The inevitable has happened with Portugal following Greece and Ireland in asking the European Union (EU) for a bailout. Today the country managed to sell government bonds in order to raise 1bn Euro funds to cover its debt payments over the next few months. But it did so at a price; the bond sale was successful only at rates twice the level they were a year previously. The Portuguese government understood that it cannot go on refinancing its debts at ever-higher rates of interest. In any case the funds raised only tide the state over for a year. They also involved Portugal accepting rates of between 5 and 6% in order to sell the bonds.
Here’s a brief analysis of the implications of this for Portugal and the Eurozone of countries in the European Monetary Union (EMU). I’ll also consider the alternatives to the bailout, but it’s important to start by reiterating the reasons for Portugal seeking a bailout. In becoming an EMU member, Portugal surrendered control of its monetary policy to the European Central Bank (ECB). That is, they accepted a single interest rate, set by the ECB. They also signed up to the EU’s stability and growth pact, which requires EMU member states to keep to the Maastricht Criteria of budget deficits no higher than 3% of GDP and national debt no higher than 60% of GDP.
For some years the arrangement suited the likes of Portugal, Greece and Ireland fine. They were able to access funds at low interest rates for whatever purpose they desired: consumer spending, infrastructure investment or a housing sector boom. But when the financial crisis which led to the credit crunch occurred from 2007 onwards, access to these funds dried up. These countries at the periphery of the Eurozone were forced to pay increasing penalties to repay their sovereign debts, which usually had materialised through inadequately regulated bank lending. Banks in Germany and France were faced with losing billions if these peripheral countries defaulted on their debts.
As I have covered in earlier blog entries, especially here, Portugal was one of the candidates for a bailout due to its failure to abide by the Maastricht Criteria. Unlike non-EMU countries, Portugal and its fellow member states, cannot issue its own currency. It relies on the ECB to do this for it. The ECB could easily issue currency or liquidity at no cost to itself, as it is the monopoly provider of its own sovereign money. But the EMU states cannot do this. Portugal was left to fund its debt by issuing bonds, or new debt, to the bond markets. The Guardian article cited above indicates that Portugal has to pay back 5bn Euro later this month and another 7bn Euro in June.
The European Financial Stability Fund (EFSF) was put together last year by the EU to provide support for countries that cannot pay their debts and face default. 750bn Euro is guaranteed as a result of the EFSF, dependent on ECB funds and financial support from the International Monetary Fund (IMF). The bailout of Greece took up 110bn of these funds; Ireland’s bailout accounts for 85bn; Portugal is thought to need between 60 and 80bn Euro. So what are the implications of this most recent bailout?
Firstly, it shows that eventually the EU is prepared to unite in the face of member states’ imminent debt default and bail them out using the EFSF. Secondly it means that bond traders are likely to turn their attention to the next weakest EMU member. That could be Spain, according to the Reuters article above (and Spain’s denials sound uncannily like those offered by Portugal and Ireland’s governments at the time). Finally it could mean that the EFSF needs to be increased, in case of default risks in Spain and Italy.
It’s important to remember that other than the financial contributions it must make to this fund, the risk of default does not affect the UK as firstly, it is not a member of the EMU. Secondly, the UK’s debt profile is organised over a much longer time frame than most countries. Finally, there is growing recognition of the fact that as the sovereign issuer of its own currency, like the ECB, the Bank of England can just issue money or liquidity to repay its debts whenever it likes. The only constraints affecting the UK’s ability to raise funds or create money are inflationary ones or those that the government chooses to impose on itself. See this PDF for explanation of the limitations of the Government Budget Constraint.
EMU countries at risk of default and seeking bailouts, have had to accept further austerity measures from the EU and the IMF. German MP Volker Vissing is quoted in the Reuters article as saying that the Portuguese had trouble accepting further budget cuts but ‘now they’ll be determined from outside’. The alternatives include default and departure from EMU, which would be chaotic for the EU and would be likely to see very tough conditions imposed on the affected countries. Finally, as this article proposes, the ECB could credit member states with sufficient liquidity to repay their debts and raise the deficit ceiling (currently 3% of GDP) to allow sufficient demand in their economies to create growth.
This would raise tax revenues and cut government spending, as the automatic stabilisers go into reverse. Ironically enough, it is the very same austerity measures, designed to cut deficits that appear to make them worse in the end. The outcome of austerity programmes in the bailed-out EMU countries and in the UK will provide research material for years to come.