DBRS Ratings GmbH (DBRS Morningstar) upgraded the Republic of Portugal’s Long-Term Foreign and Local Currency – Issuer Ratings from BBB (high) to A (low) and changed the trend from Positive to Stable. At the same time, DBRS Morningstar confirmed Portugal’s Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (low) with Stable trends.
KEY RATING CONSIDERATIONS
The ratings upgrades reflect DBRS Morningstar’s assessment that credit vulnerabilities to Portugal linked to external shocks are receding and macroeconomic prospects are improving. Following the severe 8.4% economic contraction in 2020, the recovery has been strong. GDP grew by 4.9% last year and the European Commission (EC) forecasts the economy to grow by 6.5% this year. The price shock exacerbated by Russia’s invasion of Ukraine will likely cause growth to stall during the second half of the year. Yet, the series of crises do not appear to have inflicted long-term damage to 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. Under current assumptions, government debt is expected to fall below the pre-pandemic 2019 level by 2023, a decline of nearly 20 percentage points of GDP from the peak in 2020. Improvements in DBRS Morningstar’s “Fiscal Management and Policy,” and “Debt and Liquidity” building blocks are the key factors for the upgrades.
The Stable trend reflects our view that risks to the ratings are balanced. Portugal’s Euro area membership and its adherence to the EU economic governance framework support the ratings, and help foster credible and sustainable macroeconomic policies. However, key vulnerabilities include elevated public debt and relatively low economic growth potential. These issues could become more challenging to manage if the adverse consequences of the crises prove to be long-lasting.
The ratings could be upgraded if Portuguese authorities are able to increase the country’s economic growth potential and resiliency, or if authorities achieve a further significant reduction in the public debt ratio. The ratings could be downgraded if the political commitment to sustainable macroeconomic policies weakens, resulting in a significantly worse outlook for public finances.
The Economy Accelerated Out Of The Pandemic To Start The Year; Rising Prices Place A Drag On Growth To End The Year
The Portuguese economy suffered one of Europe’s largest contractions in 2020 due to a sharp decline in private consumption and a collapse in tourism. The effective vaccine rollout, solid employment growth, pent up domestic demand, and a gradual return of tourism fuelled the strong 2021 recovery, which spilled into the first quarter of this year when growth expanded by 2.5% quarter-over-quarter. Momentum has since slowed. The shock to energy prices exacerbated by Russia’s invasion of Ukraine weighs on real incomes and consumption. The Harmonized Consumer Price Index increased by 9.4% in July 2022. Flash estimates point to a small negative quarter-over-quarter GDP contraction in Q2, and risks to economic performance – linked to higher inflation, tighter financing conditions, and uncertain energy supplies to Europe from Russia – are elevated for the second half of the year. However, even if GDP is unchanged from the second quarter, 2022 output would still result in a growth rate around 6.0%. The EC expects GDP to slow to 1.9% in 2023. Upside risk to the forecast is linked to faster than expected recovery of tourism and effective absorption of EU funds, set to total EUR 64 billion (roughly 30% of 2020 GDP) over the next decade.
The Public Balance Sheet Is Repairing Faster Than Previously Anticipated
The deterioration of public finances in 2020 was driven by a significant reduction in revenues from the economic recession and several rounds of policy measures aimed to contain the COVID-19 outbreak and support the economy. The approach was targeted and resulted in an overall budget deficit of 5.8% of GDP in 2020, better than the 7.6% previously planned. The deficit narrowed to 2.8% in 2021, already below the Maastricht threshold. The government recently approved measures to shield consumers from rising energy prices, notably a 12-month price cap on electricity prices. The 2022 Stability Programme (SP) foresees a 1.9% GDP deficit this year. However, 2022 budget execution has surprised to the upside and is so far in line with the 2019 execution, when the Treasury posted a small fiscal surplus. Rapid budget rebalancing is key because public accounts could face challenges stemming from possible calls on COVID-related credit guarantees or additional financing needs for state owned enterprises. Over the medium-term, adverse demographic trends are likely to weigh on pension and healthcare spending.
Portugal’s Debt Ratio, Though Still Comparatively High, Is Declining At A Rapid Pace
The government’s response to the pandemic along with the economic recession increased the debt-to-GDP ratio to 135.2% in 2020, nearly a 19 percentage point of GDP increase from 2019. 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 stock of debt, 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 1.9% of GDP by 2026, down from 3.0% in 2019. Likewise, Portugal’s debt dynamics point to a rapid decline of debt, which fell to 127.4% of GDP in 2021, and is set to reach 120.7% this year. The Stability Programme foresees the ratio to fall to 101.8% by 2026. These factors support DBRS Morningstar’s positive qualitative assessment in the “Debt and Liquidity” building block.
External Accounts Have Proven More Resilient In Recent Years Than During Previous Crises
Tourist spending is an important component of service exports, and the pandemic-related collapse of the tourist industry weighed on Portugal’s external sector accounts. Following seven consecutive years of surpluses, current account deficits of 1.2% and 1.1% of GDP were recorded in 2020 and 2021, respectively. These are small compared to Portugal’s double-digit deficits registered prior to the global financial crisis and mild when considering the large contraction in service exports linked to tourism. The decrease in the service surplus was largely matched by a decrease in the goods deficit. Trade links to Russia or Ukraine are limited and unlikely to affect external accounts. Neither country makes up more than 1% of total Portuguese exports or tourist visitors.
The strong performance of goods exports and the gradual recovery of tourism are expected to improve the external balance in the coming years. The number of travellers in tourist accommodations for the year to June 2022 remained about 20% lower than the pre-pandemic peak. The trend is nonetheless improving, with the amount of visitors in the second quarter of 2022 roughly matching the amount of visitors in the second quarter of 2019. External account surpluses are key to reduce the net international investment position, which improved to -95.9% of GDP in 2021 from -123.8% in 2014. 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.
Legacy Vulnerabilities In The Banking Sector Have Decreased
Capital increases and higher cash leverage levels placed the banking sector in a better position at the start of pandemic, and recent results show that banking sector profitability and asset quality have improved. After reaching a peak of 17.9% in mid-2016, the banking system’s non-performing loan (NPL) ratio declined to 3.6% of the total as of the first quarter 2022, according to Banco de Portugal. NPLs among corporates declined to 8.0% of total loans in the first quarter of 2022, down from 30.3% in the second quarter of 2016. Asset quality has remained resilient despite the end of moratoria. The direction of private sector insolvencies remains an important unknown, as inflationary pressure decelerates the economy and tightens financing conditions. Likewise, real estate prices increased by 12.9% in the first quarter of 2022 compared to a year earlier, following a long trend of near double digit price growth. The vast majority of mortgages in Portugal are at variable rates, so a rapid rise in interest rates could apply some stress to the system. However, healthy private sector deleveraging over the last decade and high bank coverage ratios mitigate these risks.
The Election Result Earlier This Year 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 41.4% of the vote, enough for a 120-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 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.
ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
Social (S) Factors
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 $24,300 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/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.
For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/401837.
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 methodology is the Global Methodology for Rating Sovereign Governments (9 July 2021) https://www.dbrsmorningstar.com/research/381451/global-methodology-for-rating-sovereign-governments. Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (17 May 2022) https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.
The sources of information used for this rating include Ministry of Finance of the Republic of Portugal (Stability Programme 2022), Agência de Gestão da Tesouraria e da Dívida Pública (IGCP Investor Presentation July 2022), Banco de Portugal (BdP: Economic Bulletin, June 2022), Instituto Nacional de Estatistica Portugal (INE), Portuguese Public Finance Council (CFP), European Commission (Summer 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.
With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, this is an unsolicited credit rating. This credit rating was not initiated at the request of the issuer.
With Rated Entity or Related Third Party Participation: YES
With Access to Internal Documents: YES
With Access to Management: YES
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.
The conditions that lead to the assignment of a Negative or Positive trend are generally 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: https://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/401836.
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 25, 2022
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