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 pandemic has left the economy as of the second quarter of this year still 4.6% below the end-2019 level of output. The magnitude of the shock reflects the small and open nature of the economy as well as the contribution to output from tourism. Improvement of face-to-face sectors like tourism depends on the pandemic and recovery is unlikely to occur before mid-2022. Growth prospects have nonetheless improved, and as the vaccine rollout advances in Portugal and across Europe, the economy should rebound in the second half of the year and over the forecast period. The impact of the crisis 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, key vulnerabilities include elevated public debt, legacy stress in the financial system, and relatively low economic growth potential. These issues could become 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.

Conversely, ratings could be downgraded if the crisis meaningfully diminishes growth prospects or weakens the political commitment to sustainable macroeconomic policies, resulting in a significantly worse outlook for public finance.

RATING RATIONALE

COVID Economic Shock Has Been Severe

Following five consecutive quarterly contractions, Portugal’s economy rebounded in the second quarter. Mobility restrictions adopted in spring 2020 that were reimposed at the end of the year and extended into the first few months of 2021 resulted in a sharp decrease in economic activity across most sectors. Stalled private consumption accounted for most of the contraction of domestic demand, while the collapse in tourism also caused a significant decrease in service exports. The economy fell by 7.6% in 2020 and by 3.2% quarter-over-quarter in the first quarter of 2021. The vaccine rollout, improved health conditions, easing of restrictions, and pent-up demand allowed for a 4.9% recovery in the second quarter. These conditions and disbursement of EU funds (nearly EUR 64 billion or 32% of 2019 GDP through 2029) should accelerate the recovery. The EC forecasts 3.9% growth in 2021 and 5.1% in 2022.

The main risk to Portugal’s economy stems from external demand. Tourist spending is an increasingly more important component of service exports. Travellers in tourist accommodations through the first two quarters of 2021 remain 70% below levels over the same period in 2019, and it is unclear when the sector will fully recover. As a result, the recovery of service sector exports will likely be protracted and weigh on external sector accounts. Following seven consecutive years of external surpluses, Portugal’s current account deficit was 1.2% of GDP in 2020. However, a stronger recovery of goods exports is expected to improve the external balance in the coming years. External account surpluses are important to reducing the net international investment position, which reached -105.1% of GDP in 2020. It is important to note that 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 Interrupted Years Of Public Balance Sheet Repair And Debt Reduction

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 from the economic recession and an increase in expenditures to confront the pandemic. The government approved several rounds of policy measures aimed to contain the outbreak and support the economy. The total budgetary cost of support programs in 2020 was 2.3% of GDP and the overall budget deficit of 5.7% was better than the 7.6% previously planned. Despite additional measures for this year, the deficit is expected to narrow to 4.5% of GDP in 2021 and fall to 2.2% by 2023. Budget consolidation over the medium-term once crisis conditions have passed is key, as adverse demographic trends are likely to weigh on pension and healthcare spending.

The COVID-19 shock interrupted progress made in recent years in reducing the debt-to-GDP ratio, which declined from 131.5% in 2016 to 116.8% in 2019. The fiscal response to the pandemic, along with the economic recession, pushed the ratio back up to 133.6% in 2020. 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 this year, declining by roughly 5 percentage points in 2021 and then by a similar amount in 2022. The government forecasts the ratio to fall to 114.3% by 2025.

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 better position at the start of 2020. Bank profitability in recent years was supported by 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 4.6% as of the first quarter 2021, according to Banco de Portugal. NPLs among corporates declined to 9.2% of total loans in the first quarter of 2021, down from 30.2% in the second quarter of 2016.

However, these improvements could reverse if the COVID-19 crisis drastically affects household and corporate solvency. For the time being, loan moratoria and state guaranteed loans have limited defaults. DBRS Morningstar expects asset quality deterioration to be more pronounced with the loosening of these support measures this year. Almost two thirds of the banking system’s total NPLs relate to non-performance in the corporate sector. While the gradual economic recovery should act as a mitigant, expected asset quality deterioration weighs negatively on DBRS Morningstar’s qualitative assessment in the “Monetary Policy and Financial Stability” building block.

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 put 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 $22,489 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/383525.

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/381451/global-methodology-for-rating-sovereign-governments (July 9, 2021). Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings 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 (Stability Programme 2021), Agência de Gestão da Tesouraria e da Dívida Pública (IGCP Investor Presentation May 2021), Banco de Portugal (BdP: Economic Bulletin, June 2021), 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/383524.

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: February 26, 2021

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