DBRS Downgrades Portugal to BBB (low) on Deteriorating Growth Outlook

DBRS, Inc. (DBRS) has downgraded the Republic of Portugal’s long-term foreign and local currency debt to BBB (low) from BBB. The trend on both ratings remains Negative. The downgrade reflects weaker growth prospects in Portugal, which are likely to make achieving ambitious deficit-reduction targets very challenging. Moreover, the unstable economic environment in Europe, uncertainty over the Greek debt exchange, and ongoing tensions in financial markets intensify downside risks to Portugal’s growth outlook and prospects for debt stabilisation.

The Negative trends reflect our assessment that the ratings have yet to stabilise and that further deterioration in the growth or fiscal outlook could result in a further ratings downgrade. Growth prospects are particularly important to debt stabilisation in Portugal, given the size of the fiscal consolidation programme and the high and rising public debt burden.

The outlook for the Portuguese economy has deteriorated since DBRS’s last review in October 2011. The Bank of Portugal estimates that the economy will contract by 3.1% in 2012 – the second consecutive year of recession – and expand by just 0.3% in 2013. Fiscal tightening, private sector deleveraging and rising unemployment are expected to weigh on domestic demand. Net exports are the only demand component expected to make a positive contribution to growth in 2012 and 2013. Indeed, the current account deficit is in decline. Nevertheless, uncertainty over economic growth prospects and policy developments in Spain in particular and Europe more generally, present downside risks to Portugal’s export performance. According to the latest IMF forecasts, the Spanish economy is expected to contract 1.7% in 2012 while the Euro area is expected to contract 0.5%.

Given the deteriorating growth outlook, DBRS believes that meeting budgetary targets is likely to be challenging and implementation risks are high. Portugal has a poor fiscal track record characterised by weak spending control. In the first half of 2011, fiscal slippage amounted to 2.2% of GDP. This was the result of expenditure overruns on employee compensation and public consumption on goods and services. Although Portugal is expected to meet the 2011 deficit target of 5.9% of GDP, budgetary shortfalls were primarily offset by a one-off transfer of bank pensions. Excluding this one-off measure, the government estimates that the deficit was 7.5% of GDP in 2011.

As a consequence, the fiscal adjustment required to meet the deficit target in 2012 will be significantly larger than initially planned, and reducing the deficit to 4.5% of GDP will be difficult in a recessionary environment. Planned austerity measures in 2012 amount to 5.3% of GDP. Moreover, off-budget spending by state owned enterprises (SOEs), fiscal support for public-private partnerships, and the accumulation of arrears by local and regional governments and the health sector could add to budgetary pressures, posing downside risks to the fiscal consolidation plan.

In light of this fiscal backdrop, prospects for debt stabilisation are also challenging. During its last review in December 2011, the IMF estimated that public debt will increase from 107.2% of GDP in 2011 to 118.1% of GDP in 2013. At such high levels, Portuguese public finances have limited room to maneuver in the event of further economic or financial shocks.

Despite these unfavourable developments, the BBB (low) ratings are supported by the strong political commitment of the coalition government to reducing the fiscal deficit and implementing structural reforms in accordance with the EU-IMF financial assistance programme. In December 2011, the EU and IMF concluded that programme implementation is broadly on track. The parliament passed an austere budget in November 2011 in order to achieve the 2012 fiscal target, and the deficit reduction plan is being reinforced with reforms to the fiscal framework that should improve budget execution and transparency across all levels of government. These include the creation of an independent Fiscal Council. Moreover, steps have been taken to carry out the reform agenda, including introducing greater flexibility in the labour market, a reduction in severance payments and the privatisation of state assets. In December 2011, Portugal sold its stake in EDP for EUR 2.7 billion. This amounts to half of the expected privatisation revenues in the EU-IMF programme.

Furthermore, the EUR 78 billion multi-year EU-IMF programme covers most of the government’s financing needs through mid-2013, in addition to providing capital and liquidity support for the banking system. Portugal was able to roll EUR 12.5 billion in T-bills in 2011, which helped meet higher-than-expected financing needs of SOEs. Nevertheless, some funding pressures emerged in the T-bill market during the second half of 2011, reflected in rising yields and shorter maturities.

It is not clear when Portugal will be able to reenter the long-term debt markets. According to the EU-IMF programme, Portugal is expected to return to the markets in time to cover a EUR 9.7 billion bond redemption in September 2013. The ratings incorporate DBRS’s expectation that additional financing would be provided to Portugal, if necessary, as long as the performance criteria and structural benchmarks are largely met, as outlined in the programme.

The evolution of the ratings ultimately depends on a sustainable debt-to-GDP ratio. Better growth prospects, combined with successful fiscal adjustment, structural reforms and a more stable policy and economic environment in the rest of the Euro area could result in a return to Stable trends. On the other hand, deviations from fiscal targets or a deterioration of Portugal’s growth prospects could trigger further downward rating actions.

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

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

The sources of information used for this rating include the Portuguese Treasury and Government Debt Agency, Ministry of Finance, Bank of Portugal, IMF Second Review Under the Extended Arrangement – December 2011, The European Commission Economic Adjustment Programme for Portugal, Second review – Autumn 2011, Eurostat, and Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This credit rating has been issued outside the European Union (EU) and may be used for regulatory purposes by financial institutions in the EU.

Lead Analyst: Michael Heydt
Rating Committee Chair: Alan G. Reid
Initial Rating Date: 10 November 2010
Most Recent Rating Update: 19 October 2011

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