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Rating action

Scope Ratings GmbH (Scope) has today upgraded the Portuguese Republic’s (Portugal) long-term issuer and senior unsecured local- and foreign-currency ratings to A- from BBB+ and revised the Outlook to Stable from Positive. Scope has also upgraded Portugal’s short-term issuer rating to S-1 from S-2 with a Stable Outlook in both local and foreign currency.

Summary and Outlook

Scope’s decision to upgrade Portugal’ credit ratings to A- from BBB+ reflects:

1. The country’s sustained progress in fiscal fundamentals supported by strong commitment to prudent fiscal policy. This improvement is highlighted by a steady decline in budget deficits vis a vis European peers, which Scope projects to continue over the medium-term. This development supports the country's long-term fiscal sustainability, as it provides greater capacity to manage fiscal pressures.
    
2. The steady downward trend in Portugal’s debt-to-GDP ratio. This positive development is further supported by the country's robust growth performance and favourable debt profile. These factors have helped to partially mitigate the increased costs of debt issuance and have contributed to reducing the country's overall debt burden.

The upgrade reflects changes in Scope’s assessments in the ‘public finance risk’ category of its sovereign methodology.

The Stable Outlook reflects Scope’s view that risks to the ratings are balanced over the next 12 to 18 months.

The rating is constrained by Portugal’s: i) small, open economy, making the country highly vulnerable to external shocks; ii) modest growth potential, constrained by structural economic weaknesses such as low productivity and concentration in low-value added sectors; and iii) elevated implicit liabilities weighing on public debt levels, including from adverse demographic trends impacting public spending.

The ratings/Outlooks could be upgraded if, individually or collectively: i) sustained fiscal consolidation is achieved, resulting in a material decline in public debt levels and additional improvement in the external position, particularly through a reduction in the requirement for external financing; and/or ii) medium-term growth prospects improved materially, supported by the implementation of growth-enhancing structural reforms.

Conversely, the ratings/Outlooks could be downgraded, if individually or collectively: i) protracted fiscal deterioration resulted in weaker debt sustainability; and/or ii) there was a fading commitment to or reversal of structural reforms, leading to markedly lower GDP growth.

Rating rationale

The first driver of the upgrade of Portugal's credit ratings to A- from BBB+ reflects the significant and sustained progress the country has made in improving its fiscal fundamentals. This improvement is highlighted by a steady decline in budget deficits, which Scope projects to continue over the medium-term. In 2021, Portugal successfully reduced its budget deficits to 2.8% of GDP, down from a peak of 5.8% in the previous year. We expect the improved fiscal position in 2022 to reach a deficit of 1.1% of GDP, driven by robust growth and the inflation effect that boosted fiscal revenue performance, particularly in direct and indirect taxes.

Despite the fiscal intervention required to support households and businesses during rising energy prices, such positive elements have countered the increase in general government expenditure. Furthermore, Portugal has achieved the most rapid recovery in primary balance compared to its rating peers, with a decline from -2.9% in 2020 to -0.5% in 2021, and it is expected to have reached a surplus above the initial government’s estimate of 0.3% of GDP in 2022. This positive trend reflects the country's commitment to reducing its debt burden and ensuring long-term fiscal sustainability.

In 2022, Portugal implemented support measures to counter the energy shock, amounting to 1.5% of GDP. These measures primarily focused on households and social benefits and included the "Iberian mechanism," which was jointly implemented with Spain (A-/Stable). This mechanism was designed to contain electricity prices, with the aim of reducing the wholesale electricity market price and containing the input costs of fossil-fuel powered stations. As a result, it was possible to put a cap on electricity prices for final consumers, which helped to save around 14% on their final bills. These measures have helped to mitigate the impact of inflation shocks on households and businesses in Portugal and maintaining social and economic stability. Moreover, the implementation of the "Iberian mechanism" has shown a concerted effort between Portugal and Spain to address common economic challenges, which may contribute to greater regional integration and cooperation.

Scope's projection for Portugal's fiscal deficit in 2023 is a continuation of the downward trend to reach 0.4% of GDP, while the primary surplus is expected to further improve to 1.7% of GDP. The reduction in pandemic support measures, which is expected to account for only 0.1% of GDP this year, and the withdrawal of some measures introduced last year to mitigate the effect of high inflation will underpin this trend. In the 2023 Draft Budget Law, the government estimated an increase in the ratio of public revenue-to-GDP to 44.5% this year, 0.44pp higher than estimates for 2022, driven by sustained taxes, social contributions, and other non-tax contributory revenues. This increase in public revenue is expected to partially offset the increase in the expenditure ratio (45.4% of GDP, 0.6pp than in 2022), which is primarily driven by current primary spending related to public wage increases but offset by lower subsidies and social benefits.

The second driver of the upgrade of Portugal's credit ratings to A- from BBB+ is the country’s steadily declining debt-to-GDP ratio. This trend is supported by robust growth performance and a favourable debt profile with a comfortable cash position, which have helped to reduce Portugal's overall debt burden. Despite higher interest rate costs, these factors have contributed to the improvement of the country's debt situation.

The debt ratio of Portugal had reached 134.9% of GDP at end-2020 due to the COVID-19 crisis. The ratio started to decrease due to higher inflation and strong nominal growth, which surpassed the implicit interest rate. Scope predicts a further decline in the debt-to-GDP ratio, from 125.4% of GDP at end-2021 to 113.5% in 2022 and 108.4% in 2023, with an ultimate convergence around 91% by 2027. This declining trend in debt is beneficial for interest spending in a context of rising interest rates and helps to contain borrowing needs. The borrowing requirement is expected to decrease slightly in 2023 to EUR 24bn from EUR 24.9bn in 2022. This is due to the lower medium-to-long-term redemptions offsetting higher net financing needs, expected to be at EUR 12.4bn compared to EUR 9.5bn in 2022. The comfortable cash position of EUR 8bn, an increase of EUR 1.7bn from last year and sufficient to cover around one third of the expected State borrowing requirements, serves as an additional solid buffer and supports funding flexibility.

Scope expects public investments in Portugal to increase significantly in the medium term, with funding from the EU's NGEU programme and the 2021-2027 Multiannual Financial Framework. This will reduce the need for the country to rely on debt to finance critical investments, resulting in a rise in the general government's gross fixed capital formation as a share of GDP, projected to reach 3.5% this year, up from 1.7% in 2019. The government has committed to accelerating the implementation of the national recovery and resilience plan, as spending remained subdued in 2022 at just above EUR 1 bn.

The recovery and resilience facility spending is set to reach EUR 3.9 bn (1.6% of GDP) in 2023, four times higher than the 2022 figure and is expected to stimulate the economy by around 1% of GDP. Although there have been delays in the execution of recovery plan projects, which are common among peer countries, Portugal has a strong track record of absorbing EU funds, with an absorption rate of 92% per 2022 of European Structural and Investment funds allocated over 2014-2020. This good performance increases confidence in Portugal's ability to accelerate recovery plan execution and effectively implement related investments.

Scope expects Portugal’s interest spending to increase this year for the first time since 2014, reaching 2.5% of GDP from 2.1% in 2022, due to tighter financing conditions in the market resulting from monetary policy normalisation. However, this expected level remains below the 2.9% of GDP recorded in 2020 and slightly above the 2.4% of GDP recorded in 2021, partly due to the substantial reduction in debt levels achieved since then. Portugal benefits from a favourable debt structure, as reflected by its long residual average maturity of 7.7 years as of February 2023 and a manageable repayment schedule. Most expected redemptions are concentrated over 2025-30, a period in which lower net financing needs are anticipated due to reduced budget deficits. These factors are likely to significantly mitigate the impact of rising financing costs and effectively contain borrowing requirements.

Finally, Portugal’s declining debt-to-GDP trajectory is supported by the country’s robust growth performance and rapid economic recovery over the past two years. The Portuguese economy grew by an average of 2.8% between 2016 and 2019, outpacing the euro area average of 2%, thanks in part to structural factors such as improvements in workers' education, reduced inequality, and decreased private sector indebtedness. After a significant decline of 8.3% in 2020 due to the Covid-19 crisis, Portugal's GDP growth rebounded to 5.5% in 2021 and this growth momentum has continued into 2022, with an expected growth rate of 6.7%. However, growth is to slow down in 2023, with an anticipated real growth rate of 1.2%, followed by a recovery of around 2% in 2024. The Russia-Ukraine conflict is expected to have an impact on Portugal's economic growth, primarily through weakened external demand and higher inflation, reducing private consumption and investment.

Despite HICP inflation of 8.1% in 2022, which was below the euro area average, core inflation is currently not showing signs of deceleration, having slightly increased in February to 7.2% from 7.0% in January. Although household consumption was sustained by significant government support for vulnerable households and businesses, private consumption is expected to remain subdued this year amid persistent but easing inflationary pressures. External demand is also expected to decelerate, driven by rising production costs, and tighter financing conditions amid monetary policy normalisation, leading to a postponement of private investments.

Despite the positive developments, Portugal continues to face significant credit challenges. These challenges include i) a small and open economy, which makes the country highly susceptible to external shocks; ii) elevated implicit liabilities that arise from adverse demographic trends and contribute to high levels of public debt and impact public spending; and iii) a modest growth potential due to low productivity and economic activity that is mainly concentrated in low-value-added sectors.

First, Portugal's small and highly open economy makes it susceptible to external shocks, such as the Covid-19 pandemic and the ongoing Russia-Ukraine conflict. The country's vulnerability to second-round effects, including shifts in growth prospects in key European trading partners, could result in unstable dynamics of exports and imports, following a trade deficit of 1.3% of GDP in 2022. However, the Banco de Portugal estimates suggest a recovery to a trade surplus of 0.1% of GDP by 2025. Given the significant contribution of the tourism sector, which accounts for 5.8% of the total Gross Value Added (GVA) as of 2021, Portugal's economy heavily relies on tourism exports, making it sensitive to macroeconomic volatility and external developments.

Second, Portugal faces significant long-term fiscal pressures due to ageing demographics, which pose challenges for the country's budget flexibility. Portugal has the fourth-highest old-age dependency ratio in the EU, at 37%, which it is expected to increase to around 50% by 2035, making it one of the highest in the EU at that time. This demographic shift will result in structural pressures on government budgets due to rising healthcare and pension expenditures, which are projected to reach 14.4% of GDP and 6.8%, respectively, by 2040. Furthermore, a shrinking, ageing labour force will put additional pressure on government revenues.

The Portuguese government's reform agenda under the EU recovery fund program includes measures to strengthen government expenditure control, enhance the resilience of the health system, and increase the capacity of social services. These efforts will be critical in addressing long-standing bottlenecks in the healthcare and pension systems and in managing the expected rise in age-related spending pressures.

Finally, despite Portugal's recent economic recovery, the country still faces significant challenges related to its modest growth potential. The country's estimated growth potential stands at 1.8%, which is relatively low compared to its euro area peers. Portugal's GDP per capita remains below 60% of the euro area average, indicating a significant income gap. One of the key factors contributing to Portugal's limited growth prospects is its concentration in low-value-added sectors. This lack of diversification in the economy leads to reduced productivity, making it difficult for Portugal to compete with more advanced economies. Additionally, low investment levels have further exacerbated the issue, hindering the country's ability to innovate.

In recognition of these challenges, the government has implemented a range of measures to address long-standing bottlenecks in the business environment. These reforms include enhancing the efficiency of public administration, improving the digital skills of workers to meet the needs of the labour market, and supporting education attainment. By addressing these structural issues, Portugal can improve its economic growth prospects and strengthen its competitiveness in the global market.

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 a first indicative credit rating of ‘a-’ as regards Portugal. The ‘a-‘ indicative rating is further supported by the methodology’s reserve currency adjustment which provides a one notch uplift to the CVS indicative. The ‘a-’ indicative rating can thereafter be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative qualitative credit strengths or weaknesses versus a peer group of countries.

For Portugal, the following relative credit strengths in the QS have been identified: i) fiscal policy framework. Relative credit weaknesses are signalled for: i) growth potential of the economy; ii) macroeconomic stability and sustainability; iii) current account resilience; iv) resilience to short-term shocks; and v) social factors.

The QS generates a one-notch negative adjustment and indicates A- long-term sovereign credit ratings for Portugal.

A rating committee has discussed and confirmed these results.

Factoring of environment, social and governance (ESG)

Scope explicitly factors in ESG sustainability issues during its rating process via the sovereign methodology’s stand-alone ESG sovereign risk pillar, with a 25% weighting under its quantitative model (CVS) as well as in the methodology’s qualitative overlay (QS).

In terms of environmental risks, Portugal's quantitative scores above-average for emissions per unit of GDP, as well as natural risks. However, Portugal has had to grapple with a series of environmental challenges lately, including forest fires, a prolonged drought period, and recurring floods in certain regions. Despite these hurdles, Portugal was among the first EU nations to commit to achieving net zero emissions by 2050 and released a long-term strategy for carbon neutrality in June 2019. Nonetheless, meeting this ambitious target requires significant investments. Air quality in Portugal continues to pose a problem, mainly due to personal transport systems, which worsen seasonal air quality problems and traffic congestion in major metropolitan areas.

In terms of social risks, Portugal faces challenges related to its ageing population, which is reflected in the country's increasing old-age dependency ratio over the long term. This demographic trend is expected to worsen, with the old-age dependency ratio projected to exceed 60 by 2050, one of the highest levels in the EU. Additionally, youth unemployment remains a significant concern, although Portugal has taken measures to address this issue. Despite above-average scores on income inequality and labour force participation rates, the country has implemented legislation to address the gender pay gap. The European Commission projects that Portugal will face an increase in health spending of 1.6 percentage points of GDP between 2019 and 2070, the fourth highest in the European Union. These factors suggest that Portugal will need to take additional measures to manage the impacts of an ageing population and address youth unemployment to maintain its social stability and ensure long-term economic sustainability.

According to Scope’s core variable scorecard (quantitative model) on governance-related factors, Portugal scores strongly on a composite index of six World Bank Worldwide Governance Indicators, indicating the presence of robust democratic institutions. Additionally, Scope’s qualitative scorecard evaluation of ‘institutional and political risks’ aligns with that of other sovereign peers, reflecting stable political conditions and consensus on key policy issues. This recognition acknowledges the authorities’ effective implementation of prudent fiscal policies and structural reforms, such as rebalancing the current account and reducing structural unemployment.

Rating Committee
The main points discussed by the rating committee were: i) fiscal fundamentals and debt trajectory; ii) macroeconomic sustainability and growth performance; iii) financial stability risks; iv) NGEU funds and past absorption of EU resources; v) external sector dynamics.

Methodology
The methodology used for these Credit Ratings and/or Outlooks, (Sovereign Rating Methodology, 27 September 2022), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. 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 Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months. 

Solicitation, key sources and quality of information
The Credit Ratings were not requested by the Rated Entity or its Related Third Parties. The Credit Rating process was conducted:
With Rated Entity or Related Third Party participation    YES
With access to internal documents                                  NO
With access to management                                           YES
The following substantially material sources of information were used to prepare the Credit Ratings: public domain, the Rated Entity.
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting these Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data.
Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings/Outlooks and the principal grounds on which the Credit Ratings/Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.

Regulatory disclosures
These Credit Ratings and Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and Outlooks are UK-endorsed.
Lead analyst: Jakob Suwalski, Director
Person responsible for approval of the Credit Ratings: Dr. Giacomo Barisone, Managing Director
The Credit Ratings/Outlooks were first released by Scope Ratings on 30 June 2017. The Credit Ratings/Outlooks were last updated on 13 May 2022.

Potential conflicts
See www.scoperatings.com under Governance & Policies/Regulatory for a list of potential conflicts of interest disclosures related to the issuance of Credit Ratings.

Conditions of use / exclusion of liability
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