Morningstar DBRS Upgrades Republic of Portugal to A (high), Changes Trend to Stable

DBRS Ratings GmbH (Morningstar DBRS) upgraded the Republic of Portugal's (Portugal) Long-Term Foreign and Local Currency - Issuer Ratings to A (high) from "A". At the same time, Morningstar DBRS upgraded Portugal's Short-Term Foreign and Local Currency - Issuer Ratings to R-1 (middle) from R-1 (low). The trends on all ratings have returned to Stable from Positive.

KEY CREDIT RATING CONSIDERATIONS
The upgrade reflects Morningstar DBRS' view that Portugal's remarkable reduction in public debt, underpinned by a strong fiscal performance, strengthened its credit quality. The upgrade also reflects the significant reduction in external vulnerabilities over the last decade and a more resilient banking system. Portugal's public debt ratio declined sharply from 116.1% of GDP in 2019 to 97.9% in 2023 and could fall below 90.0% of GDP threshold in the next two to three years. The government expects the public debt ratio to decline to 95.9% of GDP in 2024 and to continue its downward trend to 93.3% in 2025 and 83.2% in 2028, driven by large primary surpluses and moderate nominal GDP growth. The Portuguese fiscal council, the central bank, and the IMF project a sharper decline in the debt ratio over the medium term. Portugal's current fiscal position is among the strongest in the euro area. Portugal recorded an overall fiscal surplus of 1.2% of GDP in 2023 and is expected to post small surpluses in 2024 and 2025. The approval of the budget for 2025 bodes well for the durability of the current government in the near term. The fiscal uncertainty will likely increase over time, however, Morningstar DBRS views the risk of Portugal deviating significantly from its commitment to prudent fiscal policy as relatively low. The credit rating action reflects improvements in the "Debt and Liquidity", "Balance of Payments", and "Monetary Policy and Financial Stability Building" building blocks.

The Stable trend reflects Morningstar DBRS' view that the risks to the credit ratings are balanced. 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, which now appears less likely following the ECB's less restrictive monetary policy stance. 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 falls to significantly lower levels and there is persistent evidence that the country improves its economic resiliency and growth potential.

The credit ratings could be downgraded if a worsening of Portugal's growth outlook or a weaker commitment to fiscal discipline leads to a significant increase in its public debt ratio over the medium term.

CREDIT RATING RATIONALE

Portugal's Steep Public Debt Ratio 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 97.9% of GDP in 2023, shrinking by 36.2 percentage points compared with the peak reached in 2020, and by 18.2 percentage points compared with its pre-pandemic level in 2019. The public debt ratio is expected to continue to decline materially in coming years, albeit at a less spectacular pace. The government projects in its National Medium-Term Fiscal-Structural Plan 2025-2028 the public debt ratio to fall from an estimated 95.9% in 2024 to 93.3% in 2025, before shrinking to 83.2% by 2028. The estimated decline of 14.7 percentage points compared to 2023 will be driven by the conservation of healthy primary surpluses and nominal GDP growth. Furthermore, the Portuguese fiscal council, the central bank, and the IMF project a sharper decline in the debt ratio over the medium term, in part due to a more favourable stock-flow adjustments. The fiscal council projects a debt ratio at 78.3% in 2028, the IMF at 79.4% in 2028, and the central bank at 81.3% in 2027. 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 still high-interest rate environment. Interest costs as a share of GDP are estimated at 2.1% in 2024, compared to the 1.9% in 2022, and are expected to average 2.1% during 2025-28. This is still less than the 2.9% level recorded in 2019. The average maturity of outstanding debt at 7.6 years as of September 2024 limits refinancing risk and slows the increase in debt servicing costs in a higher interest rate environment. Floating rate represented 12.3% 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 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's fiscal position is currently among the strongest in the euro area after rapid repair from the pandemic and the energy crisis. Portugal recorded a fiscal surplus of 1.2% of GDP in 2023, the third largest in the euro area and outperforming its 2023 Budget forecast for a deficit of 0.9% of GDP. The improvement reflected the 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 government projects the surplus to narrow to 0.4% of GDP in 2024 driven by fiscal policy measures leading to higher public wages and pension expenditures as well as revisions to personal income taxation. The continued expansion of revenue, benefitting from dynamism in the labour market and the economy, and lower impact from the energy measures have partially compensated for the strong spending growth last year. Both the fiscal council and the central bank estimate a slightly higher surplus in 2024.

The government projects the fiscal surplus to slightly decrease to 0.3% of GDP in 2025 driven by the impact of discretionary measures approved in 2024 and new measures included in the Draft Budgetary Plan. The impact of these measures, including higher public wages, the additional reduction of personal income tax rates, the revision of the youth personal taxation scheme will be largely offset by the still strong revenue growth, the unfreezing of the carbon tax and further reduction of the energy measures in 2025. Portugal's National Medium-Term Fiscal-Structural Plan 2025-2028 projects the headline fiscal surplus to narrow further to 0.1% of GDP in 2026, before increasing to 1.1% in 2027 and 1.3% in 2028. The fiscal adjustment planned by the government for 2025-2028 is driven principally by a reduction of primary expenditures of 3% of GDP, with approximately half linked to the phase out of the Portugal's Recovery and Resilience Plan (RRP) implementation and the rest linked to gradual decline in inflation and the dissipation of one-offs. Indeed, the deterioration of the structural primary balance during 2025-2026 is largely explained by the impact of RRF loan financed projects. Under a no policy change scenario, both the fiscal council and the central bank project weaker fiscal trajectories in the latter part of their forecast horizons compared to the government. The central bank forecasts moderate fiscal deficits from 2025 to 2027, while the fiscal council forecasts smaller surpluses, especially during 2027 and 2028. Over the medium term, the budgetary impact from Public-Private Partnerships (e.g., Porto-Lisbon high speed train project), national defence expenditure commitments with NATO, and social expenditures around health care could add pressure on public expenditures. While the fiscal uncertainty will likely increase over time, Morningstar DBRS views the risk of Portugal deviating significantly from its commitment to prudent fiscal policy as relatively low.

The Portuguese Economy Is Expected to Continue to Outperform the Euro Area in Coming Years But External Risks Loom

Portugal's recovery from the pandemic outpaced that of the eurozone. Portugal's real GDP in Q3 2024 was 7.1% higher than its pre-pandemic level, compared to 5.1% in the euro area. The recovery has been widespread and has been supported by the strength of the labour market, the boost from European funds, the resilience of the construction sector and the remarkable growth of the tourism sector. The Portuguese economy is expected to continue to outperform the euro area over the next few years. The Banco de Portugal projects real GDP growth at 1.7% in 2024 and to accelerate to 2.2% both in 2025 and 2026, before decelerating to 1.7% in 2027 as the RRP growth impulse fades. Solid increases in real disposable income, supported by a strong labour market, coupled with lower inflation and less restrictive financial conditions, are expected to benefit private consumption. The central bank expects investment to regain strength during 2025 and 2026 due to the increased adoption of the RRP. The gradual easing of financial conditions and the improving global outlook bode well for exports and investment, although significant risks remain.

Risks to Portugal's favourable growth prospects in the coming years are tilted to the downside, mainly linked to external risks. Escalating geopolitical tensions, which could disrupt trade flows and commodity markets, or the imposition of protectionist measures would hurt growth in Europe and Portugal. On top of this, the increasing housing affordability issues in Portugal if sustained could put pressure on competitiveness and limit growth over time. On the other hand, the strong real disposable income gains pose upside potential to consumption 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 (8.3% of GDP of 2023's GDP) in grants and loans, which comes on top of the EUR 33.6 billion (12.6% 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 -62.8% of GDP in Q3 2024 from -124.4% in 2014. The improvement was driven by current account surpluses and nominal economic growth. Similarly, net external debt has declined to 46.1% of GDP in Q3 2024 from 107.7% 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 has remained positive since 2013 except for the period 2020-22 as result of the pandemic-related collapse of the tourism industry and the energy shock later. Following a small surplus of 0.5% of GDP, the IMF projects current account surpluses of 1.9% of GDP for the 2024-2029 period. 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 Are Receding

The Portuguese banking system weathered the succession of shocks in recent years well, helped by stronger balance sheets, government support measures, and a 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 during 2023 and 2024 due to the rapid repricing of loan books to higher interest rates. The predominance of variable interest rate mortgages has helped in this regard. The nonperforming loan ratio continued declining to 2.4% in Q3 2024 from its peak of 20.1% in mid-2016, according to the European Banking Authority. This remains slightly above the European average of 1.9%. Less restrictive monetary policy 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, has continued despite tighter financial conditions in the euro area. Higher interest rates have only decelerated the growth in housing prices, at 7.8% in Q2 2024. Both mortgage lending and transactions are recovering after cooling down especially during 2023. The risk of a sharp correction impacting banks and the economy remains limited as housing supply bottlenecks and strong demand from non-residents remain supportive. The financial stability risks from the residential real estate exposure are mitigated by the rapid deleveraging of the household sector 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 (effective in October 2024) and a countercyclical capital buffer of 0.75% (effective January 2026) should help contain further build-up of risks and strengthen the resiliency of the banking sector against future shocks.

The Stability of the Current Government Reinforced by the Approval of the 2025 Budget, But More Tests Might Lie Ahead

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 approval in parliament of the 2025 budget, with the abstention from the Socialist Party, provides visibility for the fiscal plans in 2025 and reduces the risk of snap elections in the near term. Still, the center-right government's stability and ability to implement its political agenda could face challenges as the end of the current legislature approaches, given its minority position in parliament.

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 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.

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 Rights and Human Capital. Portugal's GDP per capita, estimated at USD 29,341 in 2024 according to the International Monetary Fund, remains relatively low compared with its euro system peers. Morningstar DBRS has taken this consideration 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 Factors in Credit Ratings (13 August 2024) https://dbrs.morningstar.com/research/437781.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments at https://dbrs.morningstar.com/research/445934.

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 (15 July 2024) https://dbrs.morningstar.com/research/436000. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings https://dbrs.morningstar.com/research/437781 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 (Medium-Term Fiscal-Structural Plan 2025-2028, October 2024; Draft Budgetary Plan 2025, October 2024; MoF Presentation, January 2025), Agência de Gestão da Tesouraria e da Dívida Pública (IGCP Investor Presentation, January 2025), Banco de Portugal (BdP: Economic Bulletin, December 2024; Financial Stability Report, November 2024; Press Release on Countercyclical Capital Buffer, December 2024), Instituto Nacional de Estatística Portugal (INE), Portuguese Public Finance Council (CFP, Analysis of the Draft State Budget for 2025, October 2024; Analysis of the National Medium-Term Fiscal-Structural Plan 2025-2028, October 2024), European Commission (Autumn 2024 Economic Forecast; Commission Opinion on the 2025 Draft Budgetary Plan of Portugal, November 2024; Commission Assessment of Portugal's Medium-Term Fiscal-Structural Plan, November 2024), Portuguese Environment Agency (National Energy Plan and Climate 2021-2030, October 2024), 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 Macrobond. 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/445933.

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: 10 November 2010
Last Rating Date: 19 July 2024

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