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LISBON (Reuters) - Portugal clinched a deal on ambitious labor market reforms this week and carried out its biggest debt sale since seeking a 78-billion-euro bailout, but the challenges for the second-most risky country in the euro zone may be shifting up a gear.
Undermining the glow of Lisbon's achievements is the rapidly rising market concern that Portugal is the next potential candidate to default in the euro zone after Greece -- a point that is fast becoming clear as Athens approaches the end of its debt restructuring talks.
"Portugal is obviously the next in the line of fire," said Michael Cirami, a portfolio manager at U.S. investment managers Eaton Vance. "Portugal is unlikely to go unnoticed whether they strike a deal or not (on Greek debt restructuring)."
The concerns were clearly borne out this week as Portugal's bond yields rose virtually without interruption, to all-time highs, despite the issuance of 2.5 billion euros of short-term treasury bills on Wednesday at slightly lower yields.
The country's 10-year yields rose to almost 15 percent on Thursday and hovered around 14.80 percent on Friday. Five-year credit default swap prices implied the market was pricing in a 66.8 percent chance of a Portuguese default.
The sharp rise in bond yields was partially triggered by Standard & Poor's downgrades of European countries last week, which left Portugal as the second euro zone country to be rated "junk" by all the main rating agencies, along with Greece.
"Portugal was the only country really rattled by the downgrade because it is seen as a much more complicated case," said Gilles Moec, senior European economist at Deutsche Bank. "It combines the same high level of private sector overindebtedness as Spain, high public sector debt similar to Italy, plus the economic recession."
The key problem for Portugal, which was the third euro zone country to seek a bailout after Greece and Ireland, is whether it has enough time to restructure its economy to grow as it enacts harsh austerity and faces the worst recession in decades.
This year will be the toughest of the three-year bailout as deep spending cuts, including the elimination of two months of pay for civil servants and across-the-board tax hikes, spark a 3 percent economic contraction after a 1.6 percent slump in 2011.
The government has pledged to cut the budget deficit to meet the goals set by the bailout although it only met them in 2011 thanks to a one-off transfer of banks' pension funds to the state.
Under the bailout, Portugal also has to introduce sweeping reforms, including of the rigid labor market -- which it reached agreement on this week with unions. Cutting the cost of hiring and firing should boost competitiveness eventually.
Filipe Silva, debt manager at Banco Carregosa, said that the current record yield levels show the market perceives that Portugal will have to restructure its debt in the long-term.
"Whether this is right or not, it's too early to say because Portugal did not have enough time for the austerity measures to produce the impact politicians are hoping for," said Silva, adding much will depend on events at the European level.
"The most probable outcome is Portugal asking for longer terms or more bailout money," he said. Under the current bailout, Portugal has to return to the long-term bond market in the second half of 2013, which many analysts see as at least hard to achieve.
"In our view, the programme for Portugal should be extended beyond 2013, for the good things from their fiscal consolidation and structural reforms to have time to materialize," Moec said.
The government has repeatedly said there is no need to renegotiate debt or extend the bailout.
When asked about the record yields during a parliament debate on Friday, Prime Minister Pedro Passos Coelho insisted that Portugal's situation has "improved and not deteriorated," adding that bond markets are volatile due to lack of liquidity.
"The secondary bond market is not very liquid and as such the turmoil shown in government bond yields is not very significant these days, even though this is bad news," he said.
Elisabeth Afseth, fixed-income analyst at Investec Capital Markets in London, said Portugal's problem relates to its high level of debt, currently around 100 percent of gross domestic product, combined with low growth.
"There are not a lot of countries that have managed over time with that kind of debt," said Afseth. "Financial markets won't give Portugal that time, the question is if Europe will give it that time."
Additional reporting By Andrei Khalip in Lisbon and William James in London. Editing by Jeremy Gaunt.