Draghi Walks on Thin Ice as Portugal Fears Intensify

Mario Draghi
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Mario Draghi

A political crisis in Portugal that has sent the country's bond yields soaring to as high as 8 percent this week puts European Central Bank (ECB) President Mario Draghi back in the hot seat when the central bank meets on Thursday.

It was just a year ago that the ECB chief was forced to pledge to do "whatever it takes" to save the euro zone from collapse as a spike in Spain's borrowing costs sparked fears that the currency bloc's fourth largest economy would be forced it to seek a sovereign bailout.

Jittery investors may be looking to Draghi once more to soothe concerns that Portugal's political problems could harm the euro zone economy and stability in peripheral bond markets.

(Read More: ECB Is Ready to Act But Governments Must Reform, Says Draghi)

"Draghi is going to be walking out on thin ice. If he fails to hint at further easing or at least negative interest rates as a possibility, we could see the euro and European markets take a bit of a hit," David Rodriguez, quantitative strategist at FXCM, an online forex trading broker, told CNBC.

Last month, the ECB chief disappointed markets after he failed to offer new monetary stimulus measures, saying the euro zone economy will return to growth by the end of the year. Some had expected the central bank to cut rates from the current record low of 0.5 percent.

(Watch Now: Euro Zone 'More Stable' Than a Year Ago: Draghi)

"Worries over Portugal could strengthen the case for stronger forward guidance by the ECB to ensure that interbank and funding concerns for the peripheral area do not intensify," said strategists at Australia New Zealand (ANZ) Bank in a note.

Portugal's 10-year government bond yield rose above 8 percent and its stock market plunged over 5 percent on Wednesday on concerns that instability in the ruling coalition could lead to snap election as early as September. Both the country's finance minister and foreign minister resigned this week.

The concern is that political turmoil could obstruct Lisbon's plans to exit its bailout program and regain full access to international capital markets by mid-2014.

Contagion Fears

Experts warn that a big risk from Portugal's political woes is that a spike in Portuguese bond yields spills over into other peripheral bond markets.

(Read More: Portugal Throws New Curve Ball in Euro Debt Crisis)

"The sharp declines in Portuguese bond prices, albeit amid thin liquidity, evoke echoes of earlier phases of the euro zone crisis in 2011 and 2012. Euro zone peripheral bond markets retain the capacity for brutal price action," said Nicholas Spiro, managing director at Spiro Sovereign Strategy, a consultancy focused on analysis of sovereign credit risk.

Spiro added that political risk is increasingly becoming a bigger component of the euro zone's stability.

"While the focus has been on the financial fragmentation of the euro zone, not enough attention has been paid to its political dimension. While the acute phase of the crisis was about broken debt markets, its chronic phase has been about broken politics," he said.

(Read More: Euro Zone Faces Make-or-Break Summer)

Renowned economist Nouriel Roubini agreed the Portuguese crisis would increase pressure on periphery bonds, but said on Twitter it is unlikely to result in severe instability in the country.

Portugal's Prime Minister Pedro Passos Coelho on Wednesday said he was confident of overcoming the political problems and had no plans to resign.

"We're talking about a prime minister here that's fully committed to a program and who has some unexpected political trouble in his coalition. We have to remember this is not a political crisis cause by tens of thousands of Portuguese marching in the street," said Jacob Kirkegaard, research fellow at the Peterson Institute for International Economics in Washington DC.

According to media reports on Wednesday at least two other government ministers from the CDS-PP - the ruling coalition's junior partner - were expected to resign.

(Read More: Portugal Prime Minister Defiant After Bond Yields Spike)

"I think we're certainly continuing in the muddling through phase. This is very similar to what we saw in Greece a few weeks ago," Kirkegaard said. In late June, Greece's Democratic Left party, a junior partner supporting the coalition government, withdrew its members after a row over the closure of the state broadcaster.

"I expect this to be papered over in Lisbon and the Eurogroup and the troika as a whole to continue to support Portugal going forward," he added.

By CNBC's Ansuya Harjani; Follow her on Twitter: @Ansuya_H