DBRS Downgrades Republic of Portugal to BBB on Fiscal Risks

DBRS Inc. (DBRS) has today downgraded the Republic of Portugal’s long-term foreign and local currency debt to BBB from BBB (high). The Trend on both ratings remains Negative. In spite of strong political support to implement the EU-IMF programme and the announcement of better lending terms on official loans, the downgrade reflects DBRS’s assessment that risks to fiscal consolidation have increased since our last review. While the government expects to meet the deficit target of 5.9% of GDP in 2011, budgetary shortfalls – estimated at 2% of GDP – are being primarily offset by temporary measures. As a result, the adjustment required to achieve the deficit target in 2012 will be significantly larger than previously anticipated amid a more difficult economic environment.

The Negative trend reflects downside risks to growth, particularly given the heightened uncertainty over the economic outlook in Europe and the United States and the ongoing turbulence in financial markets.

The BBB ratings are underpinned by the strong political commitment of the coalition government to fully and expeditiously implement the EU-IMF programme. The programme covers most of Portugal’s funding needs through mid-2013, spells out a series of far-reaching structural reforms to increase growth, and provides capital and liquidity support to the banking system. In September 2011 the IMF concluded that the programme appears to be broadly on track. Initial steps have already been taken to carry out the reform agenda, including a reduction in severance payments for new contracts and the elimination of golden shares. Furthermore, the government, which took office in June 2011, presented an austere budget this week that aims to reduce the deficit to 4.5% of GDP in 2012.

The announcement of improved lending terms on EU loans is also positive for Portugal (see Policy Announcements Positive but Euro Area Debt Sustainability Still a Concern published on 27 July 2011). Portugal’s previous loan programme was scheduled to have an average maturity of 7.5 years and an average interest rate of approximately 5.5%. Depending on the maturity structure and cost of funds, the new loans could alleviate post-program refinancing pressures and lower annual interest payments by approximately €1 billion, or 0.6% of GDP.

However, the sustainability of Portugal’s public finances primarily depends on fiscal consolidation and economic growth. During the first half of 2011 the deficit was significantly higher than expected at 8.3% of GDP, partly reflecting expenditure overruns on public wages and intermediate consumption. One-off measures were adopted to offset the slippage, but achieving the 2012 target will require a larger adjustment than previously anticipated.

Budgetary weaknesses and contingent liabilities also represent fiscal risks. State owned enterprises (SOE), public-private partnerships (PPP) and local and regional governments have contributed to expenditure pressures. Previously unreported spending in the region of Madeira led to an upward revision of the general government deficit from 9.1% of GDP to 9.8% of GDP in 2010, and support for a SOE and PPP added approximately €500 million (0.3% of GDP) to the deficit in 2011. In response, the government is restructuring SOEs, reviewing PPPs, enhancing supervision of local and regional governments, and reforming the fiscal framework to strengthen expenditure control.

Nevertheless, reducing the deficit and addressing these risks is likely to be challenging while the economy is in recession. The government estimates the economy will contract 1.9% in 2011 and 2.8% in 2012. Fiscal tightening, rising unemployment and private sector deleveraging are likely to weigh negatively on domestic demand. Credit conditions are tightening as banks face acute funding pressures. The only demand component expected to make a positive contribution to growth in 2011 and 2012 is net exports. However, downside risks to the economic outlook in the United States and Europe could dampen external demand and further weaken Portugal’s growth prospects.

As a consequence, prospects for debt stabilisation remain challenging. The government estimates debt-to-GDP will increase from 100% at the end of 2011 to 106% in 2012. If bank recapitalisation funds are included, the debt ratio would reach 111% in 2012. At such high levels, Portugal would have limited room to maneuver in the event of further economic or financial shocks.

It is not clear when Portugal will be able to reenter the long-term debt markets. Private sector involvement in a restructuring of Greek debt could perpetuate uncertainty and delay Portugal’s return to market funding. Nevertheless, the ratings incorporate DBRS’s expectation that additional financing would be provided to Portugal, if necessary, as long as there are strong efforts to meet the performance criteria and structural benchmarks outlined in the programme.

Despite several positive developments in recent months, including a reinforced political commitment to implement the EU-IMF programme and improved lending terms on EU loans, risks to fiscal consolidation are significant. Material deviations from deficit targets or a sharp deterioration in Europe-wide macroeconomic conditions could derail the adjustment and exert 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, Banco de Portugal, Statistics Portugal, Eurostat, AMECO, The Economic Adjustment Programme for Portugal dated September 2011, the IMF’s First Review Under the Extended Arrangement dated September 2011, the Fiscal Strategy Document dated October 2011, and the 2012 State Budget. 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: 24 May 2011

For additional information on this rating please refer to the linking document under Related Research.