DBRS Assigns A (low) Ratings to Portugal on Fiscal Consolidation

DBRS has today assigned initial ratings on the Republic of Portugal’s Long-Term Foreign and Local Currency Debt at A (low). The trend on both ratings is Negative.

The ratings balance the benefits of Portugal’s Euro area membership and relatively stable financial system with its structural imbalances and weak public finances. The Negative trend reflects DBRS’s assessment that the ratings could come under downward pressure over the medium term if fiscal consolidation underperforms or fails to restore market confidence.

The ratings are supported by membership in the Euro area, which has brought price stability, facilitated trade and capital flows, lowered interest rates and provided banks with access to ECB liquidity. While Euro membership weakens Portugal’s ability to regain lost competitiveness through currency depreciation, it also bolsters currency stability during periods of financial turbulence. In addition, should Portugal decide that external support is necessary, the European Financial Stability Facility (EFSF) could act as a backstop and provide the government with temporary funding.

The ratings are also supported by a sound financial system, which has been relatively resilient during the global financial crisis. This resilience stems from Portugal’s stable property and housing market, a sound regulatory environment and limited bank exposure to sub-prime securities. The four largest Portuguese banks passed the July 2010 CEBS stress tests without requiring any additional capital, and although the government has provided several support facilities, the banking system has made limited use of them.

Another strength is Portugal’s relatively low long-term health and pension liabilities. Portugal faces only moderate increases in age-related expenditures through 2060. This is, in part, due to major pension reform in 2006-07, which reduced the expected increase in pension expenditure between 2010 and 2050 from 8.9% of GDP in 2006 to 1.4% in 2009. While further reforms will be needed over the long-term, Portugal’s aging costs compare favorably to other EU countries.

Portugal’s track record of structural reform also supports the ratings. Since winning the general election in 2005, the government, under the leadership of Prime Minister José Sócrates, has passed major pension and public administration reforms, revised the labor code and implemented pro-market measures to improve the business climate. Building on this reform momentum will be essential to boost productivity growth.

Despite these strengths, Portugal’s ratings are constrained by weak productivity growth, and this has dampened real economic growth to less than 1% annually over the last decade. Low productivity reflects structural weaknesses in the Portuguese economy, such as rigid labor markets, insufficient competition in the non-tradable sector and low levels of formal education. Recently passed measures, such as reduced employment protection, are positive steps, but a more comprehensive set of structural reforms is likely needed to raise growth potential and narrow the GDP-per-capita gap with the rest of Europe.

Portugal’s ratings are also constrained by low competitiveness and high current account deficits. DBRS believes that real exchange rate appreciation and greater international competition have led to a loss of competitiveness. This is reflected in rising external indebtedness and a large current account deficit, which reached 10.3% of GDP in 2009. Wage and price inflation have outpaced productivity gains, undermining the cost competitiveness of the tradable sector, and Portugal’s comparative advantage in low-tech exports is being challenged by new global players, especially China. In 2009, the negative international investment position was 109% of GDP, the highest in the Euro area. As a member of the Euro area, Portugal cannot correct these imbalances or restart growth through currency depreciation. Instead, restoring competitiveness is likely to entail an extended period of fiscal tightening, wage restraint, high unemployment and private sector de-leveraging.

A further constraint on the ratings is Portugal’s public finances, which have deteriorated markedly. Large fiscal deficits and weak economic growth have led to rising public debt ratios, with debt-to-GDP rising from 50.5% in 2000 to 76.1% in 2009. The government projects it will increase to 86.6% by 2011. In May 2010, the government announced a budgetary consolidation plan to reduce the deficit from 9.3% of GDP in 2009 to 3% by 2012. DBRS is encouraged by this plan and is confident that Portugal will take the necessary measures to reduce the deficit over the medium term. Consensus across the political spectrum on the need for deficit reduction suggests that fiscal consolidation will likely be pursued regardless of which party is in power. However, given Portugal’s low growth potential, DBRS believes debt stabilisation will require a primary surplus of approximately 2% of GDP over the medium term, and this is likely to call for additional fiscal tightening.

The ratings are also constrained by rigid labor and product markets. Portugal’s unemployment benefits are generous by EU standards and employment is among the most protected in Europe. These factors impede a more efficient allocation of labor to productive sectors of the economy and increase the unemployment levels required for economic adjustment. While Portugal has made clear improvements in the business environment in recent years, insufficient competition in the non-tradable sector has hampered competitiveness and productivity growth.

The Negative trend indicates that if fiscal consolidation fails to materialise over the next six to twelve months, or financial market turbulence derails the consolidation effort, the ratings could come under downward pressure. Another important consideration for the ratings is potential contingent support from the EFSF. In theory, EFSF support – if needed – should provide reassurance that Portugal’s financing needs will be met. However, if EFSF support fails to reassure investors, or actually fails to materialise in a timely manner, this will also place downward pressure on the ratings.

Note: The applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website under Methodologies.