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

DBRS Ratings GmbH (DBRS Morningstar) confirmed the Republic of Portugal’s Long-Term Foreign and Local Currency – Issuer Ratings to BBB (high). At the same time, DBRS Morningstar confirmed Portugal’s Short-Term Foreign and Local Currency – Issuer Ratings to R-1 (low). The trend on all ratings is Stable.

KEY RATING CONSIDERATIONS

The small and open nature of the Portuguese economy makes it vulnerable to the financial and economic turmoil brought on by the current global health crisis. DBRS Morningstar expects there to be considerable economic disruption in 2020 due to the rapid spread of the coronavirus (COVID-19). At a minimum, the Portuguese economy will likely slow in the first few quarters of the year as tourism flows decline, and consumer confidence and industrial sentiment weaken. The severity of the economic slowdown will depend on the depth and duration of the shock. Time will tell whether the spread of the disease slows and whether the domestic and global response to the pandemic is adequate.

Despite the current turmoil, the Stable trend reflects DBRS Morningstar’s assessment around several of Portugal’s key rating indicators. The Portuguese economy – having diversified in recent years to consist of higher quality exports and rising private sector investment – is in a stronger position than in the previous crisis and more capable of supporting balanced growth. The fiscal outcome was roughly in balance last year and the government debt-to-GDP ratio is declining at a healthy pace. This allows some fiscal space to cushion the shock. Credit fundamentals among Portuguese banks also continue to strengthen, as evidenced by the steady improvement in asset quality. Furthermore, the Socialist Party formed a minority government following the October 2019 election. While major economic reforms appear unlikely, there is clear commitment across political parties for sound fiscal management and public debt reduction.

The ratings are supported by Portugal’s Eurozone membership and its adherence to the EU economic governance framework. Both help foster credible and sustainable macroeconomic policies. However, legacies of the euro area crisis continue to pose vulnerabilities, including elevated public debt, high albeit declining levels of non-performing loans (NPLs) in the financial system, and relatively low economic growth potential.

RATING DRIVERS

Upward rating action could occur if sustained primary surpluses and steady economic growth further reduce the public debt ratio. Continuation of the progress made strengthening the financial sector could also be credit positive. Ratings could be downgraded if there is a prolonged deterioration in fiscal performance and a material reversal of the debt trajectory, either due to significant weakening of growth prospects or in the political commitment to sustainable macroeconomic policies.

RATING RATIONALE

DBRS Morningstar Expects the Global Health Crisis to Weaken Portugal’s Near-Term Economic Performance

The Portuguese economy is set to decelerate this year as the coronavirus COVID-19 pandemic weakens global demand. While the number of reported cases in Portugal, as of mid-March 2020, is below other European countries, the case numbers are rising quickly and the effects on the Portuguese economy will likely be broad-based. Supply-side disruptions from illness or lost workdays should adversely affect growth. Further slowing economic activity will be weaker external demand for Portuguese goods and services – tourism flows in particular – as well as weaker domestic demand as households stay home. Prior to the outbreak, the EC’s Winter Forecast projected GDP in Portugal to grow by 1.7% in 2020 and 2021. These forecasts will likely be revised downwards as the shock passes through the economy.

The Portuguese economy is better positioned to manage this shock than in the previous crisis. Years of high quality employment growth, private sector deleveraging, and healthy wage growth have improved private sector wealth, fixed capital formation, and household purchasing power. Likewise, the economic structure is supported by a larger and more diversified export base. With broader sectoral and geographical diversification, exports accounted for 44% of GDP in 2019, up from 30% in 2010. That said, domestic demand should slow significantly this year, and export diversification is unlikely to protect exports from a broad-based COVID-19 demand shock. Tourism, an increasingly more important component of service exports, has started to show clear signs of a slowdown.

Portugal’s current account position was roughly in balance last year and the government forecasts small external deficits over the coming years, as rising capital investment increases demand for imports. While the net liability position is still elevated at 100% of GDP in 2019, the rising share of direct investment has improved the composition of Portugal’s international liabilities in recent years, thereby reducing external vulnerabilities.

Balance Sheet Repair in Recent Years Provides Portugal with Fiscal Space to Try to Offset Coronavirus Shock

Portugal’s sustained commitment to fiscal consolidation has substantially improved Portugal’s fiscal position. Driven by strong tax revenues and contained spending, the headline deficit has steadily improved from 7.4% of GDP in 2014 to a near balance position in 2019. The headline balance includes the EUR 1.149 billion capital transfer to Novo Banco via the Resolution Fund in 2019. Prior to the current health crisis, the 2020 State Budget expected surpluses in each year of the forecast period.

These near-term fiscal forecasts are subject to downward revisions if the current growth shock proves long-lasting and if the fiscal policy response is large. On March 12, 2020 the government approved a series of measures meant to prevent the spread and cushion the economic impact of COVID-19, including the declaration of a state of alarm, financial support to workers, and credit lines to companies. On March 18, 2020 the government announced a package of broader liquidity measures for companies and individual workers worth EUR 9.2 billion. DBRS Morningstar considers the fiscal impulse appropriate at this moment of crisis, even if it temporarily derails the fiscal consolidation effort.

Over the medium-term, adverse demographic trends are likely to put upward pressure on pension and healthcare spending. Likewise, risks to fiscal performance could stem from high expenditures in concentrated sectors. Some state-owned enterprises (SOEs) are consistently loss-making and the management of persistent, albeit decreasing, hospital arrears is an ongoing challenge. That said, ongoing spending reviews in various sectors, as well as incentives to find additional savings in the public administration, are important fiscal efforts to improve cost efficiency.

Debt Ratios are Declining at a Rapid Pace, But High Public Debt is Portugal’s Key Vulnerability

Down from the peak of 132.9% of GDP in 2014, general government debt registered 117.7% in 2019. Higher primary surpluses, moderate economic growth, and low interest rates will likely continue to put the debt ratio on a downward trajectory. Prior to the onset of the global pandemic, the government expected the primary surplus to remain above 3.0% of GDP over the forecast period, well above the IMF’s debt-stabilising primary deficit calculation of roughly balance. As a result, the debt-to-GDP ratio was thought to decline in the coming years by several percentage points per year.

Despite the healthy debt trajectory under current assumptions, the public debt ratio in Portugal is still among the highest in Europe. The global health-related financial and economic shock could challenge the current input assumptions of the country’s debt performance. Portugal’s high debt to GDP ratio leaves public finances vulnerable to negative growth shocks or the crystallization of contingent liabilities, even if the government has made progress in reducing guarantees.

Portugal had taken advantage of favourable market conditions in recent years to improve its debt profile and to reduce interest costs. Debt maturities have been extended through active debt management operations, early repayments of IMF loans, and early partial repayment of EFSF loans. Improved market confidence in Portugal’s fundamentals combined with low interest rates are contributing to lower interest payments. General government interest costs are projected to decline to 2.9% of GDP in 2020 from 3.1% in 2019. While yields remain low, renewed uncertainty has brought some market volatility.

Financial Stability Risks are Gradually Receding

Excluding Novo Banco, banks have been profitable since 2017 and capital increases and higher cash leverage levels have placed the banking sector in a better position. Bank profitability is supported by lower cost of risk and improved efficiency. Risks to financial stability from the high levels of NPLs and corporate sector debt are receding. Non-financial corporate debt has fallen from 145% of equity in 2012 to 100% as of the third quarter of 2019, according to the IMF. After reaching a peak of 17.9% in mid-2016, the banking system’s NPL ratio declined to 7.7% in the third quarter of 2019, according to Bank of Portugal. Improved economic conditions and the broad strategy for improving asset quality have contributed to the reduction of NPLs.

However, almost two thirds of the banking system’s total NPLs relate to non-performance in the corporate sector. NPLs among corporates was 15.7% of total loans in the third quarter of 2019, down from above 30% in 2016. The still elevated NPL ratio among corporates points to still unresolved financial system stress and is in part a feature that weighs on DBRS Morningstar’s assessment in the Monetary Policy and Financial Stability building block.

DBRS Morningstar Expects Policy Continuity From the New Minority Government

Portugal is a stable liberal democracy with strong public institutions. Following the October 6, 2019 election, the Socialist Party (PS) formed a minority government without renewing the pact it held with previous coalition partners. The PS must now negotiate majority support for legislation bill by bill. While this strategy increases the risk of instability and the possibility of early elections, DBRS Morningstar expects political dynamics to broadly result in policy continuity. Moreover, Portugal’s traditional parties, which continue to dominate the political landscape, are pro-European, thereby reducing the risk of elevated political tension between Portugal and European institutions.

For more information on the Rating Committee decision, please see The Scorecard Indicators and Building Block Assessments.
http://www.dbrs.com/research/358292

EURO AREA RISK CATEGORY: LOW

All figures are in EUR unless otherwise noted. Public finance statistics reported on a general government basis unless specified.

The principal applicable methodology is the Global Methodology for Rating Sovereign Governments, which can be found on the DBRS Morningstar 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, BIS, Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

DBRS Morningstar 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 Morningstar’s outlooks and ratings are under regular surveillance.

For further information on DBRS Morningstar 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 GmbH are subject to EU and US regulations only.

Lead Analyst: Jason Graffam, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer – Global FIG and Sovereign Ratings
Initial Rating Date: November 10, 2010
Last Rating Date: October 4, 2019

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