DBRS Morningstar Upgrades Portugal to “A”, Stable Trend

DBRS Ratings GmbH (DBRS Morningstar) upgraded the Republic of Portugal’s Long-Term Foreign and Local Currency – Issuer Ratings to “A” from A (low). At the same time, DBRS Morningstar confirmed Portugal’s Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (low). The trends on all ratings remain Stable.

KEY CREDIT RATING CONSIDERATIONS
The upgrade reflects DBRS Morningstar’s view that Portugal’s material improvement in fiscal and debt outcomes in the face of challenging external developments points to enhanced resiliency and reduced credit risk. Public finances have benefitted from healthy economic growth, a steady increase in tax revenues, and unwinding of crisis-related spending. The fiscal deficit consolidated to 0.4% of GDP in 2022 and could reach a balanced or surplus position as early as this year. The combination of steady economic growth and strong primary surpluses have resulted in a sharp decline in the public debt ratio, which the Banco do Portugal (BdP) expects will reach 92.5% by 2025. Improvements in DBRS Morningstar’s “Debt and Liquidity” and “Fiscal Management and Policy” building blocks are the key factors for the upgrades.

The Stable trend reflects our view that sound economic fundamentals help balance risks linked to the above target inflation rate and the sharp increase in interest rates. High inflation and rates may persist for longer than currently envisaged and could dampen economic growth prospects, especially given the vast majority of variable-rate mortgage lending in the economy. Nevertheless, Portugal’s export-led recovery has been accompanied by continuous growth in employment, labour participation, and incomes. Likewise, banking sector metrics appear sound and well positioned to absorb any forthcoming deterioration in asset quality stemming from higher costs of capital and financial sector stress. At the start of 2023, real GDP stood 5.4% above its 2019 level, and investment linked to European recovery funds will further support economic activity in the coming years. The BdP forecasts real GDP to expand each year on average by 2.5% from 2023-2025, nearly double their euro area annual average growth forecast.

Portugal’s ratings are underpinned by the country’s euro area membership and its adherence to the EU economic governance framework. Both help foster credible and sustainable macroeconomic policies in Portugal. However, key vulnerabilities include the still comparatively elevated, albeit rapidly improving, level of public debt and relatively low economic growth potential. These issues could become more challenging to manage if the adverse effects of the price and interest rate shocks prove to be long-lasting.

CREDIT RATING DRIVERS
The ratings could be upgraded if Portuguese authorities are able to achieve a greater than expected reduction in the public debt ratio, or if the country improves its economic resiliency and growth potential. The ratings could be downgraded if the political commitment to sustainable macroeconomic policies weakens, resulting in a significantly worse outlook for public finances.

CREDIT RATING RATIONALE
Portugal’s Public Debt Ratio Is Declining At A More Rapid Pace Than Previously Anticipated

Debt dynamics in Portugal are such that public debt is expected to approach the 100% of GDP threshold this year or next, much earlier than previously anticipated. The government’s response to the pandemic along with the economic recession increased debt-to-GDP to 134.9% in 2020. The strong economic recovery and rapid fiscal repair over the last two years reduced the debt ratio to 113.9% in 2022, and the pace of debt reduction in the coming years remains rapid. The BdP in its June 2023 Bulletin projects that in the absence of additional major shocks the public debt ratio will decline to 97.1% by next year. This steep downward debt trajectory reduces sustainability concerns of the high debt stock and supports the positive qualitative assessment in the “Debt and Liquidity” building block. DBRS Morningstar welcomes such significant debt reduction, as Portugal’s still comparatively high level of debt leaves public finances vulnerable to negative growth and interest rate shocks or the crystallization of contingent liabilities.

Prudent debt management helps mitigate risks associated with the high interest rate environment. Average maturities of Portuguese Government Bonds (PGBs) above 7 years limits refinancing risk and slows the inevitable increase in the cost of issuances. Current assumptions from the 2023 Stability Programme (SP) are for interest costs to rise from 2.0% of GDP in 2022 to 2.8% by 2027, still below the 3.0% level recorded in 2019. Debt funding has also benefited from a high level of net subscriptions of saving certificates by households and a tightening of credit spreads on PGBs with comparable German Bunds.

Fiscal Accounts Could Reach A Balanced Or Surplus Position As Early As This Year, Well Ahead Of Previous Expectations

The deterioration of public finances in 2020 was driven by a significant reduction in revenues from the economic recession and several rounds of policy measures aimed to contain the COVID-19 outbreak and to support the economy. The approach was targeted and resulted in an overall budget deficit of 5.8% of GDP in 2020. The deficit improved to 2.9% in 2021, already below the Maastricht threshold, and narrowed even further in 2022 to 0.4%. The government’s SP anticipates a similar fiscal outcome for 2023, despite additional support measures announced earlier this year to protect the public against higher food and energy prices. Public finances are benefiting from healthy tax revenues and the unwinding of pandemic-related support measures. Given its forecast for stronger economic growth, the BdP expects a 0.1% of GDP deficit in 2023 and for the government to run small headline surpluses in the coming years. Recent upward revisions to economic activity and budget outcomes suggest fiscal accounts could end the year in surplus. This supports the positive qualitative assessment in the “Fiscal Management and Policy” building block.

The Portuguese Economy Thus Far Appears Resilient To The Price and Interest Rate Shocks

Following one of Europe’s largest contractions in 2020, the economy recovered strongly in the subsequent years due to strong employment growth, pent up demand, and a return of tourism. The economy expanded by 5.5% in 2021 and by 6.7% in 2022, and while most forecasters expected a flattening of growth in 2023, economic activity overperformed expectations to start the year. Real quarter-on-quarter GDP growth advanced by 1.6% in the first quarter of 2023 due primarily to the strong export performance and resilient private consumption. Goods exports benefited from the recovery in global supply chains, while the strong increase in tourism visits supported service exports. Though the economy has been constrained for various reasons – high inflation (still 4.7% in June) and interest rates, and a decline in household purchasing power – private consumption has made a positive contribution to economic activity. This is because rapid growth in employment and incomes coincided with an significant increase in labour participation rates, in large part from comparatively higher skilled foreign workers.

The BdP expects the economy to expand by 2.7% this year and remain above trend growth in the coming years, as EU transfers support investment. The revision to Portugal’s Recovery and Resilience Plan (RRP) includes an additional EUR 2.7 billion in grants (including additional funds to RePower EU). At the same time, the government requested an additional EUR 3.2 billion in loans. In all, the modified RRP now amounts to EUR 22.2 billion (9.3% of GDP) of grants and loans. This is in addition to the EUR 33.6 billion (14.0% of GDP) in grants from the Multiannual Financial Framework 2021-2027. These funds represents upside risk to the performance of the Portuguese economy. Modelling performed by the European Commission shows the economic impact of RRP alone could lead to an increase of GDP between 1.5% and 2.4% by 2026. Portuguese authorities forecast the impact on GDP growth will be 3.5% by 2025. The scenarios would be much larger if the intangible impacts of the structural reforms that accompany the funds were included.

Export Performance Is Of Increasing Importance To The Portuguese Economy; External Vulnerabilities Have Decreased

Exports of Portuguese goods and services accounted for 50.2% of GDP in 2022, up from 41.7% in 2021, and a steady increase from 27.1% recorded in 2002. Goods exports, at 31.6% of GDP, have diversified in recent years. In 2000, traditionally dominant Portuguese exports, such as vehicle parts, electronics and machinery, and textiles accounted for over-half of the total. By 2022, the share of these products declined to over one-third, and exports of metals, mineral products, and chemicals (including pharmaceuticals) have taken on greater importance. On service exports, the Information Communication, and Technology (ICT) sector has grown, and tourist spending has surged as an important component. Tourism accounted for 8.8% of GDP in 2022 and has fully recovered from the pandemic shock. The number of travellers in tourist accommodations generated EUR 22 billion in 2022, well above the EUR 16 billion in 2019.

Following seven consecutive years of small current account surpluses, the external balance turned to a small deficit in 2020, and has registered deficits around 1.0% of GDP in each of the last three years. These negative external positions are small compared to Portugal’s double-digit deficits from 2005 to 2010. The IMF expects the small deficits over the next few years to narrow toward balance by 2025, although the current account turned positive in the first quarter of 2023 due to lower energy prices and an improved goods balance. External account surpluses are key for Portugal to continue to reduce its external vulnerabilities. Net external debt declined to 64.6% of GDP as of the first quarter 2023, and the net international investment position (NIIP) improved to -81.0% of GDP from -123.8% in 2014. Net of foreign direct investment, NIIP improved to -36.5% of GDP.

Legacy Vulnerabilities In The Banking Sector Have Decreased; Risk From Rising Rates Remains

Capital increases and higher cash leverage levels placed the banking sector in a better position at the start of pandemic, and recent results show that banking sector profitability and asset quality have improved. After reaching a peak of 17.9% in mid-2016, the banking system’s non-performing loan (NPL) ratio declined to 3.1% as of the first quarter of 2023 or 1.3% net of impairments, according to BdP. NPLs among corporates declined to 6.3% of total loans as of the first quarter of 2023, down from 30.3% in the second quarter of 2016. The direction of private sector insolvencies remains an important unknown, as inflationary pressure and policy actions tighten financing conditions. Higher mortgage rates started to slow the rise in residential property prices, which increased by 8.7% in the first quarter of 2023 compared to a year earlier. The vast majority of mortgages in Portugal are at variable rates, so the rapid rise in rates could apply some stress to the system. However, risks to the banking sector are mitigated by improved asset quality, high bank coverage ratios, benefits to the banks from higher rates, strong labour markets, and healthy private sector deleveraging.

Portugal Is A Stable Liberal Democracy With Strong Public Institutions

The Socialist Party (PS) overperformed relative to expectations in the January 30, 2022 parliamentary election to secure an absolute majority. The majority outcome of the election reduces legislative obstacles at a key moment. Portugal is a significant beneficiary of EU funds. The aim of the EU transfers is to link funding to reforms and investments that attempt to enhance resiliency, and advance the green and digital transitions. Whether or not these windfalls manage to boost the economy’s productive capacity will depend on Portugal’s ability to effectively absorb the transfers and direct them to productive ends.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Social (S) Factors
Human Rights and Human Capital (S) were among the key ESG drivers behind this rating action. DBRS Morningstar considers this factor significant and has taken it into account within the Economic Structure and Performance building block. Portugal’s per capita GDP is relatively low at $24,522 in 2022 compared with its euro system peers.

There were no Environmental or Governance factors that had a significant or relevant effect on the credit analysis.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (July 4, 2023) https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/417483.

EURO AREA RISK CATEGORY: LOW

Notes:
All figures are in euros unless otherwise noted. Public finance statistics reported on a general government basis unless specified.

The principal methodology is the Global Methodology for Rating Sovereign Governments (29 August 2022) https://www.dbrsmorningstar.com/research/401817/global-methodology-for-rating-sovereign-governments. In addition DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

The sources of information used for this rating include Ministry of Finance of the Republic of Portugal (Stability Program 2023), Agência de Gestão da Tesouraria e da Dívida Pública (IGCP Investor Presentation, June 2023), Banco de Portugal (BdP: Economic Bulletin, June 2023), Instituto Nacional de Estatistica Portugal (INE), Portuguese Public Finance Council (CFP), European Commission (Summer 2023 Forecasts), European Central Bank (ECB), Statistical Office of the European Communities (Eurostat), Social Progress Imperative, Global Carbon Project, OECD, IMF, World Bank, BIS, Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing these credit ratings to be of satisfactory quality.

With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, this is an unsolicited credit rating. This credit rating was not initiated at the request of the issuer.

With Rated Entity or Related Third Party Participation: YES
With Access to Internal Documents: YES
With Access to Management: NO

DBRS Morningstar does not audit the information it receives in connection with the credit rating process, and it does not and cannot independently verify that information in every instance.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS Morningstar’s outlooks and credit ratings are under regular surveillance.

For further information on DBRS Morningstar historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see: https://registers.esma.europa.eu/cerep-publication/. For further information on DBRS Morningstar historical default rates published by the Financial Conduct Authority (FCA) in a central repository, see https://data.fca.org.uk/#/ceres/craStats.

The sensitivity analysis of the relevant key credit rating assumptions can be found at: https://www.dbrsmorningstar.com/research/417482.

These credit ratings are endorsed by DBRS Ratings Limited for use in the United Kingdom.

Lead Analyst: Jason Graffam, Vice President, Sovereign Ratings Group
Rating Committee Chair: Nichola James, Managing Director, Sovereign Ratings Group
Initial Rating Date: November 10, 2010
Last Rating Date: January 27, 2023

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