January 12th, 2011
02:23 PM GMT
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Are you confused by the market talk about Portugal needing a bailout? You might be even more so now that the country has successfully sold bonds at a lower yield than expected (20 years at 6.7 percent).

In the current market, selling bonds at a yield - or interest rate - below seven percent is seen as a small victory, though not sustainable in the long run.

The Portuguese government continues to say it can pay its bills, through bond sales and through tax rises and budget cuts, thank you very much. Of course that is what Greece and then Ireland said. Now, neither country needs the bond markets as each has been given massive loans (bailouts) by Europe and the IMF.

The worry about Portugal is all about perception and contagion.

Here is one scenario: Portugal says it does not need a bailout and refuses to ask for one. So ratings agencies downgrade the country's bonds (sovereign debt) which means Portugal's government costs rise. That means it's harder to cut its budget deficit to an "appropriate level."

It also means Portuguese (and Spanish) banks hold paper that is more risky, so rating agencies downgrade the Portuguese banks, raising their costs. Now, the market starts to sell the bonds in fear of a default (then too much paper on the market) while continuing to demand higher and higher interest rates to buy new paper from the government and from the banks.

With Ireland having to pay 5.8 percent for its bailout loans, at some point Portugal will be paying too much to sell its debt and a bailout becomes a cheaper option. But it comes with heavy (IMF) fiscal strings attached.

Portugal would have to decide which is worse. And it will have to deflect talk that other countries want it to accept a bailout to keep the debt disease from spreading into big economies like Spain and Italy.

Not that the European bailout fund has enough money to finance a Spanish bailout for more than a year and who knows what that would mean for the value or very future of the euro.

What should Portugal do?

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