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Portuguese Prime Minister Jose Socrates resigned on Wednesday and warned of grave consequences for the country after parliament rejected his government's latest austerity measures aimed at avoiding a bailout.
The move threw Portugal into uncertain political terrain after months of battling against growing investor concerns over its ability to tame its public finances and avoid following Greece and Ireland to seek international aid.
"This political crisis has very grave consequences for the confidence Portugal needs from institutions and the financial markets," Socrates said.
Socrates presented his resignation to President Anibal Cavaco da Silva.
The president said in a statement that he would hold meetings with all political parties on Friday and that the government would retain full powers at least until then. That leaves Socrates' government in place for the duration of a European summit in Brussels on Thursday and Friday.
The main opposition Social Democrats, who have previously backed austerity, said they want an election, hoping that the centre-right party's lead in opinion polls will bring it to power.
"I am convinced that the road we will follow, the normal road of democracy, is the path of giving the word back to the Portuguese so as to choose a new, stronger government with more confidence to beat the crisis," Social Democrat leader Pedro Passos Coelho said. "And that is what I'll tell the president."
The events in Portugal prompted the euro to extend losses against the dollar after trading lower all Wednesday on wariness before the Portuguese vote and on news of a delay in increasing a euro zone bailout fund. Portuguese stocks fell and bond yields shot up.
The euro slipped to $1.4103 after the news from about $1.4117 just before parliament voted and was down about 0.7% on the day.
All opposition parties voted against the measures in the 230-seat parliament, where the Socialists have 97 seats.
The government had hoped to obtain support for its plan before Thursday's EU summit, to reduce market pressure on Portugal's sovereign debt.
The EU leaders, however, look set to disappoint investors by delaying any approval of a beefed-up euro zone rescue fund till June.
Investors concerns could now grow as the country faces at least several weeks of political uncertainty.
Socrates said he would remain in power in a caretaker capacity.
"The country will not be without a government. The government will continue to fulfil all its duties as a caretaker government," Socrates said.
BOND YIELD UP
The Portuguese benchmark 10-year bond yield rose to 7.82% on Wednesday from Tuesday's 7.68% and the spread over safer German Bunds rose 16 basis points to 459 bps. Many economists see borrowing costs above 7% as unsustainable and say Portugal will have to resort to the rescue mechanism.
Shorter-dated bonds were harder hit, with Portugal's five-year bond yield at a euro lifetime high of 8.3% ahead of the vote.
"The prospect of a bailout has risen drastically and is now enormous," said Filipe Garcia, head of Informacao de Mercados Financeiros consultants in Porto, adding that Portugal has over 9 bln euros of maturing bonds through June.
The constitution stipulates that the country can hold a snap election no sooner than 55 days after the president calls one.
"My worry is the period of inaction before a new government takes over," said Silvio Peruzzo, an economist at RBS in London.
Political analyst Antonio Costa Pinto said a caretaker government would have its hands tied.
"Although a caretaker government cannot take major autonomous initiatives, it could take a decision on resorting to aid if it is backed by parliament," Costa Pinto said.
Whatever the outcome, opposition to austerity may increase as the Portuguese face lower wages and higher taxes, and the country returns to recession.
Large protests have been held against austerity on the past two weekends and on Wednesday train drivers went on strike to demand higher wages, creating traffic chaos around Lisbon as commuters were forced to take their cars to work.
