LISBON The IMF warned on Thursday that risks to Portugal's bailout plan have "increased markedly" due to lower tax revenues, growing resistance to austerity and the likelihood that it will remain in recession next year.
Economists say Portugal could face a recessionary spiral like Greece, especially if sweeping tax hikes in 2013 undermine consumer confidence. The economy is seen shrinking at least 3 percent this year and 1 percent in 2013, and unemployment is at record highs.
The International Monetary Fund said that "after a strong start, the program has entered a more challenging phase" for Lisbon to overcome its debt crisis.
"The risks to the macroeconomic outlook and fiscal targets are significant and tilted to the downside," the IMF said in its staff report on the fifth review of Portugal's 78 billion euro bailout, which was approved.
But while the 'troika' of lenders to Portugal - the European Union, the European Central Bank and the IMF - approved the latest review, it has also agreed to ease Lisbon's budget deficit goals for this year and next due to growing headwinds.
Nevertheless, while warning that "risks to the attainment of the program's objectives have increased markedly," the IMF said it still believes Portugal can finance itself in bond markets again from next year as planned. That has been borne out by sharply falling bond yields.
It said with bond yields around 8.5 percent, at the time of the review at the beginning of September, it is "now closer to the market reentry rate of 7 percent assumed in the debt sustainability analysis than at any time since the program started" in May 2011.
"This suggests that the strategy of a gradual return to markets is still viable, and the authorities are confident that a good cash management strategy will be sufficient to cover needs while access is gradually restored," the report said.
Portugal's 10-year bonds currently yield around 7.9 percent, sharply down from highs of over 17 percent in January, and near their lowest levels since before the country sought the bailout.
The IMF said that risks to the economic outlook could materialize due to weaker demand for Portuguese exports in the euro area or stress due to political difficulties in Greece.
"While the program's core objectives remain within reach, the buffers in the program to cope with further adverse shocks have narrowed," it warned.
But it also saw possible problems on the domestic front, saying the "reliance so far on raising new revenues and their disappointing performance so far point to a source of risk to achieving the targets", adding that the government needed to cut spending further to rebalance the adjustment effort.
The government is planning sweeping tax hikes next year in a draft budget which could face opposition in courts.
Under the new fiscal goals, Portugal must now post a budget deficit of 5 percent of GDP this year and 4.5 percent in 2014. In 2011 it posted a deficit of 4.4 percent of GDP, but that was only thanks to a one-off transfer of banks' pension assets to the state.
The IMF said Portugal's national debt was also now likely to climb higher than previously thought before it begins falling.
"Debt will now peak at a higher level (124 pct of GDP in 2014) and - should outturns again prove worse than expected - the room for further accommodation of shortfalls would be limited," the IMF said. It had previously expected that figure to reach 119 percent.
It added that "important strides" have been made under the loan agreement.
"Macroeconomic imbalances have been reduced sharply since the start of the program," it said, citing a sharp improvement in fiscal accounts and the current account deficit.
(Reporting By Axel Bugge; Editing by Hugh Lawson)