LISBON Portuguese will suffer from cuts to schools and hospitals to protect civil service benefits after the constitutional court rejected austerity measures that would have reduced holiday bonuses and other public sector perks.
The government has had to scramble to find new areas to cut after the court concluded that it was unfair to single out civil servants for reductions in benefits under measures imposed to meet the terms of an international bailout program.
The decision deepens the divide between a protected class of civil servants and other workers, whose lives have become far more precarious during the worst recession since the 1970s.
Although public sector pay has fallen faster than in the private sector during Portugal's economic crisis, state workers still earn on average double the wages of the private sector. Meanwhile, all Portuguese have been hit since January by the largest tax hikes in living memory, and many economists believe more austerity measures will prolong and deepen the slump.
"This decision left me very worried. Civil servants benefit, but not the private sector. It's in the public sector where the government has to cut," said Sonia Castro 39, an unemployed secretary.
Jose Manuel, 56-year-old taxi driver in Lisbon, said the only outcome he sees is that "our lives will only get worse."
The European Commission and particularly Germany have urged Lisbon to waste no time in coming up with new savings in order to keep its bailout program on track.
On Sunday, Prime Minister Pedro Passos Coelho reaffirmed Lisbon's commitments to its fiscal tightening goals under an EU/IMF bailout, promising to compensate for the court decision with other spending cuts.
Coelho has managed to avert the court decision bringing down his government. He survived a no-confidence vote last week and won President Anibal Cavaco Silva's support to stay in office.
Portuguese benchmark bond yields jumped almost 20 basis points in early trading on Monday following late Friday's constitutional court ruling - a sign of investor concern - but then rolled back to Friday's settlement level of 6.42 percent.
NO POLITICAL CRISIS
"The key thing here now is that there is no political crisis, that the government stays on and that it is not planning to renegotiate bailout targets. It could have turned out much worse," said Filipe Garcia, head of Informacao de Mercados Financeiros, an economic consultancy in Porto.
Coelho's pledge to meet targets with more spending cuts means Lisbon will now have to find another 0.8 percent of Gross Domestic Product to satisfy the "troika" of lenders - the EU, European Central Bank and International Monetary Fund - which demand austerity in return for bailout loans.
Lisbon has already promised to its lenders to cut 4 billion euros progressively in spending between 2013 and 2015, and the pace of the cuts will now have to accelerate.
Political scientist Viriato Soromenho Marques said the spending cuts were unlikely to cause new constitutional problems for now. "But most importantly, they will cause problems with people's living standards, which are already very low."
The government now plans to cut spending in areas like the healthcare system, pensions and education.
"They'll have to find solutions that don't run against the constitutional court's line, but I think it's possible to implement savings even in healthcare without getting barred by the court," Garcia said. "Judging by their early response, the government has a backup plan ready."
Analysts said freezing investment in hospitals was one possible measure that could save hundreds of millions of euros, as well as raising the share of medical bills paid by patients.
"The budget hole now opening is quite large, but not impossible to fill with other measures," Citi analysts wrote in on Monday, adding though that the ruling may delay the issuance of a new 10-year bond that had been expected soon.
Analysts say cuts will still have to fall on the public sector wage bill and pensions which make up 60 percent of state spending. But protecting the perks of those with steady civil service jobs means imposing more pain on contractors.
Some economists say new cuts are still a better option than more tax hikes.
"I was really concerned with their insistence on tax hikes, so it's probably a macroeconomic positive that they will cut spending," said Gilles Moec, Deutsche Bank economist in London.
"The overall story with the court remains a negative ... but 0.8 percent of GDP is not the end of the world," Moec said, adding that he did not expect any major delays with Lisbon obtaining new bailout tranches or extension of loan maturities that are being negotiated with its European partners.
Lisbon has to cut the budget deficit to 5.5 percent of gross domestic product this year from 6.4 percent in 2012, when it missed its goal but was still lauded by lenders for its efforts. The lenders have eased Portugal's deficit goals twice since the rescue was agreed, recognizing consolidation efforts.
Increasingly, there are economists who believe the endless rounds of austerity imposed by the international lenders are self-defeating, by preventing economic growth.
More austerity could "bring improvements in headline numbers at a great unnecessary cost," said Nicholas Spiro, Managing Director at Spiro Sovereign Strategy in London.
"If it were not for the Troika's leniency and the dramatic rally in Portuguese debt, the program would have already failed by now ... What undermines it the most is that there is no growth and no real prospects of growth soon."
(Additional reporting by Daniel Alvarenga; Editing by Peter Graff)