Morningstar DBRS Confirms Republic of Portugal at “A”, Stable Trend

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

KEY CREDIT RATING CONSIDERATIONS
The Stable trend reflects Morningstar DBRS' view that the risks to the credit ratings are balanced. The Portuguese economy grew faster than the euro area in 2023 but is losing momentum going into 2024 amid high interest rates and weak external demand. Real GDP growth is expected to gradually pick-up as the drag from inflation and weak external demand dissipate and European Union (EU) funds spur investment. Portugal’s strong fiscal position and favourable debt dynamics mitigate the risks from a still high stock of public sector debt. Portugal is expected to have recorded a fiscal surplus of around 0.8%-1.1% of GDP in 2023, on the back of a steady increase in tax revenues and the unwinding of crisis-related spending. The combination of moderate nominal economic growth and strong primary surpluses is expected to have resulted in a sharp decline in the public debt ratio from 134.9% in 2020 to 101.4% in 2023, according the Banco de Portugal (BdP). This trend is expected to be sustained albeit at a slower pace in coming years. Parliamentary elections are scheduled for March 2024. Morningstar DBRS does not expect a significant shift from Portugal’s commitment to fiscal prudence and public debt reduction, regardless of who wins. Still, the implementation of Portugal’s Recovery and Resilience Plan (RRP) could face delays, especially if the formation of the government drags on over time.

Portugal’s credit 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. Key vulnerabilities include the elevated, albeit rapidly improving, level of public debt and relatively low economic growth potential. These issues could become more challenging to manage if interest rates remain elevated for a prolonged period of time.

CREDIT RATING DRIVERS
The credit ratings could be upgraded if the Portuguese authorities are able to significantly reduce the public debt ratio, or if the country improves its economic resiliency and growth potential. The credit 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
The Portuguese Economy Is Slowing Down In the Face of External Headwinds But Showing Resilience

Following one of Europe’s largest economic contractions in 2020, activity since then has recovered strongly due to strong employment growth, pent up demand, and a return of tourism. The economy expanded by 5.7% in 2021 and by 6.8% in 2022. The Portuguese economy recovered faster than the euro area, with real GDP in Q3 2023 4.6% above its pre-pandemic level compared to 3.0% in the euro area. According to the European Commission’s latest estimates, Portugal´s real GDP growth estimated at 2.2% in 2023 will outperform the 0.6% estimated for the euro area. Still, the Portuguese economy stagnated in Q2 and Q3 of last year, reflecting the accumulated effects of higher interest rates and inflation and weak external demand. The labour market has proven resilient despite some softening recently. While activity could remain weak in the near term, growth is expected to pick up in coming quarters as the decline in inflation helps restore purchasing power, external demand strengthens, and European funds bolster investment. The BdP projects the economy to slow to 1.2% in 2024, and then to accelerate in the following years to 2.2% in 2025 and to 2.0% in 2026. A prolonged period of higher interest rates, especially given the vast majority of variable rate mortgage lending in the economy, and heighted geopolitical risks could dampen growth prospects. On the other hand, the implementation of investments and reforms under its RRP could lead to stronger growth.

The successful absorption of the EU funds is critical for Portugal to deliver long-term investments and to support companies and households at a time when economic growth decelerates. Portugal´s updated Recovery and Resilience Plan (RRP) now amounts to EUR 22.2 billion (9.2% of GDP) in grants and loans. This is in addition to the EUR 33.6 billion (13.9% of GDP) in grants from the Multiannual Financial Framework 2021-2027. Thus far, Portugal has achieved 22% of the milestones and targets and spent 14% of the funds under its RRP. The European Commission endorsed a positive preliminary assessment of part of the milestones and targets linked to Portugal's payment request for the third and fourth instalments, suspending a portion of the payment until two milestones and one target are considered to be satisfactorily fulfilled. Despite some delays in its execution, Morningstar DBRS considers that its full implementation has the potential to boost investment and potential output over the medium to long term.

Portugal Expected to Have Reached a Fiscal Surplus in 2023 and Public Finances to Remain Strong Despite Uncertainty

Portugal was one of the few EU countries entering the pandemic after reaching a balanced budget in 2019. Pandemic-related spending combined with a steep fall in revenues resulted in an overall budget deficit of 5.8% of GDP in 2020. Since then, public finances improved quickly, benefiting from healthy tax revenues and the unwinding of pandemic-related support measures. This more than compensated for the additional measures to protect the public against higher food and energy prices in 2022 and 2023. The fiscal deficit narrowed to 2.9% in 2021 and to 0.3% in 2022. Portugal is expected to have reached fiscal surplus in 2023 according to the Ministry of Finance and BdP projections of 0.8% of GDP and 1.1% of GDP, respectively. The continued dynamism of revenues in 2023, amid a strong labour market and high inflation, coupled with the complete phase out of COVID-19 support and lower fiscal impact of the energy measures are the main drivers of the improvement in 2023. The stronger budgetary outcomes during 2023 have led to MoF and BdP to improve their previous projections. This supports the positive qualitative adjustment in the “Fiscal Management and Policy” building block assessment.

The draft budgetary plan projects the surplus to narrow to 0.2% in 2024 from 0.8% in 2023, driven by the introduction of discretionary measures leading to higher expenditures in public wages, pensions and other social transfers and revenue-decreasing measures such as personal income tax cuts. The outgoing administration managed to pass this relatively expansionary budget for 2024 before the parliament was dissolved, providing broad policy continuity for 2024 in the face of a slowing economy. Going forward, while the next government could introduce additional measures, Morningstar DBRS does not expect a significant shift from Portugal´s commitment to fiscal prudence and public debt reduction.

Portugal’s Public Debt Ratio Is Declining Rapidly

The combination of steady economic growth and strong primary surpluses have resulted in a sharp decline in the public debt ratio. The debt-to-GDP ratio, which reached 134.9% in 2020, declined to 112.4% in 2022. Portugal’s public debt reduction has outpaced most other European countries and its debt ratio is set to fall further below the levels of Spain, France and Belgium in coming years. The BdP, in its December 2023 Bulletin, projects that the public debt ratio declined to 101.4% in 2023 and projects it to decline to 96.8% in 2024 and reach 87.9% by 2026, in the absence of additional major shocks. This steep downward debt trajectory reduces sustainability concerns related to the high debt stock and supports the positive qualitative adjustment in the “Debt and Liquidity” building block assessment. Morningstar DBRS 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. The average maturity of Portuguese Government Bonds (PGBs) is above 7 years, which limits refinancing risk and slows the increase in debt servicing costs in a higher rate environment. Floating rate represented 12.3% of the outstanding debt stock, however, the most recent series of floating rate certificates are capped at 2.5%. Current assumptions for 2024 are for interest costs to rise from 1.9% of GDP in 2022 to 2.3% by 2024, still below the 3.0% level recorded in 2019. Noteworthy in 2023 was that debt funding has benefited from an unusually high level of net subscriptions of saving certificates by households, although they are expected to normalise in 2024, and a tightening of credit spreads on PGBs with comparable German Bunds.

The External Sector Returned to Surpluses Help By Tourism; External Vulnerabilities Have Decreased

Following seven consecutive years of small current account surpluses, Portugal recorded moderate deficits on average of 1.0% of GDP between 2020 and 2022 due to the pandemic-related collapse of the tourism industry and the rapid rise in energy commodity prices later. These negative external flows are small compared to Portugal’s double-digit deficits from 2005 to 2010 and mild when considering the large contraction in service exports linked to tourism during 2020 and 2021. Furthermore, the current account is projected to return to surplus already in 2023 reflecting tourism activity surpassing its pre-pandemic levels and an improvement of the terms of trade as the energy crisis abated. The increased diversification of its export base, internalisation, and market share gains in recent years reflect suggest improved competitiveness and resilience of the external sector. External account surpluses are key for Portugal to continue to reduce its external vulnerabilities. Net external debt declined to 57.3% of GDP as of Q3 2023, and the net international investment position (NIIP) improved to -74.3% of GDP from -123.8% in 2014. Net of foreign direct investment, NIIP improved to -31.3% of GDP.

The Banking Sector Strengthened Resiliency in Recent Year; Risk From High Interest Rates Remains

The Portuguese banking system has improved its resiliency in recent years on the back of stronger solvency, liquidity and asset quality metrics and, more recently, higher profitability thanks to higher interest rates. This stronger position, the government support measures, and a healthy labour market helped the banking system to absorb well the pandemic and energy crisis shocks. The banking system’s non-performing loan (NPL) ratio continued declining to 2.8% in Q3 2023, from its peak of 17.9% in mid-2016, but still remains slightly above the European average of 1.8%, according to the European Banking Authority. The rapid tightening of financial conditions and its effects on private sector insolvencies as well as the pressure points in the housing markets are important sources of risks. Given that 81.5% of mortgages are at variable rates, the rapid increase in Euribor is leading to higher monthly loan payments and exerting additional stress to the most vulnerable households. Similarly, some SMEs might be facing additional pressures due to higher rates and rising costs.

With respect to the housing market, house prices and rental prices have steadily increased in recent years, underscoring some concerns of overvaluation as housing supply has been unable to meet growing demand. A sharp correction in prices, albeit unlikely at this stage, could weigh on the banks. Thus far, tighter financial conditions have slowed the rise in residential property prices, which increased by 7.6% YoY in Q3 2023, and cooled down real estate activity. The risks to the banking sector from a potential deterioration in asset quality and the housing market downturn are mitigated by the high bank coverage ratios, benefits to the banks from higher rates, strong labour markets, and healthy private sector deleveraging in recent years. In addition, the BdP introduced a 4% sectoral systemic risk buffer on exposures secured by residential real estate for institutions using an internal ratings-based (IRB) approach. This measure, which will apply from 1 October 2024, aims to increase the resilience of institutions to the materialisation of potential systemic risk in the residential real estate market in Portugal.

Upcoming Parliamentary Elections Unlikely to Significantly Alter the Direction of Macroeconomic Policy

Portugal will hold early parliamentary elections on March 10, 2024 following the resignation of Prime Minister Antonio Costa. The country’s strong political institutions and Costa’s rapid step-down amid corruption investigations mitigate reputational risks. Portugal is stable liberal democracy with strong public institutions as reflected by its strong performance in the World Bank’s Worldwide Governance Indicators, ranking roughly in line or above EU averages (see commentary “Portugal Governance: Overperforming Peers On Key Measures”). Portugal significantly outperforms the EU average in terms of Rule of Law and Voice and Accountability rankings, compares favourable in terms of government effectiveness, and marginally underperforms on in terms of Control of Corruption and Regulatory Quality.

After eight years of Socialist Party (PS) led government under Prime Minister Antonio Costa, which oversaw a process of rapid debt reduction only interrupted by the pandemic, the prospect of snap elections heightens uncertainty over the next government policies and its stability. Morningstar DBRS considers the risk that the next government significantly move policymaking away from Portugal´s decade's long commitment to prudent fiscal policy and debt reduction as low. The latest opinion polls suggest a tight race between the Social Democratic Party (PSD) and the Socialist Party, after the latter lost popular support in the polls while the far-right Chega almost doubled its popularity to 15% (Politico Poll of Polls). Since both the PSD and PS appear far from achieving an absolute majority in parliament, the parties will need to rely on third parties to form a government. The most immediate challenge for the government remains a timely and robust implementation of Portugal´s RRP at a time when economic growth appears set to slow.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS

ESG Considerations had a significant effect on the credit analysis.

Social (S) Factors
The following Social factor had a significant effect on the credit analysis: Human Capital and Human Rights (S) affects the credit ratings assigned. Portugal’s GDP per capita, estimated at USD 24,540 in 2022 according to the International Monetary Fund (IMF), remains relatively low compared with its euro system peers. Morningstar DBRS has taken these considerations into account within the ”Economic Structure and Performance” building block.

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

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS 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://dbrs.morningstar.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/426949.

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 (October 6, 2023) https://dbrs.morningstar.com/research/421590/global-methodology-for-rating-sovereign-governments. In addition Morningstar DBRS uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://dbrs.morningstar.com/research/416784/dbrs-morningstar-criteria:-approach-to-environmental,-social,-and-governance-risk-factors-in-credit-ratings in its consideration of ESG factors.

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

The sources of information used for these credit ratings include Ministry of Finance of the Republic of Portugal (Draft Budgetary Plan 2024; Recovery and Resilience Plan Addendum, MoF Presentation January 2024), Agência de Gestão da Tesouraria e da Dívida Pública (IGCP Investor Presentation, December 2023), Banco de Portugal (BdP: Economic Bulletin, December 2023; Financial Stability Report, November 2023), Instituto Nacional de Estatística Portugal (INE), Portuguese Public Finance Council (CFP), European Commission (Autumn 2023 Economic Forecast; 2023 Country Report – Portugal; Opinion on Draft Budgetary Plan 2024, Assessment of the draft updated National Energy and Climate Plan of Portugal), Politico Poll of Polls, European Banking Authority, European Central Bank, Statistical Office of the European Communities, International Monetary Fund (WEO and IFS), World Bank, Bank for International Settlements, Social Progress Imperative (2022 Social Progress Index), and Haver Analytics. Morningstar DBRS considers the information available to it for the purposes of providing these credit ratings to be of satisfactory quality.

With Rated Entity or Related Third Party Participation: YES
With Access to Internal Documents: YES
With Access to Management: YES

Morningstar DBRS does not audit the information it receives in connection with the 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. Morningstar DBRS’s outlooks and ratings are under regular surveillance.

For further information on Morningstar DBRS 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 Morningstar DBRS 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/426947.

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

Lead Analyst: Javier Rouillet, Senior Vice President, Credit Ratings, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Credit Ratings, Global Sovereign Ratings
Initial Rating Date: November 10, 2010
Last Rating Date: July 21, 2023

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