Scope upgrades Portugal’s credit rating to BBB+ and revises the Outlook to Stable
A prudent fiscal policy, sustained public debt reduction, a resilient debt profile and the gradual unwinding of economic imbalances drive the upgrade; a modest growth potential, high external debt and implicit liabilities are constraints.
For the rating action annex, click here.
Scope Ratings GmbH has today upgraded Portugal’s long-term issuer and senior unsecured local- and foreign-currency ratings to BBB+ from BBB and revised the Outlook to Stable. The short-term issuer rating has been affirmed at S-2 in both local and foreign currency with a Stable Outlook.
The drivers for the upgrade of Portugal’s long-term ratings to BBB+ reflect: i) the prudent fiscal policy, underpinned by the re-elected government’s commitment to maintain elevated primary surpluses to reduce the public debt burden, with the profile of debt having also markedly improved in recent years; and ii) the gradual unwinding of economic imbalances. The factors driving the upgrade relate to changes to Scope’s assessment of the ‘Public Finance Risk’ but also the ‘Domestic Economic Risk’ and ‘External Economic Risk’ categories of its sovereign methodology. The Stable Outlook balances these credit strengths with the still meaningful challenges stemming from the country’s relatively modest growth potential, the elevated external debt stock and implicit liabilities.
The first driver of the upgrade to BBB+ reflects the country’s prudent fiscal policy and sustained reduction in debt, the profile of which has also improved markedly in recent years. In the context of the relative political stability following the Socialist government’s re-election in October 2019, Scope expects Portuguese authorities to maintain their commitment to reduce the still-elevated public debt stock over the coming four-year legislature (until 2023) despite the cyclical economic slowdown.
Portugal’s fiscal deficit is expected at around 0% of GDP in 2019, down from -11.4% in 2010, and is expected to stay close to balance over the coming years, resulting in an average structural deficit of around 0.4% of GDP for 2019-21 based on European Commission estimates, well below that of Italy (2.5%) and Spain (3.1%). 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 2.5%-3.0% of GDP in the medium term, amongst the highest in the euro area. Revenues should remain between 43-44% of GDP, broadly in line with levels in the past 10 years, whereas expenditures are projected to remain close to about 44% of GDP, following a marked decline from the peak of 51.9% in 2010. Portugal’s fiscal strategy aimed at achieving balanced budgets whilst financing slightly higher public wages and social payments will thus be based on i) strong cyclical revenue; ii) lower interest expenditure, which is estimated at 2.9% of GDP for 2020, markedly below the peak of 4.9% in 2014; and iii) subdued public investment at about 2% of GDP, significantly below the 5.3% in 2010 and the euro area average of 2.8% but up from 1.8% in 2017. Absent a further activation of the Novo Banco contingent capital mechanism beyond the 0.3% of GDP budgeted for 2020, the primary surplus is thus expected to stay at around 3.0% of GDP in 2020 and to increase to 3.4% in 2021.
Portugal’s prudent fiscal policy has led to a gradual decline of the general government debt level, which peaked at 132.9% of GDP in 2014, to 118.9% in 2019, below Italy’s (136.2%) but still significantly above Spain’s (96.7%). Under Scope’s public debt sustainability analysis, the debt-to-GDP ratio is projected to fall to below 105% by 2024. This compares to the government’s target of a public debt-to-GDP ratio of below 100% by 2023, which assumes slightly higher growth rates and primary surpluses. The expected further decline of Portugal’s debt ratio by around 15pp to 20pp until 2024, facilitated by a negative snowball effect in the coming years, significantly outperforms the debt trajectories of Italy and Spain and underpins the upgrade to BBB+. This is further bolstered by the fact that the estimated debt reduction excludes the government’s cash buffer, currently at around EUR 7bn or 3.5% of GDP.
In this context, Scope also highlights that the broadly balanced budgets and Portugal’s active debt management, including the voluntary repayments of all IMF loans by 2018 and of EUR 2bn to the EFSF in October 2019, bond buy-backs and exchanges as well as longer-term issuances, have smoothened the redemption profile, keeping gross financing needs below 10% of GDP over the coming years. While the cash buffer will continue to decline steadily until 2022, from EUR 9.8bn in 2017 to about EUR 4.5bn in 2022, it will still cover 30-40% of the following year’s gross financing needs. This buffer, coupled with a long average debt maturity of around eight years (including official loans), the ECB’s decision in September 2019 to restart net asset purchases at EUR 20bn a month, and the country’s relative political stability and strong commitment to fiscal consolidation, have bolstered investor confidence. As a result, Portugal’s cost of issuance per year has fallen to around 1.1% in 2019 from the peak of 5.8% in 2011, which is also reflected in the 10-year government bond yield, now trading around 0.4%, in line with Spain’s and below Italy’s (1%).
The second driver underpinning the upgrade to BBB+ reflects the gradual unwinding of economic imbalances. Portugal has grown 2.3% on average over the past five years and above the euro area average since 2016. This has been driven by the economy's rebalancing towards the tradeable sector, in particular tourism; strong private consumption due to the labour market turnaround; and a sustained rebound in investment, which, excluding construction, now exceeds pre-crisis levels by about 20%.
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. Specifically, Portugal has recovered around 590k of the 800k jobs lost during the crisis and reduced unemployment to 6.9% as of December 2019, below Spain’s (13.7%) and Italy’s (9.8%) and the euro area average of 7.4%, based on European Commission data. The employment rate has reached an all-time high at around 75%, almost 10pp above its 2013 level and outperforming those of peers Italy and Spain.
These strongly improved labour market conditions are not only supporting domestic demand but also the continued deleveraging. Based on ECB data, private sector debt is now in line with the euro area average, at around 165% of GDP as of Q3 2019, down from 230% in Q1 2013. Liabilities of non-financial corporates have been reduced by EUR 40.5bn since Q1 2013 while those of households have been reduced more gradually, as most of the loans are long-term mortgages, but still by EUR 25.2bn over the same period. As a result, corporate sector indebtedness fell from 140% of GDP to 99.5% as of Q3 2019, slightly below the euro area average of 108.5%, while household indebtedness decreased from 90.1% to 64.9%, slightly above the euro area average of 57.9%.
Looking ahead, Scope expects economic growth to slow from 2.0% in 2019 to around 1.5% over the coming years, with growth driven mainly by domestic demand that is somewhat curtailed by more subdued investment growth and a slightly weaker contribution from net exports. Downside risks to the growth outlook thus stem mostly from the uncertainty of the external environment, in particular, the persistence of trade tensions that have harmed Portugal’s main trading partners in Europe.
Despite these positive developments, considerable challenges remain:
First, Portugal’s long-term economic growth prospects, estimated at around 1.5%, slightly below Spain’s (1.7%) but above Italy’s (0.7%), are still constrained by structural bottlenecks, including modest productivity growth, in part due to still-too-low investment levels, skills shortages and unfavourable labour force demographics, with Portugal’s working-age population down by about 360k over the past 10 years. Despite the recent recovery in investments from a trough of 14.4% of GDP in Q1 2013, the overall investment level of the economy, at 18.4% of GDP as of Q3 2019, still remains below the euro area average of 20.9% of GDP. In addition, while higher employment has raised Portugal’s growth potential, the percentage of low-skilled labour remains high at 44% of the total in 2018, down from 68% in 2008 but still markedly above the EU average of 20%. It will also take time to replace temporary contracts, still at around 16% of all employment contracts compared to the euro area average of 12%, with permanent ones to encourage companies to invest more in human capital.
Second, despite the rebalancing of the external sector, current-account surpluses are necessary for a sustained period to improve Portugal’s significant negative net international investment position, which remains markedly weaker than peer levels, at around -101% of GDP as of Q3 2019. The size of gross external liabilities is elevated, with Portugal’s total external debt at around 198% of GDP as of Q3 2019, down since Q1 2013 (238%) but still above that of both Spain (172%) and Italy (127%). Still, external risks have abated given i) the change in the composition of external debt, away from financial institutions towards the government and the central bank; and ii) a shift in the share of foreign liabilities, away from more volatile portfolio debt securities (from 31% in Q1 2010 to 19% in Q3 2019) to direct investment (from 19% to 30% over the same period), and official loans (a stable source of external funding). While the low interest rate environment facilitates the financing of external liabilities, external imbalances remain a source of vulnerability that could quickly materialise in case of a repricing of risk.
Third, Scope identifies risks from the financial sector as an ongoing challenge for Portugal. While the banking sector has undergone significant restructuring and consolidation, resulting in higher capitalisation levels (common equity tier 1 ratio of 13.9% of risk-weighted assets) and improved balance sheets (non-performing loans are down to 7.7% of total loans in Q3 2019 from the peak of 17.9% in Q2 2016), challenges remain. These relate mostly to i) additional capital injections to Novo Banco under the Contingent Capital Mechanism of up to EUR 2.0bn by 2025, since, of the overall EUR 3.9bn cap, EUR 1.9bn have already been used an accounted for in the deficit; ii) sector-wide profitability pressures in the context of low interest rates; and iii) the relatively concentrated exposure of the Portuguese banking system to government bonds (around 13% of total assets, 9% of which relate to Portugal and 3% to Spain and Italy combined) and real estate assets (around 38%). 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 given their high ownership of long-duration sovereign debt.
Finally, Scope notes that implicit liabilities from hospitals, state-owned enterprises and demographic trends pose long-term fiscal challenges. While hospital arrears have declined to EUR 259.4m in December 2019 from EUR 740m in October 2019, state-owned enterprises still struggle to achieve a balanced financial position, despite an improvement in their total net income from a loss of EUR 1.3bn in 2014 to a loss of around EUR 0.5bn in 2017 (latest available data). Conversely, general government guarantees have dropped to 6.4% of GDP as of 2017 (last available data) from around 13% in 2013 and are thus in line with those of Spain (6.7%) but still above Italy’s (3.9%). Looking at demographic trends, Portugal’s ageing-related expenditure is expected to increase by 3% of GDP by 2040, mostly driven by healthcare, resulting in a total ageing-expenditure burden estimated at around 22.4% of GDP by 2040, above the euro area average (21.0%) and Spain’s (20.6%) but below Italy’s (25.7%).
Core Variable Scorecard (CVS) and Qualitative Scorecard (QS)
The rating committee reviewed Scope’s Core Variable Scorecard (CVS), which is based on the relative rankings of key sovereign credit fundamentals and assigned 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; ii) fiscal policy framework; and iii) market access and funding sources. Relative credit weaknesses are: i) macroeconomic stability and sustainability. The combined relative credit strengths and weaknesses generate a positive one-notch 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, while environmental factors were considered during the rating process, including the country’s introduction of environmentally friendly measures to incentivise decarbonisation, they did not play a direct role in this rating action.
Outlook and rating-change drivers
The Stable Outlook reflects Scope’s view that risks to the ratings are balanced over the next 12 to 18 months. The rating/Outlook could be upgraded if Portugal’s: i) medium-term growth potential increases, ii) public finances continue to improve, resulting in a further significant public debt reduction; and/or iii) economic imbalances, particularly in the external sector, are further reduced.
Conversely, the rating/Outlook could be downgraded if: i) Portugal’s 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) economic imbalances were to increase further.
The main points discussed by the rating committee were: i) Portugal’s growth potential; ii) macroeconomic stability and sustainability; iii) fiscal consolidation, public-debt sustainability and debt structure; iv) external debt and vulnerability to external shocks; v) banking sector performance and private-sector deleveraging; vi) political developments; and vii) peers.
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 not participate in the ratings process. Scope had no 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.
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 05 April 2019.
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.
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