Portugal growth poses dilemma on pace of further budget cuts
* Growth still fragile, likely to diminish or turn negative
* 4.7 bln euros in new budget cuts threaten recovery
* New relief programme could ease immediate goals, uphold growth
LISBON, Aug 20 (Reuters) - Portugal's emergence from its long recession is a sign that the European austerity recipe just may work, but it also poses a dilemma for Lisbon and its lenders as a new dose of planned budget cuts may kill a fragile revival.
As a result, many economists expect the government to negotiate a new easing of the budget deficit targets during a bailout review next month with its European and IMF lenders, who could in return demand longer-term commitments on spending cuts.
With less than a year before the mid-2014 end of the current bailout, some experts suggest a second, possibly less stringent, lending programme could help Portugal spread further cuts over a longer time without compromising fledgling growth or stirring additional resistance to the dreaded austerity at home.
A sharper-than-expected 1.1 percent second-quarter growth from the previous quarter cut short two and a half years of recession, but the economy still shrank 2 percent year-on-year and is expected to contract around 2 percent for the whole of 2013.
The flash GDP estimate did not provide a breakdown, but analysts say domestic demand likely fell again under the weight of huge tax hikes applied from early 2013.
"This growth shows that they are on the right path, even though it's not an easy path," said Commerzbank economist Ralph Solveen. He did not rule out further GDP drops this year as Portugal's economic dynamics remained volatile and hinged on how much more austerity is to be applied over the coming months.
Giada Giani, a Citi economist in London said that despite "some positive shifting in exports and less bad domestic demand, the underlying climate is still very weak and I think we should see much lower growth in the coming quarters".
With domestic demand depressed by austerity measures, much of Portugal's recovery has been on the back of stronger exports, from shoes and olive oil to fuel and cars, but there are questions over how long the export momentum will continue.
Exports in the quarter were also boosted by a new diesel unit of oil firm Galp's Sines refinery that made Portugal a net diesel exporter. But the unit is already working flat out.
NO FREE LUNCH
The government expects next year to be the first full year of economic growth since 2009, but Giani said that "if they go ahead with all the planned cuts, growth will certainly be negative again next year".
In question are 4.7 billion euros ($6.3 billion) in spending cuts that Lisbon needs to enact mainly next year to hit a budget deficit goal of 4 percent of GDP. This year the deficit needs to be reduced to 5.5 percent from last year's 6.4 percent.
Without these deficit reductions designed to alleviate its debt burden, Portugal is unlikely to regain enough investor confidence to fully return to market financing by mid-2014 as planned, which would require some sort of further European aid. Just one quarter of growth is unlikely to change that.
"It could be a precautionary package or another full package. But there's no such thing as a free lunch and Europe will demand new commitments for budget cuts as their main goal is to make Portugal's debt sustainable," Giani said.
RBC Capital Markets analysts said in a research note they expected "behind the scenes negotiations on a new programme" to begin during the next bailout review in Lisbon.
GOALS RENEGOTIATION LIKELY
So far, the centre-right government has stuck to the goals and ruled out any need of a new programme, but political support for more front-loaded austerity has eroded, especially after an internal rift in the ruling coalition last month threatened to derail the bailout altogether.
The rift has since been healed, but the party that has disagreed with some austerity measures and advocated pro-growth measures has won more clout in the cabinet. The government cheered the second quarter data.
Antonio Saraiva, head of the influential Portuguese Entrepreneurial Confederation (CIP) lobby group says second-quarter growth provided some "confidence that the slump had bottomed out," but that he still thinks a renegotiation of budget goals is necessary to keep the economy on track.
While Commerzbank's Solveen also expected discussions on a new programme to start in the autumn, he said it was too early to say if Lisbon would need it after its successful first post-bailout bond issuance earlier this year and a positive economic impact from growing competitiveness of its exports.
Portugal's benchmark 10-year bond yields are at just about a third of their peak of about 18 percent in early 2012.
Some analysts see scope for them to come down from 6.4 percent now to below 5 percent in the coming months if Europe's economic recovery continues. Neighbouring Spain finances itself in the markets normally and has a 10-year yield of 4.4 percent.
Still, RBC argues that a smooth transition to full markets financing by mid-2014 was still unlikely due to a combination of still weak growth, high debt and political resistance to austerity, meaning "a follow-on programme remains necessary".