The Good, the Bad, and the Ugly of Portugal’s Bond Auction

Portugal tested the chilly New Year auction waters on January 5th as it auctioned €500 million of six-month bonds. The good news is that investors bought the small offering without too much difficulty. The bad news is that they demanded 3.68 percent from Portugal for the short-term loans. The ugly news is that this interest rate is double what Portugal had to pay only back in September, and more than six times what it had to pay a year ago.

While this soaring interest rate is inconsequential for the paltry sum auctioned, it has grave repercussions for the future.

Within the next year Portugal will need to raise as much as €20 billion. Simple arithmetic tells us that the increased interest payment will be stifling for the small Iberian country. If the situation doesn’t deteriorate any, and investors don’t change their willingness to loan insolvent countries more money, Portugal will pay 3.68 percent on its future bond sales. On €20 billion this means that Portugal will have to pay over €736 million just to keep the game going for another six months.

While trillions are quickly becoming the new billions, €736 million may seem like small potatoes. Annualized it will represent a drain of 0.67 percent of Portugal’s stagnating GDP. Meanwhile, Portugal’s existing government debt is about 77 percent of GDP.  If it were all to be refinanced at the same 3.68 percent the current offering received, it would represent an annual interest payment of 2.8 percent of GDP. That’s a grand total of about 3.5 percent of GDP entirely dedicated to servicing the national debt — a monumental drain on a country whose economy shrunk by 3.3 percent in 2009 alone!

One way to interpret the evidence is that without this staggering debt Portugal’s horrendous collapse of GDP growth would merely have been flat. Another way is that Portugal’s economy must grow faster than 3.5 percent a year just to service its existing debt (never mind paying down any of the principal).

This recent experiment in the bond market may buy some time, with the operative word being “some”. Eventually the funds will run out. The important question then becomes: what happens next?

This crisis is not one of illiquidity. If it was, continued bond auctions could potentially keep the game going and the Eurozone on track until normalcy returns. What we are in the midst of today is a crisis of insolvency. Several countries of the Eurozone – Portugal included – lack the assets (or access to assets) to pay off their liabilities.

Loaning these troubled countries more money will not solve the problem; it will only exacerbate the inevitable. In the future, Portugal will need to raise money to pay off these loans. And then the same old problem resurfaces again. In the meantime, the continual funding availability eases pressures from what should be stringent budget cuts. Getting its fiscal affairs in order is essential if Portugal (and its colleagues, the other PIIGS) want to survive.

Continued bond auctions will buy time, but without meaningful budget cuts, they will not provide a solution.