Short-term private bailout comes at crippling cost, with bonds sold to investors at rates of nearly 6% interest
The decision by Portugal to abandon its efforts to avoid an EU-led financial bailout came hours after a €1bn bond auction that had cost the country double the rates likely to be demanded as part of an EU or IMF rescue package.
The bonds, providing funds for only six months and a year, were sold to investors, but at interest rates of more than 5% and nearly 6% respectively. A month ago the cost of six-month money was less than 3%, and two weeks ago the government had been able to sell 12-month bonds at 4.3%.
Goldman Sachs chief European economist Erik Nielsen described the higher costs as "clearly unsustainable". Lisbon has to raise €5bn for debt repayments later this month, and a further €7bn in June.
Economists had been predicting that Portugal would need an external bailout since Greece was forced to go to the IMF a year ago. But the crisis moved up a gear last month when prime minister José Sócrates failed to get a fourth round of austerity measures approved by the Portuguese parliament. Sócrates quit, his government collapsed, and the credit rating agencies downgraded the country.
Since then Portugese bond yields have risen to more than 10% for 10-year money as the country has struggled to find investors willing to put cash into the country.
Earlier this week, the domestic Portuguese banks told the caretaker government that they could not carry on buying more and more bonds as their exposure to the risks presented by their own country was getting dangerously high. They urged the government to ask the ECB for a bridging loan until a new government is elected in June and able to firm a new economic plan.
Last night it was unclear whether Sócrates was planning to apply for a short-term loan until the general election, or request a fully fledged bailout such as the ones received by Greece and Ireland. Portugal is expected to need a total bailout of €70bn-€80bn.
A full EU-IMF bailout will involve the UK. The UK is responsible for 13.5% of the European Stability Fund and 4.5% of any IMF bailout. However, the UK government is unlikely to offer any additional direct loans, as it did to Ireland was forced to call in the IMF last autumn.
The Portuguese decision to ask for external help also came as the European Central Bank prepared to start raising interest rates from the emergency level plumbed during the financial crisis.
The euro rose on the foreign exchanges yesterday in expectation that the ECB will raise borrowing costs from 1% today and signal further policy tightening in the months ahead as it acts to control rising inflation.
Last night on Wall Street the euro was largely unmoved by Portugal's about-turn. The lack of market reaction suggests investors had regarded the request for a bailout as a foregone conclusion. The euro was at a 14-month high against the dollar ahead of the expected interest rate hike.
"In some ways it is a positive, I think Portugal was in denial. On this side of the pond no one understood exactly how Portugal was going to be able to dig out of its problems without getting aid," said David Dietze, chief investment strategist at Point View Financial Services in Summit, New Jersey.
But City economists warned that the looming interest rate rise would add to the debt servicing costs and generate even more problems for countries such as Portugal and Ireland than for the core single country nations of Germany and France. Ben May, of Capital Economics, said: "If interest rates were to rise in line with market expectations, their impact would be greatest in the periphery and may prompt an further escalation of the region's fiscal crisis.
"Higher official interest rates will not only lower economic growth in the periphery, but will also prompt the average interest rates that governments pay on their debts to rise."
The euro's strength coincided with a rise in the price of gold to $1,454.84 an ounce.
Marchel Alexandrovich, of Jeffries International, said a 1% increase in ECB rates would mean that home loan interest payments of eurozone households would rise by around 7% on average – but there would be a 30% jump in debt services payments for households in Portugal and Finland, a 15% increase in Ireland, and a 10% rise in Spain and Italy.
"The countries which least welcome higher interest rates on economic fundamentals are likely to be the ones most affected by them. One more reason why the ECB would be wise to tread very carefully in the months ahead."
The rising interest on Portuguese borrowing has added to the sense of crisis in the eurozone, amid reports that Greece is under pressure from the International Monetary Fund to default on its borrowing.
The Irish government is understood to be concerned about weaker than expected tax revenues and the vulnerability of its banking sector. An informal meeting of European finance ministers is planned for Friday.
Last night EU Economic and monetary affairs commissioner Olli Rehn welcomed Lisbon's decision to ask for financial help and insisted it would be good for both the country and the wider Eurozone. "This is a responsible move by the Portuguese government for the sake of economic stability in the country and in Europe," Rehn told Reuters. The amount of aid is to be determined shortly, he said.
Road to recovery?
• May 2010 Eurozone members and the IMF agree a €110bn (£95bn) three-year bailout package to rescue Greece's embattled economy.
• November 2010 Ireland asks for an international financial rescue package after denying it would need a bailout for its crippled banking system.
• January 2011 Portugal's secretary of state for treasury and finance, Carlos Costa Pina, insists the country does not need financial assistance from the EU or the IMF.
• February Germany offers to help finance a Portuguese bailout as consensus builds that Portugal will be the third eurozone country to seek a loan from the EU and IMF.
• March Portugal's minority socialist government resigns after its proposed austerity measures are defeated in parliament and it admits missing its 2010 budget deficit target. EU leaders meet in Brussels in a bid to agree a new "grand bargain" to save the eurozone.
• April Portugal's government is forced to tap the financial markets to raise money to repay loans. Caretaker prime minister José Sócrates reveals that he has asked the EU for financial assistance. He says Portugal is "at too much risk that it shouldn't be exposed to".