EU's Greece policy endangers Portugal

Europe has ring-fenced Greece's debt crisis for now, but its escalating recourse to legal legerdemain has shattered the trust of global bond markets and may ultimately expose Portugal, Spain, and Italy to greater danger.

"The rule of law has been treated with contempt," said Marc Ostwald from Monument Securities. "This will lead to litigation for the next 10 years. It has become a massive impediment for long-term investors, and people will now be very wary about Portugal."

At the start of the crisis EU leaders declared it unthinkable that any eurozone state should require debt relief, let alone default. Each pledge was breached, and the haircut imposed on banks, insurers, and pension funds ratcheted up to 75%.

Last month the European Central Bank exercised its droit du seigneur, exempting itself from losses on Greek bonds. The instant effect was to concentrate more loss on other bondholders. "This has set a major precedent," said Marchel Alexandrivich from Jefferies Fixed Income. "It does not matter how often the EU authorities repeat that Greece is a 'one-off' case, nobody in the markets believes them."

The ECB holds €220 billion (£185 billion) of Greek, Portuguese, Irish, Spanish, and Italian bonds. Its handling of Greece implicitly subordinates private creditors in each country. All have slipped a notch down the pecking order.

The Greek parliament's retroactive law last month to insert collective action clauses (CACs) into its bonds to coerce creditor hold-outs has added a fresh twist. These CAC's are likely to be activated over coming days. Use of retroactive laws to change contracts is anathema in credit markets.

This might not matter too much if Greece were really a "one-off" case, but markets are afraid that Portugal will tip into the same downward spiral as austerity starts to bite.

Citigroup expects the economy to contract by 5.7% this year, warning that bondholders may face a 50% haircut by the end of the year. Portugal's €78 billion loan package from the EU-IMF Troika is already large enough to crowd out private creditors, reducing them to ever more junior status.

EU leaders said last June that "Greece is unique" and promised that haircuts would "not be replicated in Portugal". They have since pledged that the EU's new bail-out (ESM) fund will not have protected status.

Portugal has been praised by the International Monetary Fund for grasping the nettle of reform, but the IMF's own figures show that public debt may reach 118% of GDP next year. The debts of state-owned bodies add another 10%. Combined public and private debt is 360% of GDP, 100 percentage points above Greece. This is a huge burden on a shrinking economic base. Its current account deficit was still 8% of GDP last year, much like Greece. Both countries are overvalued by 20% on a real effective exchange rate, though Portugal has barely begun to cut unit labour costs.

Dimitris Drakopoulos from Nomura said Portugal relied on "fiscal engineering" last year to massage deficit figures, raiding 3.5% of GDP from private pension funds.

Matters will come to a head soon. The IMF must decide by September whether Portugal needs more money and debt relief. If Portugal now spirals into a Grecian vortex, large haircuts loom. This time EU leaders will have to accept that their own taxpayers will suffer losses - avoided until now - or violate their pledge.

Bondholders are not waiting to learn whether Europe will keep its word this time. There has been no rally in Portuguese debt since the ECB flooded banks with €1 trillion. Ten-year yields are stuck at 13.2%. Return to market access is a distant dream.

The risk for Europe is that investors will charge a "political risk" premium to invest in any EMU country subject to EU legal whim. The greater risk is that Euroland's crisis rumbles on as fiscal contraction in Italy and Spain plays havoc with debt dynamics, and reforms come much to late to close the North-South trade gap.

Europe's handling of Greece has guaranteed that global funds will rush for Club Med exits at the first sign of trouble. The next spasm of the debt crisis will be that much more dangerous if it ever comes. As the saying goes: hell hath no fury like an abused bondholder.