LISBON Inspectors arriving in Portugal next week to conduct a fifth review of its 78-billion-euro rescue will find the country in a deepening recession under tough austerity, which is undermining its determined efforts to meet strict fiscal goals.
This could force Portugal to seek a second bailout from its lenders as it remains a long way from being able to meet its borrowing needs on the open market.
However, the country may also be found to be a candidate for a relaxation of its tough targets as European leaders start to look at alternative responses to the crisis beyond just demanding a fresh round of cuts.
Portugal has garnered less attention in the most recent phase of the euro zone's woes, lacking the power to derail the entire project like Greece or Spain, but also failing to match Ireland in charting a convincing path out of the hands of its lenders.
But the country seems to be more on the trajectory of Greece, trapped in a cycle of slow growth and rising debt made worse by the very fact it has been so effective embracing the austerity demanded of it.
"The troika would like to see growth, or else the process could be called into question," said Filipe Garcia, head of Informacao de Mercados Financeiros consultancy.
The review by the officials from the European Union, IMF and European Central Bank - the so-called troika - starts on August 28 and should last around two weeks, the finance ministry said in a statement on Friday.
So far this year the recession, already the worst since the 1970s, has only deepened. Data last week showed a 1.2 percent slump in second quarter gross domestic product from the previous quarter, after dipping just 0.1 percent between January and March, as sweeping cost cuts and tax hikes dented consumer spending and credit remained tight.
The worsening outlook has prompted economists to downgrade their outlooks, with analysts polled in a recent Reuters poll now forecasting a 3 percent decline in gross domestic product this year and 1 percent in 2013, the latter contrasting with the government's hopes of eking out modest growth.
The slump has cut into tax revenues, which fell 3.5 percent in the first seven months of the year, prompting doubts the country can meet this year's budget deficit goal of 4.5 percent of GDP and next year's target of 3 percent.
"By proceeding with what we had planned, getting to the end of the year with a deficit of 4.5 percent is becoming more difficult," a finance ministry spokesman said on Thursday after the release of January-July budget data.
The centre-right government's strategy has been to singlemindedly aim to meet all elements of the bailout terms -- fiscal goals, cost-cutting, reforms and privatizations.
Last year Portugal met the budget deficit goal thanks to a one-off transfer of banks' pension fund assets to the state but the lenders have said they do not want a repetition of that.
Garcia said the 'troika' is now likely to be flexible due to the slowing economy. "I think the troika will open space to change (fiscal goals) due to the revenue shortfall. That is what they are preparing to do for Spain and Greece," he said.
The government's challenge to meet the budget goals also became tougher due to a court ruling in July against a measure to cut civil servants' wage deals.
Still, while Portugal's economy has deteriorated, its bond yields have fallen sharply in recent weeks, largely on hopes of the European Central Bank's plans to buy peripheral eurozone bonds.
The yield on 10-year bonds now trades around 9.3 percent -- levels last seen when Portugal requested its bailout last year -- compared with highs of over 17 percent in January.
But that is still the second-highest in the euro zone after Greece, and above neighboring Spain's 6.4 percent, posing questions about Portugal's ability to return to bond markets in a year as envisaged under the bailout.
Portugal needs to meet a bond payment of 9.7 billion euros in September 2013 that is not fully covered by the bailout -- a key reason why many economists think Lisbon will need an extension of the bailout.
"While sovereign yields have considerably come down over the last months, the return of the country to long-term debt markets is still uncertain, thus raising questions about how to cover the September maturity," said Antonio Barroso, an analyst at Eurasia Group in a research note.
The government has said it aims to cover the maturing debt through longer Treasury bills or medium-term notes, hoping that yields come down over time.
If that fails, the prospect of extending the bailout could become necessary, but both donors in northern Europe and Portugal would be reluctant to do that now, especially since the euro debt crisis has moved on to the much bigger economies of Spain and Italy.
Barroso said that as the troika needs to review Portugal's strategy in advance, "the funding strategy will be one of the centerpieces of the discussions between the donors and the government in the upcoming mission."
(Reporting By Axel Bugge)