City experts fear Portugal will be soon be forced to apply for a bailout package worth up to €70bn (£61bn), following the Lisbon government's failure to push through its austerity measures on Wednesday.
Portugal is teetering on the brink of becoming the third member of the eurozone to seek assistance from the EU – and as with Greece and Ireland the International Monetary Fund would probably also be involved.
Prime minister José Sócrates's resignation on Wednesday night has left the country in political limbo, and piled extra pressure on European leaders who are gathering at a summit in Brussels on Thursday.
"The resignation of the Portuguese prime minister adds a political crisis to a fiscal crisis, and brings a bailout a step closer," said Kevin Dunning at the Economist Intelligence Unit.
Sócrates quit after opposition parties voted down his austerity measures. European commission president José Manuel Barroso quickly warned, though, that the country must stick to the latest reforms announced earlier this month.
Britain could be forced to contribute more than £3bn to a Portugal bailout package, according to the Open Europe thinktank. It claimed on Thursday that the UK's share of any rescue package would be between €810m and €3.7bn, via the commission's €440bn bailout fund.
"Portugal will inevitably ask for a bailout," said Open Europe's Raoul Ruparel. "But the cases of Ireland and Greece clearly illustrate that the EU's strategy – to throw good money after bad – is failing. Rather than simply taking a bailout, it would be better in the long run for Portugal to restructure its debt now," Ruparel added.
Sócrates had proposed a wide-ranging plan of tax rises and spending cuts, in an attempt to cut Portugal's deficit and retain market confidence. The yields on Portuguese government debt has reached record highs, with the 10-year bond trading hitting 7.6% – widely seen as an unsustainably high cost of borrowing.
Now that the austerity programme has been rejected, economists also believe Portugal must ask for help.
"Portugal moved another step closer to needing a bailout yesterday," said Gary Jenkins, the head of fixed interest research at Evolution Securities. "Even with complete political harmony it was always going to be difficult for Portugal to persuade investors to continue to fund them and thus yields are likely to rise further from what has already been described as unsustainable levels by Portuguese officials."
George Osborne concerned
Chancellor George Osborne tried to calm nerves, saying talk of a bailout was "speculation" at this stage, but conceded that the situation was unsettling.
"What is happening in Portugal is certainly concerning. It reminds us that we are not alone in facing these challenges," said Osborne.
Portugal needs to refinance around £4bn of bonds in April.
It also emerged last night that the new European Stability Mechanism – to which Britain will not sign up – will not be signed off at the two-day meeting in Brussels, as had been planned. Instead, the deadline for a final agreement has been pushed back to the end of June.
"When I started working in the City I was often told to follow the old 'under promise and over deliver' formula; the EU seems to be going for the opposite strategy when it comes to dealing with the crisis," Jenkins added.
Fears that the European debt crisis may spread to Madrid were heightened on Thursday morning, when Moody's downgraded most of the Spanish banking sector.
Holger Schmieding, chief economist at Berenberg Bank, argued that Spain was in much better shape than its Iberian neighbour.
"You can never say anyone is safe in these times. There is always the danger of a run on a country. But Spain is in a significantly better position than Portugal, which in every likelihood will need a bailout now," Schmieding told Bloomberg TV.
Britain's inclusion in the €440bn temporary stabilisation mechanism is controversial, as Alistair Darling signed up for the plan on 10 May 2010 – during the hiatus between the general election and the formation of the coalition government. Osborne, who replaced Darling as chancellor later that week, has insisted that he would have taken a different decision.
The UK is lending a total of £7bn to Ireland, partly through the European rescue and partly as a bilateral loan. Osborne has said that he expects Britain will make a profit on the agreement, as long as the money is eventually repaid.