About a year ago, I wrote that although the focus (at the time) was on Portugal, the viability of the euro would largely depend on what happened with Spain. At the time, the warning signals – rising interest rates and increased distrust from international creditors – were already visible, but the depth of the Spanish crisis was not yet publicly acknowledged. Developments over the last few months have changed that and now the focus is largely on the Spanish crisis and also on the developments in Italy.

While this focus on the problems of larger European economies is understandable, there are nevertheless important lessons to be learned from the evolution of the Portuguese case over the last year. An important difference from the situation in Greece is that in Portugal the implementation of the so-called ‘troika’ agreement has, so far, created favorable conditions for budget consolidation. Public announcements of successful implementation from Portuguese authorities should, of course, be taken with a pinch of salt but there are positive signs. Among these, the interest rate on Portuguese government 2-year bonds has fallen back to pre-rescue levels and now hovers at around 6 per cent, having exceeded 20 per cent only a few months ago. ECB actions and public statements are certainly partly responsible for this but credit is also due to the perceived credibility of the budget consolidation efforts led by Finance Minister Vitor Gaspar.

However, there are also reasons for concern and significant factors of uncertainty in the horizon. The most significant spending cut so far – a 100% cut in holiday and Christmas subsidies to a large share of public sector workers and pensioners – has been ruled unconstitutional by the Portuguese Constitutional Court. Since the measure will still stand in 2012, the government will have to come up with an alternative way to cut about €2 billion in state expenditure. Also, notwithstanding a few encouraging signs, spending cuts in other areas have been slow to materialise. The same can be said of market-oriented structural reforms, which – contrary to increases in taxation which were quickly enacted – have so far lagged behind in terms of implementation. Accordingly, the economy continues to be in recession and unemployment is now at 15 per cent.

Furthermore, there is also uncertainty regarding the political situation. Miguel Relvas, minister of parliamentary affairs and widely regarded as the second most powerful political player in government, has had his credibility seriously weakened by a succession of media scandals. While none of these directly involves the prime minister Pedro Passos Coelho, given the close links between Coelho and Relvas and his support for his minister, it is inevitable that part of the political cost is bearing on his leadership and on the government as a whole. At the same time, questions may also be raised about conditions for the long-term stability of the ruling centre-right coalition. The minority party in the coalition is led by the current minister of foreign affairs Paulo Portas, whose larger political ambitions are well known and may be a risk factor for stability, particularly if public support for the government coalition starts slipping. An additional uncertainty factor is related to the major opposition party. So far the current leadership of the Socialist Party has for the most part stood behind the implementation of the agreed bailout conditions, but if this support fades it is likely that the international credibility of the Portuguese efforts will suffer.

Additional uncertainty comes, of course, from the evolution of the international situation, particularly in Spain, Portugal’s most important commercial partner, and also from the evolution of the European Union as a whole.

To sum it up, over the last year there have been some (limited) positive signs in Portugal that have been recognised by international financial markets. Nevertheless, Portugal needs to step up and reinforce budget consolidation efforts through more substantial spending cuts, and also to enact structural reforms conducive to greater economic freedom, more competition, lower taxes and reduced levels of corruption and cronyism, which continue to be pervasive. To achieve this, internal political stability and the credibility and commitment of the Portuguese government will be essential. Equally important will be the external incentives coming from the eurozone: any sign of debt mutualisation at the European level or increased direct intervention by the ECB in debt monetisation is likely to reduce even more the prospects for the enactment of meaningful structural reforms.