investment grade by all three major rating agencies.

The government raised 3 bln euros and has easily covered this year's long-term funding need and the government says it has begun pre-funding next year's needs. The rating agencies often lag behind developments and Moody's which rates Portugal at the equivalent of BB- is the most likely candidate to hike its rating. The EU have agreed in principle to extend the duration of the aid loans by seven years. This apply to around 52 bln euros of Portuguese debt and would increase the average duration to 8.5 years from around 7 years

As recently as last month, some critics were still calling for Portugal to exit the monetary union. To the contrary, Portugal is moving in the opposite direction. Last week, the government announced additional measures to make up for the savings that the constitutional court had ruled illegal and more.

The 4.8 bln in savings announced through the end of 2015, includes 30k cuts in the public sector (580k employees) and an increase in the work week for public employees to 40 hours from 35. Their social security contributions will also be increased. All the ministries face a 10% cut in spending. There is also a new tax on all but the lowest pensions, while the retirement age will be raised to 66 from 65.

Portugal's austerity measures comes amid a general relaxation of the austerity push by the EU and IMF. Even the ECB, the last of the Troika austerians, recognizes the changing winds and delivered a rate cut in the face of a shift in the trajectory of fiscal policy and simply hopes countries do not back track on the progress already made. Arguments that somehow these measures have less meaning because the surplus countries in northern Europe are not pursuing more stimulative policies needlessly make the good the enemy of the perfect.

Portugal's measures are consistent with the post-crisis response. They remain pro-cyclical in the sense that fiscal policy is tightening as the economy weakens. Last week, the EU revised its forecast for the Portuguese economy to show a contraction of 2.3% this year. A few months ago it forecast a 1.9% contraction. Its growth forecast for next year was shaved to 0.6% from 0.8%.

The measures are also consistent with the other policy thrust seen in the periphery. The decline in unit labor costs has taken place primarily as a function of cut in the public sector. Reforms in the private sector remain quite modest. Enhanced competitiveness requires private sector reforms.

Separately, Portugal's central bank reported today that Portuguese banks increased their borrowings from the ECB in April for the first time in six months. The increase was about 2 bln euro to bring total borrowings to almost 50 bln euros. The government has injected a little more than 5.5 bln euros into non state-owned banks under the auspices of a recapitalization program that is funded by the aid.

The risk is that Portuguese banks may need more aid. That said, the virtuous circle of a decline in the sovereign yields helping banks remains very much intact. Consider that today the Portuguese equity market was up about 0.7%, while financials led the way with a 2.75% gain.