DBRS Confirms Republic of Portugal at BBB, Stable Trend

DBRS Ratings Limited (DBRS) confirmed the Republic of Portugal’s Long-Term Foreign and Local Currency – Issuer Ratings at BBB and Short-Term Foreign and Local Currency – Issuer Ratings at R-2 (high). The trend on all ratings remains Stable.

KEY RATING CONSIDERATIONS

The confirmation of the Stable trend reflects DBRS’s view that risks to the rating are broadly balanced. Although moderating in the first half of 2018 compared to 2017, real GDP growth is projected at a healthy 2.3% for the full year, still above the euro area average. The fiscal deficit and the government debt-to-GDP ratio are expected to continue declining, and Portuguese banks’ non-performing loans (NPLs) are decreasing. Nevertheless, the still high government debt ratio limits the fiscal space and leaves public finances vulnerable to negative shocks. NPLs also remain high, especially in the corporate sector.

The ratings are supported by Portugal’s Eurozone membership and its adherence to the EU economic governance framework, which help foster credible and sustainable macroeconomic policies. A favourable public debt profile and a sound current account position, in part supported by improved trade competitiveness, also support the rating. However, Portugal faces significant credit challenges, including elevated levels of public sector debt, high NPLs and corporate sector debt, and still relatively low growth potential.

RATING DRIVERS

The ratings could come under upward pressure as a result of sustained primary surpluses and steady economic growth, leading to a further reduction in the public debt ratio. Additional progress in reducing NPLs could also be positive for the ratings. Nevertheless, the ratings could come under downward pressure if there is a reversal in the downward trajectory in public debt, a material deterioration in growth prospects, or a weakening in the political commitment to sustainable economic policies.

RATING RATIONALE

The Economy Continues to Perform Well

Following strong and partly cyclical growth of 2.8% in 2017 – the highest rate since 2000 – growth has moderated in 2018 in line with the trend seen in the euro area. A slowdown in investment has driven the moderation. Nevertheless, growth is projected at a healthy pace for the full year. Labour market conditions continue to improve, with the unemployment rate falling to 6.8% in August 2018. In DBRS’s view, downside risks to the near-term growth outlook are mainly external, related to a sharper-than-expected tightening in financial conditions and rising trade protectionism. For the next three years, the Portuguese government expects growth to remain around 2.3% each year, while the IMF and the Bank of Portugal forecast slower growth rates.

Raising the growth of potential output is important in the longer run. Higher growth would help reduce high levels of public and private sector debt. Over the past few years, the ability of Portugal to grow has been improving. While still lower than an average of close to 2.0% in the decade to 2007, various estimates indicate faster growth potential in the near-term. Although still below pre-crisis levels, investment is recovering, and employment rates have increased. However, low productivity growth and a declining working-age population remain a concern. (For further details, please see DBRS commentary entitled “Italy and Portugal – Improving Their Ability to Grow”, available at www.dbrs.com).

The Fiscal Deficit and The Public Debt Ratio Continue to Decline

The budget position continues to improve. Driven by strong tax revenues and contained public spending, the headline deficit fell to 0.9% of GDP in 2017, excluding the capital injection to state-owned bank CGD for €3.9 billion (equivalent to 2% of GDP). The primary surplus reached a new high of 3.0% (excluding one-offs). In 2018, the deficit is projected to decline to 0.7%. This projection incorporates the capital transfer to Novo Banco (via the Resolution Fund). Under a contingent capital mechanism, the Fund is responsible for the compensation of losses up to EUR 3.9 billion on some of Novo Banco’s problematic assets, if the capital ratio falls below certain level. Over the next five years, projections indicate an average primary surplus between 2.2% and 3.8%, well above the debt-stabilising primary balance.

High expenditure in the health sector remains the main risk to the fiscal outlook. Some state-owned enterprises (SOEs) also continue to be loss-making, and some of the temporary austerity measures adopted during the IMF/EU economic adjustment programme have been reversed. While not a risk to the budget, persistent arrears in hospitals is an indication of fiscal mismanagement. In the longer term, adverse demographic trends could pose a challenge to the pension system.

Nevertheless, risks to the fiscal outlook seem contained. Ongoing spending reviews on various sectors, including the health sector and SOEs, as well as incentives to find additional savings in the public administration, are important efforts. Indeed, further adjustment in structural terms is needed to meet the medium-term objective of a structural balance of 0.25%, which the government aims to achieve by 2020 – one year earlier than previously planned.

The government debt ratio is projected to continue declining. In 2017, the ratio posted its first significant reduction since the crisis. The government debt-to-GDP ratio fell to 124.8%, after stabilising at around 130% in 2014-2016. For 2018, the government’ Stability Programme forecasts a ratio of 122.2%. The reduction of public debt is being driven by a higher primary surplus, economic growth and lower interest costs. Sustained primary surpluses and steady growth over time are needed to maintain the downward trajectory of public sector debt. According to the Stability Programme’s forecasts, the debt ratio is set to fall below 110% by 2021. The still high debt ratio leaves public finances vulnerable to negative shocks, particularly a materialisation of contingent liabilities and an adverse growth shock.

The public debt profile is favourable, which reduces rollover risks. Through active debt management operations, extension of EFSF and EFSM loans, and early repayments of IMF loans, debt maturities have been extended. Fixed-rate debt accounts for 90% of total debt. Moreover, interest costs have been falling from 4.9% of GDP in 2012-2014 to a projected 3.5% in 2018, closer to pre-crisis levels. Portugal’s favourable financing conditions have benefited from the ECB’s Public Sector Purchase Programme. The ECB has reduced the monthly net asset purchases and announced its intention to stop them at the end of 2018, but investor sentiment has so far remained benign.

The Decline of High Levels of Corporate Debt and Non-Performing Loans Is Progressing

The high levels of NPLs and corporate sector debt remain the key risks to financial stability. Non-financial corporate debt has fallen from a peak of 142% of GDP in 2013 to 104% in Q1 2018, still relatively high. After reaching a peak of 17.9% in Q2 2016, the banking system’s NPL ratio has also declined, standing at 11.7% in Q2 2018, according to Bank of Portugal. Almost two thirds of the banking system’s total NPLs relate to corporate NPLs. The NPL ratio in the corporate sector, while lower, remains high at 22.3%. Improved economic conditions are contributing to the reduction of NPLs. Portugal is also following a strategy comprising three pillars: 1) Legal and judiciary reform; 2) Prudential supervisory action; and 3) NPL management. (For further details, please see DBRS commentary entitled “Portugal: Tackling Risks to Financial Stability is Paying-off”, available at www.dbrs.com). Another risk could emerge to mortgage holders from sharp increases in interest rates, as most residential mortgages are at variable interest rates.

The banking sector continues to recover. Bank capital increases in 2017 and higher cash coverage levels placed the banking sector in a better position. Banks, excluding Novo Banco, also returned to profitability. Domestic profitability is improving helped by a better operating environment. Direct and indirect exposure of the banking sector to the residential real estate market accounts for almost 40% of the sector’s total assets. Therefore, the 33% rise in house prices since the beginning of 2015 is favourable for banks. However, sustained strong increases in house prices would raise concerns. In response to the acceleration in house prices and strong consumer credit over the past year, the Bank of Portugal has adopted some macroprudential measures. DBRS sees risks to financial stability as gradually receding.

The Large Net External Debtor Position Is Gradually Improving

On the external sector, the current account position remains sound, contributing to the reduction of external liabilities. In part supported by improved trade cost and non-cost competitiveness, the current account has remained in small surplus, averaging 0.7% of GDP between 2013 and 2017. Services exports have been strong, driven by tourism, resulting in a surplus in the services balance. Although external accounts have improved from a flow perspective, the stock of net external liabilities remains high. The negative net international investment position stood at 106% of GDP in 2017, but it appears on a declining trend. Sustained current account surpluses are needed to reduce Portugal’s net external liabilities.

The Government Continues to Demonstrate Commitment to the EU Framework

Portugal benefits from a broadly stable political system. The Socialist government has a minority position in the parliament and support from the Left Bloc, the Communists and the Greens. DBRS expects political dynamics to remain broadly stable, as popular support remains centred on mainstream pro-European political parties.

The government has also shown ongoing commitment to further fiscal adjustment. Although the governing party’s minority position raised concerns in the past about its ability to maintain a durable long-term fiscal strategy, the government has ensured compliance with the fiscal rules under the EU Stability and Growth Pact. DBRS expects Portugal’s commitment to the EU framework to remain solid.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the A (low) – BBB range. The main points discussed during the Rating Committee include economic performance and outlook, fiscal performance and risks, outlook for public debt, and the banking sector.

KEY INDICATORS

Fiscal Balance (% GDP): -3.0 (2017); -0.7 (2018F); -0.2 (2019F)
Gross Debt (% GDP): 124.8 (2017); 122.2 (2018F); 118.4 (2019F)
Nominal GDP (EUR billions): 194.6 (2017); 200.2 (2018F); 207.0 (2019F)
GDP per Capita (EUR): 18,790 (2017); 19,376 (2018F); 20,000 (2019F)
Real GDP growth (%): 2.8 (2017); 2.3 (2018F); 2.3 (2019F)
Consumer Price Inflation (%): 1.6 (2017); 1.4 (2018F); 1.4 (2019F)
Domestic Credit (% GDP): 253.6 (2017); 250.5% (Mar-2018)
Current Account (% GDP): 0.5 (2017); 0.7 (2018F); 0.7 (2019F)
International Investment Position (% GDP): -104.9 (2017); -105.7% (Jun-2018)
Gross External Debt (% GDP): 209.4 (2017); 207.7% (Jun-2018)
Governance Indicator (percentile rank): 85.6 (2016); 87.5 (2017)
Human Development Index: 0.85 (2016); 0.85 (2017)

Notes:

All figures are in EUR unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Notes: Forecasts based on the 2018-2022 Stability Programme. Fiscal balances include one-offs related to capital injections to Caixa Geral de Depositos and Novo Banco (2.0% in 2017; 0.4% in 2018). Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The sources of information used for this rating include Ministry of Finance of the Republic of Portugal, Agência de Gestão da Tesouraria e da Dívida Pública (IGCP), Banco de Portugal (BdP), Instituto Nacional de Estatistica Portugal (INE), Portuguese Public Finance Council (CFP), European Commission, European Central Bank (ECB), Statistical Office of the European Communities (Eurostat), OECD, IMF, World Bank, UNDP, Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

This is an unsolicited rating. This credit rating was not initiated at the request of the issuer.

This rating included participation by the rated entity or any related third party. DBRS had no access to relevant internal documents for the rated entity or a related third party.

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.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period. DBRS’s outlooks and ratings are under regular surveillance.

For further information on DBRS 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.

Ratings assigned by DBRS Ratings Limited are subject to EU and US regulations only.

Lead Analyst: Adriana Alvarado, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global Financial Institutions Group
Initial Rating Date: 10 November 2010
Last Rating Date: 20 April 2018

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