Editor's note (9 April 2019): The latest information on the rating, including full rating reports and related methodologies, are available at this LINK.

Scope Ratings GmbH has today affirmed Portugal’s BBB long-term issuer and senior unsecured local- and foreign-currency ratings and revised the Outlook to Positive. The short-term issuer rating has been affirmed at S-2 in both local and foreign currency with a Stable Outlook.

Rating drivers

The drivers for the Positive Outlook on Portugal’s long-term BBB rating reflect: i) the sustained debt reduction and resilient debt structure; and ii) the gradual unwinding of economic imbalances. In Scope’s assessment, both positive developments address the still meaningful challenges stemming from high public, private and external debt stock levels, elevated implicit liabilities and a low growth potential. The factors driving the Outlook revision relate to changes to Scope’s assessment of ‘Public Finance Risk’ but also the ‘Domestic Economic Risk’, ‘External Economic Risk’ and ‘Financial Stability Risk’ categories.

The first rating driver of the Positive Outlook reflects Scope’s expectation of the country’s sustained debt reduction, the profile of which, has also improved markedly over the past few years. Scope expects, in the context of relative political stability, the Portuguese authorities’ commitment to reducing the elevated public debt stock will continue even after the elections in October – regardless of the next government formation – and despite the cyclical slowdown.

Portugal’s fiscal balance stood at -0.5% in 2018, down from 11.2% in 2010, and is expected to stay close to balance, and even in surplus, over the coming years. The strong consolidation is supported by the favourable, albeit moderating growth outlook, but especially the high primary surpluses, which Scope expects to remain at around 2% to 2.5% of GDP in the medium term, among the highest in the euro area. While this adjustment has been driven mostly by cyclical factors stemming from the favourable economic environment and by a steady reduction in public investment, the gains from improving labour market conditions, resulting in lower benefits, as well as from lower interest charges, facilitated by the ECB’s accommodative monetary policy stance and by the early full repayment of more expensive IMF loans, are expected to persist over the coming years.

Looking ahead, Scope expects tax revenues to remain unaltered at around 43% of GDP, whereas expenditures are projected to continue their gradual decline from the peak of 51.8% of GDP in 2014 down to around 41.4% by 2022 (43.9% in 2018). This trajectory includes minor expenditure increases of around 0.2% of GDP in 2019 resulting from pressures to raise the wage bill. Still, these expenditure increases are also partially off-set by the ongoing spending review which is expected to yield savings of EUR 236 million (around 0.1% of GDP). The government has also extended spending reviews to new sectors including justice and internal affairs, education, healthcare (addressing persistent arrears, which at end-2018 amounted to around EUR 500mn), State Owned Enterprises (which are expected to achieve the first net income balance in 2019), public sector real estate management and centralised public procurement. Scope notes positively that, contrary to previous years, the declining expenditure trajectory will not come at the expense of public investments which are expected to increase to around 2.5% of GDP, still below the 5.3% recorded in 2010 but up from 1.8% of GDP in 2017.

Scope’s expectation of a broadly unchanged fiscal policy stance over the coming years is underpinned by the stable political environment, evidenced by a persistent 12pp polling advantage of the governing Socialist Party over the conservative Social Democratic Party since elections in 2015. While it is unclear with whom the Socialist Party will form a coalition, their continued leadership should limit major fiscal policy reversals. Thus, even in the absence of additional consolidation efforts, the EC’s baseline assumptions for the 2019-23 period point to an average structural primary balance of 2.2% of GDP for Portugal, well above those of Italy (0.4%) and Spain (-1.1%).

In this context, Portugal’s general government debt level, which peaked in 2014 at 130.6% of GDP, has gradually declined to 121.5% in 2018, which is below the level of Italy (131.1%) but still significantly above Spain (96.9%). Under Scope’s public debt sustainability analysis, based on IMF forecasts and a combination of growth, interest-rate and primary-balance shocks, the debt-to-GDP ratio is projected to fall to around 105% by 2023. Conversely, under an adverse scenario assuming a combined 1 percentage point shock to real GDP growth (lower) and interest payments (higher) and a 2pp shock to the primary balance (lower) for each year over the forecast horizon, the debt-to-GDP ratio would remain broadly unchanged at around 123% by 2023. The expected decline of Portugal’s debt-ratio underpins the Positive Outlook given that the estimated debt reduction of around 25pp from 2014 to 2023, also facilitated by a negative snowball effect in the coming years, excludes the government’s cash buffer which currently stands around EUR 9bn or 4% of GDP.

In this context, Scope also highlights Portugal’s active debt management, which, following the full early repayment to the IMF, bond buy-backs and exchanges as well as longer-term issuances, has smoothened the redemption profile, keeping gross financing needs below 20% of GDP over the coming years. Gross financing needs are estimated at EUR 16.9bn for 2019, down from EUR 20.6bn in 2018, and EUR 10.3bn in 2020. It is only in 2021 that financing needs rise again to EUR 17.0bn. Thus, over the 2019-2021 period, the cash buffer will remain well above 50% of the following year’s gross financing needs before dropping to around 41% in 2021 for the expected 2022 financing needs of EUR 15.8bn.

The second driver underpinning the Positive Outlook reflects the gradual unwinding of economic imbalances. Since Portugal exited the three-year economic adjustment programme in June 2014, its economy has grown, on average, around 1.9%, in line with the euro area, driven by the rebalancing of the economy towards the tradable sector, in particular tourism, strong private consumption due to the turnaround in the labour market and a sustained rebound in investment, which, excluding construction, is approaching pre-crisis levels. The increase in employment and economic stability has led to the resumption of investment and private consumption despite a marked decline in private-sector liabilities.

Portugal has recovered around 530k of the 800k jobs lost during the crisis and reduced unemployment to 6.6% as of December 2018, the lowest since 2002, and below the euro area average of 8.4%. At the same time, the Portuguese private sector has significantly reduced its indebtedness to levels similar to those of its euro-area peers. Based on ECB data, non-financial corporates have reduced their liabilities by EUR 34.4bn since Q1 2013 while households have reduced their liabilities more gradually, given that most loans are long-term mortgages, but still by EUR 16.3bn over the same period. As a result, corporate sector indebtedness fell from 141.5% of GDP to 101.3% as of Q4 2018, slightly below the euro-area average of 101.1%, while household indebtedness decreased from 90.0% to 67.1%, above the euro-area average of 57.6%. Similarly, Scope notes that the rebalancing of the Portuguese economy has resulted in minor current-account surpluses since 2013, which is a significant turnaround after a deficit of 12.1% in 2008, reflecting the greater openness of the Portuguese economy.

Despite these positive developments, considerable challenges remain: First, Portugal’s long-term economic growth prospects, estimated at around 1.5% – the third lowest rate among euro-area members, just above Italy and Greece – are constrained by structural bottlenecks, including weak productivity growth, in part due to low investment levels, skill shortages and unfavourable labour force demographics. Despite the recent recovery in investments, the overall investment-level of the economy, at 17.1% of GDP for 2018, remains significantly below the euro area average of 20.9% of GDP. Similarly, the percentage of the low skilled labour force, defined as individuals with lower secondary education or below, remained high at 46% in 2017, down from 61% in 2011 but still markedly above the EU average of 20%.

Second, despite the rebalancing of the external sector, current-account surpluses for a sustained period are necessary to gradually improve Portugal’s significant net debt position, which remains markedly below its peers at around negative 101% of GDP as of Q4 2018. The size of gross external liabilities is elevated, with Portugal’s total external debt at around 203% of GDP as of Q3 2018, slightly down since Q1 2010 (234%) but still above that of Spain (167%) and Italy (122%). Still, external risks have abated given i) the change in the composition of external debt, away from financial institutions given the on-going deleveraging process towards the government and central bank, and ii) a reduction in the share of portfolio debt securities of foreign liabilities from around 32% in Q1 2010 to around 18% as of Q4 2018, reflecting an improved debt-equity mix and official loans; a stable source of external funding.

Third, while the banking sector has undergone a significant restructuring and consolidation process, resulting in higher capitalisation levels (CET 1 ratio of 13.2%) and improved balance sheets (NPLs are down to 9.4% of total loans in Q4 2018 from the peak of 17.9% recorded in Q2 2016), challenges remain. These relate mostly to i) profitability pressures in the context of low interest rates, and ii) the relatively high exposure of the Portuguese banking system to government bonds (12.7% of total assets, 9% of which related to Portugal and 3.2% to Spain and Italy combined) and real estate assets (around 38.9%). While Scope does not expect a drop in real estate prices, a global reassessment of risk leading to higher government yields, would expose Portuguese banks particularly given their relatively high share of long-duration sovereign debt.

Finally, in line with peers, the ageing population is contributing to fiscal pressures in Portugal. Several reforms have improved the long-term sustainability of the pension system, albeit, according to the IMF, via a backloading effort to protect current pensioners. Still, until 2040, Portugal’s ageing-related expenditure increase of 3pp is mostly driven by healthcare, which is set to increase 1.8pp, more than twice the euro area average of 0.7pp. Overall, the ageing-expenditure burden is estimated at around 22.4% of GDP by 2040, above the euro area average (21.0%), Spain (20.6%) but below Italy (25.7%).

Core Variable Scorecard (CVS) and Qualitative Scorecard (QS)

Scope’s Core Variable Scorecard (CVS), which is based on the relative rankings of key sovereign credit fundamentals, provides an indicative ‘BBB’ (‘bbb’) rating range for the Portuguese Republic. This indicative rating range can be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative credit strengths or weaknesses versus peers based on qualitative analysis. For the Portuguese Republic, the following relative credit strengths have been identified: i) economic policy framework and ii) market access and funding sources. Relative credit weaknesses are: i) macroeconomic stability and sustainability. The combined relative credit strengths and weaknesses generate no adjustment and indicate a sovereign rating of BBB for the Portuguese Republic. A rating committee has discussed and confirmed these results.

Factoring of Environment, Social and Governance (ESG)

Scope considers sustainability issues during the rating process as reflected in its sovereign methodology. Governance factors are explicitly captured in Scope’s assessment of ‘institutional and political risk’ under its methodology, in which Portugal has moderate scores on a composite index of six World Bank Worldwide Governance Indicators.

Social factors are reflected in Portugal’s comparatively moderate GDP per capita, declining rates of unemployment, and high old-age dependency ratios (for 2020, the third highest after Italy and Finland among euro area peers). In addition, Scope observes that the comparatively elevated, albeit declining, level of low-skilled and low-income jobs may weigh negatively on productivity and the tax base in the long run as well as increase the risk of sustained income inequality, poverty and social exclusion among vulnerable groups. Finally, environmental factors are considered during the rating process, but did not play a direct role in this rating action.

Outlook and rating-change drivers

The Positive Outlook reflects i) Scope’s view that, in the context of relative political stability, the Portuguese authorities’ commitment to reducing the elevated public debt stock will continue even after the elections in October – regardless of the next government formation – and despite the cyclical slowdown and ii) the continuous unwinding of economic imbalances.

The rating could be upgraded if the sovereign: i) achieves sustained debt reduction, ii) implements additional reforms, raising the country’s medium-term growth potential, and/ or iii) further reduces its economic imbalances. Conversely, the Positive Outlook could be reversed to Stable if: i) public finances deteriorate due to a reversal of fiscal consolidation, ii) there is a fading commitment to or a reversal of structural reforms, leading to an adverse impact on the medium-term economic and fiscal outlook, and/ or iii) the economic imbalances were to increase further.

Rating committee
The main points discussed by the rating committee were: i) Portugal’s growth potential; ii) macroeconomic stability and sustainability; iii) fiscal consolidation, contingent liabilities, public-debt sustainability, debt structure and market access; iv) external debt sustainability and vulnerability to external shocks; v) banking sector performance and private-sector deleveraging; vi) political developments; and vii) peers.

Methodology
The methodology applicable for this rating and/or rating outlook, ‘Public Finance Sovereign Ratings’, is available on http://www.scoperatings.com. The historical default rates used by Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. Please also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope’s definition of default and definitions of rating notations can be found in Scope’s public credit rating methodologies on www.scoperatings.com. The rating outlook indicates the most likely direction in which a rating may change within the next 12 to 18 months. A rating change is, however, not automatically a certainty.

Solicitation, key sources and quality of information
The rating was initiated by Scope and was not requested by the rated entity or its agents. The rated entity and/or its agents did participate in the ratings process. Scope had access to accounts, management and/or other relevant internal documents for the rated entity or related third party. The following material sources of information were used to prepare the credit rating: public domain and third parties. Key sources of information for the rating include: Ministry of Finance of Portugal, the Bank of Portugal, the BIS, the European Commission, the European Central Bank, Instituto Nacional de Estatística Portugal, Portuguese Treasury (IGCP), Eurostat, the IMF, the OECD, and Haver Analytics.
Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data. Prior to publication, the rated entity was given the opportunity to review the rating and/or outlook and the principal grounds upon which the credit rating and/or outlook is based. Following that review, the rating was not amended before being issued.

Regulatory disclosures
This credit rating and/or rating outlook is issued by Scope Ratings GmbH.
Rating prepared by Alvise Lennkh, Director
Person responsible for approval of the rating: Dr Giacomo Barisone, Managing Director
The ratings/outlook were first assigned by Scope as a subscription rating in January 2003. The ratings/outlooks were last updated on 8.06.2018.

Potential conflicts
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.

Conditions of use / exclusion of liability
© 2019 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Analysis GmbH, Scope Investor Services GmbH and Scope Risk Solutions GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data. Scope’s ratings, rating reports, rating opinions, or related research and credit opinions are provided ‘as is’ without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or other damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party as, opinions on relative credit risk and not a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings GmbH at Lennéstrasse 5, D-10785 Berlin.

Scope Ratings GmbH, Lennéstrasse 5, 10785 Berlin, District Court for Berlin (Charlottenburg) HRB 192993 B, Managing Directors: Torsten Hinrichs and Guillaume Jolivet.