PSD starts forming centre-right Portuguese government

LISBON (Reuters) - Portugal's centre-right Social Democrats (PSD) began forming a coalition government with their traditional rightist allies Monday, promising to take tough austerity steps under the country's bailout program.

The PSD's convincing victory Sunday with 39 percent of the vote ended months of political uncertainty following the collapse of the minority Socialist government in March, when it failed to pass its latest austerity package.

Submerged in an acute debt crisis, Portugal received a 78 billion euro (69 billion pound) bailout last month from the European Union and IMF. The terms include higher taxes and tough spending cuts that will weigh on an economy already deep in recession.

"Portugal needs to return to creating a wave of confidence in the markets," PSD leader and prime minister-elect Pedro Passos Coelho said in an exclusive interview. "I think we can surprise and go beyond the (bailout) agreement."

He added that he seeks to form a majority government in coalition with the ultra-conservative CDS-PP "in record time" so that "all deadlines in the agreement can be respected."

Passos Coelho said his government would set an example by cutting spending as it seeks to cut the budget deficit and debt level. The 46-year-old was set to meet President Anibal Cavaco Silva Monday for consultations on forming a new government.

"There are many difficult measures planned that will be taken. All the Portuguese will need a lot of courage, and I'm sure they'll have enough," Passos Coelho told reporters earlier.

Paulo Portas, head of the CDS-PP, had already said he was ready to rule together with the Social Democrats.

Portuguese stocks opened higher Monday, but later followed European stocks lower. The 10-year bond yield was steady at around 10.4 percent, but analysts expected investors to react positively and bring the yield down.

"BIGGEST RISK OUT OF THE WAY"

"The biggest risk, of a hung parliament, is out of the way, so we should have a rather safe government, a coalition government. I'd say it is as good as it gets -- there should be positive underlying impact from the election," said David Schnautz, debt strategist at Commerzbank in London.

The PSD won 105 seats while the CDS won 24, giving the two parties, which have a record of working together in coalitions, a clear majority in the 230-seat parliament.

This should allow the coalition to enact reforms and austerity measures included in the bailout, such as sweeping tax rises and deep spending cuts, to reduce Portugal's large deficit and debt.

"The next thing to see will be, obviously, how quickly do we get some unpopular decisions, and how big is the backlash in society," Schnautz said.

Political analyst Adelino Maltez, said the election "puts Portugal in the normal European groove of centre-right governments, which deserves more investor confidence."

He said the PSD and CDS-PP should be able to agree on ministerial portfolios quickly, perhaps this week.

But he said a new government might have a better chance of riding out a popular backlash over the austerity measures if it was broadened out to include the outgoing Socialists, and this might take longer.

"The solution should go via a regime pact with the Socialists, the party that negotiated the bailout. Maybe the government could include one of their ministers, say Luis Amado staying on as foreign minister," Maltez said.

DEEP RECESSION

Portugal faces its highest level of unemployment in three decades and the economy is expected to contract 2 percent both this year and next, presenting the new government with tough challenges as disposable incomes fall.

The PSD has long argued for cuts in government spending, which the Socialists have managed to reduce only slightly.

The PSD also advocates a smaller role for the state in the economy, and privatisations of state-run companies. A sell-off of state assets is also part of the bailout program.

"This victory will probably result in a more aggressive privatisation program," BPI analysts wrote in a research note.

Filipe Garcia, head of the consultants Informacao de Mercados Financeiros in Porto, said the clear election result would help investor sentiment, but that Portugal's economic problems could not be solved quickly.

"This major result will allow the right to pass more unpopular measures," Garcia said. "But the pact does not solve the country's problems, does not bring growth, and the success of the government's economic policy will depend very much on the Europe-wide sovereign debt crisis."

So far there have been few strikes or protests against austerity measures in Portugal, in contrast to Greece and neighbouring Spain, but analysts say that could change as the recession deepens.

(Additional reporting by Sergio Goncalves and Shrikesh Laxmidas; Editing by Sonya Hepinstall)