By Greg Peel

"I would say that Greece would probably leave the euro, but Portugal might stay," said Nobel prize-winning economist Paul Krugman this week, "It all depends on how things play out in the next two or three years".

Krugman suggests the odds of Portugal staying a member of the eurozone are about 75%. Given the guy was granted the first ever combined causa" degree from three different Portuguese universities, we can probably assume he's talking with a degree of insight. Quite simply, Krugman believes the Portuguese are yet to feel the full effects of imposed austerity measures on their way of life. And of course, so too the Greeks.

This is not really an assessment global investors want to hear. While 75% is good odds for Portugal, the implication is we may be looking at a 25% chance some time in the next two to three years we will have not only to go through another nightmare of will it-won't it default, but also through some ordeal of final death throes for a doomed Greece. In other words, while we may be feeling more complacent right now, chances are we have another two-three years of Euro-uncertainty ahead to provide market volatility.

It was in April 2011 that Lisbon first had to request financial assistance from the EU and IMF in order to avoid default. Portugal was granted E78bn with the usual set of austerity measure requirements we've come to recognise. This was the point at which the world started to greatly fear euro-contagion. Greece and Ireland, then Portugal, whose next? Spain? Italy? History now records that thanks to vigilante bond traders all of the PIIGS got very close, before the ECB floodgates opened.

Yet with those floodgates still well open, and Greece now sorted out for at least the short term, why is it that Portugal's sovereign debt continues to trade at a full 10% spread over the benchmark German bund? Are bond traders just assuming that if one of the PIIGS goes to the slaughter house the rest must surely follow? Are they bored now that Greece is no longer fun? Or is there a legitimate risk in the wake of Greece's second bail-out that Portugal may yet need something similar?

Portugal's main problems, Seeking Alpha suggests, are its structural unemployment (14% compared to 7% pre-GFC), lack of productivity, and loss of competitiveness compared to peers. The government is introducing initiatives to combat these issues, but the reality is Portugal's fiscal deficit is somewhat entrenched. No government has run a surplus in 30 years. Government forecasts now have the Portuguese GDP contracting by 3% in 2012 under tight austerity, and for a recession to continue through at least 2013. Wage cuts and VAT increases are weighing heavily on an economy 70% reliant on the domestic consumer, and as Paul Krugman suggests, "more austerity would be counterproductive".

Yet Portuguese prime minister Pedro Passos Coelho said on Monday the Portuguese economy is behaving as expected, making additional requisite austerity measures unlikely. The Opposition is nevertheless calling for the troika to grant the country one more year to meet deficit targets.

Such an extension does not appear immediately likely, given last night Portugal passed the periodic inspection by the troika required to be granted the next E14bn of the E78bn total bail-out package. Such an uneventful "pass" contrasts with the Greek experience in which every periodic inspection found Greece had not tightened its belt as required, and indeed found Athens had largely ignored its responsibilities altogether. In fact to this day Greece has not raised one euro-cent of the E50bn supposedly on offer from divesting of public assets, despite such sales being seen at one point as somewhat of a potential saviour. Greek politicians, it seems, are stubborn when it comes to questions of sovereignty.

Portugal, on the other hand, moved quickly to sell a government-owned bank and stakes in two Portuguese companies as soon as asked to do so in 2011. To date Lisbon has acquiesced with regard to all austerity requests made of it. Portugal's public debt currently represents more than 100% of GDP and should continue to grow to reach a peak of 115% in 2013 according to troika estimates. By late 2013, after austerity measures have had some impact, it is hoped Portugal will be able to return to sovereign debt markets for funding. By contrast, even with the 53.5% bond haircut Greece is expected to reduce its public debt only to 130% by 2020.

So the troika has high hopes for Portugal, and hopes to use it as a "model student" example for Greece and others. But the question remains: Given the level of strict austerity being imposed on the Portuguese and the restraints it implies for economic growth, will Portugal get across the debt reduction line and into a comfort zone without requiring a second bail-out, a la Greece?

The general feeling on that answer appears to be "no".

Citi economists released an extensive paper last week suggesting that in order to close Portugal's funding gap by 2015 the country would need a further E70bn from the troika along with haircuts for private sector bondholders. Citi's earlier expectation was that a 35% haircut would be needed by the end of 2012 but now they have moved that up to 50% ? almost Greek levels.

We recall that earlier this month, when it appeared the Greek haircut was all but agreed upon, Ireland piped up with a cry of "what about me?" ECB president Mario Draghi was nevertheless quick to play down any idea of a haircut for Greece implying equivalent deals for Ireland or anyone else, claiming Greece's problems to be "unique". Ireland has since gone quiet on the matter, suggesting it wouldn't push the point. But where does this leave expectations of a haircut required for Portugal?

Citi does not believe Portugal will fail to meet its austerity requirements and not receive the ongoing tranches of the E78bn granted in 2011, the economists simply believe it won't be enough. The recession in Portugal is intensifying, they suggests, and GDP growth prospects remain weak over the medium term. Even the Portuguese government admits it may fall a bit short on delivering the budget debt to GDP ratio target set for 2012.

The troika is hoping Portugal can return to the market for funding in 2013 after the bail-out package winds down. Citi believes it will be "impossible" for Portugal to reach 2012 targets, and that even if it were able to access market funds the interest rates required would be at levels Portugal could not afford. By 2013 a funding gap will have appeared, Citi suggests. While the Portuguese government is forecasting 3% GDP contraction in 2012, Citi is expecting 5.5%, followed by 3.4% in 2013 and 0.4% in 2015, with growth of around 1.3% from 2016 onwards.

Even if Portugal receives a second bail-out, Citi calculates its public debt to GDP ratio would continue to blow out to 146% by 2015-16. This is in stark contrast to the 115% "peak" in 2013 the troika is hoping for under only the original bail-out. That is why Citi believes Portuguese bondholders will also be forced at some point to take haircuts of up to 50%. The sooner this occurs, the economists note, the sooner Portugal can get back on a sustainable fiscal path.