DBRS Upgrades Republic of Portugal to BBB, Stable Trend

DBRS Ratings Limited (DBRS) upgraded the Republic of Portugal’s Long-Term Foreign and Local Currency – Issuer Ratings from BBB (low) to BBB and its Short-Term Foreign and Local Currency – Issuer Ratings from R-2 (middle) to R-2 (high). The trend on all ratings is Stable.

KEY RATING CONSIDERATIONS

The upgrade reflects DBRS’s assessment that Portugal’s outlook for public debt sustainability has improved. The improvement in Portugal’s public finances has become more durable, which is supporting the emerging downward trajectory in the public debt ratio. After stabilising at around 130% in 2014-2016, the government debt-to-GDP ratio fell to 125.7% in 2017 and is projected to continue declining. Fiscal discipline has been maintained, while interest costs have continued to fall. The Portuguese economy also continues to grow at a steady pace. Moreover, banks’ non-performing loans (NPLs) are declining. Improvements in DBRS’s “Debt and Liquidity” and “Monetary Policy and Financial Stability” building blocks were the factors for the upgrade.

RATING DRIVERS

The ratings could come under upward pressure as a result of sustained primary surpluses and steady economic growth, leading to a further reduction in the public debt ratio. Additional progress in reducing NPLs could also be positive for the ratings. Nevertheless, the ratings could come under downward pressure if there is a deterioration in public debt dynamics or a weakening in the political commitment to sustainable economic policies.

RATING RATIONALE

The Public Debt Ratio Has Started to Fall Driven by Higher Primary Surpluses and Lower Interest Costs

The government debt ratio posted its first important reduction in 2017 since the crisis. The government is forecasting a ratio of 122.2% in 2018. The reduction of public debt is being driven by a higher primary surplus, economic growth and lower interest costs. Sustained primary surpluses and steady growth over time are needed to secure the downward trajectory of public sector debt. Under DBRS’s baseline scenario, the debt ratio is set to fall below 120% by 2019. Nevertheless, the high level of public debt remains one of Portugal’s major rating challenges. This leaves public finances vulnerable to negative shocks, particularly a materialisation of contingent liabilities and an adverse growth shock.

The public debt profile is favourable, which reduces rollover risks and supports Portugal’s ratings. Through active debt management operations, extension of EFSF loans, and early repayments of IMF loans, debt maturities have been extended. Fixed-rate debt accounts for 89% of total debt. Moreover, Portugal’s favourable financing conditions have benefited from the ECB’s Public Sector Purchase Programme. The ECB has gradually reduced its purchases of Portuguese bonds since July 2016, but after some market pressures at the start of 2017, investor sentiment has remained benign. Interest costs have fallen from 4.9% of GDP in 2014 to 3.9% in 2017, and are set to fall further.

The budget position also continues to improve, supporting the reduction of public debt. Driven by strong tax revenues and contained public spending, the primary surplus reached a new high of 3.0% of GDP (excluding one-offs) in 2017. Projections indicate an average surplus between 2.5% and 3.8% over the next five years, well above the debt-stabilising primary balance. The headline deficit has also continued to decline. It fell from 2.0% in 2016 to 0.9% in 2017, excluding the capital injection to state-owned bank CGD for €3.9 billion (equivalent to 2% of GDP). In 2018, the deficit will also be affected by the capital transfer to Novo Banco (via the Resolution Fund), but it is still projected to decline. Under a contingent capital mechanism, the Fund is responsible for the losses on some of Novo Banco’s problematic assets.

Potential fiscal pressures are being addressed. High expenditure in the health sector represents the main risk to the fiscal outlook. Some state-owned enterprises (SOEs) also continue to be loss-making. Moreover, some of the temporary austerity measures adopted during the IMF/EU economic adjustment programme have been reversed, which could add pressure to expenditures in the longer term. While not a risk to the budget, persistent arrears in hospitals is an indication of fiscal mismanagement. On the other hand, ongoing spending reviews on various sectors, including the health sector and SOEs, as well as incentives to find additional savings in the public administration, are important efforts. Further adjustment in structural terms is needed to meet the medium-term objective of a structural balance of 0.25%, which the government aims to achieve by 2020 – one year earlier than previously planned.

The Decline of High Levels of Corporate Debt and Non-Performing Loans Is Progressing

Non-financial corporate debt has fallen from a peak of 127% of GDP in 2012 to 104% in Q2 2017, still relatively high. After reaching a peak of 17.9% in Q2 2016, the banking system’s NPL ratio has also declined, standing at 13.3% in Q4 2017. The NPL ratio in the corporate sector, while lower, remains high at 25.2%. Improved economic conditions are contributing to the reduction of NPLs. Portugal has also adopted an NPL strategy comprising three pillars: 1) Legal and judiciary reform; 2) Prudential supervisory action; and 3) NPL management. Nevertheless, the still high levels of NPLs and corporate sector debt remain the key risks to financial stability, and an additional challenge to Portugal’s ratings.

The banking sector continues to recover. Bank capital increases in 2017 have placed the banking sector in a better position. Banks, excluding Novo Banco, also returned to profitability. Domestic profitability is improving helped by a better operating environment. Direct and indirect exposure of the banking sector to the residential real estate market accounts for almost 40% of the sector’s total assets. Therefore, the 25% rise in house prices since the beginning of 2015 is favourable for banks. However, sustained strong increases in house prices would raise concerns. In response to the acceleration in house prices and strong consumer credit over the past year, the Bank of Portugal has adopted some macroprudential measures. DBRS sees risks to financial stability as gradually receding.

The Economy Continues to Perform Well, Also Supporting Public Debt Reduction

Following strong and partly cyclical growth of 2.7% in 2017, real GDP growth is forecast to moderate to a still solid 2.3% in 2018. Growth has been driven by gross fixed investment and exports. Investment, which declined sharply by 41% between 2008 and 2013, has recently been boosted in part by construction related to tourism and infrastructure projects. Private consumption has moderated as expected, but remains a major growth driver. Labour market conditions have also continued to improve, with the unemployment rate falling to 7.8% in February 2018. In DBRS’s view, downside risks to the near-term growth outlook are few and mainly related to external factors.

Although the near-term growth outlook is robust, potential growth remains relatively low, posing a challenge to Portugal’s rating. The contribution of labour to potential growth is hampered by low labour productivity, still high long-term unemployment, and a declining working-age population. Remaining inefficiencies in the judicial system and the public administration affect the business environment, while capital accumulation is somewhat constrained by corporate sector deleveraging. Estimates of potential growth have shown some improvement in recent years, now ranging between 1.4% and 1.9%. Reforms to raise education levels and efficiency in the public administration are being implemented. The recovery in investment, while still at low levels, could also support potential growth in the longer term.

The Large Net External Debtor Position Is Gradually Improving

On the external sector, the current account position remains sound, supporting Portugal’s ratings and contributing to the reduction of external liabilities. The adjustment of the large current account deficit has been maintained, in part supported by improved trade cost and non-cost competitiveness. The current account has remained in small surplus, averaging 0.6% of GDP from 2013 to 2017. Services exports have been strong, driven by tourism, resulting in a surplus in the services balance. Although external accounts have improved from a flow perspective, the stock of net external liabilities remains high. The negative net international investment position stood at 106% of GDP in 2017, but it appears on a declining trend. Sustained current account surpluses are needed to reduce Portugal’s net external liabilities.

The Government Continues to Demonstrate Commitment to the EU Framework

Portugal benefits from a broadly stable political system. The Socialist government has a minority position in the parliament and support from the Left Bloc, the Communists and the Greens. DBRS expects political dynamics to remain broadly stable, as popular support remains centred on mainstream pro-European political parties.

The government has also shown ongoing commitment to further fiscal adjustment. Although the governing party’s minority position raised concerns in the past about its ability to maintain a durable long-term fiscal strategy, the government has ensured compliance with the fiscal rules under the EU Stability and Growth Pact. Portugal’s ratings are indeed supported by its adherence to the EU economic governance framework. The country’s Eurozone membership has allowed Portugal to benefit from the credibility of Euro area institutions and helped foster sounder macroeconomic policies. DBRS expects Portugal’s commitment to the EU framework to remain solid.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the A (low) – BBB range. The main points discussed during the Rating Committee include fiscal performance, debt projections, economic growth, corporate debt, and the banking sector.

KEY INDICATORS

Fiscal Balance (% GDP): -3.0 (2017); -0.7 (2018F); -0.2 (2019F)
Gross Debt (% GDP): 125.7 (2017); 122.2 (2018F); 118.4 (2019F)
Nominal GDP (EUR billions): 193.0 (2017); 200.4 (2018F); 207.9 (2019F)
GDP per Capita (EUR): 18,790 (2017); 19,376 (2018F); 20,000 (2019F)
Real GDP growth (%): 2.7 (2017); 2.3 (2018F); 1.9 (2019F)
Consumer Price Inflation (%): 1.4 (2017); 1.4 (2018F); 1.4 (2019F)
Domestic Credit (% GDP): 262.6 (Sep-2017)
Current Account (% GDP): 0.5 (2017); 0.7 (2018F); 0.7 (2019F)
International Investment Position (% GDP): -105.7 (2017)
Gross External Debt (% GDP): 211.0 (2017)
Governance Indicator (percentile rank): 85.6 (2016)
Human Development Index: 0.84 (2015)

Notes:
All figures are in EUR unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Notes: Forecasts based on the 2018-2022 Stability Programme. Fiscal balances include one-offs related to capital injections to Caixa Geral de Depositos and Novo Banco (2.0% in 2017; 0.4% in 2018). Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/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 at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

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), Banco de Portugal (BdP), Instituto Nacional de Estatistica Portugal (INE), Portuguese Public Finance Council (CFP), European Commission, European Central Bank (ECB), Statistical Office of the European Communities (Eurostat), OECD, IMF, World Bank, UNDP, 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 and US regulations only.

Lead Analyst: Adriana Alvarado, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global Financial Institutions Group
Initial Rating Date: 10 November 2010
Last Rating Date: 3 November 2017

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