Portugal's central bank said today the country's banks faced an "intolerable risk" unless the government manages to bring its public spending under control as it struggles to combat a debt crisis.
The Bank of Portugal report spelled out a tricky scenario for the banks as concerns grew in markets over the nation's prospects of avoiding a bailout and thus becoming the next domino to fall in the euro zone.
Prime minister Jose Socrates last week pushed through an austerity budget which will raise taxes and cut public sector wages and he insists no international rescue package is needed.
But for many economists, the question is not if a bailout will happen, but if it will be sooner rather than later.
Following Ireland's €85 billion bailout package, economists fear that unless Portugal takes the same medicine, the contagion will spread to its neighbour Spain, a considerably larger economy than the peripheral countries hit so far by the crisis.
The Bank of Portugal financial stability report said that failure to consolidate public finances would put the Portuguese banking sector in jeopardy, especially if the sovereign debt crisis continued in Europe.
"The risk will become intolerable if we do not see the implementation of measures that consolidate public finances in a credible and sustainable way," it said.
Budget execution has been poor so far this year, with the core state sector deficit widening 1.8 per cent in the first 10 months, and Brussels is pushing Socrates to do more.
The government has promised to cut next year's budget deficit to 4.6 per cent of gross domestic product from 7.3 per cent this year with across-the-board tax hikes and five per cent cuts in civil servant wages.
Portugal's risk premium, measured by the spread on its 10-year government bonds over safer German Bunds, was two basis points higher at 458 basis points.
Banking shares led Portuguese stocks lower, with Banco Espirito Santo slumping 2 per cent and Millennium BCP down 0.5 per cent.
The report said the austerity measures would harm the economy next year although the impact could be mitigated by external demand for Portuguese products.
An economic downturn would mean the banks had less money to offer companies and households in credit. They needed to find new strategies to tap clients' resources in order to dampen liquidity risks as they had been shut out of the interbank funding and have had to rely on European Central Bank funding.
Banco BPI said in a research note that the report "outlines a difficult scenario for Portuguese banks for upcoming years...we believe that the sector will continue to be penalized by sovereign concerns in coming times."
Mr Socrates, who heads a minority socialist government, is due to meet business leaders in an effort to boost exports, a path he sees as vital to Portugal's recovery.
However, union leaders are also expected to outline their strategy. Unions have protested against the austerity measures and last week a general strike paralysed public transport, grounded airplanes and shut some public services.
The timing of any potential bailout for Portugal is very difficult to predict as it now depends more on decisions at the European level and the markets, said Filipe Garcia, an economist at Informacao de Mercados Financeiros consultants.
"The market is pushing rates higher to a level where countries are being obliged to ask for help," Mr Garcia said. "This is not really in our hands any more. I think if Portugal seeks a bailout depends more on Europe."
He said a key event will be tomorrow, when Portugal issues €500 million of 12-month treasury bills and the rate at which the debt is issued. If the borrowing costs are high, it would be further bad news for Portugal.
Citigroup said it saw little prospect of market conditions improving for peripheral countries in the near future.
"Market doubts over longer term fiscal stability are likely to continue to plague weaker EMU peripheral markets, including Spain and Portugal," it said.
Reuters