Moody's Downgrades Portugal: Junk Alert

The financial domino game in the eurozone hasn’t stopped. With Moody’s downgrade of Portugal, the sovereign debt crisis has began to spread beyond Greece again, even as the funding of the southern European nation still faces hurdles such as austerity, taxes and renegotiations with banks. Word is that the EU banks have sold much of their Greek debt, so the idea that they can extend that debt to help Greece is not more than a fantasy.

Now. Portugal is in trouble.

Moody’s announced:

Moody’s Investors Service has today downgraded Portugal’s long-term government bond ratings to Ba2 from Baa1 and assigned a negative outlook. Concurrently, Moody’s has also downgraded the government’s short-term debt rating to (P) Not-Prime from (P) Prime-2. Today’s rating action concludes the review of Portugal’s ratings initiated on 5 April 2011.

The following drivers prompted Moody’s decision to downgrade and assign a negative outlook:

1. The growing risk that Portugal will require a second round of official financing before it can return to the private market, and the increasing possibility that private sector creditor participation will be required as a pre-condition.

2. Heightened concerns that Portugal will not be able to fully achieve the deficit reduction and debt stabilisation targets set out in its loan agreement with the European Union (EU) and International Monetary Fund (IMF) due to the formidable challenges the country is facing in reducing spending, increasing tax compliance, achieving economic growth and supporting the banking system.

The action will raise questions about the viability of Greece, Ireland and Portugal as a group once again. It will also raise issues of whether the EU and banks, which have made loans to support troubled sovereign debt, have the capital to prevent what could be a series of defaults.

Martin Wolf brought up the issue in the FT that the financial viability of the three weakest EU nations is lost and cannot be effectively found again. He points out that one option is that these three nations will withdraw from the eurozone. What he does not mention is whether banks that hold the debt of these countries will be ruined in the process.

The EU and IMF have another alternative that has little political support now. They could raise bailout funds to unprecedented levels, which may have to be well above $1 trillion. That money could be used to guarantee the obligations of Greece, Portugal and Ireland. The case against this is the three nations cannot rekindle GDP growth and will need bailouts that will go on ad infinitum.

There is no sign the the largest and most prosperous countries in the eurozone — Germany and France — and the IMF are ready to abandon the three troubled countries. Cynics say this is to cover potential losses by banks within their borders. It may be more realistic to assume that they believe that the concept of a united Europe as a balance to the economic power of the U.S. and emerging nations led by China  is worth the trouble to save. Europe’s countries one by one do not have the power to stand individually as competitive economies in a world in which their individual GDPs are dwarfed by larger or more rapidly growing nations. That concern may be be behind the rush to keep the eurozone together.

Douglas A. McIntyre