Portugal's international creditors may soon have to ease termsof the country's bailout to prevent the plan from derailing as thegovernment faces setbacks in attaining its deficit goals.

Prime Minister Pedro Passos Coelho's struggle to meet deficitpledges were further hampered last week when about 2 billion euros($2.5 billion) of planned cuts to pensions and civil servants'holiday pay were ruled unconstitutional. With Portugal's 10-yearbond yield above 10 percent, returning to the markets next year maybe untenable, requiring more international aid despite thepremier's insistence he won't seek concessions.

“Lisbon's strategy is to continue to be the good student amongbailed-out countries until it becomes clear that Brussels andBerlin must ease the rules of the game for it to succeed,” saidAntonio Barroso, a London-based analyst at Eurasia group.

Portugal completed the fourth review of its 78 billion-eurobailout plan on June 4 and progress helped bring down the benchmarkyield from a euro-era record of 18.3 percent on Jan. 31. Now adeepening recession and the court ruling are putting pressure ongovernment finances, and raising doubts about the chances of thenation reducing its deficit to within the European Union's limit of3 percent of gross domestic product next year.

Portuguese bonds gained almost 30 percent this year as thegovernment stuck to terms of the international rescue, the mostamong euro-area government debt, according to indexes compiled byBloomberg and the European Federation of Financial AnalystsSocieties. In the same period, German securities returned 3.6percent and Spanish debt declined 5.3 percent.

Finance Minister Vitor Gaspar signaled the government'sintentions not to seek concessions yesterday in Brussels even aftereuro-region finance ministers agreed to give Spain an extra year tomeet its deficit goals and eased terms of its 100 billion-euro bankbailout. The Portuguese and Spanish cases are different and thegovernment won't be deterred by the court ruling, Gaspar said.

“The Portuguese government is studying measures of equal impacton the budget” to compensate for the court's ruling, he said.

After seeking a bailout last year, Portugal has increased taxes,reduced spending to shrink the size of government and sold stakesin companies, including utility EDP-Energias de Portugal SA andpower-grid operator REN-Redes Energeticas Nacionais SA, to bolsterpublic finances.

Austerity Plans

The austerity measures have deepened the recession withPortugal's economy forecast to contract 3 percent this year andunemployment set to rise to a euro-era record 15.9 percent in 2013,according to government estimates. Economic growth has averagedless than 1 percent a year for the past decade, placing Portugalamong Europe's weakest performers.

Portugal has pledged to have a budget deficit equal to 4.5percent of GDP this year and to trim that to the EU limit of 3percent in 2013. The central government's shortfall widened to 7.9percent in the first quarter from 7.5 percent a year earlier,leaving those goals looking optimistic. The budget gap probablywill be on the agenda, when Portugal's creditors carry out thefifth review of the bailout plan starting on Aug. 28.

Portugal may end the year with a deficit of more than 5.5percent of GDP, missing the rescue plan's target by more than 1percentage point and prompting an easing of bailout terms, saidRicardo Santos, a London-based economist at BNP Paribas SA.

“Because of the size of the slippage, however, the new targetswill have to be combined with further fiscal tightening, putting atrisk the domestic political consensus on the program,” Santos saidin a June 28 research report.

Portugal's 10-year bond yield was little changed today at 10.44percent, while the rate on Spanish debt of similar maturity rose 2basis points to 6.83 percent. The difference in yield thatinvestors demand to hold Portugal's 10-year bonds instead of Germanbunds has narrowed to 9.1 percentage points from 10.8 percentagepoints on June 1.

The government's decision last year to cut pensions andpublic-sector workers' summer and Christmas salary payments through2014 was central to its deficit-reduction effort. The 2 billioneuros a year in projected savings are more than 1 percent of thecountry's GDP. Even after the ruling, which affects cuts in 2013and 2014, Passos Coelho insisted that he won't seek easierterms.

Political Tension

The response shouldn't be to “renegotiate everything,” PassosCoelho said in July 9 comments broadcast by SIC Noticias. “We mustredouble our effort and attention to meet those goals andobjectives.”

His determination to stick with the current targets isheightening political tension at home. He faced a wave of criticismfrom the main opposition Socialist Party for failing to push forconcessions even after euro-area leaders agreed to ease terms forSpain and to relax conditions on potential help for Italy.

Socialist Party leader Antonio Jose Seguro said in a June 3interview with Diario Economico that Portugal needs at leastanother year to complete the program.

The good news for Portugal is the country's austerity trap mayprompt the EU and the International Monetary Fund to heed Seguro'scalls and grant the government more time to carry out its aid plan,even if Passos Coelho won't ask for an extension.

“It may be that, given the impact simultaneous austerity ishaving on economic activity within Europe, the EU might be open toreassess the targets set in the bailout program to Portugal,” saidGoncalo Pascoal, chief economist at Banco Comercial Portugues inLisbon.

Bloomberg News

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