Two months into the job, Portugal’s Prime Minister Pedro Passos Coelho is deepening the budgetary pain without feeling any gain. Swept to office June 5 on the back of a 78 billion-euro ($110 billion) rescue sought by his predecessor, Passos Coelho has announced a tax charge and spending cuts together worth more than 1 percent of gross domestic product to ensure he meets the targets set out in the aid package. All he’s got in return are higher borrowing costs as contagion spreads to Italy and Spain. “There was and there will be a contagion effect,” Andre Pinheiro, who helps oversee 100 million euros of assets at Orey Financial SA in Lisbon, said in a telephone interview. “Our recovery depends on their recovery, and our yields won’t decline if they don’t recover.” The first review of Portugal’s aid program began this week as the sovereign debt crisis shifted to Italy and Spain, driving yields on 10-year bonds to euro-era records. With the third- and fourth-biggest economies in the common currency now shouldering yields closer to 7 percent than Germany’s 2.30 percent, Coelho’s bid to show he’s serious about taming Portugal’s deficit has yet to impress investors. “The government’s making an effort at budget consolidation but it’s not possible to assess the program using the yields of the secondary market,” Amilcar Morais Pires, chief financial officer of Banco Espirito Santo SA (BES), Portugal’s biggest bank by market value, told reporters in Lisbon on Aug. 1. ECB Bond-Buying Portugal’s 10-year bond yield fell 5 basis points today to 11.252 percent as the European Central Bank bought Portuguese and Irish government bonds for the second straight day, two people with knowledge of the transactions said today. The yield reached a euro-era record of 13.441 on July 11. The two-year bond yield slid 99 basis points today to 13.813 percent. The spread means there is more perceived risk in lending to Portugal for two years than for a decade. The difference in yield that investors demand to hold Portugal’s 10-year bonds instead of German bunds was 891 basis points today. That’s up from 511 basis points on April 6, when then Prime Minister Jose Socrates sought outside help, making Portugal the third euro country to need an international rescue after Greece and Ireland. On June 6, the day after Passos Coelho defeated Socrates to take power, it was 670 basis points. The government has fought back, saying that it aims to beat some of the targets set out in its European Union-International Monetary Fund bailout program. Element of Surprise “We’ll do everything so that our return to the market will be even faster” than the two years envisaged, Passos Coelho said on June 16. “We will have to be very diligent in meeting the agreement that was signed with the EU and the IMF. But we will also have to surprise.” Two weeks later, the prime minister announced that he was planning a one-time income-tax surcharge this year equal to 50 percent of the Christmas supplements all workers receive. The yuletide payment is the equivalent of one month’s salary. The measure represents an additional annual tax rate of 3.5 percent, according to Finance Minister Vitor Gaspar, who expects to raise a total of 1 billion euros this year and next with the seasonal surcharge on salaries, pensions and capital gains. The government says it needs the tax charge and spending cuts, worth about 2 billion euros in all, to meet this year’s deficit targets. Analysts such as Pinheiro of Orey Financial say there’s a need to focus on growth besides just raising taxes. ‘Lack of Growth’ “It seems we’re correcting the deficit more on the revenue side,” Pinheiro said. “Structurally we continue to have high spending. We are also being penalized by the rating agencies for the lack of growth forecast for this year and next.” Portugal’s credit rating was cut to below investment grade by Moody’s Investors Service last month, after Standard & Poor’s lowered the country’s creditworthiness twice in a week in March to one notch above junk status. Fitch Ratings said July 28 that it expects to resolve its rating watch negative on Portugal in the fourth quarter. Portugal’s economic growth has averaged less than 1 percent a year over the past decade, one of Europe’s weakest rates. The government expects the economy to contract 2.3 percent this year and 1.7 percent in 2012. Portugal had the fourth-biggest budget deficit in the euro region last year at 9.1 percent of GDP. The bailout sets goals for a deficit of 5.9 percent this year, 4.5 percent in 2012 and 3 percent in 2013. “It’s very important for this government to be more ambitious than the aid program,” Gaspar said on July 14. By the end of the year the government aims to sell state- held stakes in companies including EDP-Energias de Portugal SA, the biggest electricity provider, and REN-Redes Energeticas Nacionais SA, the national power grid operator. High-Speed Rail It’s put on hold a high-speed railway project from Lisbon to Madrid, and plans to sell state-owned airline TAP SGPS SA and one of broadcaster RTP’s television channels. The government is meanwhile freezing public workers’ salaries, lowering pensions and raising value-added tax rates. There are signs the measures are bearing some success. The first-half central government deficit narrowed 27 percent from a year earlier, while all of Portugal’s lenders passed the European Banking Authority’s stress tests last month. Passos Coelho still has the public on his side. His Social Democrats had 42 percent support, up from the 39 percent it took at the election, a July 20 poll for Jornal de Negocios newspaper showed. The main opposition Socialists had 24 percent, down from 28 percent. Portugal’s borrowing costs eased at an Aug. 3 auction of 750 million euros of three-month bills. The securities due in November were issued at an average yield of 4.967 percent after 4.982 percent at a July 20 auction. Trichet’s Verdict European Central Bank President Jean-Claude Trichet, in a July 7 interview with Portugal’s TVI, said that the government’s measures show the country is “ahead of the curve.” That didn’t stop Moody’s from cutting Portugal to junk two days earlier on concern it will need to follow Greece and seek a second bailout. “We have not seen all the debt restructurings that we’re expecting,” Otto Waser, chief investment officer of R&A Research & Asset Management AG, said in a July 25 interview with Linzie Janis on Bloomberg Television’s “Countdown.” “We have seen a small restructuring for Greece. It’s not quite clear on the timing, but Portugal and Ireland are candidates.” To contact the reporter on this story: Joao Lima in Lisbon at jlima1@bloomberg.net. To contact the editor responsible for this story: Tim Quinson at tquinson@bloomberg.net

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