Portugal Ratings Affirmed with Negative Outlook

Fitch Ratings has affirmed Portugal’s long-term foreign and local currency issuer default ratings (IDRs) at BB+. The outlooks are negative. Fitch has simultaneously affirmed Portugal’s country ceiling at AAA and short-term foreign currency IDR at B.

The affirmation reflects the progress made under the International Monetary Fund (IMF)/EU programme to date, but rising political, implementation and macroeconomic risks warrant the maintenance of a negative outlook. Although the programme remains on track, it is going through a delicate phase. Cross-party commitment to its implementation and social cohesion are being tested by the 2013 budget, while institutional constraints could limit the government’s room for manoeuvre. Institutional gridlock leading to policy paralysis would be negative for the rating.

The current account has declined to 3.7% of gross domestic product (GDP) in 2012 from a peak of 12.6% of GDP in 2008, according to Fitch’s estimates. External competitiveness measures are improving. The flipside is that domestic demand is contracting and the unemployment rate is increasing at a faster pace than anticipated. This ‘internal devaluation’ is a painful process but remains, in the agency’s view, necessary to restore Portugal’s competitiveness within the eurozone.

Fitch expects real GDP to contract by 1.5% in 2013 before gradually recovering in the medium term. There are significant downside risks to this forecast. The recently adopted 2013 budget, which includes measures worth around €5.3bn (3.2% of GDP), is strongly reliant on revenue-raising measures and thus likely to exert further negative pressure on economic growth. Moreover, difficult economic conditions in Spain, Portugal’s main trading partner, could also hamper GDP growth in 2013.

The weak economic outlook will continue to challenge the government’s deficit reduction plan. Given the sharp revenue shortfalls in 2012, the Troika, which includes the European Central Bank (ECB), has already agreed to revise the fiscal deficit targets to 5% of GDP in 2012 and 4.5% of GDP in 2013, from 4.5% and 3% previously. The 2014 target remains unchanged at 2.5% of GDP.

Fitch judges the government’s commitment to the programme to be strong. The agency’s baseline is that the programme targets will be met. Still, despite the strong commitment to the programme, fiscal adjustment still has some way to go and the risk of slippage remains large. In the event of slippage caused by a deeper economic contraction, Fitch believes the Troika will allow further target revisions as long as Portugal remains on track with programme implementation.

Portugal is still at an early stage of its adjustment. A sizeable effort is required to achieve sustainable public finances in the medium-term. Portugal will have to maintain primary surpluses of 3% of GDP a year from 2013 to stabilise public debt at 116% of GDP by 2020, with risks to the downside should a reformed economy fail to outperform the long-term growth rate of barely 2% in 1992-2008.

However, the social cohesion and political consensus that has facilitated implementation of the government’s austerity measures has started to wane, raising concerns about reform fatigue. The IMF-EU programme supports Portugal’s sovereign rating. While the macroeconomic adjustment takes place, external funding support remains crucial to underpin confidence. Portugal’s €78bn financial assistance programme and government commitment to its conditions alleviate short-term liquidity concerns. It also helps accelerate the pace of structural reforms which will underpin productivity growth and competitiveness in the medium term.

The recent bond-exchange has improved Portugal’s funding profile as the operation cuts the €9.6bn repayment due in September 2013 to €5.8bn. However, Fitch’s base case remains that further official support will be needed and provided over the medium term. The weak economic outlook in Portugal, the size of the fiscal adjustment and fragile nature of the eurozone sovereign debt market means there would need to be a significant improvement in sentiment for it to return to the market in full next year.

Political uncertainty or material slippage in fiscal consolidation could put negative pressure on the ratings. Weaker than expected GDP growth, leading to a significantly higher peak in public debt would also be a trigger for negative rating action.

Conversely, evidence that the adjustment is working as planned (with the continued reduction of current account and fiscal deficits) and the moderation of the eurozone crisis would stabilise the rating outlook.

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