Scope affirms Portugal’s BBB+ ratings, revises Outlook to Positive from Stable

Sustained fiscal improvements backed by sound long-term growth prospects drive the outlook revision. An elevated stock of public debt and exposure to global shocks as a small, open economy are challenges.

Rating action

Scope Ratings GmbH (Scope) has today affirmed the Portuguese Republic’s BBB+ long-term issuer and senior unsecured local - and foreign-currency ratings, along with its short-term issuer rating of S-2 in both local and foreign currency. All Outlooks have been revised to Positive from Stable.

Summary and Outlook

The revision of the Outlook on Portugal’s sovereign credit ratings to Positive reflects Scope’s expectation of a sustained improvement in Portugal’s fiscal fundamentals in the medium term. Portugal’s public debt ratio resumed its downward trend in 2021, and Scope expects Portugal’s debt-to-GDP ratio continue its downward trajectory over the longer term. This will follow from the combined effects of a credible long-term fiscal consolidation plan and sound long-term growth prospects – underpinned by ongoing access to substantial EU investment and recovery fund inflows. The government’s ongoing commitment to fiscal discipline and debt reduction, along with a favourable debt profile and high cash buffer, should support improved fiscal consolidation.

The affirmation of the BBB+ long-term ratings incorporates Portugal’s institutional strength, which is bolstered by the country’s membership in the EU and euro area. The ratings recognise the authorities’ good record of prudent fiscal policy and credible macroeconomic policymaking, which has facilitated a rebalancing of fiscal and external accounts and a reduction of structural unemployment.

However, Portugal still faces considerable credit challenges related to: i) its small, highly open economy, making the country vulnerable to external shocks; ii) modest growth potential, despite a significant wealth gap versus euro area peers; and iii) elevated public debt and implicit liabilities, including from adverse demographic trends impacting public spending.

The Positive Outlook represents Scope’s view that risks to the ratings over the next 12 to 18 months are tilted to the upside. The rating/Outlook could be upgraded if, individually or collectively, Portugal’s: i) debt sustainability strengthened as a result of a material decline in its debt burden; and/or ii) continued implementation of growth-enhancing structural reforms supported greater diversification into higher-value-added activities and growth potential.

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

Rating rationale

The revision of the Outlook to Positive on Portugal’s BBB+ rating reflects Scope’s expectation of a sustained reduction in debt, the profile of which has improved markedly over the past few years. Scope expects the Portuguese authorities’ commitment to fiscal discipline and reducing the elevated public debt stock will continue in the context of relative political stability.

Portugal’s fiscal balance stood at negative 2.8% in 2021, down from negative 5.8% in 2020. Scope expects Portugal’s budget deficit to narrow to 2.0% of GDP this year, backed by an improving primary balance, as pandemic-related fiscal support measures are withdrawn. Scope expects the fiscal balance to improve gradually to close to balance by 2024 as the economy recovers. This view is supported by recovering tax revenue growth and a credible fiscal consolidation plan with high primary surpluses, which Scope expects to average 1.8% of GDP in 2023-26. Additional support for this view comes from the Portuguese government’s good record of primary surpluses in recent years, averaging 1.9% of GDP over 2015-19, among the highest in the euro area.

Scope’s expectation of a broadly unchanged fiscal policy stance over the next few years is underpinned by the country’s stable political environment. Recent snap elections after failing to approve the 2022 state budget last October threatened to undermine the relative political stability and reform momentum that the country had benefitted from under the previous two minority governments led by Socialist Party leader Antonio Costa. Instead, elections ended up strengthening political stability, with incumbent Prime Minister Costa securing an absolute majority. Notably, the smaller left-wing parties that withdrew their support during the budget-approval process last year experienced markedly lower voter shares in the general election, providing popular support for Costa’s policies. On this basis, Scope expects Portugal’s government to continue striking a delicate balance with reforms that enhance the country’s competitiveness, address its social needs and maintain fiscal consolidation in the coming post-pandemic years.

In this context, Portugal’s general government debt-to-GDP ratio in gross terms, which peaked in 2020 at 135.2%, has resumed its downward trend in 2021 and declined to 127.3%. Under Scope’s public debt sustainability analysis, the debt-to-GDP ratio is projected to decline to below pre-pandemic levels of around 106% of GDP by 2026. The expected decline in Portugal’s debt ratio underpins the Positive Outlook. This is considering that the estimated debt reduction of around 20 pp from 2020 to 2026, facilitated by the long-term downward trend in the cost of debt driven by lower issuance costs and a substantial negative snowball effect in the coming years, excludes the government’s cash buffer. This buffer stood at 7.4% of GDP in 2021. Conversely, under an adverse scenario assuming a combined one percentage point shock to real GDP growth (lower) and interest payments (higher) and a 1.0 pp shock to the primary balance (lower) on average over the forecast horizon, the debt-to-GDP ratio would remain at elevated levels of around 120% by 2026.

Portugal’s favourable debt profile and active debt management also support the Positive Outlook. Following bond buybacks and exchanges as well as longer-term issuances, this has smoothened the redemption profile, keeping gross financing needs at around 10% of GDP over the coming years. Portugal’s debt management strategy aims to maintain a high cash buffer above 30% of the following year’s gross financing needs, further reducing refinancing risks. The country benefits from a favourable debt profile, with an average debt maturity of 7.7 years as of February. The cost of outstanding debt has shown a steady declining trend in recent years, at 2.2% of GDP in 2020 and 1.9% in 2021, down from 4.1% in 2011.

Fiscal consolidation is also supported by favourable growth prospects along with incoming EU funds and the authorities’ good record of EU fund absorption and structural reform. Increased FDI, current account rebalancing and structural unemployment reduction confirm positive structural changes in the Portuguese economy. Despite the short-term growth outlook being affected by the deterioration in global growth prospects because of the conflict in Ukraine and rising inflationary pressures, Scope expects a sustained economic recovery, assuming economic growth of about 4.2% this year and 2.0% in 2023, after the 4.9% rebound in 2021. This view is supported by the EU’s NGEU funds of which Portugal is set to receive EUR 13.9bn in grants over the lifetime of its plan and a gradual recovery in tourism which will provide additional support for growth.

Inflation is set to rise to around 4% in 2022, with the recent rise in food and energy prices representing a shock to purchasing power. However, we expect the shock from higher energy prices to be more contained in Portugal than in the euro area. While Portugal is dependent on external energy, with an import share of around 65% of energy consumed (mostly natural gas and oil), only 5% of these imports came from Russia in 2020. In addition, a temporary mechanism (lasting 12 months) that will cap the price of natural gas, resulting in lower electricity bills for a notable share of Spanish and Portuguese consumers with regulated rates. The Portuguese government expects to make up those costs through additional levies on energy companies’ windfall profits.

These factors increase the country’s resilience to economic shocks in the current uncertain external environment and have enabled a moderate countercyclical fiscal response to the current crisis.

Despite the positive developments, Portugal still faces considerable credit challenges relating to: i) its small, highly open economy, making the country vulnerable to external shocks; ii) modest growth potential despite a significant wealth gap versus euro area peers; and iii) elevated public debt and implicit liabilities, including from adverse demographic trends impacting public spending.

First, as a small, highly open economy with a large tourism sector, Portugal is subject to macroeconomic volatility and exposed to developments in the external environment. Indeed, growth prospects are highly reliant on tourism exports which account for more than half of total expected economic growth in 2022-23 according to recent forecasts by Banco de Portugal. Risks from the war in Ukraine mainly constitute inflationary pressure in case of the Portuguese economy, with second-round effects in the form of changing growth prospects for key European trading partners.

Second, the Portuguese economy has a modest growth potential, estimated at 1.8% despite a still significant wealth gap versus euro area peers, along with low investment levels. With GDP per capita below 60% of the euro area average, Portugal’s growth prospects are constrained by low productivity and an economy concentrated in low-value-added sectors. Here, the government’s reforms to address long-standing bottlenecks in the business environment and to boost the skills of the workforce, with a focus on digital skills to meet the needs of the labour market, will be critical.

Finally, substantial long-term age-related spending pressures continue to mount, adversely affecting Portugal’s budget flexibility. The country has the EU’s fourth highest old-age dependency ratio, at 37%, which is set to increase to 53% by 2035, making it the EU’s second highest at that time. Ageing dynamics in Portugal will place structural pressure on government budgets through higher healthcare and pension spending, while government revenues will be squeezed by a shrinking, ageing labour force. These pressures have continually increased over time, creating economic, budgetary, and social challenges. Scope expects additional public finance efforts will be required to maintain the level of social benefits currently provided. In this respect, Portugal’s reform agenda under the EU recovery fund programme includes measures to strengthen government expenditure control, enhance the resilience of the health system and raise the capacity of social services.

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 20% weighting under the quantitative model (CVS) and in the methodology’s qualitative overlay (QS).

Under governance-related factors captured in Scope’s core variable scorecard (quantitative model), Portugal has strong scores on a composite index of six World Bank Worldwide Governance Indicators, reflecting strong democratic institutions. Furthermore, Scope’s qualitative scorecard evaluation of ‘institutional and political risks’ indicates Portugal’s performance is in line with that of indicative sovereign peers, reflecting stable political conditions and broad consensus on key policy issues. The ratings recognise the authorities’ good record of prudent fiscal policy and structural reform, including current account rebalancing and structural unemployment reduction.

As regards social risk factors, the quantitative model score is constrained somewhat by an ageing society in an international context, reflecting an increasing old-age dependency ratio over the long term. Portugal is facing severely adverse age dynamics impacting public spending, with an old-age dependency ratio forecasted to rise above 60 by 2050, one of the highest levels in the EU. In addition, youth unemployment remains relatively high, although measures have been taken to tackle this challenge. The country has above-average scores on income inequality and labour force participation rates, and it has implemented legislation to address the gender pay gap. In the area of health spending, the European Commission projects Portugal will face an increase of 1.6 pp of GDP between 2019 and 2070, the fourth highest in the European Union.

Finally, in the sovereign ESG pillar’s environmental risk subcategory, Portugal’s quantitative scores are strong in terms of the carbon intensity of its economy (as measured by emissions per unit of GDP) and as regards natural risks. However, Portugal has recently experienced forest fires and a protracted drought period, while flooding has been a recurrent problem in other regions. Portugal was one of the first EU countries to commit to net zero emissions by 2050, and it published a long-term strategy for carbon neutrality in June 2019. A significant investment effort is required to meet the carbon neutrality goal. Air quality in Portugal remains a challenge. This mainly relates to personal transport systems, which exacerbate seasonal problems with air quality and traffic congestion in the major metropolitan areas.