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Fitch Affirms Portugal at 'BB+'; Outlook Positive

fitchFitch Ratings has affirmed Portugal's Long-term foreign and local currency Issuer Default Rating (IDRs) at 'BB+'. The Outlook is Positive.

The issue ratings on Portugal's unsecured foreign and local currency bonds have also been affirmed at 'BB+'. Fitch has also affirmed Portugal's Short-term foreign-currency IDR at 'B' and Country Ceiling at 'A+'.


The affirmation and Positive Outlook reflect the economy's gradual rebalancing, underpinned by structural reforms in areas such as the labour and product markets. This has helped boost competitiveness and growth and address external and fiscal imbalances, although the pace of fiscal consolidation has slowed this year. Portugal also benefits from high level of human development, high GDP per capita relative to peers and a favourable business environment.

A moderate economic recovery will help narrow the headline fiscal deficit to slightly below 3% of GDP in 2015, from 7.2% in 2014 (revised from 4.5% previously, due to the inclusion of the one-off effect of the capitalisation of Novo Banco), allowing Portugal to exit the EU's European Deficit Procedure (EDP) in line with the government's expectations. However, the structural fiscal deficit (excluding one-offs and the impact of the economic cycle) is set to widen instead of falling. This is in large part due to the upcoming legislative elections on 4 October, which has reduced the scope for further fiscal measures.

The two parties/alliances leading the opinion polls (the ruling coalition comprising the Social Democratic Party and CDS-People's Party and the main opposition, the Socialist Party) are both pro-European and centrist. Fitch does not expect a major change in fiscal or economic policy direction after the elections. Nevertheless, the tight electoral contest means that various political scenarios are possible and there is uncertainty over how quickly a new government can be formed and its subsequent cohesion and stability. Furthermore, meeting EU deficit and debt reduction targets will be challenging, partly as some recent consolidation measures are scheduled to be reversed. On the upside, the gradual implementation of a budget framework law should help improve transparency and compliance.

Fitch forecasts gross general government debt (GGDD) to decline to 127.9% of GDP at end-2015, from its peak of 130.2% at end-2014, supported by modest primary fiscal surpluses, lower financing costs and a EUR3.4bn draw down in cash balances. The agency forecasts that GGDD will remain above 125% of GDP in 2016-17, before trending down gradually to around 116% by 2020, partly reflecting weak nominal GDP growth. This elevated debt level leaves public finances with limited flexibility if faced with future shocks.

Portugal continues to enjoy broad capital market access at favourable yields. This has allowed the early repayment of EUR8.4bn in IMF loans this year, the lengthening of maturities to an average of 8.8 years and the build-up of a sizeable deposit buffer (7% of GDP).

Economic recovery remains on track, underpinned by a positive performance across most sectors. Real GDP grew by 0.5% qoq in 2Q15 (broadly in line with the eurozone average), supporting Fitch's forecast that the economy will expand by 1.5% this year. Domestic demand growth was robust in 1H15, reflecting improved confidence indicators and rapid employment creation. Increased demand for labour in the services sector (particularly tourism) has helped bring down the seasonally adjusted unemployment rate to 12.1% in July 2015 from a peak of 17.4% in early 2013, according to Eurostat data.

Medium-term growth prospects are weighed down by public and private sector deleveraging, low investment rates and adverse demographic trends. Non-consolidated corporate debt is high at 152.5% of GDP at 2Q15, albeit down from 162.1% in 2013, while household debt is 83.4% of GDP (down from 91.8% in 2013). In this context, Fitch expects GDP growth to average 1.5% in 2016-17, below the 2% forecast by the authorities.

Portugal's external rebalancing is continuing, but the stock of net external debt is exceptionally high at almost 100% of GDP at end-2014. Fitch forecasts the current account surplus set to widen to 0.8% of GDP in 2015. Real exports grew 7.4% in 1H15 yoy, despite a drop in exports to Angola (its fourth-largest market), helped by an improvement in competitiveness and a strong tourism performance. However, imports surged, leading to a negative contribution from net trade to GDP in 1H15.

The banking sector is stable, underpinned by a gradual improvement in liquidity conditions (the loan to deposit ratio fell to 107% in 1Q-2015 from 160% in 2010) and solvency. However, profitability is weak and deleveraging continues to affect asset quality (particularly in the non-financial corporate sector), with the overall ratio of non-performing loans rising to 12% in 1Q15. Fitch expects lending to contract in 2015, although credit growth to export-oriented firms is positive.

The failure to sell Novo Banco (the 'good' bridge-bank formed from Banco Espiritu Santo; BES) by the original planned date has raised uncertainty regarding the present value of the bank and its asset quality. The authorities will wait until the release of an upcoming comprehensive assessment by the European Central Bank to begin a new bidding round but there is a high risk that Novo Banco will be sold for less than the value of its rescue (EUR4.9bn). This would create new costs for the country's banks and limit a potential positive stock flow adjustment to public debt (the BES operation resulted in an original increase in net general government debt of 2.6% of GDP, which the Portuguese government had projected recouping by end-2015).

The main factors that could individually or collectively lead to an upgrade to investment grade are:
-Increased confidence in fiscal policy consistent with a downward trend in the general government debt/GDP ratio.
-Continued recovery in economic prospects, supporting gradual progress in private sector deleveraging.
- A reduction in external indebtedness.

The Outlook is Positive. Consequently, Fitch does not currently anticipate development with a material likelihood of leading to a downgrade. However, the following factors could lead to negative rating action:
-A relaxation of the fiscal stance, resulting in a less favourable trajectory in government debt/GDP levels.
-Weaker economic growth that could forestall corporate sector deleveraging or have a negative impact on the banking sector or public finances.
-Failure to make further progress in unwinding external imbalances.

Although the outcome of the elections is highly uncertain, Fitch expects no major deviation in the direction of policy in the new government.

Fitch's public debt dynamics do not include any government bank asset disposals as the timing and values of such operations remain uncertain.

The European Central Bank's asset purchase programme should help underpin inflation expectations, and supports our base case that the eurozone will avoid prolonged deflation. Nevertheless, deflation risks could re-intensify in case of adverse shocks.


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