| COIMBRA, Portugal
COIMBRA, Portugal Stuffed into a time capsule, this ancient university town's local newspaper would give future historians a good idea of the pain that Europe's first financial crisis of the century inflicted on Portugal.
The Diario de Coimbra reported on its front page last Thursday how bankers had called in a loan on a local sports stadium. A piece on the back page asked whether a rise in suicide rates was linked to the deepening economic downturn.
A bank advertised the auction of 38 foreclosed properties. Other ads promoted some of the many gold and silver dealerships that have sprung up since the onset of the crisis for people forced to sell the family jewels.
Burdened with public debt that will approach 120 percent of national output this year, Portugal is suffering so badly that many in the market wonder whether, along with Greece, it can escape its debt trap without abandoning Europe's single currency.
The economy is contracting sharply due to tax increases and spending cuts demanded last May by the International Monetary Fund, the European Union and the European Central Bank in return for an emergency 78 billion euro loan.
Output is projected to shrivel 3.3 percent this year, after a fall of 1.6 percent in 2011. With tax revenues withering, the government's core budget deficit nearly tripled in January and February. Unemployment jumped to 14 percent in the fourth quarter of 2011 as slumping domestic demand was compounded by a dearth of credit, forcing small and medium-sized enterprises to shed labor.
"The financial sector just isn't injecting money into the economy," said the president of Centro region's chamber of commerce, Jose Couto. Coimbra, two hours north of Lisbon by train, is Centro's largest city. "It's got to the point where even viable export companies are having problems managing their cash flow."
NO FUTURE TO WORRY ABOUT
The manager of a small firm that produces medical equipment, Faria Joao, says he has had to trim his work force to 36 from 42 because the government is cutting health care spending. A second local company that supplies construction materials reports that 14 of its customers have gone bust since the start of the year.
Manuel Afonso, 24, is looking for a job so he can afford to complete his journalism studies at Coimbra University, founded in 1290 and one of the oldest in the world.
"I'm neither a worker nor a student because I have to be a worker to be a student," he said.
Afonso fears it could be years before he gets another job as good as the one he held at Portugal Telecom for six months before he was fired. Asked whether he was worried about the future, he replied: "If they go on like this there's no future to be worried about."
This is what the dry phrase "economic adjustment" means in practice. A lot is riding on how Portugal gets through the adjustment and learns again to live within its means.
If Portugal follows Greece and forces losses on private bond holders to reduce its debt to sustainable levels, markets are bound to ask which financially strapped country is next in line. Spain and Italy, with debts that make them too big to bail yet too big to fail, would be in the speculators' cross hairs.
Yet if Portugal succeeds in putting its debt on a downward trajectory while sparing private investors, it would be a vote of confidence in the new German-inspired fiscal discipline pact aimed at putting the euro on a more solid footing after the near-death experience of the past two years.
For that to happen, budget cuts alone will not be enough. Portugal also needs to rediscover its economic vigor after a decade in which it has eked out growth of just 0.7 percent a year.
On the outskirts of Coimbra, Bluepharma is the sort of small, export-orientated firm that shows how it might be done.
One of the four directors of the generic drugs manufacturer, Isolina Mesquita, describes how nervous she was the day before as a crane maneuvered a new German-built machine into place with inches to spare. The company, which already exports 73 percent of its 18 million euros in annual output, needs the extra production line to make bigger batches of drugs and so become more competitive.
"We're looking for new markets. That's the way it has to be," said Mesquita, a bundle of energy as she showed a pair of visitors her laboratories and testing rooms.
NO SECRET, JUST HARD WORK
Bluepharma, with a workforce of 180, is lucky in these credit-starved times to have the financial backing of a state-owned venture capital company that owns a 17 percent stake.
"Suppliers asked very politely whether it made sense to buy new equipment," Mesquita said. "There's no secret: just work and work - a lot of work."
Research by Goldman Sachs gives a sense of how hard Portugal will need to work to dig itself out of its hole. The investment bank reckons that Portugal needs the biggest price adjustment of any country on the euro zone periphery, about 35 percent, to restore competitiveness and put its external accounts on a sustainable footing.
As a member of the euro, Portugal does not have the option of devaluation. So that means bearing down on wages and prices. Civil servants' salaries have already been cut by 20 percent.
Assuming all the adjustment were to come by crushing demand to lower wages, rather than through productivity-enhancing structural reforms, Goldman estimates that Portugal would have to depress economic growth by 3 percent to 6 percent, relative to trend output, over the next decade. The additional output cost for Greece would be a whopping 7 percent to 12 percent.
"Our message from this exercise is a fairly bleak one for Greece and Portugal, and underscores just how important making the right structural reforms is for those economies," Goldman economist Andrew Benito said in a report.
So how well is Portugal doing on the reform front?
On the positive side of the ledger, recent labor reforms are making it easier and cheaper for companies to fire workers and opt out of nationwide collective bargaining arrangements.
The chief executive of call centre company Teleperformance Portugal, Joao Antonio Cardoso, says the country has a more flexible labor market than Spain, Italy or France. Cardoso's business is growing by 15 percent to 25 percent a year and he plans to add significantly to his 3,000-strong workforce in the next six months.
The government is taking an axe to wasteful health spending and has met 60 percent of its privatization target by selling stakes in two energy companies to investors from China and Oman.
But critics fret that the government has backed away from confronting EDP Energias de Portugal, the dominant utility, over high electricity prices. Plans to inject more competition into the telecommunications sector are on ice. The judicial process is jammed up, deterring investors. And selling off the national airline will provide a much sterner test of the political appetite for privatization.
"They've gone beyond what the international lenders asked. We're on the right track," said Joao Leite, head of investment at Banco Carregosa in Lisbon. "But we'll have to do the right things for two or three years before we start to see results."
THE WEAKEST LINK
And there's the rub. Portugal does not have that sort of time on its side: under the EU/IMF/ECB plan, the government is scheduled to re-enter the bond market in September 2013.
To investors, this is wishful thinking. With 10-year Portuguese bonds yielding an unaffordable 12.6 percent, only a miracle will enable Prime Minister Pedro Passos Coelho to avoid a second bailout.
The burning question instead is whether the lenders will demand, as they did with Greece, that private holders of Portuguese bonds take a write-down as part of a new rescue. Citi economist Juergen Michels in London is among those who expect such a restructuring, probably next year.
The chief economist at Banco BPI in Lisbon, Cristina Casalinho, said this would be the "worst nightmare" for euro zone policymakers, who are determined not to repeat Greece's exercise in private sector involvement (PSI) - a euphemism for write-offs.
"The weakest link will always be the next one in line. So if you say Portugal's debt is unsustainable, what about Italy?" Casalinho asked. "If you really want to ring fence Greece, you can't afford to have a PSI for Portugal. It would unleash a set of events that European politicians are unwilling to allow."
There's an undercurrent of irritation in Portugal that markets are not giving it the benefit of the doubt, in contrast to Italy, Ireland and Spain. Bond yields in those three countries have fallen from critical levels, even though they remain uncomfortably high.
Yes, Portugal wasted a golden opportunity when interest rates plummeted on joining the euro. The country remains the poorest and most unequal in western Europe. Its productivity record is dismal.
But IMF/EU/ECB lenders are optimistic that Portugal's debt-to-GDP ratio will peak in 2013. The budget is programmed to be in primary surplus - before interest payments - this year and the overall deficit will drop in 2013 to the mandated threshold of 3 percent of GDP. What's more, the country managed to reduce its current account deficit in 2011 by 35 percent.
Part of the problem, some think, is that Portugal is not getting its message across. Lisbon has no Mario Monti, Italy's eloquent and persuasive reform-minded prime minister.
But one economist said markets were displaying a deeper mistrust: Lisbon might be sticking to an austerity program for now at the behest of international lenders, but are Portuguese willing to lash themselves to the mast for what could be as long as a decade?
"There has to be a sense that they're not doing this because the IMF/EU/ECB troika has imposed it on them. It has to come from within," the economist said. He declined to be identified for fear of ruffling local sensitivities.
STIFF UPPER LIP
The overriding impression is that people are prepared to tough it out - for now. A documentary on Portuguese television, depicting abject poverty in parts of the country a generation ago, is a reminder of the remarkable rise in living standards and longevity Portugal has enjoyed since it returned to democracy in 1974 after a military dictatorship.
"There's a feeling that for a long time we overspent. It was like a dream. But now the bills have come due," said BPI economist Casalinho. "Even the younger generation felt it was too good to be true."
A visitor is repeatedly told that Portugal is more stoical than Greece - and is willing to do what is necessary to avoid a similar financial downfall. Private investors in Greece suffered real losses of about 74 percent on their bonds.
Tellingly, Portugal has not witnessed the violent protests that have shaken Greece. Support for a general strike last Thursday was tepid.
"We're the good student now. We're not throwing rocks through windows and we're trying to do whatever is needed to escape restructuring," added Carregosa executive Leite.
But the belt-tightening has only just begun. Growth will be needed to sustain hope and social cohesion in a country where youth unemployment is 35 percent and more and more youngsters are emigrating.
"We're different from the Greeks, but I don't know how long people are going to put up with this. We can support pain amazingly, but there's always a limit, and we're close to that limit," said Antonio Almeida, a taxi driver in Lisbon. (editing by Janet McBride)