What sparked yesterday's renewed concerns around the eurozone?

Over on his Forbes blog Open Europe's Raoul Ruparel provides a comprehensive analysis of the renewed concerns around European banks, centred around Banco Espirito Santo (BES), which saw stocks falling across Europe yesterday. The full post is here and reproduced below.

Firstly, there’s no doubt there are some valid concerns surrounding BES, the key ones of which are:

• The ownership structure is a mess. BES is 25% owned by Espirito Santo Financial Group, which is 49% owned by Espirito Santo Irmaos SGPS SA, which in turn is fully owned by Rioforte Investments, which is fully owned by Espirito Santo International (last two are based in Luxembourg).
• The exposure between these level is equally opaque, with the WSJ highlighting back in December that ESI was utilising different branches of its structure, including BES, to fund itself up to the tune of €6bn. Currently, BES has admitted it has the following exposure: €980m debt from Rioforte, but it also helped place €651m of debt issued by Rioforte and ESI to retail customers and €1.9bn to institutional clients.
• This debt could essentially be worthless or massively written down. It’s not clear how open BES was about its conflicts of interest and if it mislead buyers. There is a serious risk of lawsuits here. Citi has put potential total losses at €4.3bn, this could wipe out BES capital buffer and force it to raise a similar amount again.
• BES also has a worrying exposure to its subsidiary in Angola which is draining €2bn worth of funding. This is substantial for a bank with a €6bn loan book. The bank has also required a 70% guarantee from the Angolan state, which itself has a poor credit rating meaning the usefulness of such guarantee may be limited (the fact it was needed at all says a lot). This has also been weighing on the share price.

All this culminates into some very real concerns. While there are plenty of unfounded rumours flying around, the fact is they are hard to disprove because the structure of the bank and its affiliates is so maddeningly complicated. The exposure has also been continuously underestimated and hidden so it’s only right to ask, what else might they be hiding?

But all of these are very specific BES problems, why has this suddenly sparked Europe-wide contagion. I believe there are a few factors behind this:

• The market has pulled too far ahead and was looking for an excuse to pull back. The market is also in a bit of a price discovery phase, still trying to figure out how to balance the issues of low inflation, search for yield, remaining eurozone risks and future ECB action, so it can be prone to sharp moves. The lower volumes and liquidity in certain markets may also exacerbate the move. Lastly, with the recent market convergence, there is bound to be more spill over between and within markets. All to say, part of this may be the confluence of market factors and circumstances – such a situation can last but is more likely to be temporary.

• More importantly though, investors are realising that, if the bank got into trouble it would have to rely on its sovereign for help. The bank cannot afford to recapitalise to the tune of €4bn. Equally though, Portugal (in the midst of trying to find further budget savings) would struggle to stump up the cash – hence the sovereign spill over. Talk of the sovereign-bank loop being broken are seemingly premature (as I have said before). 

• On top of this, investors are also looking at a lot of uncertainty about how a bailout/bail-in might work and what the exact rules would be. The eurozone’s rules on bank bail-ins and the single bank resolution mechanism don’t kick in for some time and while the state aid rules make it clear investors will take losses the exact format is very uncertain. These two points should once again peak investors’ concerns about how such bank resolutions might be handled. Throw the political obstacles in the mix surround a national flagship bank such as BES and one might wonder how much has really changed since such questions were asked at the peak of the crisis.

• More generally, BES’s problems show some elements indicative to periphery banks (particularly in Portugal and Italy). It has a very old, complex and opaque structure and its exposures are still not well known. Too little attention has been paid to this in the past year. The loan books are also weighed down by investments and lending to zombie firms. Let’s not forget, these two countries did not suffer from bubbles but chronic low growth and high corporate debt levels – neither of which has been tackled.

There are clearly some lessons in this situation for eurozone investors and they would do well to remember the short comings in the eurozone architecture, particularly when it comes to the banking sector which is yet to be cleaned up even after six years of crisis. That said, given the specific nature of the problems it is unlikely to mark a huge turnaround in market sentiment. Sure, the market will pull back a bit but we still have the injection of the new ECB lending operations (TLTRO) to come and the hope of some positive data on the GDP and inflation front.

One final point out of all of this is to watch how BES does in the upcoming ECB Asset Quality Review (AQR) and bank stress test. If it is not seen to have been rigorously assessed and problems highlighted then serious questions will begin to be asked about the credibility of an exercise. Now, the failure of the AQR would really be the start of bigger problems for the eurozone. 

Beyond appearances, the recent political crisis has changed things in Portugal

Political stability seems to have returned to Portugal - at least for now. The country's ruling coalition and the opposition Socialist Party have failed to agree on the 'national salvation pact' demanded by President Aníbal Cavaco Silva to help the country successfully complete its EU/IMF bailout programme.

Nonetheless, Cavaco Silva said in a speech yesterday that the continuation of the existing centre-right coalition was "the best [alternative] solution" - thus ruling out snap elections. The Portuguese President also stressed that the government would request a vote of confidence in parliament on its future economic and social policy plans.

So are we back to square one in Portugal? Not entirely.

First of all, there will soon be a cabinet reshuffle - as agreed by the two ruling parties before President Cavaco Silva stepped in. In particular, Paulo Portas - the leader of junior coalition member, the People's Party (CDS-PP) - should become Deputy Prime Minister and be in charge of dealing with the EU/IMF/ECB Troika from now on.

This could be an important change. Let's not forget Portas tendered his resignation from the government because he disagreed with Prime Minister Pedro Passos Coelho over the appointment of Maria Luís Albuquerque as new Finance Minister. On that occasion, Portas made clear that he was hoping for a change in the country's economic policy approach (in substance, less austerity).

This leads to a more general point, which we already made in the past (see here and here). Political consensus around EU-mandated austerity is shrinking in Portugal, and although the turmoil seems to have passed for now, tensions within the ruling coalition will remain - with Prime Minister Passos Coelho's Social Democratic Party (PSD) clearly more in favour of sticking to the current economic policy course than its junior coalition partner.

Furthermore, as Prime Minister Passos Coelho himself admitted this morning, the recent political crisis has "undermined" confidence in Portugal's determination to push ahead with the implementation of its bailout programme - something which could make it more difficult to obtain concessions from the European Commission and its eurozone partners in future.

As we noted in our flash analysis on this issue, these tensions have come at an inopportune moment for the country given that it still needs to enforce significant austerity to meet its targets and that its economic reforms to improve competitiveness now look off track. As political consensus wanes and protests increase, these tasks will become ever more challenging. 

Needless to say, Portugal's return to the markets - currently scheduled for June 2014 - is already looking quite complicated. Further delays or disagreements within the ruling coalition could make things even worse.

Portugal's coalition fights to keep its head above water

UPDATE (17:15) - First reports of an agreement to keep the coalition alive. Stay tuned for more details.

UPDATE (16:40) - Portuguese Prime Minister Pedro Passos Coelho and Foreign Minister Paulo Portas have just come out of another (swift) round of talks.

The outcomes of their third meeting in less than 24 hours are still unclear. Passos Coelho is now heading to the Belém Palace - where Portuguese President Aníbal Cavaco Silva is waiting for him.

UPDATE (14:45) - The second meeting between Portuguese Prime Minister Pedro Passos Coelho and Foreign Minister Paulo Portas is over. It was "very positive" - according to the Prime Minister's office - but inconclusive. Negotiations over a new coalition agreement will therefore continue.

According to the Portuguese media, Portas may backtrack on his resignation. If he did so, he would reportedly be appointed Deputy Prime Minister (the post is now vacant after former Finance Minister Vítor Gaspar quit) and Economy Minister (which in Portugal is a separate portfolio from Finance Minister).

More interestingly, a source quoted by Diário Económico suggests that a revamped coalition agreement would involve discussing "a new compromise with the [EU/IMF/ECB] Troika" - so potentially a relaxation of Portugal's deficit and reform targets.

ORIGINAL BLOG POST (11:25) 

As we noted in yesterday’s flash analysis, tensions in the Portuguese coalition reached critical levels over the past few days. They have eased off somewhat overnight, but there is still plenty of uncertainty around.

Key developments:

• Despite tendering his resignation from his post as Foreign Minister, the leader of junior coalition member CDS-PP, Paulo Portas, now seems to be backtracking somewhat. This is down to both internal pressure from his party, which is clearly not keen to be seen as bringing down the government, and external pressure from markets and eurozone partners over fears of snap elections which would delay the implementation of key reforms in Portugal.

• Portas already met Prime Minister Pedro Passos Coelho, with another meeting due later this morning. The two will also meet Portuguese President Aníbal Cavaco Silva this afternoon.

What are the potential outcomes?

• Portas is reportedly seeking a renegotiation of the coalition agreement. At the moment, it's not entirely clear whether his desire is more power for his party or less focus on austerity - or both. The former seems possible, although his party is significantly smaller (Passos Coelho's Social Democratic party controls 108 seats compared to 24 for CDS-PP). The latter seems less likely. The government has very little scope to adjust its economic policy due to the bailout requirements, while, as we noted yesterday, austerity and structural reforms need to continue with the country already falling behind in terms of implementing its programme.

• It is, of course, still possible that no agreement is reached and the CDS-PP confirms its withdrawal from government. However, the Portuguese media seem to agree that, even in that case, CDS-PP would keep granting parliamentary support to the government (an arrangement the Portuguese call incidência parlamentar).

• No matter the outcome, the divisions within the coalition are clear and present. There are likely to be some tough votes to come, particularly on labour market reform and further budget cuts. Whenever these take place, the spotlight will be on the coalition to see if it holds up under pressure.

We will continue to update this blog throughout the day with developments and news as we get them.

Governo em risco: Portuguese government at risk of collapsing after Foreign Minister resigns

UPDATE (18:15) - We thought it would be useful to explain quickly how things work in Portugal when a government crisis occurs. If the Prime Minister resigns, the Portuguese President is the one who decides when and if parliament has to be dissolved.

Under Portugal's electoral law, new elections must be held at least 55 days after parliament is dissolved. This would mean almost two months with a caretaker government at a rather unfortunate time for Portugal. 

ORIGINAL BLOG POST (17:45)

One day after the resignation of Finance Minister Vítor Gaspar, the Portuguese government has just lost another one of its key players. But the impact could be a lot bigger this time.

Paulo Portas, the country's Foreign Minister (see picture), has resigned because he disagreed with the appointment of Maria Luís Albuquerque as new Finance Minister.

Portas is also the leader of the People's Party (CDS-PP), the junior coalition partner of Prime Minister Pedro Passos Coelho. If the party pulls out of the coalition (which looks likely in light of Portas's resignation) Passos Coelho will lose his majority in parliament. So this is critical as it can potentially trigger new elections. 

Passos Coelho will make a TV statement tonight. We'll keep you posted. In the meantime, it's worth keeping in mind the economic and social challenges Portugal faces - which we outlined here.

Portugal's Finance Minister quits: A bolt out of the blue? Not really...

A surprise development in Portugal this afternoon, as Finance Minister Vítor Gaspar has announced his resignation. The office of Portuguese President Aníbal Cavaco Silva has said in a note that Gaspar will be replaced by Maria Luís Albuquerque - one of his deputies, with a long career in the Portuguese Treasury.  

Initially, the news sounded very much as a bolt out of the blue. That was until Jornal de Negócios published Gaspar's letter of resignation on its website. The letter reveals the following:

• Gaspar had already written to Portuguese Prime Minister Pedro Passos-Coelho in October 2012, stressing "the urgency of [his] replacement as Finance Minister."

• At the time, Gaspar had decided to quit over "a series of important events". In particular, he mentions the Constitutional Court ruling that struck down the government's plan to limit extra holiday and Christmas pay for public sector workers as unconstitutional in July 2012, and "the significant erosion of public support" for the austerity measures attached to the Portuguese bailout.

• However, Gaspar was asked to stick around a bit more - at least until the 7th review of the Portuguese bailout by the EU/IMF/ECB Troika was finalised and an extension of the bailout loan maturities was secured. Incidentally, the fact he has now been allowed to leave could be seen as a vote of confidence from the government in the strength of the Portuguese economy (although Gaspar may simply have been stepping up the pressure to be allowed to exit).

• Gaspar also points out that Portugal's consistent failure to meet its deficit and debt targets under the EU/IMF bailout agreement had "undermined [his] credibility as Finance Minister." On this point, it is probably worth reminding that, on Friday, it came out that Portugal's public deficit in the first quarter of 2013 had reached 10.6% of GDP - with the target for this year set at 5.5% of GDP.

• Interestingly, Gaspar concludes his letter by saying, "It's my firm conviction that my exit will contribute to reinforce your [Prime Minister Passos-Coelho's] leadership and the cohesion of the cabinet". This seems to suggest Gaspar may have lost faith in the reform approach taken in Portugal, and may not have been willing to push ahead with it (not least for the reasons mentioned above).

In any case, the news of Gaspar's resignation hardly comes at a great time for Portugal. As we noted in a recent briefing, the country faces some tough challenges this year:

• Domestic demand, government spending and investment are contracting sharply, leaving the country heavily reliant on uncertain export growth to drive the economy. 

• By cutting wages and costs at home (internal devaluation), Portugal has in recent years improved its level of competitiveness in the eurozone relative to Germany. However, this trend actually started to reverse sharply in 2012, meaning that the divergence between countries such as Portugal and Germany has begun growing again – exactly the sort of imbalance the eurozone is seeking to close. 

• In its austerity efforts, Portugal is now coming up against serious political and constitutional limits. For the second time, the country’s constitutional court has ruled against public sector wage cuts – a key plank in the country’s EU-mandated austerity plan – while the previous political consensus in the parliament for austerity has evaporated. 

How much impact this will have remains to be seen, although in a country where the economic future remains uncertain, suprises such as this are hardly ever welcome. In practice, though, the approach is likely to continue in much the same vein, firstly because the EU/IMF/ECB Troika has shown little willingness to be flexible with Portugal, and secondly because Maria Luís Albuquerque has often voiced her support for the approach taken so far.

That said, it is an interesting reminder of the strains the bailout programme is putting on the Portuguese government, as it begins the difficult task of finding a way to smoothly exit from its reliance on external funding.

Yet again the eurozone crisis is butting heads with national democracy

After a lengthy absence Portugal returned to the headlines over the weekend with the Constitutional Court ruling that some of the government austerity measures were unconstitutional. Here are the key details:

• The court found that four out of nine key savings measures included in the government’s latest budget were unconstitutional. These measures focused on cuts to public sector wages and pensions – the court deemed these unconstitutional since they hit public sector workers disproportionately hard. They also ruled against cuts to unemployment and sickness benefits.
• The measures amount to savings of €1.3bn (0.8% of GDP) which will now need to be found elsewhere. If they are not found, then Portugal’s deficit this year could reach 6.4% rather than the 5.5% currently targeted.

What does this mean for Portugal and the eurozone?

• The ruling was the cherry on top of a bad week for the government after a close ally of Prime Minister Pedro Passos Coelho resigned and the government faced a no-confidence vote in the parliament. Fortunately, it has so far survived these problems (new elections would bring huge uncertainty) but its support continues to be eroded.
• The previous political consensus in favour of the bailout and the accompanying austerity has now vanished, the opposition is likely to become increasingly vocal in its anti-austerity approach.
• The Commission has warned that the extension of the bailout loans agreed recently will be under threat if the government does not meet its targets.
• The cuts are likely to be found elsewhere but they may have more of a negative impact on growth, although this remains uncertain. One thing that is clear is that the public sector wage and pensions do need to be adjusted if Portugal is to become competitive and particularly if it is to recover through export led growth as the bailout programme currently targets. The inability to adjust these areas could harm Portugal in the long run.
• That said, this is not the first time this has happened. Last July, the court made a similar ruling on public sector wage cuts. The fact that this has happened again suggests the government may be struggling to find savings elsewhere (why else push on with cuts it knows stand a good risk of being blocked), and doing so may take longer than some expect.
• Legal points aside, experience (particularly in the Baltics) suggests that wage cuts in the private sector often follow or go hand in hand with public sector ones – at the very least, buy-in is needed across the economy and the private sector is unlikely to lead such an adjustment unless prompted to (wages are sticky on the downside). In this sense, although the cuts may have disproportionately hit public sector workers initially it may be necessary part of the internal devaluation approach taken (whether this approach is correct or not is another question).
• And of course, this adds further delays and uncertainty in the eurozone – along with lack of government in Italy and capital controls/bailout in Cyprus.

This is likely to rumble on for a while yet as the Portuguese government searches for savings elsewhere which will meet the requirements of the troika. Yet again, the eurozone crisis is butting heads with national democracy, in this case specifically constitutionality. Plenty more of that to come we expect.

Ave Angela, morituri te salutant

The spotlight is back on Greece today with the release of the much anticipated Troika report (read our daily press summary or follow us on Twitter for the latest updates), meaning that German Chancellor Angela Merkel's visit to Portugal has been pushed to the background.

However, clearly not everyone in Portugal is enthusiastic about Merkel's arrival. After the open letter signed by over 100 academics and intellectuals, arguing that the German Chancellor "has to be considered persona non grata in Portuguese territory", this is the front page of today's edition of Portuguese newspaper I Informação,

Another Latin expression, this one translates as, "Hail Angela, those who are going to die salute you" - a paraphrase of the famous salute made by gladiators to the Roman Emperor before the fights in the arena started. And another example that tensions can run high in Portugal too - even if the country does not usually receive the same degree of foreign media coverage as Greece or Spain.  
 

The 'forgotten man' of the euro crisis catches a break...

While everyone is gearing up for the EU's 'Super Wednesday', Portuguese Finance Minister Vítor Gaspar has made a quite important announcement. As we anticipated in our daily press summary more than two weeks ago, following its fifth monitoring mission to Lisbon, the EU-IMF-ECB Troika has decided to give Portugal one extra year to make the budget cuts agreed under its bailout programme.

The 'forgotten man' of the euro crisis will therefore be allowed to close the year with a deficit of 5% of GDP (instead of the previously agreed 4.5%). Portugal will then have to cut its deficit down to 4.5% of GDP (instead of 3%) next year and to 2.5% of GDP in 2014. No doubt the one off transfers from pension funds to push the deficit below previous targets finally caught up with them. 

The news is particularly interesting - and not only because Portugal seems to have fairly easily achieved what Greece has failed to obtain so far, despite Greek Prime Minister Antonis Samaras's recent 'diplomatic offensive'. In fact, Portugal is still expected to return to the markets in September 2013 (exactly one year from now). Given that the country has been allowed to run a larger deficit for this and next year, this suggests that it will have to borrow more money to cover for it.

For the moment, Gaspar has made clear that nothing has changed on that front, and Portugal will try to raise the money from private lenders (i.e. will not ask the EU and the IMF for more cash).

However, this brings us on to another interesting fallout from the ECB's new Outright Monetary Transactions (OMTs). Since currently bailed out countries, such as Portugal, can access support from the ECB when they are due to return to the markets, there is a good chance that the ECB could buy up some existing Portuguese debt from the secondary markets in September 2013, allowing banks to reinvest this money in the  new debt Portugal will issue. This also allows Portugal (and the eurozone) to sidestep the IMF's demand that countries be able to show clear funding streams for 12 months (which led to the second Greek bailout request).

So, despite delaying its deficit target and not being guaranteed market access within twelve months, Portugal looks able to avoid a second bailout with the help of the ECB (at least for the moment). One should now only ask whether the conditions attached to the Portuguese bailout programme will satisfy the ECB, especially after they have been eased...