DBRS Confirms Republic of Portugal at BBB, Trend Changed to Positive

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 has been changed to Positive.

KEY RATING CONSIDERATIONS

The Positive trend reflects DBRS’s view that risks to the ratings are tilted to the upside. The fiscal deficit is slowly approaching balance and the government debt-to-GDP ratio is declining at a healthy pace. Portuguese banks’ non-performing loans (NPLs) are also decreasing in a meaningful way. Although real GDP growth is moderating, economic performance is expected to remain above the euro area average. In contrast, the level of public and private financial metrics still signals vulnerabilities. The high government debt ratio limits the government’s fiscal capacity to manage negative shocks, and the still high stock of NPLs – particularly in the corporate sector – weighs on financial stability.

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. Also supporting the ratings are a favourable public debt profile and balanced external sector metrics, in part supported by improved trade competitiveness. However, Portugal faces significant credit challenges, including elevated levels of public sector debt, high albeit declining NPLs and corporate sector debt, and still relatively low growth potential.

RATING DRIVERS

The ratings could be upgraded if sustained primary surpluses and steady economic growth further reduce the public debt ratio broadly in line with current DBRS expectations. A continuation of the progress made in reducing NPLs could also be positive for the ratings.

Although less likely under current assumptions, ratings could return to Stable trend if there is a material weakening in growth prospects, in the current fiscal path or debt trajectory, or in the political commitment to sustainable macroeconomic policies.

RATING RATIONALE

Repair of the Fiscal Deficit is Credit Positive

The budget position is gradually approaching balance. Driven by strong tax revenues and contained public spending, the headline deficit has steadily improved from the 7.2% result in 2014. The deficit declined from 3.0% of GDP in 2017 (0.9% excluding the recapitalization of Caixa Geral de Depositos) to 0.5% in 2018. This includes the capital transfer to Novo Banco via the Resolution Fund. The government anticipates a budget surplus in 2020 and expects the primary surplus – of 3.0% of GDP in 2018 – to persistently improve over the forecast period. The Stability Programme forecasts a 4.4% primary surplus by 2022, well above the IMF’s debt-stabilising primary deficit calculation of roughly balance.

Long-term risks to fiscal performance primarily stem from high expenditures in concentrated sectors. Some of the temporary austerity measures adopted during the IMF/EU economic adjustment programme have been reversed, and some state-owned enterprises (SOEs) are persistently loss-making. 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 appear 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. Further adjustment in structural terms is needed to meet the medium-term fiscal objective. The Stability Programme projects a structural fiscal position as a share of potential GDP to improve from a 1.0% deficit in 2017 to a 0.3% surplus in 2020.

The Comparatively High Public Debt Ratio Continues to Decline

For the second straight year, reduction in the public debt ratio in 2018 was significant. After stabilising at around 130% in 2014-2016, debt declined to 121.5% last year. 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 still needed to maintain the downward trajectory of public sector debt. Debt dynamics suggest a persistent downward decline in the debt ratio, which the 2019 State Budget expects to fall to 118.5% this year and 2018-2022 Stability Programme projects a result of 102% by the end of the forecast period. Irrespective of the favourable downward trend of debt dynamics, public debt remains comparatively high. This leaves public finances vulnerable to negative growth shocks or the materialisation of contingent liabilities.

Portugal’s favourable public debt profile 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. Full repayment of the IMF loan was completed in 2018. Fixed-rate debt accounts for approximately 90% of total debt. Moreover, general government interest expenditures have been falling from 4.9% of GDP in 2012-2014 to 3.5% in 2018, closer to pre-crisis levels. Recent 2019 bond issuances have been at all-time low yields. This suggests strong investor sentiment for government bonds, even as the ECB ended its net purchases of public assets and entered the reinvestment phase.

Economic Growth Performance to Moderate Along with External Demand

GDP growth slowed in 2018 to 2.1%, following the 2.8% 2017 result. Weaker external demand and export growth from the general slowdown among EU partners was the main cause for the moderation. In contrast, domestic demand remained strong. Private consumption has been supported by healthy job creation and wage growth, while non-construction related investment has picked up. Investment is set to rebound further in 2019 as the private sector continues to deleverage, capacity utilization increases, and there is greater absorption of EU structural funds. The European commission, the IMF and the Bank of Portugal forecast growth to moderate to around 1.7%-1.8% in the next few years. Given the link between external demand and domestic investment decisions, downside risks to the near-term growth outlook stem primarily from further deterioration in the external environment.

The current account, which averaged a 0.7% of GDP surplus between 2013 and 2017 due to improved trade cost and non-cost competitiveness, is expected to have declined to a broadly balanced position last year and to turn negative in 2019-2020. The deterioration of the current account is due to strong import demand and weakening of the goods balance, even as services exports driven by tourism remain strong. While the shift in the current account back to deficit does not, in DBRS’s view, point to a return of economic imbalances, Portugal will likely need sustained current account surpluses to reduce its high stock of net external liabilities. The negative net international investment position stood at 101% of GDP in 2018.

Risks to Financial Stability are Gradually Receding

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 101% in the third quarter of 2018, according to the IMF’s International Financial Statistics. After reaching a peak of 17.9% in mid-2016, the banking system’s NPL ratio declined to 9.4% in 2018, according to Bank of Portugal. Almost two thirds of the banking system’s total NPLs relate to non-performance in the corporate sector, where the NPL ratio remains high at 18.5%, down from the 30% peak in 2016. 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.

The banking sector continues to recover. Bank capital increases in 2017 and higher cash coverage levels placed the banking sector in a better position. Excluding Novo Banco, banks have been profitable since 2017. Bank profitability is supported by a better operating environment, lower cost of risk, and the steady rise in real estate prices. The banking sector’s direct and indirect exposure to the residential real estate market accounts for almost 40% of the sector’s total assets. Housing price growth cooled some in 2018 but sustained strong increases in house prices could begin to raise concerns. The Bank of Portugal has adopted macroprudential measures in response to the acceleration in house prices and strong consumer credit.

Regardless of the Election Outcome, DBRS Still Expects Strong Commitment to the EU Framework

Portugal benefits from a broadly stable political system. The government led by the Socialist Party (PS) has a minority position in the parliament and support from the Left Bloc, the Communists, and the Greens. 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.

Legislative elections are scheduled for October of this year. According to a Eurosondagem poll conducted in March 2019, the PS would outperform its showing from 2015 by around five percentage points. If these results hold, the PS would not capture an absolute majority, which would necessitate the formation of another coalition government. The opposition Social Democratic Party trails the PS by double digit points according to the same poll. Irrespective of the election outcome, DBRS expects political dynamics to remain broadly stable, as popular support remains centred on mainstream pro-European political parties.

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 progress on NPL reduction, economic and fiscal performance, and the outlook for public debt.

KEY INDICATORS

Fiscal Balance (% GDP): -0.5 (2018); -0.6 (2019F); -0.2 (2020F)
Gross Debt (% GDP): 121.5 (2018); 119.2 (2019F); 116.8 (2020F)
Nominal GDP (EUR billions): 201.6 (2018); 208.4 (2019F); 215.3 (2020F)
GDP per Capita (EUR): 19,589 (2018); 20,260 (2019F); 20,939 (2020F)
Real GDP growth (%): 2.1 (2018); 1.8 (2019F); 1.7 (2020F)
Consumer Price Inflation (%): 1.7 (2018); 1.6 (2019F); 1.8 (2020F)
Domestic Credit (% GDP): 256.1 (2017); 247.9% (Sep-2018)
Current Account (% GDP): -0.6 (2018); 0.1 (2019F); 0.0 (2020F)
International Investment Position (% GDP): -104.9% (2017); -100.8% (2018)
Gross External Debt (% GDP): 209.4 (2017); 204.7% (2018)
Governance Indicator (percentile rank): 87.5 (2017)
Human Development Index: 0.85 (2017)

EURO AREA RISK CATEGORY: LOW

Notes:
All figures are in EUR unless otherwise noted. Public finance statistics reported on a general government basis unless specified. The 2018 fiscal balance and gross debt figures from latest Instituto Nacional de Estatistica Portugal. Forecasts from European Commission. Fiscal balances include one-offs related to capital injections to Novo Banco (0.4% in 2018). GDP and inflation figures and forecasts from Instituto Nacional de Estatistica Portugal and the European Commission. Domestic credit and external debt from Bank of Portugal and Instituto Nacional de Estatistica Portugal. 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: Jason Graffam, Vice President, Global Sovereign Ratings
Rating Committee Chair: Alan Reid, Group Managing Director, Global Financial Institutions & Sovereign Ratings
Initial Rating Date: 10 November 2010
Last Rating Date: 12 October 2018

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