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

KEY RATING CONSIDERATIONS

The disruption to the Portuguese economy brought on by the global health crisis has been severe. The economy contracted by 7.6% in 2020 due to the rapid spread of the Coronavirus Disease (COVID-19) and subsequent mobility restrictions. The magnitude of the shock reflects the small and open nature of the economy as well as the contribution to output from tourism. As the vaccine rollout advances, the economy should rebound this year, although the strength of the recovery remains uncertain. The impact on Portugal’s credit profile will depend on the duration of the shock and whether it structurally alters medium-term growth prospects and weakens government finances.

Confirmation of the Stable trend balances the abrupt health and economic shock with improvements of key rating indicators in the years prior to the crisis. Higher investment and export diversification into higher quality goods and services points to strong growth prospects over the medium term. Years of primary fiscal surpluses and a declining government debt-to-GDP ratio gave the government space to provide temporary fiscal stimulus to cushion the impact of the shock on the economy. There is a commitment across political parties for rebalancing fiscal accounts once conditions improve. Moreover, credit fundamentals among major Portuguese banks strengthened prior to the COVID-19 shock.

The ratings are supported by Portugal’s Euro area 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, still comparatively high levels of non-performing loans (NPLs) in the financial system, and relatively low economic growth potential. These legacy issues could become even more challenging to manage if the adverse consequences of the current crisis prove to be long-lasting.

RATING DRIVERS

Ratings could be upgraded if the macroeconomic outlook improves and authorities are able to return the public debt ratio to a firm downward trajectory. Continuation of the progress made strengthening the financial sector could also be credit positive.
Conversely, ratings could be downgraded if the crisis significantly diminishes growth prospects or weakens the political commitment to sustainable macroeconomic policies, resulting in a significantly worse outlook for public finance.

RATING RATIONALE

Portugal’s 2020 Economic Contraction Was Deep; External Sector Uncertainty Could Weigh On Future Performance

Portugal’s economy is set to recover in 2021, following a deep recession last year. The strict mobility restrictions adopted last spring and then reimposed at the end of the year resulted in a sharp decrease in economic activity across most sectors. Stalled private consumption and investment accounted for most of the contraction of domestic demand, while the near-total collapse in tourism also caused a significant decrease in service exports. Although 2020 performance appears to have been stronger than estimates made early on in the pandemic, the economy still contracted by 7.6%.

The European Commission forecasts the economy to grow at an annual rate of over 4% in 2021 and again in 2022, due to improved health conditions and pent up demand. The government expects 70% of the population to be vaccinated by the end of the summer. Programs aimed to support firms and households via employment protection schemes, deferred tax payments, and state-guaranteed credit lines create conditions for a strong recovery. In addition, the disbursement of European funds accompanied by favourable financing conditions could spur a rebound in investment. A main risk to Portugal’s economy stems from external demand. Tourist spending is an increasingly important component of service exports. Travellers in tourist accommodations declined by 60% last year and it is unclear when the sector will fully recover.

External sector accounts will deteriorate slightly over the coming years. Portugal’s balanced current account position in 2019 reverted to deficit in 2020 and the IMF expects it to remain in deficit in coming years. This could stall progress made in reducing the net international investment position, which reached -106% of GDP in 2020 according to the Banco de Portugal. However, the rising share of direct investment (versus portfolio inflows) has improved the composition of Portugal’s international liabilities in recent years, thereby reducing external vulnerabilities associated with the high stock.

The Coronavirus Shock Reversed Years Of Public Sector Balance Sheet Repair

The fiscal accounts shifted from a small surplus position in 2019 to a large deficit in 2020. The deterioration was driven by a significant reduction in revenues and an increase in expenditures to confront the COVID-19 shock. The government approved several rounds of policy measures aimed at containing the outbreak and supporting the economy through employment protection schemes, enhanced social welfare, and state guaranteed credit lines to corporates. The 2021 Draft Budget projects the total budgetary impact of support programs in 2020 to be 2.8% of GDP and the overall budget deficit to be 7.3% of GDP. The final deficit outcome was better than the government’s expectations earlier in the year.

The fiscal impulse is necessary at this moment of crisis, even if it temporarily derails the fiscal consolidation effort. Assuming the pandemic wanes, the economy recovers, and crisis-support measures decline, the 2021 Draft Budget foresees the deficit narrowing to 4.3% in 2021 and to 2.8% in 2022. Risks to these forecasts are tilted to the downside, which weighs negatively on DBRS Morningstar’s assessment in the “Fiscal Management and Policy” building block. Budget consolidation over the medium-term once crisis conditions have passed is key, as adverse demographic trends are likely to put upward pressure on pension and healthcare spending.

The Large Increase In The Debt-to-GDP Ratio From The Crisis Is Offset By Declining Interest Costs

The COVID-19 shock reversed progress made in recent years in reducing the debt-to-GDP ratio. Primary surpluses, moderate economic growth, and low interest rates placed the debt ratio on a firm downward trajectory in the years prior to the pandemic. The debt-to-GDP ratio declined from 132% in 2016 to 117% in 2019. The fiscal response to the pandemic, along with the economic recession, increased the ratio to 134% in 2020 according to Banco de Portugal, among the highest in Europe but below previous estimates. Portugal’s high debt ratio leaves public finances vulnerable to negative growth and interest rate shocks or the crystallization of contingent liabilities. Under current assumptions, Portugal’s debt ratio should return to its downward trajectory. The government expects the ratio to decline to 131% in 2021.

Despite the large increase in the debt-to-GDP ratio, the cost of servicing that debt has declined in recent years. Low interest rates – as a result of improved market confidence in Portugal’s fundamentals combined with the European Central Bank’s asset purchase programmes – are contributing to lower debt servicing costs. General government interest costs are projected to decline to 2.6% of GDP in 2021, from 3.4% in 2018, and will likely continue to decline over the forecast period. These factors support DBRS Morningstar’s positive qualitative assessment in the “Debt and Liquidity” building block.

Banking Sector Asset Quality Likely To Deteriorate As A Result of The COVID-19 Shock

Financial stability risks gradually receded prior to the crisis. Capital increases and higher cash leverage levels placed the banking sector in a stronger position at the start of 2020. Bank profitability in recent years was supported by the lower cost of risk and improved efficiency. Risks to financial stability from the high levels of NPLs also receded. After reaching a peak of 17.9% in mid-2016, the banking system’s NPL ratio declined to 5.3% in the third quarter of 2020. NPLs among corporates declined to 10.6% of total loans in the third quarter of 2020, down from above 30% in 2016.

However, these improvements could somewhat reverse if the COVID-19 crisis drastically affects household and corporate solvency. While loan moratoria and state guaranteed loans for the time being mask financial sector stress, asset quality deterioration will be more pronounced with the loosening of these support measures likely in 2021. Almost two thirds of the banking system’s total NPLs relate to non-performance in the corporate sector.

DBRS Morningstar Expects Policy Continuity From The Minority Government

Portugal is a stable liberal democracy with strong public institutions. Following the October 2019 election, the Socialist Party (PS) formed a minority government without renewing the pact it held with previous coalition partners. DBRS Morningstar expects policy continuity. Portugal’s centrist politics, including its commitment to EU institutions, helped the country navigate the last debt crisis. All major parties took part in the fiscal repair over the last decade and policy decisions in recent years placed Portugal in a stronger position to manage this crisis than the previous one.

ESG CONSIDERATIONS

Human Rights and Human Capital (S) were among the key ESG drivers behind this rating action. Portugal’s per capita GDP is relatively low at $21,607 in 2020 compared with its euro system peers. This factor has been taken into account within the “Economic Structure and Performance” building block.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/374340.

EURO AREA RISK CATEGORY: LOW

Notes:
For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

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

The principal methodology is the Global Methodology for Rating Sovereign Governments https://www.dbrsmorningstar.com/research/364527/global-methodology-for-rating-sovereign-governments (July 27, 2020). Other applicable methodologies include DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/373262/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (February 3, 2021).

The sources of information used for this rating include Ministry of Finance of the Republic of Portugal (Draft Budget 2021), Agência de Gestão da Tesouraria e da Dívida Pública (IGCP Investor Presentation February 2021), Banco de Portugal (BdP: Economic Bulletin, December 2020), Instituto Nacional de Estatistica Portugal (INE), Portuguese Public Finance Council (CFP), European Commission (Winter 2021 Forecasts), European Central Bank (ECB), Statistical Office of the European Communities (Eurostat), Social Progress Imperative, Global Carbon Project, 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 12-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. DBRS Morningstar understands further information on DBRS Morningstar historical default rates may be published by the Financial Conduct Authority (FCA) on its webpage: https://www.fca.org.uk/firms/credit-rating-agencies.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/374339.

This rating is endorsed by DBRS Ratings Limited for use in the United Kingdom.

Lead Analyst: Jason Graffam, Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: November 10, 2010
Last Rating Date: September 18, 2020

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