Why Portugal Matters

Many observers continue to tout Italian risks
as the greatest in the euro area into the
year end.
  The constitutional referendum that would emasculate the
Senate, and end the perfect bicameralism that has contributed to more than 60 governments
since the end of WWII.

The fact that Prime Minister Renzi indicated he would resign if the referendum did not pass
highlighted the political risk. 
The second largest party in Italy
after Renzi’s PD coalition is the Five-Star Movement which wants to leave the
monetary union.

However,  judging from various news
accounts and the social media, it has largely been missed that Renzi has
backtracked from this.
  He has indicated the linkage was an error and
that regardless of the results of the referendum, the next parliamentary
election would take place as scheduled in 2018.   Italy’s Interior
Minister, who does not hail from Renzi’s PD, confirmed that the government
would not resign if the referendum lost.   Just like Italy is not
Greece, Renzi is not Cameron.

To be sure, the loss of the referendum could be seen as a sign that Renzi’s reform efforts
have stalled. 
It could weaken him, but the that is not the same as
toppling him.  The contagion emanating from Italian politics is less than
was the case say three months ago, though it may not be widely recognized yet
by global investors.

Portugal does not pose systemic risk, but
there may be contagion to Spanish banks that have exposure and Italian assets
that often appear correlated to risk assets.
  The way access to the
ECB facilities works is that a country
needs at least one of the top four rating agencies to recognize it as
investment grade credit.  That is the case for Portugal, where only DBRS
sees the sovereign as investment grade. 

DBRS is set to review Portugal’s credit rating
on October 21.
  It has expressed concern about rising yields and the
fragility of the recovery.   The sovereign-bank link has not been severed.   Portuguese banks are large
holders of its sovereign bonds (35 bln euros at the end of July). The
combination of weak growth and rising yields means that Portugal’s debt/GDP
cannot stabilize.  Portugal’s debt/GDP is roughly 136%, trailing Italy
(142%) and Greece (185%) in Europe.

DBRS has a stable rating for Portugal. 
It could still cut the rating, but it is unlikely.  Barring a shocking development, the first step is to
change the outlook.  This alone
could spur some additional pressure.  The market, however, has shunned Portugal bonds.  The benchmark
10-year yield has risen 42 bp over the
past three months.  A similar tenor Greek bond yield has risen 35
bp.  Spain’s benchmark yield has fallen 16 bp, while Italy’s is up nine bp.  Year-to-date Portugal’s
performance is even more extreme.  The yield is up 92 bp, while Spain is
off 75 bp and Italy off 25 bp.  Greece’s 10-year yield is up 25 bp since
the start of the year.  

If DBRS does take away Portugal’s investment
grade rating, there would be significant implications.  Portuguese banks,
which are heavier users of ECB facilities, could no longer use government bonds
as collateral, without a waiver from the central bank.
  Its bonds
would no longer qualify under the ECB’s sovereign bond purchase
program.   Portuguese banks could be forced, like Greek banks to rely
on credit from the national central bank (Emerging Lending

Although a loss of Portugal’s investment grade
status is not the most likely scenario, the contagion effect could be
  It comes at a time, where domestic political
considerations, especially in Germany, would leave little room to maneuver.
  A new assistance program cannot be ruled out.   


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