Portugal – Novo Banco Standoff Highlights Risks

Relations between the government and the further-left parties on whose support Prime Minister Antonio Costa depends for a parliamentary majority have become testy amid the social and economic strains arising from the COVID-19 pandemic. Ostensibly, the Socialist government is still in a strong position, with no election required until 2023 and the PS holding a comfortable lead over the center-right PSD in the most recent polls of voter preferences.
The government does not have a formal arrangement with the left-leaning BE and the CDU, a coalition of Communists and Greens, which theoretically frees the government to negotiate with any or all opposition parties on a case-by-case basis. However, the shortcomings of the strategy have been made apparent by the united opposition of the PSD, the BE, and the CDU to a proposed transfer of funds to Novo Banco to cover the losses from the sale of bad debts, property, and other assets formerly owned by the failed BES bank.
So far, the total amount transferred into Novo Banco is about $3.6 billion, short of the contracted sum, and the government has proposed an additional injection under the 2021 budget. Finance Minister João Leão insists that the government will meet its contractual obligations, and Costa has offered similar assurances to ECB President Christine Lagarde.
The risk of a crisis is fairly low. PSD leader Rui Rio has stated that his party will drop its opposition if auditors determine that the transfer is appropriate. Moreover, the 2021 budget has already been approved, thanks to abstentions that enabled the PS to achieve a majority on its own. Nevertheless, the episode demonstrates the potential for protracted legislative delays and roadblocks that could lead to the minority government’s early downfall.
Yields on 10-year benchmark government bonds have fallen below zero for the first time, although there are reasons not to read too much into the market behavior. Some 40% of Portuguese debt is held by the IMF, with the debt stock biased toward long-term maturities contracted at low interest rates, and the ECB’s unprecedented asset purchase program effectively amounts to an underwritten guarantee for government bonds that were trading at a significant spread to the German benchmark.
To be sure, fiscal risks are present, given the potentially long-lasting impact from the health crisis on unemployment and incomes, which will create a potential impediment to rapidly reining in the budget deficit. A slow rollout of vaccines and a possible third wave of the virus could cause more pain for the economy in 2021 than is anticipated, delaying a reversal of the upward trajectory of a debt burden that is forecast to peak at 140% of GDP in 2022.
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