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Portugal’s political strain remains despite growth

Demonstrators march during a protest against economic austerity measures in Portugal
Francisco Seco
Demonstrators march during a protest against economic austerity measures in Portugal

Portugal delivered a pleasant surprise on Wednesday, posting the euro zone's strongest growth in the second quarter, but its political fragility is still concerning analysts.

The peripheral euro zone economy exited recession after two and a half years of contraction in the second quarter of 2013, with a better-than-expected 1.1 percent jump in GDP (gross domestic product) growth. This was fueled in part by improved tourism revenues.

The growth was hailed by the government as vindication of its austerity-based policies – and that government needs a bit of good news after a high-profile squabble last month.

(Read more: Why Portugal has to save itself)

A crisis in the coalition government began at the start of July with the resignations of Finance Minister Vitor Gaspar and Foreign Minister Paulo Portas. Portugal's vulnerability in the bond markets was demonstrated by a spike in 10-year yields to over 8 percent. While Portas has since returned to government, and the coalition seems to have been patched up, there are worries that this is a band-aid rather than a plaster cast.

An election is expected next year, and the opposition Socialists would probably win, according to Robert Parker, senior adviser at Credit Suisse.

He said there would be "significant problems" with the country's 78 billion euro ($104 billion) bailout if this were the case, as there are concerns that a Socialist government would seek to renegotiate the terms of the bailout aggressively.

"Portuguese bonds will continue to have a political risk premium," he wrote in a research note – and predicted that they will stay over 6 percent.

(Read more: Portugal throws new curve ball)

If yields remain high, the chances of Portugal's government returning to the bond market to raise more money will worsen. On Thursday, the yields on Portugese 10-year bonds was at 6.516 percent.

There is still the distinct possibility that the original European Union/International Monetary Fund bailout will have to be expanded. Unless the economy continues to grow more quickly than anticipated, Portugal will need more funds to repay its debts, according to analysts at Barclays, who warned that public debt relief is also likely to be needed.

Yet Portugal is still a relatively small, inexpensive-to-bail-out cog in the euro zone machine.

"As long as the Portuguese government avoids a political crisis and delivers pending reforms, the euro area would continue to fund Portugal," Barclays analysts argued.

Follow Catherine on Twitter: @cboylecnbc

Contact Europe: Economy

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