Portugal Upgraded To 'BBB/A-2' From 'BBB-/A-3' On Declining Debt And Balanced Growth; Outlook Stable


  • We expect the Portuguese economy to post balanced growth of between 1.5% and 1.7% during 2019-2021.
  • Over the next three years, we project that Portugal will continue to operate budgetary surpluses, excluding interest payments in excess of 3% of GDP, maintaining public debt to GDP on a firm downward path.
  • We are raising our sovereign credit ratings on Portugal to 'BBB/A-2' from 'BBB-/A-3'.
  • The outlook is stable.
RATING ACTION
On March 15, 2019, S&P Global ratings raised its unsolicited foreign and local 
currency long- and short-term sovereign credit ratings on Portugal to 
'BBB/A-2' from 'BBB-/A-3.' The outlook is stable.

OUTLOOK
The stable outlook balances our expectations that, over 2019-2022, government 
debt to GDP will continue to decline as the economy expands against risks 
connected to high, albeit declining, levels of private external debt, and a 
more uncertain external environment. We could upgrade Portugal if the economy 
generates larger surpluses on its external current and capital accounts, while 
posting growth above that of key trading partners. 

We could lower the rating on Portugal if recent progress in lowering public 
debt as a percentage of GDP were to stall, or authorities reversed past 
reforms that benefited the flexibility of Portugal's product and labor 
markets.

RATIONALE
The upgrade reflects:
  • At close to 3% of GDP, last year's primary budgetary surplus was one of the highest in the euro area and the Organization for Economic Co-operation and Development (OECD), putting public debt to GDP on a firm downward path.
  • In our view, the government's target to operate an overall budgetary surplus by 2020 (including interest spending) is credible, and based on conservative growth assumptions, reflecting the effects of Europe's cyclical slowdown.
  • Portuguese authorities have taken appropriate measures to at least dampen the effects of a potential no-deal Brexit on tourism, a major driver of growth and balance of payments resilience since 2012.
  • Exports now make up an estimated 43.3% of GDP, marking an increase of more than 16 percentage points (ppts) since 2005. Last year's external services surplus was an estimated 8.7% of GDP--an all-time high.
  • Average annual net foreign direct investment (FDI) inflows of about 2% of GDP per year, combined with recurrent capital account surpluses of over 1% of GDP per year, have enabled the Portuguese economy to pay down net external debt at close to 4.5% of GDP annually since 2014.
  • Authorities have used the recent period of low interest rates to lengthen the average maturity of the sovereign's debt toward eight years, while locking in average funding costs of about 2.8%. As of end-2018, the Portuguese treasury and debt management agency (Agência de Gestão da Tesouraria e da Dívida Pública) had retired all of the government's International Monetary Fund (IMF) debt ahead of schedule, leading to further reductions in the average interest rate on the stock of debt.
  • Credit conditions in Portugal have converged toward eurozone averages.
Institutional and Economic Profile: A gradual slowdown is not unwelcome
  • Given capacity constraints in key sectors, including tourism, a cyclical slowdown this year is not without benefits.
  • Foreign interest in the property market and equity investments in Portuguese banks explain much of the strength in net FDI inflows into Portugal since 2015.
  • We anticipate that the government will continue to operate primary surpluses of no less than 3% of GDP, ensuring steady declines in debt to GDP over the 2019-2022 ratings horizon.
For 2019, we project a mild cyclical economic slowdown in Portugal toward 1.7% 
GDP growth. Real wage growth and improving credit conditions should support 
consumption over the next two years, despite slower job creation and softer 
external demand. At the same time, we forecast that net exports will subtract 
from headline GDP growth again this year--as they did in 2017 and 2018, when 
they lowered GDP by 0.3 ppts and 0.7 ppts, respectively.  

Also supporting the consumer over the next couple of years is the likelihood 
that the pace of private sector deleveraging eases. Between 2012 and last 
year, resident nonfinancial gross debt levels declined by 61 ppts of GDP to 
199% of GDP, equivalent to about 10 ppts of GDP per year. This is not going to 
continue, partly because household balance sheets (as well as household 
confidence) are considerably stronger than a few years ago. As of end-2018, 
Portuguese households' net worth exceeded 3x the GDP--an all-time high. 

Further improving household confidence, over the past several years, real 
estate prices have recovered. At end-September 2018, house prices in Portugal 
were 8.5% higher than a year earlier and nearly 19% above their pre-crisis 
peak (2008). The run up in housing prices is not, in our opinion, a financial 
stability issue, since house price inflation has occurred in tandem with a 
steady reduction in the size of the mortgage book, as Portuguese households 
continue to pay back their house loans at a faster pace than other households 
that take on new mortgage lending. Higher real estate prices have also 
benefited the banks, given much of the collateral they hold is property.

The importance of tourism to the Portuguese economy continues to rise; the 
national statistics office estimates that between 2008 and 2015 tourism 
spending increased by approximately 3 ppts to 12.2% of GDP, of which 7.5% is 
non-resident spending. This figure is probably underestimated since related 
services (i.e. car rentals and retail trade) are not included in projections 
of non-resident travel spending. Another indication that tourism receipts are 
underestimated would be increasing errors and omissions surpluses on 
Portugal's balance of payments, which averaged 0.2% of GDP over the past two 
years. U.K. residents make up about one-sixth of tourist arrivals in Portugal, 
meaning a no-deal Brexit would at least initially incur a cost. The government 
has introduced measures to facilitate the arrival of U.K. nationals in 
Portugal in the event of a no-deal Brexit. Services exports other than tourism 
still make up half of the total, and there has been a long-standing trend 
towards diversifying tourism receipts away from the U.K.

While labor productivity data has been weakening over the past few years, we 
do not think this proves a loss of competitiveness. In our opinion, it is more 
likely that real GDP data is failing to reflect qualitative improvements in 
Portugal's tradeable and non-tradeable output, including tourism. We think 
that because, over the past two years, demand for Portuguese exports has 
remained strong despite rising export prices, suggesting that value added may 
not be fully reflected in the real data. Despite recent hikes to the minimum 
wage, Portugal's hourly labor costs remain 54% below the eurozone average. 

Flexibility and Performance Profile: Outlook for export performance is more 
uncertain than in the recent past
  • While in absolute terms Portugal's net international investment position has barely changed since 2014, its composition implies far lower refinancing risk than in the past.
  • Because of continuous budgetary consolidation, we project that Portugal's net general government debt will steadily decline, relative to GDP.
Between, 2007 and 2018, Portuguese exports of goods and services increased by 
an estimated 13 ppts to 43%, enabling the current account deficit to improve 
by over 9 ppts of GDP during the past decade. Nearly all of this adjustment 
occurred on the back of a strengthening of exports, in particular services 
exports, which increased €16.1 billion (8.1% of GDP) over the same period. 
Merchandise exports increased by similar values, as did merchandise imports. 

Evidence of softer external demand at the onset of 2019 leads us to project an 
end to a decade of external rebalancing. Therefore, for 2019, we forecast the 
second consecutive annual current account deficit in two years--but only about 
1% of GDP (after a deficit of 0.6% of GDP for 2018). Because these external 
deficits are financed by capital transfers and net FDI, they are not debt 
creating. Nor do we think last year's shift of the current account into a 
modest deficit signifies rising external vulnerabilities. Indeed, given that 
the key driver of Portugal's current account deficits has been the strength of 
investment in machinery and equipment, we believe that somewhat higher 
external deficits will benefit the economy's capital stock and its growth (as 
well as export) prospects over the longer term. 

At the same time, because Portugal's stock of net external liabilities to 
non-residents remains substantial (about 100% of GDP) a more permanent shift 
of the current account into recurrent deficits would raise questions about the 
sustainability of Portuguese external debt levels over a longer period. 

There are several reasons why we feel Portugal's capacity to service its net 
obligation to the rest of the world is stronger today than it was five years 
ago. First, the size of the Portuguese economy itself has increased by about 
16.4% since 2014 (in nominal terms), while exports make up a larger share of 
GDP.

Second, over the past five years, the composition of Portugal's external 
balance sheet has altered to less riskier forms of liabilities. Specifically:
  • The corporate sector's net external liability position, while having deteriorated by close to €30 billion since 2014 is more dominated by equity and FDI rather than debt compared to before, with the exception of a rise in lower risk trade financing; and
  • The banking system's net liability position remains modest at an estimated 6% of GDP, as is that of the Banco de Portugal at about 4% of GDP, implying limited financial sector recourse to official financing.
Nevertheless, Portuguese banks still face obstacles concerning profitability 
and efficiency in an environment of weak credit demand. Although Portuguese 
banks' reliance on funding from the European Central Bank has declined to 
about 6% of their liabilities, it may be difficult to find other low cost 
sources to replace this. Banks' earnings generation capacity also remains 
under significant pressure, given the ultra-low interest rates, muted volume 
growth, and still large stock of domestic nonperforming assets (NPAs) and 
foreclosed real estate assets. We calculate that problematic domestic assets 
make up an estimated 16% of gross domestic loans as of mid-2018 (versus the 
central bank's calculation, following EBA Guidelines, of 11.3% of 
nonperforming loans as of September 2018, a figure that is not completely 
comparable). Finally, banks' recent propensity to pay dividends to 
shareholders rather than to use retained earnings to increase loan loss 
provisions suggests mixed incentives for them to rebuild their financial 
strength (see "Banking Industry Country Risk Assessment: Portugal," published 
Feb. 19, 2019). 

Budgetary consolidation has been another economic policy priority. We project 
the 2018 headline general government deficit for 2018 (which includes interest 
payments) at 0.5%-0.6% of GDP, reflecting the strength of the domestic 
economy, further declines in borrowing costs, and stringent cost containment, 
including in sectors (especially health) that are typically sources of 
overspending across developed economies with ageing populations similar to 
Portugal's. Excluding interest expenditure, last year's budget posted a 
surplus of just under 3% of GDP, one of the highest of all OECD member states. 
This includes the estimated 0.4% of GDP payment made by the Resolution Fund to 
cover Novo Banco's 2017 losses under the Contingent Capital mechanism (agreed 
upon in 2014). For 2019, we expect already announced losses at Novo Banco to 
lead to another 0.4% of GDP charge to the budget under the mechanism.

Ahead of upcoming parliamentary elections, expenditure pressures may 
resurface, particularly on the public wage bill. But we are fairly confident 
that the government will reduce the headline deficit further this year by 
another 0.2-0.3 ppts of GDP. We anticipate savings via controls on line 
ministries' expenditure and ongoing spending reviews. The government has 
launched spending reviews in health care, education, public procurement, and 
state-owned enterprises, to be followed by budgeting audits for internal 
administration, justice, and human resource management. 

We consider that, if effectively implemented, the spending reviews could 
contribute to a more efficient public sector. Overall government 
spending--estimated at about 44% of GDP in 2018--appears relatively high, even 
compared with considerably wealthier eurozone member states such as Germany or 
The Netherlands. This implies a correspondingly high tax burden, including on 
labor incomes. 

Perhaps the greater long-term fiscal and economic risk is Portugal's ageing 
demographics, given the country's old age dependency ratio of 33.2 (the ratio 
of dependents older than 64 to the working age population) is the fourth 
highest of all rated sovereigns--after Japan, Italy, and Finland--and has 
increased by 20.4 ppts since 1960, according to World Bank data.

We expect Portugal's net general government debt to decline to 99% of GDP in 
2022, from an estimated 111% at end-2018. At the end of last year, Portugal 
had prepaid its IMF loan in entirety, thereby improving its debt profile while 
taking advantage of stronger borrowing conditions to lower its interest 
burden. The average remaining term of the government's debt stock is around 
eight years, including the extension of the European Financial Stability 
Mechanism loans. By 2022, average general government interest payments will 
likely drop to about 7% of general government revenues from 8% last year, as 
the government refinances more expensive debt at lower interest rates. We 
expect that Portugal's cash buffer, which we estimate at about 9% of GDP at 
end-2018, will decline only gradually over the coming years. However, we do 
not factor in the future reimbursement of the 2014 government loan to the 
Resolution Fund for the purpose of recapitalizing Novo Banco, which was 
extended last year to 30 years. 
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