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Portugal's Effect on the Eurozone

15/04/2013 11:17 BST | Updated 12/06/2013 10:12 BST

The decision on April 5 by Portugal's Constitutional Court to strike down a number of savings measures contained in the government's 2013 budget has increased the chances that Portugal will need a second bail-out and shortened the odds on an early election.

The court rejected four of nine measures referred to it by the president, Aníbal Cavaco Silva. Most important, it threw out plans to eliminate one of two annual bonus payments for public-sector workers and pensioners on the grounds that these breached the principle of equal treatment--workers in the private sector continue to benefit from such payments. It also ruled out levies on unemployment and sickness benefits, on the basis that minimum levels are established in law.

The ruling has created a €1.4bn hole in the public finances this year. In the absence of compensatory measures, the budget deficit would hit at least 6.5% of GDP in 2013, compared with a target of 5.5%. Having excluded the possibility of further tax increases, the government is instead looking to accelerate cuts to public spending, with social security, education and health likely to bear the brunt. Implementing new expenditure savings will be difficult to do in a hurry, however, suggesting the government's already demanding budget target has slipped further out of reach.

Medium-term budget plans have also been thrown into doubt because the decision effectively establishes limits on the sacrifices to be borne by civil servants and pensioners. Following a similar ruling last year, the prime minister, Pedro Passos Coelho, called for constitutional revisions, but to do this he need a two-thirds parliamentary majority and the support of the opposition Socialist Party. The Socialists would rather wait until after the next election, increasingly confident that the will win and be in a position to oversee the implementation of a redesigned reform programme.

While attention has focused on how the government in Lisbon will respond to the ruling, equally important is what Portugal's creditors do now. Until recently, Portugal was seen as a model pupil. The centre-right government has been gung-ho about the need for savings and has done much of what has been asked of it. It is the judicial branch that has laid down markers on what is and what isn't acceptable. Yet disregarding accounting fiddles, the underlying budget deficit has hardly budged over the last couple of years. The best that can be said is that the authorities have managed to shrink the state sector in step with the contraction of the economy, at the cost of pushing the unemployment rate above 17%. This is hardly a ringing endorsement of the euro zone's Plan A.

So what is the appropriate course for Portugal's creditors now? First, euro zone finance ministers should grant the request by Portugal (and Ireland) to extend the maturities of existing bail-out loans. Without this help, Portugal would face impossible debt repayment humps in 2016 and 2021. The country's financing needs still remain formidable. Some €14bn of medium- and long-term debt must be rolled-over in 2014 alone, while the deficit is likely to remain higher than planned at around €8bn (or 5% of GDP). The current EU/IMF programme extends only €8bn in loans next year, with Portugal expected to raise the rest. Even with the maturity extension, access to markets is likely to remain irregular, depending on investors' appetites for risk.

The prime minister is thus boxed in by the dire state of the economy, the judiciary and the opposition in parliament. The EU/IMF should recognise this and allow Portugal the time it needs to redesign a programme that can fit within current constitutional limits, pending political conditions that are more conducive to revising the constitution. An insistence on hurried reforms is likely to back-fire as they either depress growth even more or result in an ever higher social cost.

Of course, more time equals more money. The best option for the government would be to negotiate a precautionary credit line from the European Stability Mechanism, which would open the way for secondary market bond-buying by the European Central Bank to contain borrowing costs. However, for this to work the ECB would have to show some flexibility over its conditions, having previously insisted that Portugal would need to demonstrate full market access as a pre-condition.

If such support is excluded, then talks should begin sooner rather than later on a second bail-out package. For a government that has repeatedly denied the need for any more funds, such a U-turn would undermine its credibility, but the damage could be limited if talks were concluded swiftly. The longer the denials go on, the more likely it will be that negotiations over a second package will have to include the Socialists and be followed up by fresh elections. The alternative of maintaining the fiction that Portugal can get by with ever harsher austerity would be to invite even greater political instability, which risks spilling over into the rest of the euro zone.