Morningstar DBRS Changes Trends on Republic of Portugal to Positive, Confirms Ratings at "A"

DBRS Ratings GmbH (Morningstar DBRS) changed the trends on the Republic of Portugal's (Portugal) Long-Term Foreign and Local Currency - Issuer Ratings to Positive from Stable and confirmed the ratings at "A". At the same time, Morningstar DBRS changed the trends on Portugal's Short-Term Foreign and Local Currency - Issuer Ratings to Positive from Stable and confirmed the ratings at R-1 (low).

KEY CREDIT RATING CONSIDERATIONS
The Positive trends reflect Morningstar DBRS' assessment that Portugal's credit vulnerabilities continue to recede, driven by the rapid decline in the public debt ratio as well the sustained improvement in the external accounts. Portugal's public debt ratio declined from 112.4% of GDP in 2022 to 99.1% in 2023. This is the lowest level since 2009 and is 17.5 percentage points lower than in 2019. The public debt ratio is expected to continue falling in the coming years, albeit at a slower pace, driven by sizable primary surpluses and moderate nominal GDP growth. After recording an overall fiscal surplus of 1.2% of GDP in 2023, Morningstar DBRS expects the new administration to remain committed to delivering small fiscal surpluses. While the new government's minority position in parliament complicates its ability to legislate and could undermine its stability, Morningstar DBRS views the risk of Portugal deviating significantly from its commitment to prudent fiscal policy as relatively low.

Portugal's credit ratings are underpinned by the country's euro area membership and its adherence to the EU economic governance framework. These factors help foster credible and sustainable macroeconomic policies and complement the country's strong governing institutions. Portugal's strong fiscal performance since 2016 and the strengthened position of the Portuguese banking system also underpin the country's credit rating. Key vulnerabilities include the elevated level of public debt, high external debt, and relatively low economic growth potential. These issues could become more challenging to manage if interest rates remain elevated for a prolonged period of time. Nevertheless, public finance concerns and external imbalances have receded significantly over the last decade and, unless there are additional shocks, these trends are expected to continue.

CREDIT RATING DRIVERS
The credit ratings could be upgraded if Portugal's public debt ratio continues on a firm downward trajectory, or if the country improves its economic resiliency and growth potential.

The trends on the credit ratings could be returned to Stable if the projected reduction in the public debt ratio materially underperforms. The credit ratings could be downgraded if the political commitment to sustainable macroeconomic policies weakens, resulting in a significantly worse outlook for public finances.

CREDIT RATING RATIONALE

The Continuation of Portugal's Steep Public Debt Reduction Lowers Underlying Credit Vulnerabilities

Portugal significantly reduced its public debt ratio on the back of high nominal growth and strong primary surpluses. The debt ratio declined to 99.1% of GDP in 2023, shrinking by 35.8 percentage points compared with the peak reached in 2020, and by 17.5 percentage points compared with its pre-pandemic level in 2019. The steep reduction in the public debt ratio is expected to continue in coming years, albeit at a slower pace than in the post-pandemic period. The European Commission expects Portugal's public debt ratio to drop to 91.5% in 2025, putting it close to the euro area as a whole (90.4%) and putting it on a different path than countries such as Italy, France, Belgium, and Spain. Under a no-policy-change assumption and in the absence of additional shocks, the Stability Programme 2024-28 estimates that the public debt ratio would fall to 95.7% in 2024 and 91.4% in 2025, before shrinking to 79.8% by 2028. The estimated decline of 19.3 percentage points compared to 2023 will be driven by the conservation of healthy primary surpluses and nominal GDP growth. This steep downward debt trajectory reduces sustainability concerns related to the high debt stock and supports the positive qualitative adjustment in the "Debt and Liquidity" building block assessment. Morningstar DBRS welcomes such significant debt reduction, as Portugal's still comparatively high level of debt increases the vulnerability of public finances to negative growth and interest rate shocks or the crystallization of contingent liabilities.

Prudent debt management and a declining public debt ratio help mitigate risks associated with the high interest rate environment. Despite a rapid increase in the costs of funding, interest costs as share of GDP ticked up to 2.2% in 2023 from 1.9% in 2022, and are expected to remain fairly stable around 2.3% during 2024-28. This is still less than the 3.0% level recorded in 2019. The average maturity of outstanding debt at 7.7 years as of March 2024 limits refinancing risk and slows the increase in debt servicing costs in a higher interest rate environment. Floating rate represented 12.5% of the outstanding debt stock; however, the refixing risk is controlled by the presence of caps for savings certificates (e.g., 2.5% for the most recent series). Furthermore, tighter credit spreads against German bonds over time, with Portugal trading below Spain and, more recently, France, are suggestive of financial market perceptions that the credit quality of Portuguese sovereign debt has improved.

Portugal's Strong Fiscal Performance Expected to Continue Over the Medium Term, Despite Some Uncertainties

Portugal was one of the few EU countries entering the pandemic after reaching a balanced budget in 2019. Pandemic-related spending combined with a steep fall in revenues resulted in an overall budget deficit of 5.8% of GDP in 2020. Since then, the fiscal deficit ratio narrowed quickly to 2.9% in 2021 and to 0.3% in 2022, benefitting from strong revenue growth and the unwinding of pandemic-related support measures. Portugal recorded a fiscal surplus of 1.2% of GDP in 2023, the fourth largest in the EU and outperforming its 2023 Budget forecast for a deficit of 0.9% of GDP. The improvement reflected the continued dynamism of revenues in 2023, amid a strong labour market and high inflation, coupled with the complete phase out of coronavirus support and lower fiscal impact of the energy measures. The budgetary measures included in the previous administration's 2024 Budget, including higher pensions, wages, and other social transfers and some revenue-decreasing measures such as personal income tax cuts, are expected to narrow the fiscal surplus in 2024.

The Stability Programme 2024-28 submitted by the new government, under a no-policy-change scenario, projects a fiscal surplus of 0.3% of GDP for both 2024 and 2025 and an average 0.4% of GDP for 2026-28. While the approval of some deficit-increasing measures this year creates additional budgetary pressures, a stronger-than-assumed economic performance could help on the revenue side. Morningstar DBRS expects the new administration to pace the implementation of its policy agenda, with targeted tax cuts and spending measures, to remain broadly consistent with the new European fiscal framework and continued public debt reduction. If no budget is passed and the risk of political elections increases, Morningstar DBRS sees limited risks of a material deviation from Portugal´s commitment to fiscal prudence and public debt reduction.

The New Centre-Right Minority Government Faces Stability Challenges but Unlikely to Derail the Current Public Debt Reduction Path

After the early parliamentary elections on March 10, 2024, a minority government led by Prime Minister Luís Montenegro from the Democratic Alliance (AD) came to power. The snap elections were triggered by the resignation of former Prime Minister António Costa from the Socialist Party, which ruled the country for previous eight years. The AD won the elections by a narrow margin and holds 80 of the 230 seats in parliament. The stability of the centre-right government remains fragile, given its minority position in parliament, and passing legislation remains challenging. Failure to pass the 2025 budget could precipitate early elections and raise policy uncertainty. While Morningstar DBRS sees limited fiscal risks, the most immediate challenge from the fragile political equilibrium is potential delays on the implementation of Portugal's Recovery and Resilience Plan (RRP) at a time when monetary policy and external constraints are easing only gradually.

Portugal is a stable liberal democracy with strong public institutions as reflected by its strong performance in the World Bank's Worldwide Governance Indicators. Portugal ranks roughly in line or higher than EU averages (see Morningstar DBRS' commentary "Portugal Governance: Overperforming Peers On Key Measures"). Portugal significantly outperforms the EU average in terms of the Rule of Law and Voice and Accountability, compares favourably in terms of Government Effectiveness, and marginally underperforms in terms of Control of Corruption and Regulatory Quality.

The Portuguese Economy Has Successfully Navigated a Challenging External Environment Thus Far

After a sharp contraction in 2020, Portugal's post-pandemic recovery was faster than anticipated and stronger than in the euro area aggregate. Portugal's real GDP in Q1 2024 was 6.3% higher than its pre-pandemic level compared with 3.4% for the euro area (EA-19). Growth has been broad-based, underpinned by a strong labour market, the impulse from European funds, the resiliency of the construction sector, and remarkable growth in the tourism sector. The Portuguese economy accelerated in Q4 2023 and Q1 2024 as the negative effects from the inflationary shock, higher interest rates, and weaker external backdrop receded. The Portuguese economy grew 2.3% last year, faster than the 0.5% for the euro area. The European Commission expects this outperformance to continue with Portugal's economy projected to expand by 1.7% in 2024 and by 1.9% in 2025. The Banco de Portugal projects economic growth between 2.0% and 2.3% in 2024-26, close to their estimate of potential growth. The central bank foresees that the positive impulse from European funds and continued export market share gains will lead to a higher investment rate and boost exports during this period. Lower inflation and less restrictive financial conditions, coupled with strong but decelerating wage growth, are expected to sustain private consumption.

The main downside risks to the growth outlook are linked to heightened geopolitical risks, which could dampen trade flows and increase inflationary pressures; weaker economic activity in Europe; and the possibility of sticky inflation leading to higher for longer interest rates. The latter is especially important for Portugal given the predominance of variable rate mortgages. On top of this, the increasing housing affordability issues in Portugal if sustained could put pressure on competitiveness and limit growth. On the other hand, stronger growth in real disposable income and a full implementation of investments and reforms under Portugal's RRP could feed into stronger growth. Portugal's updated RRP now amounts to EUR 22.2 billion (8.4% of GDP of 2023's GDP) in grants and loans, which comes on top of the EUR 33.6 billion (12.7% of GDP) in grants from the Multiannual Financial Framework 2021-27. Despite some delays in its execution, Morningstar DBRS considers that its full implementation has the potential to boost investment and potential output in coming years.

Portugal's External Vulnerabilities Have Decreased Significantly Over The Last Decade

The improvement in Portugal`s external accounts over the last decade, coupled with the deleveraging process on the private and public sector, was reflected in the European Commission's decision to remove Portugal from the list of countries experiencing imbalances in the context of the macroeconomic imbalance procedure for 2024. Portugal's net international investment position (NIIP) remains elevated but has improved significantly to -72.5% of GDP in 2023 from -123.8% in 2014. The improvement was driven by current account surpluses and nominal economic growth. Similarly, net external debt has declined to 53.8% of GDP in 2023 from 107.6% of GDP in 2014. These trends are expected to continue over the medium-term. Furthermore, Portugal's favourable NIIP structure, with non-defaultable instruments representing around 70% of the NIIP, mitigate the risks associated with its external position.

The current account returned to positive territory in 2023 with a surplus of 1.4% of GDP. The shift reflected the buoyancy of the tourism sector, surpassing its pre-pandemic peak, and an improvement of the terms of trade, as the energy crisis abated. The current account has remained positive since 2013 with the exception of the period 2020-22 because of the pandemic-related collapse of the tourism industry and the energy shock later. Going forward, current account surpluses are expected to continue in the absence of an adverse external shock. The increased diversification of its export base, internalisation, and market share gains in recent years suggest improved competitiveness. Furthermore, Portugal has benefitted from a structural improvement in its energy trade balance, reflecting the increased share of renewable energy in the country's energy power generation. Portugal's membership in the euro system, expected current account surpluses, and the structure of its external position mitigate risks and support the positive qualitative adjustment for the "Balance of Payments" building block assessment.

The Banking Sector Strengthened Resiliency in Recent Years; Risk From High Interest Rates Remains

The Portuguese banking system weathered the succession of shocks in recent years well, helped by stronger balance sheets, government support measures, and strong labour market. In aggregate, the Portuguese banking sector compares favourably to the European average in terms of capitalisation and liquidity metrics. Profitability improved markedly last year because of the rapid repricing of loan books to higher interest rates. The predominance of variable interest rate mortgages has helped in this regard. Despite higher interest rates and inflationary pressures, the nonperforming loan ratio continued declining to 2.5% in Q1 2024 from its peak of 20.1% in mid-2016, according to the European Banking Authority. This still remains slightly above the European average of 1.9%. Credit risks could materialise in coming quarters in certain pockets of vulnerable households or small- or medium-size enterprises. However, the start of the European Central Bank's monetary policy easing cycle, lower inflation, and strong labour markets should keep any deterioration of asset quality limited.

The rapid rise of house prices, which more than doubled since start of 2016, raises concerns about the risks of a sharp correction in prices impacting banks and the economy, especially if interest rates remain high for a prolonged period. Thus far, tighter financial conditions have cooled down real estate activity and slowed the increases in residential property prices to 7.0% year over year in Q1 2024 from 8.2% in 2023 and 12.6% in 2022. The risk of a sharp correction remains limited as housing supply bottlenecks and strong demand from non-residents remain supportive. The financial stability risks from the residential real estate exposure is mitigated by the rapid deleveraging of the household sector, with the stock of mortgages that barely grew since 2016, and a small fraction of mortgage loans with loan-to-value ratios of more than 80%. The borrower-based macroprudential measures, introduced in 2018, and the most recent introduction of a sectoral systemic risk buffer on exposures secured by residential real estate should help contain further build-up of risks.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
ESG Considerations had a significant effect on the credit analysis.

Social (S) Factors
The following Social factor had a significant effect on the credit analysis: Human Capital and Human Rights (S) affects the credit ratings assigned. Portugal's GDP per capita, estimated at USD 27,880 in 2023 according to the International Monetary Fund, remains relatively low compared with its euro system peers. Morningstar DBRS has taken these considerations 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 Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (January 23, 2024) at https://dbrs.morningstar.com/research/427030.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments.

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 (July 15, 2024) https://dbrs.morningstar.com/research/436000. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://dbrs.morningstar.com/research/427030 in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://dbrs.morningstar.com/about/methodologies.

The sources of information used for these credit ratings include Ministry of Finance of Portugal (Stability Programme 2024-2028; MoF Presentation June 2024), Agência de Gestão da Tesouraria e da Dívida Pública (IGCP Investor Presentation, June 2024), Banco de Portugal (BdP: Economic Bulletin, June 2024; Financial Stability Report, May 2024), Instituto Nacional de Estatística Portugal (INE), Portuguese Public Finance Council (CFP), European Commission (Spring 2024 Economic Forecast; 2024 Country Report - Portugal; In-Depth Review 2024; Post-Programme Surveillance Report, Spring 2024; Assessment of the draft updated National Energy and Climate Plan of Portugal; 2024 European Semester - Spring Package), European Banking Authority, European Central Bank, Statistical Office of the European Communities, International Monetary Fund (WEO and IFS), World Bank, Bank for International Settlements, Social Progress Imperative (2024 Social Progress Index), and Haver Analytics. Morningstar DBRS considers the information available to it for the purposes of providing these credit ratings to be of satisfactory quality.

With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, these are unsolicited credit ratings. These credit ratings were 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

Morningstar DBRS 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. Morningstar DBRS' outlooks and ratings are under regular surveillance.

For further information on Morningstar DBRS historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see: https://registers.esma.europa.eu/cerep-publication. For further information on Morningstar DBRS historical default rates published by the Financial Conduct Authority (FCA) in a central repository, see https://data.fca.org.uk/#/ceres/craStats.

The sensitivity analysis of the relevant key credit rating assumptions can be found at: https://dbrs.morningstar.com/research/436412/.

These credit ratings are endorsed by DBRS Ratings Limited for use in the United Kingdom.

Lead Analyst: Javier Rouillet, Senior Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Global Sovereign Ratings
Initial Rating Date: November 10, 2010
Last Rating Date: January 19, 2024

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