Cameron’s €4 billion Portuguese challenge

As if the budget and Libya weren’t enough, the UK Government woke up today with another major challenge on its hands – yet another flare-up in the eurozone debt crisis, which has been continuing to bubble away under the radar.

Yesterday, Portugal’s Prime Minister José Sócrates literally walked out of Parliament, during a debate on EU-backed austerity measures. The austerity package was subsequently voted down and shortly afterwards Sócrates announced his resignation. Portugal is now facing the prospect of being without a government for months, as its electoral rules require a 55 day break between the dissolution of Parliament and new elections.

The episode has increased the already heavy market pressure on Portugal’s finances. That the country will be the third of the eurozone dominos to ask for an EU/IMF bail-out looks almost inevitable. In 2011, the country needs to refinance 25 percent of its national wealth – in relative terms, this is even more than Greece. The country’s borrowing costs have been above 7 percent for 38 consecutive days. Greece and Ireland lasted 13 and 15 days respectively at these kinds of rates before asking for a bail-out. Its economy is expected to contract by 1.4 percent this year.

In a briefing published today, Open Europe estimates that Portugal will need a bail-out in the region of €60-70 billion in order for it to cover its debts and deficits over the next three years – though the rescue package could soar beyond €80 billion should things get messier.

In terms of the EU economy getting on with business, the timing could hardly have been worse. David Cameron and the EU’s other 26 heads of government are meeting in Brussels today and tomorrow for a long planned EU summit. The Portugal bust-up is an embarrassment to many of them, as they had claimed in recent weeks that the sovereign debt crisis in the eurozone was now under control.

What happens in Portugal has huge implications for Britain. The UK’s exposure to debt in the eurozone is absolutely massive, and should Portugal’s problems spread to Spain – where UK banks hold £80 billion in debt for example – the potential impact on the UK economy is scary.

So should the UK participate in a bail-out of Portugal? As in the case of Ireland, it may not have much of a choice. Under the deal that was agreed by the Labour government during the last 48 hours of its administration, the UK doesn’t have a veto over the bail-out fund (the €60bn EFSM) that it’s partially liable for.

If the loans to Portugal were to replicate the structure of the Irish bail-out, we estimate that Britain may have to contribute €3.7bn (under a €60bn bail-out) or €4.3bn (under a €70bn bail-out) – although, as with any moving target, it could be even more. If Cameron convinces EU leaders to involve only eurozone countries and the IMF, it may get away with only its IMF share, which would be far less.

Apart from the lack of democratic legitimacy underpinning the UK’s potential contribution, a bail-out is unlikely to solve any of Portugal’s or the eurozone’s fundamental problems. Both Ireland and Greece are already looking to renegotiate their bail-out terms – clearly, the EU’s current strategy isn’t working. Even with fresh cash from a bail-out, Portugal will remain uncompetitive and its growth prospects poor. In turn, Britain will remain just as exposed to future meltdowns and contagion effects in future.

A more viable solution would be to restructure some of Portugal’s debt, once the country gets a new government. In the long run this may prove cheaper despite a larger initial cost, since, unlike in the case of a bail-out, it would cut Portugal’s debt rather than increase it. It would also reduce the burden on taxpayers, instead transferring more of it to investors.

Kicking the can down the road will only make things more painful. The longer Portugal waits, the costlier restructuring will be for the country: its debt is expected to continue to build over the next three years.

So what about the next domino: Spain? Our briefing deals with a possible contagion to Spain. In order to pre-empt any problems, it would be best to combine the Portuguese bailout with a limited Spanish bail-out. This would involve smaller contributions from member states, since more of the cost would be borne by investors. Despite not having a veto, the UK should look to make its participation in any bail-out conditional on restructuring. It’s about time that the UK develops a coherent eurozone strategy. This one just won’t leave them alone.