Portuguese turmoil looms over European summit

Portugal was left hanging in financial limbo yesterday as an international bail-out loomed ahead of a meeting of European leaders intended to draw a line under the eurozone's debt crisis.

An international bail-out looked inevitable as markets battered the value of Portugal's debt. José Sócrates offered his resignation as prime minister on Wednesday after the parliament rejected his latest programme of austerity measures designed to help the country's fiscal crisis. The yield on Portugal's two-year government bonds surged to 6.89 per cent during yesterday's trading, the highest since the euro's launch. The cost of insuring the country's sovereign debt also came close to January's record high.

To add to the sense of crisis surrounding the country, Fitch, the credit rating agency, cut its long-term foreign and local currency issuer ratings on Portuguese debt to A-minus from A-plus. However, though a rescue package from the International Monetary Fund or the eurozone's bailout fund looked inevitable, Mr Sócrates' resignation is likely to leave Portugal without a stable government to negotiate terms.

Mr Sócrates remained in power yesterday but responsibility for maintaining political stability now falls to the country's president, Cavaco Silva. Options include calling an election, which could take two months, or patching together an interim government. A lengthy delay in securing a bail-out, estimated at €50bn-€80bn, risks feeding market fears and sending Portugal into an economic downward spiral. Nick Kounis, an economist at ABN Amro, said: "The political crisis in Portugal makes it even more likely that the government will need a bailout but it makes it more complicated. This is because the authorities need a stable, legitimate government to negotiate the package with and this could take some time."

Portugal has to refinance €4.3bn euros of its government bonds next month and another €4.9bn in June. If political uncertainty prevents a permanent deal being negotiated by April, Portugal might need a bridging loan from the European Union or the International Monetary Fund.

Without such a loan, Portugal could be forced to pay sky-high interest rates on its new bonds, increasing its borrowing costs and sending it into a vicious circle of ever increasing debt, interest payments and economically damaging spending cuts.

"A key factor is the rise in bond yields, which has made bond market concerns a self-fulfilling prophecy," Mr Kounis said in a note to investors.

Portugal has already raised taxes and slashed spending to convince the markets it can reduce its budget deficit. But like Greece and Ireland before it, the moves failed to convince markets it could go it alone.

The Portuguese crisis comes at a terrible time for the European Union as its leaders meet in Brussels to approve measures designed to build confidence in the euro.

The rejection of Mr Sócrates's austerity measures by his parliament has reinforced markets' belief that highly indebted peripheral eurozone nations will not stomach the tough measures Germany and other heavyweight nations are trying to impose.

European leaders will fear that if Portugal is bailed out, the markets will chase down other stretched countries such as Spain, whose smaller banks were downgraded yesterday.