Sovereign Rating of the Republic of Portugal

08th January of 2021

The Portuguese economy will not return to pre-crisis GDP levels until 2023. In addition, the deficit is expected to increase to -7.3% and the level of public debt is expected to reach a record high of 135%. Despite the economic shock, Portugal maintains the strength of its labor market with an estimated unemployment rate of 7.7% at the end of 2021 and 6% in 2022. The unsolicited credit rating of BBB with a Stable outlook assesses the economic impact that the health crisis COVID-19 is having on the Portuguese economy, not returning to pre-crisis GDP levels until 2023. In fact, growth is expected to be 5.4% in 2021, almost one point lower than expected in last July’s review. In addition, the final fiscal deficit at the end of 2020 is expected to reach 7.3%, also over the initial expected deficit in the same review. However, the labor market has established itself as one of the strengths of the Portuguese economy with an expected unemployment rate of 7.7% by the end of this year. Regarding debt, it is expected to reach a record high of 135%, although showing a better maturity profile. The rating also assesses the remarkable improvement of the Portuguese financial system as well as the role that the banking industry, "more capitalized and with higher levels of asset quality and liquidity", will have in the recovery process. Madrid, Monday, January 11, 2021 Axesor Rating has downgraded its unsolicited rating on Portugal from BBB+ to BBB with a Stable outlook due to the impact that the health crisis is having on the Portuguese economy, highly tertiarized and dependent on tourism. Despite the positive development in recent years —with a year-on-year growth rate of 2.2% in 2019 (almost double that of the eurozone, 1.2%) —, the rating reflects how the severity of the measures taken to address the circumstantial impact derived from the pandemic have affected the Portuguese economy. In fact, although the lower impact of the first wave of the pandemic allowed it to improve eurozone’s expectations for the first quarter, its increased reliance on the service sector accentuated the difference in comparison to the average of the eurozone during the second and third quarters. Thus, GDP in 2020 is projected to fall by -9.3%, a drop that is more severe than the EU-27 average of -7.6%. For 2021, a GDP rebound of up to 5.4% is expected, lower than the 6.3% forecast in the July 2020 review. The reason for this review lies in the greater impact the second wave of the pandemic is having on GDP in the fourth quarter and also in structural events, such as the exit of the UK from the EU (one of its main tourism markets). In this regard, Axesor Rating stresses that Portugal will not return to pre-crisis GDP levels until 2023. The credit rating assesses the strength of the Portuguese labor market which, despite the economic contraction, has a better starting point than that of its European counterparts and will not be particularly affected. The unemployment rate will actually be around 8% at the end of 2020, in line with that of the eurozone, and well below the rate in Spain (15.9%) and Italy (9.4%) and will return to a recovery path in 2021 and 2022, when it is expected to close at 7.7% and 6% of the workforce respectively, in line with the structural unemployment rate of 7% estimated by the European Commission. At this point, the credit rating agency stresses the duality of the Portuguese labor market as the main weakness "since it implies a decrease in future growth potential while encouraging the exodus of workers". Moreover, the rating assigned is limited by a negative demographic evolution, with a negative natural growth forecast of -0.17% in 2021, and a high dependency ratio of 54.7% of the population between 16 and 65 years of age. These issues present "quite a challenge to the growth potential of the economy, both because of the lower propensity to consume of the elderly and because of the pressure that welfare spending will exert on public finances". Furthermore, the rating is constrained by the high dependence on energy exports,/ which has had an impact on the evolution of the current account balance, normally in deficit. It has also increased external financing needs, with high levels of foreign debt that accentuate their sensitivity to external financial shocks. Fiscal deficit and public debt at record highs The economic shock caused by the health crisis will fully affect Portugal’s public finances, which will leave behind the surplus achieved in 2019 and will make way for a foreseeable fiscal deficit of -7,3% in 2020. A figure which is almost one percentage point above the forecast in the July review (-6.5%) and which will be extended in 2021 and 2022. In these years, the imbalances are estimated to reach -4.5% (previous forecast of -1.8%) and -3% of GDP, respectively. At this point, it should be noted that the Budget Plan drawn up by the Portuguese Government for 2021 includes new expenditure measures aimed at the recovery of employment and the reactivation of the economy, which will reach 0.9% of the GDP. Current expenditure is expected to stand at €91.2 billion, some €600 million more than in 2020. Axesor Rating considers that the new situation of fiscal deficit will exert upward pressure on the already high level of public debt that will reach a peak of over 135% of GDP during 2020, the highest level of the historical series and then stabilize at 130% of GDP in subsequent years. However, the rating also considers "The improvement in the debt profile", with an increase of its average life up to 7.7 years and a reduction of its average cost to 2.5%, mainly focused on debt issuance. An increasingly capitalized banking industry with higher levels of liquidity The rating assigned to Portugal by Axesor Rating has considered the "intense cleanup exercise" of the banking industry’s balance sheets since the crisis of 2008. In this process, the Portuguese State has played a key role having made successive capital injections into the country's major banks (CGD, BCP, and NovoBanco). Even though banks are entering the crisis with tight profitability levels and an increase in non-performing loan is expected for 2021, Axesor Rating stresses that "we see a more capitalized banking industry, with superior asset quality and considerable liquidity". Appropriate institutional framework Portugal has the best governance metrics in the European Union and shows an appropriate institutional framework that is recognized by its leading position in the transparency, supervision, and control rankings produced by the World Bank. This fact is considered in the credit rating assigned to the country. Despite the current minority government, the rating positively assesses the climate of understanding and coordination among the different parties with regards to the upcoming economic recovery and that is reflected in the recent approval of the additional budgets for 2020. However, recent clashes between the government and its informal partners from the Bloco de Esquerda party, especially in reference to financial and fiscal policy, could stress the parliamentary term that began in 2019 and delay the path of implementation of structural measures that Portugal had been taking since the beginning of the recovery after the financial crisis. Nevertheless, Axesor Rating positively assesses Portugal’s membership in the European Union ̶ whose rotating presidency the country holds during this first half of the year- where the economy is favored by the use of a single currency, economic cooperation among the different member countries, and access to aid for situations of imbalance, such as the current economic crisis caused by COVID-19.