Erico Matias Tavares of Sinclair & Co.
Portugal’s Debts Are (Also) Unsustainable
Everyone seems to be focusing on Greece these days – a country so indebted that it needs even more loans to repay just a fraction of its gigantic credits. Clearly this is unsustainable and something has to give. Even the IMF agrees.
But what about the other Southern European countries?
Actually, Portugal’s financial situation is looking particularly shaky, and any hiccups could have serious cross-border repercussions from Madrid all the way to Berlin.
The prevailing narrative is that Portugal has been a star pupil compared to Greece, with austerity delivering much better results:
- The government, a coalition of a center party and center-right party that together have held the majority of parliamentary seats since the 2011 election, pretty much followed all the major guidelines demanded by its creditors (the famous “Troika”) pursuant to the 2010 bailout, and was even praised for it.
- Exports have performed exceedingly well given everything that was going on domestically and abroad; the managers of small and medium enterprises in Portugal are true heroes, operating in difficult conditions and with limited access to credit.
- Portugal has recently become a darling of international real estate investors and tourists.
- The country’s citizens have stoically endured a range of tough austerity measures with surprisingly little social disruption.
So it is understandable that hopes for Portugal’s future are much rosier than in Greece… AND YET ITS FINANCIAL SITUATION IS ALSO UNSUSTAINABLE!
We realize that this is quite a bold statement. So to support our argument we will use some simple math to show where government finances stand after five years of austerity.
Simple Math, Hard Truths
The Bank of Portugal (“BdP”), Portugal’s central bank, publishes debt statistics of key sectors in the economy on a quarterly basis. The link to the latest publication can be found here.
As of March 2015, non-financial public sector debt stood at €288 billion, or 166% of GDP. You may think that there’s something odd right there because you are used to hearing that the Portuguese government “only” owes 130% of its GDP. That’s because the media generally uses Maastricht treaty calculations, not the total amount that the government owes as a whole (which includes public companies, for instance). But what’s 36 percentage points of GDP among friends?
OK, let’s do some math:
- We start by dividing €288 billion by 166% to find out what nominal GDP the BdP used in its calculation: about €174 billion;
- Next, let’s assume that the cost of debt on all that government debt is only 1%. In this case, the annual interest expense for the government should be 1% x €2.88 billion, or €2.88 billion. We know that this is very low as the actual interest expense in 2014 was almost €7 billion (and likely not all of it, but government accounts can get quite murky);
- Then we assume that Portugal’s nominal GDP grows at 1%, which is not stellar but certainly better than recent years – from December 2011 to December 2014, the average nominal growth rate was actually -0.6% (BdP figures). So that’s 1% x €174 billion, or €1.74 billion;
- Finally, we compare the assumed interest costs with the nominal GDP growth: €2.88 billion vs €1.74 billion.
See what we are getting at here?
USING FAIRLY OPTIMISTIC ASSUMPTIONS, THE PORTUGUESE ECONOMY IS UNABLE TO GROW ENOUGH TO COVER THE INTEREST ON ITS GOVERNMENT DEBTS, LET ALONE AFFORD ANY PRINCIPAL REPAYMENTS!
As a result, government debt-to-GDP can only rise from here, especially as the government seems incapable of balancing the books.
Recent historical performance is particularly revealing:
Portuguese Government Debt as % of GDP
It should be obvious why Portugal’s creditors expect more austerity still: the government needs to generate a big budget surplus to at least stabilize the debt situation (and a gigantic one to actually start paying down the debt). But with an ageing population, sluggish internal demand and the recessionary impact of having to further reduce government expenditures in this context, the hurdle keeps getting higher. And if the global economy goes into a recession, the government’s debt ratios might just explode higher from here.
A Portuguese default could be much more problematic than Greece’s for a couple of reasons: i) despite trillions in central bank intervention and taxpayer funds at risk, it becomes undeniable that the Southern European crisis is far from being resolved – Mario Draghi’s “whatever it takes” was just not enough; ii) European taxpayers are primarily on the hook in case of a Greek debt haircut, but there are still plenty of private creditors left in Portugal – including from Spain, France and Germany. So things could escalate fairly quickly.
“But Portugal Can Grow its Way Out of this Mess!”
As any skeptic would argue: Portugal’s debt-to-GDP statistics are skewed because if the economy was operating normally the GDP would be much higher and the debt ratio would thus be much more manageable…
Sorry, but this is a speculative statement – and certainly not based on fact. That “normal” GDP was inflated by way too much debt, both public and private, accumulated over many years.
Of course anything can happen in these uncertain times, but there’s a large body of evidence suggesting that Portugal is in big financial trouble. Far from us wanting to be the prophets of doom here, but to come up with a viable solution we need to fully understand the problem first.
Consider the following:
- If the downturn had been purely cyclical, five years after the crisis the economy should have recovered much quicker. The fact that it hasn’t reveals some important structural deficiencies. This becomes even more apparent when looking at real GDP performance since 1988 (graph below). So the oddity at this point would be to see strong economic growth – not the opposite.
Portugal Quarterly Real GDP Growth Rate: 1Q’88 – 2Q’15
Source: www.tradingeconomics.com, BdP.
- People don’t pay attention to the “productivity of debt” as much as perhaps they should. In good times, one Euro of debt can generate more than one Euro of economic growth. However, once an economy hits the skids and starts taking on too much (unproductive) debt, that ratio becomes less than one. What does this mean? To generate one Euro of economic growth you now need more than one Euro in debt – or stated differently, YOU CAN NO LONGER GROW YOUR WAY OUT OF DEBT. Portugal’s experience since 2010 has been a little different because accessing the credit it needed to grow became increasingly harder. It was the private sector who did all the deleveraging as government debts skyrocketed, so much so that from December 2011 to March 2015 total non-financial debt in the country flatlined at €702 billion. And the impact on nominal GDP? A REDUCTION of €2.4 billion over that period (BdP figures).
- Even if Portuguese citizens and companies could borrow more, the country’s banking sector may not be healthy enough to address their needs. Almost 9% of total bank credit is past due or uncollectible (BdP figures). Not the best environment to stimulate growth.
- In a 2010 paper, Carmen Reinhart and Kenneth Rogoff argued that GDP growth slows to a trickle once government debt levels exceed 90% of GDP. While their work received more than its fair share of criticism (some of it unjustified, in our view), the authors observed a strong correlation between high debt levels and slower growth across a large sample of countries over many years. Purely judging by the experience of other countries, a 166% government debt-to-GDP ratio should most certainly curtail Portugal’s growth prospects.
- According to a recent McKinsey study, Portugal is one of the most indebted countries in the world, as shown the graph below – EVEN MORE THAN GREECE! This means that BOTH the government and its citizens need to tighten the belt, making the prospect of paying down those burgeoning government debts even more problematic.
Source: McKinsey Global Institute.
- The composition of that debt is also very important. Productive debt can be a good thing for the economy; non-productive debt is a whole different ballgame. Think about it in terms of borrowing money to finance an investment, which should generate a return and hopefully pay the debt by itself over time, or instead to buy a car or go on holidays, which can only be funded out of savings and/or future earnings. As unemployment rose, a lot of that non-productive debt became impaired, as we have shown above. It could get worse.
- Then there’s malinvestment, which is related to the point above. Austrian economists define it as “badly allocated business investments, due to artificially low cost of credit and an unsustainable increase in money supply”. Being in the Euro since 2000 gave Portugal an unprecedented access to credit at very low interest rates, resulting in a splurge in imported consumer goods and new highways up and down the country. Credits associated with malinvestment sooner or later need to be liquidated, which will also hit growth.
- Portugal has one of the highest income inequality ratios in the Eurozone. Therefore, a new round of austerity measures will disproportionately hit a large percentage of the population at the lower income levels. As we argued previously, a similar dynamic was one of the nails in the coffin of previous Troika bailout policies in Greece.
- Last but not least, those debt figures do not include contingent liabilities, such as pensions and healthcare costs over time. The graph below shows the dire situation of Portuguese demographics. Fewer and older people simply can’t pay ballooning debts. And as the recent Grupo Espirito Santo debacle has shown, the government may still have to incur further costs to help the country’s financial sector regain its footing.
Portuguese Population by Age Group (‘000s): 1985 – 2050 (at constant fertility rates)
So what do bond investors make of all of this?
Evidently, that the European Central Bank has their backs, because 10-year Portuguese bonds are currently trading at only 186 basis points over German Bunds, compared to Greece at 1043 basis points and the US at 155 basis points (in USD of course).
But should they be concerned?
Here’s what José Socrates, Portuguese Prime Minister from 2005 to 2011, had to say about the country’s financial situation, soon after leaving office:
“For countries like Portugal and Spain, the idea that we now have to pay the debt is a childish idea. Sovereign debts, as it is taught in economics – that’s what I have studied for some time – are by definition eternal. Debts are to be managed.That’s what I studied. Of course we should not let debt grow too much because that’s a burden on expenses (…)”.
Yes. They should be very concerned indeed. And so should the rest of us.