DBRS Downgrades Portugal to BBB (high) with a Negative Trend on Weaker Outlook

DBRS Inc. (DBRS) has today downgraded the Republic of Portugal’s Long-Term Foreign Currency and Long-Term Local Currency ratings to BBB (high) from A (low), and maintained the Negative trend on the ratings. This action is in accordance with the DBRS statement on 10 November 2010 that Portugal’s ratings would be reassessed within a six to twelve month timeframe.

DBRS views the EUR 78 billion EU-IMF programme, which was approved last week by EU finance ministers and the IMF, as supportive of the ratings, although the prospect of official financial assistance was incorporated into DBRS’s previous ratings assessment. The programme covers Portugal’s funding needs through 2013, spells out a series of structural reforms to increase economic growth and earmarks EUR 12 billion for bank recapitalisation.

However, the downgrade is appropriate due to Portugal’s significantly weaker than expected growth outlook and larger than expected fiscal imbalances. Consequently, prospects for debt stabilisation are more challenging. Furthermore, there is heightened uncertainty over Portugal’s funding capacity as of mid-2013 in the context of the proposed European Stability Mechanism (ESM), which could impose losses on private bondholders if borrowers are deemed insolvent.

The Negative trend reflects DBRS’s assessment that Portugal’s creditworthiness could deteriorate further if budgetary targets are not achieved, the economy underperforms, or there is insufficient political support to effectively implement the measures outlined by the EU-IMF programme. In DBRS’s view, significant fiscal slippage or a sharp deterioration in external conditions could undermine the credibility of the adjustment and put strong downward pressure on the ratings.

According to an Economic and Financial Adjustment Programme published by the Ministry of Finance on 5 May 2011, the fiscal adjustment is slower than previously envisaged, but DBRS believes that the new targets are more credible, if still ambitious. The deficit is now expected to narrow from 9.1% of GDP in 2010 to 5.9% in 2011, and the goal of reducing the deficit below 3% of GDP has been postponed by one year to 2013. Reforms to the budgetary framework could strengthen the quality, control and transparency of public finances and increase the likelihood of successful consolidation.

In addition to fiscal retrenchment, structural reforms outlined in the programme aim to raise the economy’s potential growth rate. Portugal’s economic expansion averaged 0.7% over the last decade, the second lowest growth rate in the euro area after Italy. Measures to increase productivity growth and improve external competitiveness include a recalibration of the tax structure, reform of unemployment insurance and employment protection and elimination of barriers to competition in the non-tradable sector. DBRS believes effective implementation of these reforms could improve growth prospects and facilitate an orderly unwinding of external imbalances over the medium-term.

The EU-IMF programme also seeks to strengthen the financial sector. Under the programme, banks can issue up to EUR 35 billion in government-guaranteed bank bonds to ensure that liquidity is maintained. Banks are also expected to reduce leverage and increase core Tier 1 ratios to 10% by 2012. If banks are unable to raise capital in the private market, the programme provides EUR 12 billion as a backstop. Prior to the programme, Portuguese banks were already taking a range of actions to enhance liquidity, reduce wholesale funding and increase capitalisation. The programme is expected to accelerate the pace of these actions.

Nevertheless, the sustainability of Portugal’s public finances primarily depends on reducing the deficit while fostering economic growth. Deficit reduction will likely be challenging given the scale of consolidation needed. The deficits in 2009 and 2010 were revised upwards to 10.1% of GDP and 9.1% of GDP, respectively. While the upward revisions are partly due to the reclassification of several state-owned companies and public-private partnerships, the budgetary adjustment in 2010 was limited.

Reducing the deficit and stabilising debt dynamics is likely to be more challenging while the economy is in recession. The European Commission estimates that the Portuguese economy will contract 2.2% in 2011 and 1.8% in 2012. Fiscal tightening, rising unemployment and private sector deleveraging are likely to weigh negatively on domestic demand. Consequently, the EC estimates general government debt will increase from 93% of GDP in 2010 to 102% in 2011 and peak in 2013.

As DBRS has commented, the lack of clarity regarding euro area policymakers’ intent over potential restructuring of sovereign debt is a source of instability in the markets (See DBRS Commentary: “Euro Zone Clarity on Debt Resolution Key to Confidence,” 28 February 2011). While the EU-IMF financial assistance programme provides financing through mid-2013, it is not clear when Portugal will be able to re-access long-term debt markets. Moreover, the European Financial Stability Fund’s proposed successor, the European Stability Mechanism, introduces the possibility of imposing losses on private bondholders in 2013 if borrowers do not pass a solvency test. Uncertainty regarding the implications of Portugal potentially accessing the ESM is a source of concern.

General elections are scheduled for 5 June 2011, and there appears to be consensus among the main political parties in favour of the measures outlined in the EU-IMF program. However, the formation of a coalition or minority government could increase implementation risk as persistent political support will likely be needed to pass austere budgets and structural reforms, particularly in a recessionary environment.

Portugal’s ability to return to market financing by the end of the programme will largely depend on generating confidence that public finances are sustainable. In this regard, maintaining the ratings at BBB (high) is contingent on clear evidence that budgetary targets are being achieved and macroeconomic imbalances are being unwound. Alternatively, deviations from the fiscal targets, or weaker than expected growth, would likely lead to downward pressure on the ratings.

Notes:
All figures are in Euros (EUR) unless otherwise noted.

The principal applicable methodology is Rating Sovereign Governments, which can be found on our website under Methodologies.

The sources of information used for this rating include The Ministry of Finance and Public Administration, Economic and Financial Adjustment Programme dated 5 May 2011, Banco de Portugal, Statistics Portugal, Eurostat, AMECO, European Commission European Economic Forecast Spring 2011, and the International Monetary Fund. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

Lead Analyst: Michael Heydt
Rating Committee Chair: Alan G. Reid
Initial Rating Date: 10 November 2010
Most Recent Rating Update: 10 November 2010

For additional information on this rating please refer to the linking document located below.