Portugal’s slow-motion train crash

Last Friday’s announcement by S&P that it was lowering Portugal’s credit rating to below investment grade was another nail in the coffin of the embattled nation. For those that had not already done so, the downgrade forced those money managers who still had exposure to Portugal to offload. The ten-year bond yield rose to 14.40% yesterday, 1250bp above comparable Bunds. Although the Portuguese Prime Minister has been praised by other EU leaders for his austerity measures, it is clearly weighing heavily on the economy. In 2012, it is entirely plausible that GDP will decline by at least 5%, with further falls in prospect next year. In the year to September 2011, GDP fell by 1.7%.

Portugal is on a path of deeply painful internal devaluation, as it does not have control of monetary levers such as interest rates or an exchange rate. Private-sector deleveraging is proceeding very quickly and bank balance sheets are under enormous strain, which is accelerating the economic misery. Because of the financial lifeline supplied by both the EU and the IMF last year, there is no imminent trigger for a debt-restructuring. However, bondholders must surely realise that Portugal has very little realistic prospect of paying back its debts in full.

As we move through 2012, discussions will commence regarding the size of haircuts that Portuguese bondholders might need to take. Some suggest it could be up to one-third. Right now, that seems like the best-case scenario for this struggling country.