Surging unemployment is stretching Portugal's austerity program to breaking point, and its international lenders are likely to respond by giving the country more time to hit its budget targets, likely paving the way for a second bailout.
Portugal passed the latest of several performance reviews under its 78-billion-euro rescue package on Monday.
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But inspectors from the European Union and International Monetary Fund said the soaring jobless rate required "decisive policy action", adding fuel to a region-wide debate on whether to extend or row back on the austerity programs that have put a brake on growth in Europe's most vulnerable economies, including Portugal.
The 'Troika' of lenders from the IMF, European Union and European Central Bank also said they anticipated that recent labor reforms would cut an unemployment rate that, at 15 percent, is the third highest in the euro zone.
But economists say the reforms will take time to have an impact, while Lisbon hiked its jobless forecast for next year to 16 percent on Friday, reflecting rising levels of corporate bankruptcy as the country struggles through its worst recession since the 1970s.
"It's simple math. More spending with unemployment welfare and less tax revenue makes a social security deficit practically certain this year," said Rui Bernardes Serra, chief economist at Montepio bank.
Corroding an account that has traditionally been in surplus would undermine the overall budget deficit reduction plan agreed with creditors.
That would mean that, if the country is to continue to comply with the bailout program, it will either have to implement more austerity or persuade the lenders to grant more leeway on fiscal targets.
With neighboring Spain gaining more time to cut its budget deficit as it battles to avoid becoming the euro zone's fourth bailout recipient, expectations are high that the lenders will go down the same route for Portugal.
That would leave Lisbon's ambitions of re-entering debt markets during 2013 - when its bailout program ends - hanging by a thread, making a second rescue package likely.
Former finance minister Manuela Ferreira Leite said on Monday that the austerity should be "slower to avoid killing the patient with the treatment".
"Austerity has been the German answer. But I doubt that (German Chancellor Angela) Merkel defend austerity as the way out of the crisis if unemployment in Germany were at 15 or 20 percent," added Montepio's Bernardes Serra added.
Now at 15.2 percent, Portugal's jobless rate is the euro zone's third highest after Spain and Greece, almost doubling since 2008, when the international financial crisis broke out.
The government had previously expected the rate to start retreating in 2013 after peaking at 14.5 percent this year.
Union leaders say unemployment has reached "socially and economically unsustainable levels" for Portugal.
Pedro Pita Barros of Nova School of Business and Economics in Lisbon said the dramatic rise could bring about "long-term, entrenched unemployment at very high levels".
"That is worrying, complicated and can become a very heavy and permanent burden on public accounts," he said.
NO MORE AUSTERITY
Filipe Garcia, head of Informacao de Mercados Financeiros economic consultants in Porto said it would be practically impossible for Portugal to meet this year's deficit target of 4.5 percent of economic output without extraordinary revenues.
"The public deficit goal for 2012 is now at risk because of that (unemployment), and it already was due to the economic performance," he said.
The lenders have said the one-off measures Portugal used to hit last year's 5.9 percent goal are not an option either this year or next, urging the country to rely more on spending controls and reforms.
But piling more austerity on an economy in recession and expected to shrink by a further 3.3 percent this year is increasingly viewed as untenable.
"What we are witnessing in Portugal and in peripheral (euro zone) countries is close to being 'destructive napalm', making companies simply disappear," said Filipe Garcia, economist at IMF-Informacao Mercados Financeiros in Porto.
Structural reforms that the government is implementing to make labor laws more flexible and cut labor costs will be crucial to boost Portugal's competitiveness.
But the transformation will take time and in the meantime, firms are suffering from the economic slump and a lack of financing amid the debt crisis. Corporate bankruptcies spiked 50 percent last year to 32,990 firms, according to National Statistics Institute data.
The head of the Portuguese Industry Confederation, Antonio Saraiva, said unemployment could rise as high as 17 percent.
Montepio's Bernardes Serra said that, at bottom, Portugal's compliance with its bailout should be judged not so much by the deficit goal but on structural reforms.
"(So) there's probably no more room for austerity via tax hikes or cuts in household income due to their recessive, counter-productive impact," he said.
Pita Barros said more taxes or pay cuts risked pushing over the brink parts of the Portuguese population that has been behind a recent increase in bank deposits even as lenders in Greece and Spain registered huge outflows.
"There is still money in the banking system that allows, despite all factors, to maintain some financing of the economy. But if these funds disappear, we'll probably have a collapse."