The collapse of Portugal’s government would matter

It would be a mistake to dismiss Portugal as a small economy on Europe’s southern periphery of little systemic consequence. The imminent rise to power of a Socialist government, dependent on the support of a far left anti-austerity bloc, could usher in a new phase of the European sovereign debt crisis. It could also draw attention to the process of political fragmentation across Europe over the past few years that shows no sign of losing momentum.

{mosads}Portugal’s indecisive Oct. 4 election, in which no single party won an overall majority, is very likely to have ushered in a prolonged period of political uncertainty. After this weekend’s cementing of an alliance between the Socialists, the Left-Bloc, and the Communist Party, Aníbal Cavaco Silva, Portugal’s president, would seem to have little alternative but to allow that alliance to form Portugal’s new government should the current government of Pedro Passos Coelho lose this week’s scheduled confidence vote. Under the Portuguese constitution, Silva is precluded from calling a new election now since his term of office expires in January.

Judging by its agreed economic policy platform, a left-bloc government is likely to strongly resist Brussels’s call for further budget austerity. It is also more than likely to roll back a number of the economic reforms adopted by the previous government, including those regarding privatization policy and the minimum wage. This could pose a real risk to both domestic and international confidence in the Portuguese economy.

Portugal is hardly in a position to afford a period of political instability and economic policy drift. Despite its past efforts at budget reform, Portugal remains among Europe’s most highly indebted economies. Its sovereign debt currently stands at around 130 percent of gross domestic product (GDP), while its total public and private sector debt stands at over 350 percent of GDP. Heightening Portugal’s vulnerability to a loss in foreign investor confidence is the fact that its net external debt exceeds 100 percent of GDP.

Against this backdrop, it has to be of concern that Portugal’s political crisis is occurring at the same time that the global economic environment confronting the country is taking a decided turn for the worse. Both the International Monetary Fund (IMF) and the Organisation for Economic Cooperation and Development (OECD) are now expecting that global economic growth will slow to its weakest pace since the 2008-2009 economic recession. Meanwhile, the Federal Reserve is poised to start raising interest rates before year-end, which could make global investors more discerning about those countries whose bonds they are prepared to buy.

Since the beginning of this year, Portugal has been receiving support from the European Central Bank (ECB), which has been buying Portuguese government bonds as part of its quantitative easing program. However, should Portugal now turn its back on budget austerity and economic reform, it would risk losing its investment grade status with all of the rating agencies. Since investment grade status is a necessary condition for the ECB to continue buying Portuguese government bonds, its loss could lead to a new phase in the European sovereign debt crisis.

A further discouraging aspect of the Portuguese political crisis is that it is not occurring in isolation, but rather appears to be part of a larger process of political fragmentation that has taken root in Europe. It is coinciding with renewed foot-dragging in Greece about the implementation of its IMF-EU program; separatist tendencies in Catalonia (Spain); Spain moving from a two-party system to a four-party system; a rising anti-euro movement in Italy; and Angela Merkel’s authority in Germany coming into increased question over the immigration issue.

At a time when a slowing in the Chinese and emerging market economies are casting a long shadow over the global economic outlook, the last thing that the world economy now needs is a return of the euro debt crisis. For this reason, one has to hope that the new government likely to take office in Portugal will back away from its agreed policy platform and opts for policies that will not undermine investor confidence.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.