DBRS Morningstar Changes Trend on Portugal to Positive, Confirms at BBB (high)

DBRS Ratings GmbH (DBRS Morningstar) confirmed the Republic of Portugal’s Long-Term Foreign and Local Currency – Issuer Ratings at BBB (high). The rating trends on the Long-Term Ratings have been changed to Positive. 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 Short-Term ratings is Stable.

KEY RATING CONSIDERATIONS

The Positive trend on the Long-Term Ratings reflects DBRS Morningstar’s assessment that credit vulnerabilities for Portugal linked to the pandemic appear to be receding, while macroeconomic prospects are improving. Despite the abrupt health and economic shock that caused the economy to contract by 8.4% in 2020, a healthy recovery began last year and the economy is expected to return to its pre-pandemic level in the second quarter of 2022. The crisis does not appear to have inflicted severe long-term economic damage. Furthermore, growth prospects are strong in the coming years, supported by enhanced political stability following the government majority outcome of the January 2022 election, a population with the highest vaccination rates in Europe, and large EU transfers that aim to improve the productive capacity of the Portuguese economy. Positive growth and repair to the public balance sheet in 2021 initiated a return to a steep downward trajectory of Portugal’s debt-to-GDP ratio.

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

The ratings could be upgraded if Portugal’s macroeconomic performance continues to improve and the public debt ratio is placed on a firm downward trajectory. The trend on the Long-Term Ratings could return to Stable if growth prospects significantly deteriorate. The ratings could be downgraded if the political commitment to sustainable macroeconomic policies weakens, resulting in a significantly worse outlook for public finances.

RATING RATIONALE

Following A Severe Economic Shock, Prospects Are Strong For A Healthy Multi-Year Recovery

The pandemic and the ensuing mobility restrictions shocked the Portuguese economy. A sharp decline in private consumption accounted for most of the contraction of domestic demand in 2020, while the collapse in tourism caused a significant decrease in service exports. The economy rebounded by 4.9% in 2021, recovering a little more than half of the output it lost in 2020. The recovery has been supported by one of the most effective vaccine rollouts in Europe, strong employment growth, and pent up demand. Investment and goods exports recovered in 2021 to pre-pandemic levels. The EC expects the economy to expand by 5.5% in 2022 and 2.6% in 2023, although DBRS Morningstar considers upside risks to the forecast. While faster than expected inflation or unforeseen challenges to the corporate sector could hinder currently envisioned growth, above trend performance in the coming years will be supported by the disbursement of EU funds – set to total EUR 64 billion (roughly 30% of 2020 GDP) over the next decade.

A risk to the economy stems from external demand. Tourist spending is an important component of service exports. Travellers in tourist accommodations in 2021 remained 46% below 2019 levels 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 returned to deficit in 2020 and stood at 1.1% of GDP in 2021. Nevertheless, external accounts have proven much more resilient in recent years than during the previous crisis. The strong performance of goods exports and the gradual recovery of tourism are expected to improve the external balance in the coming years. External account surpluses are key to reduce the net international investment position, which improved to -95.8% of GDP in 2021. 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.

Public Finances Are Repairing Faster Than Previously Expected

The deterioration of public finances in 2020 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. However, the targeted approach to support meant the overall budget deficit of 5.7% of GDP in 2020 was better than the 7.6% previously planned. Despite additional support measures last year, the government estimates that the deficit narrowed to below 3.0% in 2021 and that it is likely to once again overperform previous estimates in 2022 and reach 1.9% of GDP. Rapid budget consolidation as crisis conditions pass is key because public accounts could face challenges stemming from possible execution of COVID-19 related credit guarantees or additional financing needs for state owned enterprises. Furthermore, adverse demographic trends are likely to weigh on pension and healthcare spending over the medium-term.

Portugal’s debt-to-GDP ratio, though still comparatively high, is repairing rapidly. The fiscal response to the pandemic along with the economic recession increased the ratio to 135.2% in 2020, nearly a 19 percentage point of GDP increase from the 2019 result. Portugal’s high debt ratio leaves public finances vulnerable to negative growth and interest rate shocks or the crystallization of contingent liabilities. Despite the large increase in the debt-to-GDP ratio, the cost of servicing that debt has declined in recent years. Portugal’s favourable funding profile with long average maturities mitigates risk associated with tighter than expected financing conditions. Current assumptions are for interest costs to be 1.8% of GDP by 2025, down from 3.0% in 2019. Likewise, Portugal’s debt dynamics point to a rapid decline of the ratio. Debt-to-GDP fell to 127.5% in 2021 and the government forecasts the ratio to fall to 120.9% this year. These factors support DBRS Morningstar’s positive qualitative assessment in the “Debt and Liquidity” building block.

Unclear Banking Sector Asset Quality Deterioration 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 a 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 4.0% as of the third quarter 2021, according to Banco de Portugal. NPLs among corporates declined to 8.3% of total loans in the third quarter of 2021, down from 30.2% in the second quarter of 2016.

These improvements could nonetheless reverse if the COVID-19 crisis drastically affects household and corporate solvency. Loan moratoria and state guaranteed loans limited defaults, but those support measures have started to be phased out. The direction of private sector insolvencies remains an important unknown. While the economic recovery and high coverage ratios should act as a mitigants, DBRS Morningstar expects asset quality deterioration could be more pronounced due to the end of moratoria. Almost two thirds of the banking system’s total NPLs relate to non-performance in the corporate sector.

The Election Result Delivered Stability At An Important Time

Portugal is a stable liberal democracy with strong public institutions. The Socialist Party (PS) overperformed relative to expectations in the January 30, 2022 parliamentary election to secure an absolute majority. The PS won 41.5% of the vote, enough for a 119-seat majority in the 230-seat assembly. The majority outcome of the election reduces legislative obstacles at a key moment. Portugal is a significant beneficiary of EU funds, including the EUR 16.4 billion (8% of GDP) through 2026 from the Recovery and Resilience Facility (RRF) – the pre-funding tranche of which has already been disbursed. The aim of the EU transfers, especially RRF, is to link funding to reforms and investments that attempt to enhance resiliency, and advance the green and digital transitions. Whether or not these windfalls manage to boost the economy’s productive capacity will depend on Portugal’s ability to effectively absorb the transfers and direct them to productive ends.

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 $24,500 in 2021 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 at: https://www.dbrsmorningstar.com/research/392920.

EURO AREA RISK CATEGORY: LOW

Notes:

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, Draft Budget 2022), Agência de Gestão da Tesouraria e da Dívida Pública (IGCP Investor Presentation December 2021), Banco de Portugal (BdP: Economic Bulletin, December 2021), Instituto Nacional de Estatistica Portugal (INE), Portuguese Public Finance Council (CFP), European Commission (Winter 2022 Forecasts), European Central Bank (ECB), Statistical Office of the European Communities (Eurostat), Social Progress Imperative, Global Carbon Project, OECD, IMF, World Bank, 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/392919.

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: August 27, 2021

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