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Portugal’s Dead Man’s Hand

November 24th 2010

James Butler Hickok, a renowned gunfighter, drew his last breath on the second day of 

August in 1876. ‘Wild Bill’, as he is better known, entered Deadwood’s Nuttal and

Mann’s saloon that day with a desire to satisfy his unquenchable thirst for gambling. Hesat with his back to the door and Lady Luck deserted him when ‘Crooked Nose’ McCall

came through the drinking emporium’s entrance and fired a shot through the back of hishead.

Death was almost immediate, but as the dying gambler slipped to the floor, his fellow

 poker-players seemed more concerned with his five cards. He was revealed to be holding

a pair of aces and two eights – the fifth card is a matter of dispute – though Hickok’s lastdraw will always be known as a, ‘Dead Man’s Hand.’  

Ireland appeared to be holding a winning hand in its own high-stakes poker game, though

the confidence espoused by members of our investment elite ultimately proved to be

nothing more than a bluff. The cards held by the Irish government were revealed to be a‘Dead Man’s Hand’ when Angela Merkel, the German Chancellor, stated towards the

end of October that any future euro-zone rescue scheme should include a mechanism for 

an orderly sovereign-debt default.

Merkel’s sentiments are correct in their entirety, and particularly so, given that the belief  pre-crisis that a euro-zone nation would not be allowed to default gave bond investors

every reason not to distinguish between good and bad sovereign credits. Timing is

everything however, and her comments gunned down any hopes of an Irish full house.

Ireland has followed Greece into intensive care and the question now is how soon it will be before the financial market’s call Portugal’s bluff.

Portugal did not enjoy a growth boom following the launch of the euro in 2002 and thus,

the economy suffered neither a precipitous decline in activity nor a destructive collapseof its financial system, as the crisis reverberated through the developed world. Nevertheless, the Portuguese face several daunting challenges that must be overcome if 

the EU/IMF is to be kept from its door.

The Portuguese economy suffered a dramatic loss of competitiveness in the years

immediately preceding the launch of the euro. A sharp drop in interest rates triggered aconsumption and investment boom that saw household and non-financial sector debt

more than double as a per cent of GDP between the mid-1990s and 2002.

The private sector boom was accompanied by pro-cyclical fiscal policy and the resulting

tightening of the labour market saw wages per capita increase by roughly six per cent a

year from 1995 to 2002. The loss of competitiveness led to a dramatic loss in exportmarket share and a decline in foreign direct investment inflows.

Large private sector debt burdens and an increasingly uncompetitive economy saw

growth slow to less than one per cent in the years following the launch of the euro.Though the economy did not suffer a dramatic collapse in activity of the magnitude seen

in Ireland, it remains to be seen whether a further economic contraction can be avoided in

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2011, as the government attempts to reduce the budget deficit from 7.3 per cent of GDP

this year to below five per cent.

Domestic demand is almost certain to fall next year, as higher taxes and increasing

unemployment constrain household consumption, while higher borrowing costs and a poor growth outlook are likely to deter business investment. Thus, the economy is

dependent on exports to do the heavy-lifting.

The export outlook however, is far from encouraging. Portugal’s export structure is

weighted towards traditional slow-growing sectors such as paper and wood products.Comparative advantage in these segments has shifted to the developing world, which has

contributed to an alarming fall in the country’s export market share since the mid-1990s.

Furthermore, roughly one quarter of its exports go to neighbouring Spain, which is hardlyan example of a thriving economy.

The Portuguese economy faces enormous structural hurdles from low productivity to

slow growth, but its most pressing need is to convince bond investors that its fiscal

austerity programme is on track. The government has been slow to address the problem

and its plans are still based on excessively optimistic growth projections. Time is fastrunning out and the sternest test of its borrowing capacity will come early next year,

when the government needs to raise a large part of its €20 billion annual borrowingrequirement.

The financial markets have already spoken. The yield on ten-year bonds has increased by

125 basis points since the middle of October, while the spread versus German bunds has

widened by one percentage point to 4.2 per cent over the same period. The Portuguesecould well be holding a ‘Dead Man’s Hand’.

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