New risk factor

The stability of the euro zone as of Wednesday was confronted with a new and serious risk factor. Prime Minister José Sócrates handed in his resignation to President Cavaco Silva after parliament had rejected the government's austerity plan included in its Stability and Growth Program (SPG), a plan which had the backing of the European Commission and the European Central Bank. If the only way out is to hold elections, the most favorable outcome for Portugal would be for the new government to have a big enough majority to muster support for the deficit-reduction plan demanded by Brussels and the markets.

The main opposition party, Pedro Passos Coelho's PSD, has already flagged its willingness to comply with the SPG. But until the country goes to the polls, Portugal faces an unsustainable situation. The yield on the Portuguese five-year government bond on Wednesday was over 8 percent and the 10-year reached 7.63 percent.

In this situation, the likeliest outcome is for the Portuguese authorities having to ask for a bailout, similar to those granted to Greece and Ireland. Portugal has dropped into recession and is being systematically punished by investors due to persistent doubts about the solvency of its public finances. These doubts are not warranted by the performance of the government, which is committed to making the required budget cuts. However, analyst and ratings agencies have engaged in what has turned out to be self-fulfilling augury. Under the pretext that Portugal's weak growth is an impediment to increasing public revenues, cutting spending and paying back loans, practically all economic analysts have warned investors off Portuguese assets. In the end run, political instability, and the persistent misgivings of the markets have driven the country to the brink of outside intervention and ushered in a new wave of financial turbulence for the euro zone.

Faced with such a serious situation as presented by Portugal it is essential that the European summit that kicked off on Thursday reacts swiftly. In the first place, it needs to iron out the details of the increase in the European rescue fund to 500 billion euros. Ideally, the changes need to be approved quickly enough to allow Portugal to avail itself of them. Any delay on this front would be a source of concern.

The Spanish government has been overly sanguine in affirming that the crisis in Portugal will not affect Spain. That affirmation needs to be qualified to indicate that it should not affect Spain given the political decisions that have been adopted and the economic and financial fundamentals of the country. A bailout for Portugal, however, would spark another spiral of doubts, such as Spanish banks' exposure to Portuguese debt. And that might give rise to another round of self-fulfilling prophecies by analysts.