Portugal spats jeopardize economic improvement in Europe's shaky south

With Europe’s economy on edge, Portugal is doing its homework, cutting the deficit, and rebooting the economy.

But the encouraging news is also emboldening politicians to once again play political games that could spin out of control and into another test for the region.

Last week, Prime Minister Pedro Passos Coelho reportedly suggested he would resign if a court forces him to revise the 2013 fiscal budget in a pending ruling over the constitutionality of some of his unpopular austerity measures.

He quickly retracted in response to broad criticism of what was interpreted as undue pressure on courts. “I will not speculate or create expectations around possible [court] decisions. I won’t contribute to instability,” Mr. Passos Coelho said.

Although the threat was headline-grabbing – especially as markets sniff more fractures in Europe’s economic recovery – experts also warn that it may indicate that Portugal is reverting to a familiar, albeit dangerous, political game of power-jockeying as its economic restructuring shows signs of improvement.

On the upswing

At the moment, political brinkmanship and the court decision are not an imminent threat. In fact, Portugal is generally considered to be on the mend. Though still in the midst of a grueling recovery after unprecedented government austerity, the economy is expected to start growing next year.

The center-right Social Democrat government has cut salaries and hiked taxes to meet stiff deficit-cutting terms of its 78 billion euro bailout program, negotiated in 2011 with the "troika" of the European Union, the International Monetary Fund, and the European Central Bank.

Now in its third year of recession, the Portuguese economy is expected to contract 2.3 percent in 2013, the Central Bank said last week, revising its previous 1.9 projection. The gross domestic product has contracted around 7 percent since 2011. Unemployment will top a record 18 percent this year. Poverty is soaring along with public discontent.

But the government also has wiggle room because it secured most of its cash requirements for 2013, along with an extension to deficit-cutting targets. Portugal’s bailout terms required the country to cut its deficit from 9.8 percent of GDP in 2013, to 5 percent in 2012 and 4.5 percent in 2013. The 2012 deficit closed at a distant 6.4 percent, but the troika in March certified Portugal is “on track” and relaxed its targets for 2013 and 2014 to 5.5 percent and to 4 percent respectively.

“The government has resumed issuance in the bond market, while domestic financing conditions have eased somewhat. At the same time, weakening export demand, particularly from the euro area, low confidence, and the private sector debt overhang are providing stronger-than-expected headwinds to economic activity,” the troika said in a statement.

Political games

But while the numbers appear to line up, experts warn that politicians could miscalculate and push the country into a second bailout and more European economic turmoil.

“Yes, there is a possibility of political instability, but I believe it’s quite small for the time being. The worst scenario is that politicians think they will have enough money to play the political game, but I don’t know if we could recover from a second stroke,” said Joao Duque, head of the School of Economics at Lisbon’s Technical University.

That was the worry raised by Passos Coelho's recent threat to resign. His government's 2013, 5 billion euro budget contemplates pension and salary reforms worth 1 billion euros. President Aníbal Cavaco Silva and the opposition Socialist Party asked the Constitutional Court in January to review the government’s budget bill.

The prime minister was likely trying to bolster the budget's approval with his threat – it would be a setback for Passos Coelho if the court concludes some of the measures are unconstitutional, as that could trim planned cuts equivalent to between 20 and 40 percent of the overall goal.

“We are used to these types of politically intentioned headlines,” notes José Adelino Maltez, a political scientist at Lisbon Technical University. “Clearly this is just a political game between the opposition and the government because any other scenario” could be destabilizing.

High risk, low return

But by threatening political disruption if his budget isn't found constitutional, Passos Coelho may have harmed his own case.

“It was stupid for the prime minister to exert this kind of pressure on the court, and it might make [the court] more reactive, and be more affirmative to show its independence. If they say this budget is constitutional, everyone will laugh,” Professor Duque said.

Worse yet, Passos Coelho's threat could cause the markets – which Portugal is trying to woo – to second-guess the country’s leaders ability to keep up the good work, thereby sapping the confidence Portugal critically needs to maintain its upward trajectory.

“We need huge amounts of money in 2014, in 2015, and in 2016, and beyond,” Duque said. “We don’t need too much money this year, but if markets start factoring this instability into interest rates, banks will not succeed in getting the funds, and then it will be a disaster.”

Were Passos Coelho to resign, his Social Democrats would likely be asked to form a new government, although pressure would also build for another potentially destabilizing snap election.

That scenario, while still conjecture, is an additional source of concern for Europe and the markets, especially if a domino effect derails ongoing Portuguese talks to end the draconian troika bailout program and regain access to markets. Or worse, it could lead to a bank decapitalization and a second bailout.

Ultimately, Duque says, there's little Passos Coelho and others can gain from political games, since it makes little difference who governs Portugal right now. “It’s not a question of who the prime minister is. We have no money. Whoever is there they have to do the same. We can discuss wages, pensions, but the hedge is there.”