DBRS Confirms Republic of Portugal at BBB (low), Stable Trend

DBRS Ratings Limited (DBRS) has confirmed the Republic of Portugal’s long-term foreign and local currency issuer ratings at BBB (low) and its short-term foreign and local currency issuer ratings at R-2 (middle). The trend on all ratings remains Stable.

The rating reflects Portugal’s Eurozone membership and its adherence to the EU economic governance framework, which helps foster credible macroeconomic policies and makes available financial facilities from European institutions. A favourable public debt maturity structure and a small current account surplus also support the rating. However, Portugal faces significant challenges, including elevated levels of public sector debt, low potential growth, fiscal pressures, and high corporate sector indebtedness.

The Stable trend reflects DBRS’s assessment that risks to the ratings are fairly balanced. The 2016 headline fiscal deficit came in well below the target set by the European Commission, demonstrating the government’s commitment to comply with the EU fiscal rules. However, the improvement in the structural deficit was more limited. Government bond yields have also increased in recent months, but borrowing costs remain manageable and mitigated by a favourable debt profile. Despite higher yields, public debt dynamics are currently supported by a higher primary fiscal surplus and continued economic growth. The trend also reflects ongoing efforts to address the remaining vulnerabilities in the banking sector.

Ongoing efforts have resulted in a significantly lower fiscal deficit. The headline fiscal deficit fell to an estimated 2.0% of GDP in 2016, following a substantial reduction under the 2011-2014 EU/IMF economic adjustment programme. The primary surplus reached 2.2%, one of the highest in the Eurozone. DBRS expects the government to maintain the fiscal adjustment, in line with its commitments to the EU Stability and Growth Pact. As a result, DBRS believes that Portugal will continue to benefit from the credibility of Euro area institutions, and additional EU financial support to Portugal would likely be available if necessary.

The public debt maturity structure is also favourable. Government bond yields have risen since last year, most likely reflecting investor concerns over both the scaling back of the European Central Bank’s Public Sector Purchase Programme and the domestic banking sector. Nevertheless, the public debt profile provides resilience to temporary rises in interest rates, making the impact from higher bond yields on interest costs more gradual. Through active debt management operations and extension of EFSF loans, the average debt maturity has reached 8.3 years (6.5 years excluding EU/IMF loans). Fixed-rate debt also accounts for 86% of total debt.

However, Portugal faces important credit challenges. The government debt ratio remains very high at 130.4% of GDP in 2016 and is projected to decline only gradually. This leaves public finances vulnerable to adverse shocks. Sustained primary surpluses and steady growth over time are needed to firmly place debt dynamics on a downward trajectory. After underperforming in the first half of 2016, growth strengthened in the second half and was higher than expected for the full year at 1.4%. In 2017, growth is forecast at 1.8% by the Bank of Portugal (BoP). The improvement, however, seems cyclical. Portugal’s longer-term growth prospects are modest, with estimates of potential growth around 1.0%. Low levels of public and private investment, and low labour productivity continue to constrain potential growth. Reforms to raise education levels and efficiency in the public administration are being implemented, but these could take time to yield results.

Fiscal pressures also pose a risk, despite the improving headline position. On the revenue side, some measures adopted in 2016 were temporary. A tax and social security debt settlement programme provided a one-off boost to tax revenues at the end of last year. The use of frozen appropriations contributed to control spending, but arrears in hospitals and public employment increased, which could add some pressure to expenditure. Moreover, capital expenditure was restrained sharply. All this raises some concerns about the durability and quality of the consolidation. In structural terms, the improvement in the 2016 deficit was relatively modest. Official medium-term growth forecasts of 2% could also prove optimistic.

In the private sector, challenges stem from still highly indebted non-financial corporations and banks’ high non-performing loans (NPLs). Although falling, corporate sector debt remains just below 100% of GDP. This continues to weigh on investment and on the performance of the banking sector. NPLs stood at 17.2% of total loans in Q4 2016, mostly accounted for by the corporate sector. Banks’ profitability also remains weak, limiting their internal capital generation capacity. The recapitalisation of state-owned CGD and the capital increases by the other largest banks at the beginning of 2017, together with spread out contributions to the Resolution Fund, should place the banking sector in a better position. Moreover, the government, in collaboration with the Bank of Portugal, is working on proposals to address NPLs in a systemic way. This approach would include an enhanced insolvency framework and a non-state aid solution to help banks offload NPLs.

RATING DRIVERS

The ratings could come under downward pressure if there is a weakening in the political commitment to sustainable economic policies or a deterioration in public debt dynamics, resulting from markedly lower growth or a prolonged period of elevated interest rates. Specifically, policy inaction to deal with budget pressures or a reversal of structural reforms that materially reduces growth prospects, would raise concerns about the commitment to sustainable policies. Conversely, the ratings could be upgraded if the improvement in public finances proves durable and is sustained over time, and medium-term growth prospects strengthen, thus improving the outlook for public debt sustainability.

Notes:

All figures are in euro [EUR] unless otherwise noted.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website under Methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website under Rating Scales. These can be found on www.dbrs.com at: http://www.dbrs.com/about/methodologies

The sources of information used for this rating include Ministry of Finance of the Republic of Portugal, Agência de Gestão da Tesouraria e da Dívida Pública (IGCP), Bank of Portugal (BoP), Instituto Nacional de Estatistica Portugal (INE), Portuguese Public Finance Council, European Commission, European Central Bank (ECB), Statistical Office of the European Communities (Eurostat), IMF, OECD, and Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

This is an unsolicited rating. This credit rating was not initiated at the request of the issuer.

This rating included participation by the rated entity or any related third party. DBRS had no access to relevant internal documents for the rated entity or a related third party.

DBRS does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period. DBRS’s outlooks and ratings are under regular surveillance.

For further information on DBRS historical default rates published by the European Securities and Markets Authority (“ESMA”) in a central repository, see:
http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Ratings assigned by DBRS Ratings Limited are subject to EU regulations only.

Lead Analyst: Adriana Alvarado, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer – Global FIG and Sovereign Ratings
Initial Rating Date: 10 November 2010
Last Rating Date: 21 October 2016

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