DBRS Morningstar Confirms the Republic of Portugal at A (low), Stable Trend

DBRS Ratings GmbH (DBRS Morningstar) confirmed the Republic of Portugal’s Long-Term Foreign and Local Currency – Issuer Ratings at A (low). 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 confirmations of the ratings and trends reflect DBRS Morningstar’s view that external risks to economic performance are balanced by persistent improvement of key public finance metrics. Following the severe 2020 GDP contraction, growth recovered strongly in 2021 and during the first half of 2022. The price shock exacerbated by Russia’s invasion of Ukraine and the corresponding rise in interest rates caused growth to decelerate sharply in the second half of 2022. Output growth this year is expected to be positive, but likely below trend. Despite the reoccurring economic shocks, the fiscal deficit narrowed again in 2022 and remains below the Euro area average. Positive growth and rapid repair to the public balance sheet allowed the public debt-to-GDP ratio to return to its steep downward trajectory. DBRS Morningstar expects the ratio to fall to around 100% by mid-decade.

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.

RATING DRIVERS
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.

RATING RATIONALE
The Economy Accelerated Out Of The Pandemic To Start 2022; Rising Prices Decelerated Growth To End 2022

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. Solid employment growth, pent up domestic demand for private consumption, and a return of tourism fuelled the 2021 recovery, which spilled into the first half of 2022. Momentum has since slowed. The shock to energy prices and the rise in interest rates weighs on economic activity. The Harmonized Consumer Price Index in December 2022 declined slightly from the October peak but remained elevated at 9.8%. In its latest Economic Bulletin, the Banco de Portugal (BdP) forecasts that GDP growth, having expanded by 6.8% in 2022, will slow to 1.5% in 2023 and then recover to 2.0% growth in 2024. Downside risk to the forecast stems primarily from the evolution of prices and thus the pace of interest rate increases. Stress to household balance sheets from the rapid rise in interest rates on variable mortgages is an important concern. Mitigants to this risk include a healthy labour market, strong wage growth, and accumulated private sector savings. Furthermore, authorities through the end of 2023 allow stressed customers to renegotiate their mortgage under certain conditions. Upside risk to economic performance, especially over the medium term, is linked to effective absorption of EU funds, set to total EUR 64 billion (roughly 30% of 2020 GDP) over the next decade.

The Public Balance Sheet In 2022 Once Again Likely Consolidated 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 2.9% in 2021, already below the Maastricht threshold and the 2023 budget forecasted further consolidation of the deficit to 1.9% of GDP last year. However, 2022 budget execution surprised to the upside, suggesting possible overperformance of the balance in 2022. The 2023 budget provisions still around 2% of GDP in discretionary spending this year, roughly half of which is meant to shield consumers from rising energy prices. Measures include a reduction of VAT on electricity and an extension of the fuel tax reduction. Despite the support, current expenditure growth remains contained and the government expects the deficit to narrow in 2023 to 0.9% of GDP. Rapid budget rebalancing is key because public accounts could face challenges stemming from possible calls on crisis-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 134.9% in 2020. 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. While the cost of issuing debt has inevitably increased, current assumptions are for interest costs to continue to decline, falling to 1.9% of GDP by 2026, down from 3.0% in 2019, as the cost of new long-term issuances remains below that of legacy debt. Likewise, Portugal’s debt dynamics remain on a downward path. The budget projects debt to have fallen to 115.0% of GDP in 2022, and is forecasted to reach 110.8% this year. DBRS Morningstar expects the rapid decline in debt to continue in the coming years and anticipates the ratio falling to around 100% by 2025 in the absence of additional major shocks. These factors support DBRS Morningstar’s positive qualitative assessment in the “Debt and Liquidity” building block.

Tourism Has Recovered; 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 averaged 1.1% of GDP in 2020-22. 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. At the height of the Covid-19 shock, the decrease in the service surplus was largely matched by a decrease in the goods deficit. Trade links to Russia and Ukraine are limited and unlikely to affect external accounts. Neither country makes up more than 1% of total Portuguese exports or tourist visitors. Looking ahead, the external balance is expected to gradually repair on the back of a recovery in service sector exports. The number of travellers in tourist accommodations recovered above pre-covid levels in 2022 when tourist revenues reached EUR 22 billion, well above the EUR 16 billion generated in 2019. External account surpluses are key to reduce the net international investment position, which improved to -86.3% of GDP as of the third quarter 2022, 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; Risk From Rising Rates Remains

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 3.2% of the total as of the third quarter 2022, according to Banco de Portugal. NPLs among corporates declined to 7.2% of total loans as of the third quarter of 2022, down from 30.3% in the second quarter of 2016. The direction of private sector insolvencies remains an important unknown, as inflationary pressure decelerates the economy and tightens financing conditions. Higher mortgage rates have yet to slow the rise in residential property prices, which increased by 13.1% as of the third quarter of 2022 compared to a year earlier.

The vast majority of mortgages in Portugal are at variable rates, so the rapid rise in interest rates could apply some stress to the system. Authorities recently put in place a set of measures to mitigate the effects to households of rising variable rate property loans. The aim is to provide some relief to borrowers whose debt service to income ratio has deteriorated in the new environment, principally via the option to renegotiate their owner-occupied mortgage. This could increase operational risk to banks, and have implications for their revenues and provisioning. However, healthy private sector deleveraging over the last decade, improved asset quality, high bank coverage ratios, and benefits to the banks from higher rates help mitigate risks.

The Election Result Last 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 $24,900 in 2022 compared with its euro system peers. This factor has been taken into account within the “Economic Structure and Performance” building block.

There were no Environmental or Governance factors that had a significant or relevant effect on the credit analysis.

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. (May 17, 2022)

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments at: https://www.dbrsmorningstar.com/research/408861.

EURO AREA RISK CATEGORY: LOW

Notes:
All figures are in euros 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/401817/global-methodology-for-rating-sovereign-governments (August 29, 2022). In addition, DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings, https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (May 17, 2022) in its consideration of ESG factors.

The sources of information used for this rating include Ministry of Finance of the Republic of Portugal (Budget 2023), Agência de Gestão da Tesouraria e da Dívida Pública (IGCP Investor Presentation, January 2023), Banco de Portugal (BdP: Economic Bulletin, December 2022), Instituto Nacional de Estatistica Portugal (INE), Portuguese Public Finance Council (CFP), European Commission (Autumn 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/408860.

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 26, 2022

DBRS Ratings GmbH, Sucursal en España
Paseo de la Castellana 81
Plantas 26 & 27
28046 Madrid, Spain
Tel. +34 (91) 903 6500

DBRS Ratings GmbH
Neue Mainzer Straße 75
60311 Frankfurt am Main Deutschland
Tel. +49 (69) 8088 3500
Geschäftsführer: Detlef Scholz
Amtsgericht Frankfurt am Main, HRB 110259

For more information on this credit or on this industry, visit www.dbrsmorningstar.com.