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LONDON (Reuters) - A slump in Portuguese bond prices in the past month shows there are parts of the euro zone government debt market that massive shots of cheap money from the European Central Bank cannot reach.
Italian, Spanish and Irish bonds have all rallied as banks used some of the 489 billion euros they borrowed from the ECB in December to buy such debt, a profitable trade because the special three-year loans were so cheap.
But this cash has not helped Portugal, whose borrowing costs recently rose to levels that could eventually force it to seek a second international bailout or even a debt restructuring.
"It doesn't work for Portugal because, for it to work, people need to be persuaded that the economy and the debt (situation) are sustainable," said Bill Blain, senior director at Newedge.
"Investors are being pragmatic. They are looking at the sustainability of Portuguese debt and saying there will have to be a restructuring. They are more confident about buying Spain and Italy because these are big bond markets where banks are piling in surplus liquidity."
The conditions of the bailout Portugal received from the International Monetary Fund and European Union last year also help explain why the country's own banks aren't ploughing ECB loans into the government bond market.
The lenders said Portugal must ensure its banks increased the capital they set aside in case loans they had made turned sour. The banks are therefore putting aside more cash and cutting lending.
"The Portuguese banks have to reduce their loan to deposit ratio and while the IMF's fear is that it might happen too fast, it would be a contradiction to ask Portuguese banks to make full use of the LTRO (the ECB's three-year loans) to buy sovereign debt," said Gilles Moec, co-head of European economic research at Deutsche Bank.
Given this backdrop, and a need for all European banks to build up a bigger capital buffer against exposure to government debt, Portuguese banks have not been among the biggest borrowers from the ECB.
A Credit Agricole CIB analysis of central bank data estimated they borrowed far less than banks from many other countries -- including Italy, Spain, France, Greece, Netherlands, Ireland and Germany.
There was very little net increase in Portuguese banks' ECB borrowing once Credit Agricole analysts had taken into account the value of their maturing ECB loans.
By contrast, they estimate Italian, Spanish, French, Greek and Italian banks borrowed twice as much from the ECB as they needed to roll over maturing loans, leaving them spare cash to buy government bonds.
Of course, those foreign banks who borrowed more ECB money than they needed could have bought Portuguese bonds.
But Portugal is traditionally more dependent than Spain or Italy on overseas investors buying its bonds and this is working against it as foreigners stay away.
They are concerned about Portugal's deteriorating economic outlook, its lack of competitiveness, and the scale of the fiscal problems the government has to fix.
And those financial institutions and investors still holding Portugal's debt started to think again after Standard & Poors cut its credit rating to junk on January 13.
"There is clear evidence from flows that there has been a steady loss of confidence in Portugal since the summer of last year," said Simon Derrick at Bank of New York Mellon.
"What is noticeable is that in mid-January you see a pick up in these outflows which coincides with the credit downgrade."
Portuguese 10-year bond yields soared above 17 percent this week, prompting the ECB to buy Portuguese debt in the secondary market to bring them down again.
While the central bank's intervention is helping in the short term, analysts say trading conditions in the Portuguese bond market may have deteriorated beyond the point of no return.
One of the most worrying developments has been the widening gap between the prices that banks quote to buy Portuguese bonds and those they quote to sell them. <For graphic see link.reuters.com/zys36s
The wider this gap, known as the bid/offer spread, the harder it is to make money by buying and selling a financial asset.
"You can drive a truck through the bid/offer spread and so no-one is buying Portuguese bonds in any significant amount, apart from the ECB," said Frederik Ducrozet, euro zone economist at Credit Agricole CIB in Paris.
"Restructuring makes no sense on fundamental grounds but this is not about fundamental reasons or rational behavior because we are well beyond that point and this is a broken market."
Editing by Anna Willard