LONDON (Reuters) - Budgetary rigour demanded by international lenders may be the proximate cause of Portugal's political crisis, but Lisbon is also paying the price for not whipping its economy into shape in better times.
The survival of Prime Minister Pedro Passos Coelho's centre-right coalition was hanging by a thread on Wednesday as the rightist CDS-PP party debated whether to withdraw its support and leave the government without a majority.
Like ordinary Portuguese, the CDS-PP is resisting further spending cuts needed to keep Portugal on track to meet the debt-reduction goals laid out in its 78 billion euro (66 billion pound) bailout programme with the European Union and International Monetary Fund.
Patrick Artus, chief economist with French bank Natixis fears Portugal is battling a lost cause, for as its economy keeps contracting so does the tax base needed to put the public finances on a stable footing. The result is a recessionary spiral - as Greece has already discovered.
"This is one of the biggest problems we have in the euro area: in the peripheral countries, how do you repay the old debts if the macroeconomic base of the country is shrinking?" Artus asked.
Despite an extension of maturities on loans from Europe, Lisbon is very far from stabilising its ratio of public debt to GDP, Artus said. "If you measure it against the usual definition of solvency, Portugal is clearly not solvent."
Portugal needs to grow out of its debt, but its potential growth rate is less than 0.5 percent a year, according to the Organisation for Economic Cooperation and Development.
Yet economic performance was poor even in the years after the launch of the euro in 1999 when credit was flowing freely.
Real gross domestic product growth averaged just 1.3 percent a year between 1999 and 2008 as productivity slowed substantially and competitiveness deteriorated. Per capita GDP growth was flat between 2001 and 2011.
Artus traces the stagnation to the very structure of the economy. Portugal has lost over 15 percent of its manufacturing capacity since the launch of the euro as competition from eastern Europe and China crushed low-end industries.
And with a poorly skilled workforce - two out of three Portuguese left school at 15 or 16 - trend labour productivity growth has averaged around just 1 percent a year.
Rigid goods and services markets, which have kept the price level high in Portugal despite a drop in wages, thus throttling domestic demand, compound the gloomy picture.
"Comprehensive structural reforms to revive productivity and competitiveness are critical to rebalancing the economy and restoring sustained growth," the OECD said in a recent report.
Optimists point out that Portuguese exports have performed well. But Eileen Zhang, director of European sovereign ratings at Standard and Poor's, said the outlook for further improvement was weak given a failure to lure significant foreign direct investment.
"The hope for Portugal is that the structural reforms that were introduced during the first two years of the programme can be implemented to increase the flexibility of the economy to attract FDI in order for economic potential to pick up again," she said.
Evidence of stabilisation in neighbouring Spain, Portugal's biggest market, is also encouraging. Manufacturing held steady in June after a two-year slide, according to the latest purchasing managers' index, while services contracted at the slowest pace in two years.
Edward Hugh, an independent economist based outside Barcelona, said Spain was enjoying some cyclical relief, linked in part to a relaxation of deficit reduction targets this year, but it was premature to call it a recovery.
"We're seeing little signs that things are getting better, but it doesn't mean there's a great game-changer in Spain. Property prices continue to go down and domestic demand continues to decline. The boost is really coming from exports," he said.
Hugh said Portugal's case was not that different from that of Greece in that both countries needed a debt restructuring from the outset.
Instead, Portugal plumped for overly rapid fiscal adjustment that generated a deeper-than-necessary depression and, by sparking a wave of emigration, was putting the country's long-term future at risk.
Just as the IMF had acknowledged making excessively optimistic economic projections in the case of Greece, Hugh expects a similar ‘mea culpa' from the Fund in relation to Portugal.
This was likely to be followed by tense negotiations with European governments after September's German elections on how to make up funding shortfalls in both countries.
The crumbling of political support in Portugal for continued austerity reduces the chance of a smooth exit from the current bailout programme in mid-2014 and makes a second rescue package more likely, according to Citi.
"This also increases the probability that some form of government debt restructuring may eventually be needed - following the footsteps of Greece and Cyprus," the bank's economists said in a note.
Portugal's political strains also invite comparisons with Italy, where former prime minister Mario Monti has threatened to
withdraw support from the coalition of his successor, Enrico Letta.
There are worrying economic parallels, too, starting with a woeful track record since the launch of the euro. Italy is the only one of the OECD's 34 member states whose GDP per capita fell between 2000 and 2011.
Like Portugal, Italy has lost around 10 percent of its output since the financial crisis and this will reduce the economy's capacity to stabilise its debt-GDP ratio, Artus said.
"In a regular recession GDP goes down and then recovers back to the level of potential GDP. In this crisis, potential GDP is converging down to the level of GDP, so there's a permanent loss of potential output. And with smaller economies it's hard to service large old debts. Italy and Portugal are very similar in that respect," he said.
Editing by Mike Peacock