Lisbon: Portugal is deriving no pleasure from Spain joining it in the Euro-area bailout club as concern over the economic health of its biggest trading partner overshadows any Schadenfreude over its neighbour’s €100 billion($125 billion) bank rescue.

“There is no doubt the situation in Spain has an impact on the Portuguese economy,” said Diogo Teixeira, chief executive officer at Optimize Investment Partners, a Lisbon-based firm that manages €55 million of assets and holds Portuguese government debt. “Portuguese bond yields have declined, but this situation can change if there is a much stronger blow involving Spanish banks and if there is no solution for the European debt crisis.”

Portugal is earning praise from creditors for meeting terms of a €78 billion rescue plan from the European Union and the International Monetary Fund. Borrowing costs have dropped as it seeks to regain access to bond markets in 2013, with the rate on the nation’s 10-year debt declining to 11 per cent from a record 18 per cent on January 31. Yields on two-year debt are 9.2 per cent, less than half the almost 22 per cent at the end of January.

“If Spain is dragged into a more serious situation, that could harm Portugal,” Teixeira said.

Portuguese debt gained about 14 per cent in the three months through May, the most among Euro-area government bonds, according to indexes compiled by Bloomberg and the European Federation of Financial Analysts Societies. German securities returned 4.5 per cent, while Italian bonds slipped 4 per cent and Spanish debt lost 8 per cent.

Yield Gap

Portugal’s 10-year yield dropped 40 basis points to 10.7 per cent on Monday, while the rate on Spanish debt of similar maturity rose 29 basis points to 6.5 per cent. The difference in yield that investors demand to hold Portugal’s 10-year bonds instead of German bunds has narrowed to 9.4 percentage points from 12 percentage points three months ago. The Spanish spread to bunds has widened to 5.2 percentage points from 3.2 percentage points.

The decoupling with Spain may prove short-lived should the economic conditions of its Iberian neighbour deteriorate further. Even before the bank bailout announced on June 9, Spain had slipped into its second recession since 2009. The European Commission forecasts the Euro-region’s fourth-biggest economy will contract 1.8 per cent this year.

“If there is a recession in Spain, or if the recession is aggravated, obviously that will impact our exports,” Economy Minister Alvaro Santos Pereira said in a June 1 interview.

Export Outlook

Portugal is counting on exports to emerge from its own economic slump and spur growth in 2013 for the first time in three years. Spain could help Portugal make that happen as the country buys about 25 per cent of Portuguese exports, almost twice as much as Germany, its second-biggest trading partner.

“Without correcting its deficit, Spain won’t enter a new period of economic growth, and evidently, we want that to happen,” Prime Minister Pedro Passos Coelho said on June 11. Portugal is “very integrated” with Spain, he said.

Spanish companies also are direct investors in the Portuguese economy. Banco Santander SA, Spain’s biggest bank, owns Portugal’s fourth-biggest lender. CaixaBank SA, Spain’s fourth-biggest bank, holds 39.5 per cent of Banco BPI SA, Portugal’s fifth-biggest bank. Spanish banks and retailers, including Adolfo Dominguez and Massimo Dutti, line Lisbon’s main shopping thoroughfare, Avenida da Liberdade.

Market Watch

While Spain remains the biggest trading partner, Portugal has sought other export markets, according to Cristina Casalinho, chief economist at Banco BPI in Lisbon.

“In these last few years, there has been a reduction in the relevance of Spain as an export market as alternative markets emerged,” she said. “In the first quarter, Spain was the only main market to which Portuguese exports declined. Despite that, Portugal’s overall exports increased.”

Portugal’s trade deficit narrowed in the first quarter as exports rose 11.6 per cent and imports fell 3.3 per cent. The government is counting on exports to limit the contraction in GDP this year to 3 per cent, less than the European Commission’s 3.3 per cent forecast, and predicts an economic expansion of 0.2 per cent in 2013. The country’s deficit is forecast to be 4.7 per cent of GDP this year, less than the 6.4 per cent for Spain, according to the commission.

Portugal’s first-quarter budget results indicate there is “room for optimism,” Moody’s Investors Service said May 28. In January, Standard & Poor’s followed Fitch Ratings and Moody’s in cutting Portugal’s credit rating to non-investment grade, or junk.

IMF Report

The IMF said in a report published April 5 that it assumes Portugal will return to selling bonds in the middle of 2013, with yields on medium- and long-term debt of about 7 per cent, and added that rates will then “decline gradually to 5 per cent over the next four years and remain stable thereafter.”

“I was very positively impressed by the way they’re adhering to their austerity plan,” William Rhodes, president and chief executive officer of William R. Rhodes Global Advisors LLC, said in a May 31 television interview. “Of course, they have their neighbour Spain that has its problems.”