Why Portugal Should Be Most Worried About ‘Grexit’

Portugal is becoming the new sick man of Europe, despite sticking to the troika’s hard-to-swallow medicine of austerity, while the prognosis for Greece is much worse- and potentially contagious- according to the latest report from Citi.

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The markets’ focus should be firmly on Greece — and Portugal’s — immediate economic future, according to the research by economists in the bank’s global research group.

According to Citi, Portugal’s economy is shrinking and, like Greece, it will “probably require an extension of its bailout package despite the fact that the government has dutifully reduced its expenditure and diligently implemented most of the measures mandated under the Troika program.”

The report notes, however, that unlike Greece which could leave the euro “as early as September”, the prospect of a Portugal exit is slim. Rather, Portugal could face a flight of bank deposits and a reduction in consumer confidence, trade and foreign investment because of a Greek exit.

“In our base case scenario, we expect that Portugal will remain a member of EMU, in contrast to Greece, for which we see a 90% probability that it exits the euro area,” the report states.

“We continue to expect the contraction in [Portuguese] GDP in 2012 and 2013 to be deeper than the consensus view,” the report states, “and believe that Portugal will miss this year’s deficit target (of 4.5 percent), despite having met the target in the first half of 2012.”

The researchers at Citi note that despite reducing government expenditure, such as the suspension of 13th monthly payments for public sector workers’ wages and pension benefits in line with targets, Portugal’s tax revenues have been much weaker than expected and it will most likely remain in recession until 2014.

Though Portugal has fulfilled most of its commitments to the troika austerity program, the report states Portugal is unlikely to “return to fiscal sustainability” and forthcoming sovereign debt restructuring – and haircuts- are increasingly likely.

“While an upcoming extension of the bailout package would be unlikely to come with debt restructuring, we expect that, in the next 1 to 3 years [that] debt restructuring, including private-sector involvement (PSI) and official sector involvement (OSI), will take place as the Troika program likely fails to return Portugal to fiscal sustainability.”

Portugal’s contracting economy, means it will most likely be pressured to request an extension of the current rescue package, or a second bailout from the troika (the European Central Bank , IMF and European Commission), a fate similar to that of Greece. (link)

This scenario would provide a “test case” for the solidarity of the euro area creditor countries, says Citi. Should Greece leave the euro in September, Citi expects that Portugal would still be able to renegotiate its austerity program and place within the single currency, but the future would not look bright for Portugal, or indeed for the euro itself.

“If Portugal were to be forced out of the euro for not meeting the deficit targets, despite having implemented the required structural reforms and austerity measures, it would be a sign that the creditor countries are not willing to expand their support for the periphery countries in general,” the report states, ominously adding, “This probably then would lead to broader dismantling of the euro.”