Portugal’s External Adjustment Expected to Begin This Year

Fitch Ratings has said in a new comment that it views a significant adjustment in Portugal’s external finances as inevitable during 2011. The European Central Bank (ECB) has been covering a large share of the economy’s net external financing needs since April 2010 via repo operations with Portuguese banks.

Although the stock of ECB repo liabilities declined from August to December, it is nevertheless still a clear sign of stress in the country’s external finances. The current account deficit (CAD) also remained large at 9.5% of gross domestic product (GDP) in the 12 months to October 2010. As noted in its 23 December 2010 commentary, the agency is now forecasting a recession in 2011 – a 1% contraction in GDP – which will start to narrow the CAD this year.

The timing and scale of the adjustment in Portugal’s external finances is important and will depend on both external and domestic factors. Externally, an improvement in market conditions and continued official support would allow the adjustment to be smoothed over time. The government’s consolidation plans will play a vital role in restoring confidence in the country (which should lower borrowing costs) and reorienting economic growth away from consumption towards exports. Foreign demand for Portuguese goods and services will also affect the pace of adjustment. Fitch expects the ECB’s ‘non-conventional’ liquidity support to be extended as long as needed.

Despite clear downside risks, Fitch is forecasting the adjustment to be smoothed over the medium term. Government consolidation should help to restore market confidence over the course of 2011. The agency also expects the ECB (and other official lenders if necessary) to continue to provide a backstop to external financing if the market retreats further.

On 23 December 2010, Fitch downgraded Portugal’s rating by one notch to A+ and retained the negative outlook. This reflected the slow pace of external adjustment to date and risks to economic and budgetary performance.


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