By Axel Bugge
LISBON (Reuters) - Germany's Angela Merkel will hear a reassuring message when she visits Portugal on Monday -- a likeminded, center-right leader will tell her he believes deeply in the tough reforms his country is undertaking under a 78-billion-euro bailout.
But the latest review of Portugal's economy by the European Union and IMF, which starts on the same day, could be a stark reminder of the problems with Lisbon's bailout script which mean economic risks are rising by the day.
Germany has heaped praise on Portugal, hoping for a southern European success story to contrast with Greece, where Merkel is widely blamed for the country's parlous economic state.
But the 'troika' of lenders -- the European Commission, European Central Bank and IMF -- have already agreed to relax Portugal's budget goals as tax revenues fell short due to the worst economic slump since the 1970s.
And the IMF has warned that risks to the bailout have "increased markedly" due to growing resistance to austerity and the likelihood of a third year of recession next year.
"Portugal is going through a moment of great uncertainty over the (bailout) programme and whether it will succeed," said Antonio Costa Pinto, an analyst at the University of Lisbon.
Portuguese Prime Minister Passos Coelho has repeatedly insisted that Portugal's best bet is to end its dependence on foreign creditors as soon as possible by strictly meeting budget goals under the bailout.
He will be able to tell Europe's most powerful politician that Lisbon has launched labor market reforms, sold state assets, sharply cut spending and is edging closer to returning to bond markets next year.
"Austerity policies implemented in Europe have not been imposed by Germany's chancellor, they are the result of too much debt taken on by European governments for too many years," he said this week.
That will be music to Merkel's ears on her first official bilateral visit to Lisbon.
A month ago, she paid her first visit to Greece since the euro crisis erupted, and the two trips reflect a shift in her tone on the currency bloc's weakest members, whom she spent much of last year chastising.
Less than a year before a German election, she is keen to send a message to her domestic audience that tough reforms in Europe's southern periphery are paying dividends. After deciding the risks of a Greek exit from the euro zone outweigh the benefits, she also wants to send a message of German solidarity to markets worried about the future shape of the bloc.
In Portugal, a planned protest entitled "Merkel doesn't call the shots here" is likely to be far smaller than the one which greeted her in Greece.
PORTUGAL AS SUCCESS STORY
"We believe we can be the success story in the southern rim of Europe that the EU needs," Portugal's ambassador to Germany, Luis Almeida Sampaio, told journalists this week.
But Passos Coelho can no longer count on the broad consensus behind austerity that existed during the first year of the bailout, that had set Portugal apart from countries like Greece.
That changed at the end of summer, when the government proposed a hike in social security contributions, prompting the first mass protests in Portugal in years.
Since then, protests and strikes have become common and the junior party in Passos Coelho's ruling coalition, the CDS, balked at the largest tax rise in Portugal's modern history, central to the 2013 budget.
It accepted them in the end, but there is growing unease that the third year of recession that will come in 2013 could send Portugal into a recessive cycle, with more budget cuts needed to meet fiscal goals, deepening the economic slump.
Unemployment is already at record highs above 15 percent and is set to rise further.
The government has forecast a contraction of just 1 percent in GDP next year, widely seen as too optimistic by economists, after a decline of 3 percent in 2012.
"This forecast corresponds to the best that may happen if everything goes well," warned Teodora Cardoso, the head of an independent body that monitors the budget, this week.
The government has already announced plans to identify 4 billion euros in long-lasting spending cuts for the 2013-14 period. These are not yet part of the bailout but will be discussed in the review and IMF experts have helped in the process of identifying what cuts to be made.
THREAT TO WELFARE STATE?
The Portuguese fear more reductions in spending will chip away even more of the dwindling welfare state, which has already seen large cuts to health, pension and unemployment benefits.
"I try to be as optimistic as I can," said Carolina Muniz, 20, a medical student. "Still, with these spending cuts, they must be very careful in some areas, like health. We could be talking about how far and how long we go in treating people with cancer, for example."
Analysts say spending cuts have so far only dented people's living standards but more austerity may have more far-reaching effects, driving up poverty in western Europe's poorest country.
"If the austerity measures fail again in delivering the desired result, levels of opposition and social strife could reach unacceptable levels," said Pedro Magalhaes, political scientist at the Social Sciences Institute of Lisbon University.
Markets have paid little attention to the growing economic troubles, driving benchmark 10-year bond yields sharply lower this year, to around 8.7 percent now from above 17 percent in January, when fears of default gripped many investors.
That has raised hopes the country can return to the bond markets in the second half of next year as envisaged under the bailout. Portugal managed to swap shorter-term debt for longer bonds in a 3.76-billion-euro operation in October, but still faces an uphill struggle.
"The main challenge for Portugal is to demonstrate growth that would start to reduce the debt to GDP ratio, that it is no longer locked in the recession-fiscal retrenchment cycle," said Gilles Moec, an economist at Deutsche Bank in London.
"Before that there is not much sense in returning to the debt market."
(Additional reporting by Stephen Brown and Noah Barkin in Berlin, Daniel Alvarenga, Andrei Khalip and Sergio Goncalves in Lisbon; editing by Philippa Fletcher)
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