Moody's Cuts Portugal's Rating as Debt Soars

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Moody's Cuts Portugal's Rating as Debt Soars Portugal, one of the countries at the heart of the European debt crisis, had its bonds downgraded by Moody's Investors Services Tuesday. The ratings agency warned that the Lisbon government's financial strength will continue to weaken because of heavy indebtedness.

Moody's cut Portugal's government bond ratings two notches from Aa2 to A1, which is still investment grade. The decision by Moody's follows similar action by Standard & Poor's in April.

"The Portuguese government's debt–to-GDP and debt-to-revenues ratios have risen rapidly over the last two years," said Anthony Thomas, a Moody's senior analyst in the sovereign risk group, in a statement. "This crisis came about due to the government's anti-crisis measures and the operation of the budget's automatic stabilizers, such as higher unemployment benefits, when the economy went into recession."

As a result of the downgrade, the euro fell 0.2% against the yen as European investors worried about the sovereign debt crisis facing the continent. Those fears had somewhat subsided earlier in the day when Greece, which is at the heart of the euro crisis, was able to sell Treasury bills below the 5% rate charged by the European Union for the first time since the country was bailed out by the EU in May.

The Downside to Budget Cuts


Portugal has adopted an austerity program designed to cut its deficit to 7.3% of GDP this year and 4.6% next year, down from the 9.4% of GDP it hit last year. The program of Prime Minister Jose Socrates includes 5% pay cuts for public officials and tax increases ranging from 1% to 2.5%.

But Luis Garicano, professor of economics at the London School of Economics, says that the austerity plan is unlikely to solve Portugal's underlying problems.

"I think the worry with the austerity programs is that they decrease the growth rate," Garicano says. "The problem with countries like Portugal and Spain is they are faced with a really tricky situation, which is you increase the austerity and you grow less. So then you get less funding, people are more worried and you have to increase the austerity. You get into a vicious circle because the country is not growing."

Garicano says the main problem with Portugal and Spain is their labor markets are too inflexible because of strict regulations. Both countries need to undertake structural reforms of the labor market to increase their potential growth rates, he says.


Total Debt Nearly 350% of GDP


The Organization for Economic Cooperation and Development in Paris says that Portugal's labor market performance is "worrisome." "To facilitate the adjustment of the economy to the forces of globalization and reduce the social costs of the adjustment process, policies have to focus on easing labor market regulations that hinder workers' mobility," the OECD said in a 2008 study of the Portugal's labor force.

Harvinder Sian, strategist at the Royal Bank of Scotland, says that in addition to a low growth rate, Portugal's total debt is nearly 350% of GDP. Borrowing from abroad, both public and private, is at 205% of GDP. Foreign funds have become scarce and that helps explain why Portuguese banks are now being forced to borrow heavily from the European Central Bank. This borrowing hit $42 billion in May, double April's amount. "The market still does not understand that Greece is a pure sovereign crisis while the Spanish/Portugal/Irish situation is much more about Northern Europe losing appetite to fund leverage in public but especially private sector debt," Sian said in a note to investors release Tuesday.He added that he expected Moody's to downgrade Spain by two notches as well in the next couple of weeks. Moody's has the country on a review for a downgrade.

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