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Lisbon: the standoff with Brussels begins

And so it begins.

On Tuesday the European Commission demanded from Lisbon to take back its budget, revise it, until it fits the pre-defined framework.

The response was bitter: “We have to be demanding and disciplined, but Portugal is not a pupil. There are no professor-states or student-states in the EU.” These were the words of the Portuguese Foreign Minister on Wednesday evening, Augusto Santos Silva.

It is an awfully familiar discourse for anyone who has spent some time in Athens over the last year. But, Lisbon is far from Athens and the Socialist-led government has experience. By Thursday, Portugal’s left-wing government turned around a promised to lower its 2016 budget deficit and growth projections.

Lisbon meets Brussels half-way

Lisbon revised its objectives for 2016.

The Finance Minister Mario Centeno must defend budget consolidation measures vis-à-vis the Socialist party leftist allies, the Left Bloc and the Communists.

The government objective is now to limit the budget deficit to 2,4% rather than 2,6% originally envisaged. But, that has to be achieved with a 1,9% growth projection rather than the more optimistic of 2,1%.

The European Commission’s Winter Report 2016 published on Thursday made clear that Brussels expects Portugal’s growth to surge by a timid 1,6% for 2016 and 1,8% in 2017. That is up from 1,5% in 2015, but is much lower than the 2,1% Lisbon projected and it is still lower than the revised 1,9%.

Bottom line: the Commission wants deficit reduction by 0,6% and a revision of GDP by 0,6%.

So, perhaps Lisbon met Brussels less than half way. Brussels was to rule on Friday, 5 February, whether Lisbon was in violation of Eurozone’s rules on the budget.

The view from Brussels

In 2015, Portugal’s public deficit closed at 4,2% deficit, following the recapitalization of Banif bank, at the cost of 1,2% of Portugal’s GDP. That was a one-off expenditure that Brussels cannot hold against Lisbon.

Core deficit without one-off payments remains below the 3% target.

However, the European Commission suggests that the “pro-cyclical” measures envisioned by Lisbon are likely to push deficit in excess of 3,4% in 2016. In effect the European Commission told Lisbon to rethink its program. Make no mistake: the European Commission does not like the politics of Lisbon.

Eurostat facts on the ground

Over the last quarter of 2015, growth in Portugal came to a 0,0% standstill, mainly due to a decrease in private consumption and investment.

In 2016, growth will rebound mainly by fiscal expansion, including an expected rise in Portugal’s minimum wage. On the contrary, private investment is expected to decelerate, until it picks up again in 2017, aided by EU structural funds.

The European Commission believes a downward trend of debt-to-GDP ratio will continue.  The economy remains highly volatile due to the high indebtedness of the Portuguese economy. Although the European Commission refers mostly to the 130% public debt, in reality, it is private indebtedness the Portuguese worry about. Given an overleveraged private sector and in combination with public debt, Portugal owes 350% of its GDP.

Contrary to public debt, in my opinion, pro-cyclical policy helps keep private debt in check. But, that is my assertion, it could be totally wrong, and it is not what the European Commission thinks.

Growth has not sustained employment. The reduction of unemployment is mainly due to mass migration. Employment creation is expected to decelerate during 2016-2017, while the working force continues to shrink. In turn, that will put pressure on social insurance (pensions) and the standoff with Brussels will continue.

Traditionally, the left does pension cuts with less resistance than the right. But, this could kill the government in Lisbon; Brussels would not mind if that were to happen.

The new government and the balance of power

Passos Coelho pushed through a series of austerity measures, managing to have the Troika leave before the end of his term. And managed to push the hardest austerity measures in forty years and land on his two feet in October, bringing his centre-right PSD first with 107 seats, although not gaining a parliamentary majority.

But failing to form a government, the Socialist Costa – former Mayor of Lisbon – was given the mandate to form a government with the Left Bloc and the Communist Party. This was breaking a number of taboos: the Communists do not like the Left Bloc of the Euro-Communist tradition, and none of them like the Socialists that have shared Portugal’s wheel since the carnation revolution.  The balance of power is sensitive.

Costa has promised to keep government deficit below the 3% deficit threshold and fight poverty.  That is a tall order. His left-wing allies do not want to stay in the Eurozone “at all costs.”

With the Troika out of Lisbon, the ultimate test is access to international capital markets and Portugal’s credit ratings.

Thus far, the ECB’s fiscal expansion policy has pushed down sovereign debt yields and Lisbon just might be able to hold the balance of power between a highly demanding set of left-wing partners in Parliament and Brussels pressure. I would not count on this, but it may be possible.