DBRS Extends Its Review on Portugal’s Ratings

DBRS, Inc. (DBRS) has extended the Under Review with Negative Implications on the Republic of Portugal’s long-term foreign and local currency ratings. The ratings are currently BBB (low). On May 22, 2012, DBRS placed Portugal’s ratings Under Review with Negative Implications reflecting DBRS’s assessment that downside risks to growth in the Euro Area could adversely affect Portugal’s efforts to stabilise its public debt.

However, there is an unusually high degree of uncertainty regarding Portugal’s growth outlook, which is essential for debt stabilisation. As a result, DBRS will wait for the conclusions of the EU-IMF 5th Program Review, which is expected in September 2012, and the 2013 budget proposal, which must be presented by October 15, 2012, prior to finalising its review.

The European Commission and IMF estimated in July 2012 that Portugal’s GDP would contract 3.0% in 2012 and expand 0.2% in 2013, broadly in line with previous forecasts. However, downside risks have increased since then, as the 2013 growth forecast for Spain, Portugal’s largest trading partner, has worsened. The EU-IMF Program Review and 2013 budget proposal will provide updated growth forecasts as well as the planned fiscal response in the context of this new economic outlook. This will enable DBRS to assess the extent of the deterioration in Portugal’s growth and fiscal outlooks, as well as their impact on public debt dynamics. DBRS will conclude the review by November 2012.

Marked deterioration in public debt dynamics due to fiscal slippage, the materialisation of contingent liabilities, or a worsening of the growth outlook could lead to a downgrade of the ratings. On the other hand, if public debt dynamics remain broadly unchanged, the ratings could be confirmed at their current level.

Fiscal consolidation and private sector deleveraging are contributing to a sharp contraction in consumption and investment. Domestic demand declined 6.4% (rolling 4 quarters) in the first quarter of 2012. This has been accompanied by a sharp deterioration in the labour market, partly reflecting the shift in factor resources from the labour-intensive non-tradable sector to the export sector. The unemployment rate increased to 15% in June 2012 from 12.1% one year earlier. Moreover, credit conditions continue to tighten amid weak demand. Loans to households and firms contracted at annual rates of 3.6% and 5.5%, respectively, in May 2012. Supply-side credit constraints, particularly as the banking system deleverages, could intensify the economic downturn.

In 2012 and 2013, net exports are expected to help mitigate the deep contraction in domestic demand. However, concerns over sovereign debt sustainability and financial sector fragility in the Euro area, combined with uncertainty over the future of Greece, have increased downside risks to growth for Portugal’s main trading partners, particularly Spain. The IMF expects Spain’s economy to contract 1.7% in 2012 and 1.2% in 2013. Portuguese exports expanded at a strong pace in 2011 but decelerated over the first five months of 2012.

DBRS recognises that Portugal is making significant progress in consolidating public finances. According to the IMF, the structural primary balance improved by 3.2 percentage points of potential GDP in 2011, and further rebalancing is expected in 2012, even if nominal deficit targets are not reached.

However, despite this strong policy action, weaker-than-expected domestic demand and rising unemployment are complicating efforts to correct fiscal imbalances. During the first six months of the 2012, tax revenues declined compared to one year ago, reflecting weakness in VAT and corporate income tax receipts, and the weak labour market has led to reduced social security contributions and increased outlays. As a result, achieving the deficit target of 4.5% of GDP in 2012 and 3.0% of GDP in 2013 appears difficult.

The outlook for Portugal’s public debt dynamics remains challenging. The IMF estimates that debt-to-GDP will peak at 118.6% in 2013 and gradually decline to 105.3% by 2020. Debt stabilisation primarily depends on the pace of fiscal adjustment and economic recovery. With a more gradual consolidation plan or weaker growth, debt ratios would stabilise at higher levels, leaving Portugal with limited room to absorb adverse external shocks or the materialisation of contingent liabilities. However, Portugal’s debt ratios could improve in the future if bank support from the sovereign is fully or partially replaced by direct capital injections by the EFSF/ESM.

Despite these challenges, the strong political commitment of the coalition government to correct fiscal imbalances and implement structural reforms provides support to the credit profile. Labour reforms passed in 2012 have reduced employment protections, revised unemployment benefits, and introduced more work-time flexibility. These measures, combined with product market reforms, particularly in energy and telecommunications, aim to enhance productivity and boost long-term growth. Moreover, the privatisation program is proceeding on schedule. The sale of government shares in EDP and REN has been completed, with proceeds amounting to 60% of the expected privatisation revenues under the EU-IMF program. The sale of TAP and ANA, among other entities, is expected later this year.

The external adjustment is also well underway. The current account deficit narrowed from 10% of GDP in 2010 to 5.4% in March 2012 (rolling 4 quarters), and preliminary data suggests further correction took place in the second quarter of 2012. Both strong export growth and import compression have contributed to the adjustment. Sustained progress will largely depend on improving cost competitiveness through productivity growth and wage restraint.

It is not clear when Portugal will be able to reenter the medium and long term debt markets. However, 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 EU-IMF program.

Notes:
All figures are in Euros unless otherwise noted.

The 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, European Commission and Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

Lead Analyst: Michael Heydt
Rating Committee Chair: Alan G. Reid
Initial Rating Date: 10 November 2010
Most Recent Rating Update: 22 May 2012

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