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People look at the front pages of newspapers displayed behind the window of a shop in Ericeira village, 40 km (24 miles) north of Lisbon July 11, 2013. Portugal's political crisis deepened on Thursday after the president rejected a plan to heal a government rift and critics accused him of igniting a "time bomb" by calling for early elections next year. President Anibal Cavaco Silva proposed a cross-party agreement between the ruling coalition and opposition Socialists to guarantee wide support for the austerity measures needed for Portugal to exit its bailout next year, followed by elections. The headlines of the newspaper on the wall reads, "Cavaco deepens political crisis". (Jose Manuel Ribeiro/Reuters)
People look at the front pages of newspapers displayed behind the window of a shop in Ericeira village, 40 km (24 miles) north of Lisbon July 11, 2013. Portugal's political crisis deepened on Thursday after the president rejected a plan to heal a government rift and critics accused him of igniting a "time bomb" by calling for early elections next year. President Anibal Cavaco Silva proposed a cross-party agreement between the ruling coalition and opposition Socialists to guarantee wide support for the austerity measures needed for Portugal to exit its bailout next year, followed by elections. The headlines of the newspaper on the wall reads, "Cavaco deepens political crisis". (Jose Manuel Ribeiro/Reuters)

Portuguese President’s call for unity risks undoing coalition Add to ...

The likelihood of another European debt crisis, this time centred in Portugal, is increasing.

Portuguese President Aníbal Cavaco Silva made an unexpected political move Thursday, offering the opposition Socialist party an election in early 2014, a year ahead of the expected date. In return, Mr. Silva asked the opposition to join his coalition government in supporting the country’s European Union-mandated austerity plan, on which the country’s €78-billion ($106-billion) bailout depends.

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Mr. Silva was expected to endorse a cabinet shuffle after a crisis that had threatened to destabilize the country’s coalition government, as popular support for the government’s economic austerity program waned. Finance Minister Vítor Gaspar and Foreign Minister Paulo Portas stepped down last week, their resignations widely interpreted as protests against austerity. Now, with Mr. Silva’s proposal unlikely to appear palatable to the strongly anti-austerity Socialists, observers worry that a snap election or some other form of bailout-threatening instability is more likely than before, not less.

In response, Portuguese 10-year bond yields rose 13 basis points to 6.90 per cent. The strain in fixed income rippled through auctions for Italian and Spanish bonds as well, stoking fears of contagion.

Royal Bank of Scotland analyst Harvinder Sian wrote in a note to clients that a large-scale sovereign debt restructuring will be the end result of Portugal’s political morass. “The [austerity plan] is too hard and the social consensus on more austerity/reform is collapsing,” Mr. Sian said. “Debt restructuring is a correct economic outcome.”

Michael Hewson, senior market analyst at CMC Markets U.K. in London, wrote of Portugal’s political woes that “the question remains for how long these politicians can keep the train on the tracks, with a second bailout looking more and more likely.”

Mr. Sian mused that a bailout or restructuring would not occur without significant collateral damage in the region’s markets. “A risk-scenario is actual [restructuring] followed by rating downgrades across the board, taking Spain and perhaps Italy to junk.”

Italy and Spain represent the eighth- and 13th-largest economies on the planet, and both have sovereign bond markets on a scale to match. A downgrade to below investment-grade, or junk, status for both countries’ bonds would likely cause a steep sell-off, at least initially. The ensuing uncertainty would affect credit markets worldwide – particularly the balance sheets of banks across the EU, and in turn, Canadian banks.

The interconnected nature of global finance has seen Canadian banks closely follow the path of European bond yields, particularly during periods of market stress. Since the onset of the euro crisis in 2012, the S&P/TSX Bank Index has been closely correlated with indicators of stress such as the difference in yields between German and Italian two-year government bonds. In general, when European yields rise, Canadian bank stocks fall.

The resumption of tensions in Europe couldn’t come at a worse time for Canadian banks. They are faced with difficulty meeting new capital standards set by the Basel Committee on Banking Supervisions, as well as fears around Canadian households’ super-high debt levels. Another bout of crisis in Europe would be a road block in the way of further stock appreciation.

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