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

Prime Minister Pedro Passos Coelho's struggle to meet deficit pledges 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-year bond yield above 10 percent, returning to the markets next year may be untenable, requiring more international aid despite the premier's insistence he won't seek concessions.

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

Portugal completed the fourth review of its 78 billion-euro bailout plan on June 4 and progress helped bring down the benchmark yield from a euro-era record of 18.3 percent on Jan. 31. Now a deepening recession and the court ruling are putting pressure on government finances, and raising doubts about the chances of the nation reducing its deficit to within the European Union's limit of 3 percent of gross domestic product next year.

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

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

“The Portuguese government is studying measures of equal impact on 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 stakes in companies, including utility EDP-Energias de Portugal SA and power-grid operator REN-Redes Energeticas Nacionais SA, to bolster public finances.

Austerity Plans

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

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

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

“Because of the size of the slippage, however, the new targets will have to be combined with further fiscal tightening, putting at risk the domestic political consensus on the program,” Santos said in a June 28 research report.

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

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

Political Tension

The response shouldn't be to “renegotiate everything,” Passos Coelho said in July 9 comments broadcast by SIC Noticias. “We must redouble our effort and attention to meet those goals and objectives.”

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

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

The good news for Portugal is the country's austerity trap may prompt the EU and the International Monetary Fund to heed Seguro's calls 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 is having on economic activity within Europe, the EU might be open to reassess the targets set in the bailout program to Portugal,” said Goncalo Pascoal, chief economist at Banco Comercial Portugues in Lisbon.

Bloomberg News

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Portugal Lurches into Austerity Trap

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