The rating action concludes the review that Moody's initiated on Portugal on 21 December 2010 and is the last of the reviews on several of the European periphery countries that were initiated in December last year.
Moody's rating action was driven by the following four factors:
1. Subdued growth prospects and productivity gains over the near to medium term until structural reforms, especially in the labor market and the justice system, begin to bear fruit;
2. Implementation risks for the government's ambitious fiscal consolidation targets;
3. The government's balance sheet may need to expand further in the event it has to provide financial support to the banking sector and government-related institutions (GRIs), which are currently unable to access capital markets; and
4. Challenging market conditions that have led to increases in the government's financing costs, which, if sustained, will cause its debt affordability to weaken, particularly in the context of generally higher European interest rates.
Accessing the European Financial Stability Facility may lead to a reduction in financing costs, but questions would remain as to when the government would be able to re-access the capital markets and on what terms.
The new measures in the recent update on the stability and growth program announced by the Portuguese government figured prominently in the rating conclusion. Moody's expectation that the revenue increases, expenditure reductions, and structural reforms specified by the government will be achieved is a critical consideration underlying the A3 rating.
Moody's has also downgraded Portugal's short-term debt rating from Prime-1 to Prime-2. Portugal's country ceilings for bonds and bank deposits are unaffected by today's rating action and remain at Aaa (in line with the eurozone's rating).
The first key driver of today's rating action is the uncertainty over how quickly Portugal's task of improving its competitiveness and reducing its external imbalances can be achieved against the background of the country's already strained net international position and the government's continuing heavy reliance on external financing. In order to reduce the external imbalances, exports will have to grow and/or imports slow. Notwithstanding last year's good export performance, the small scale of the external sector means a large share of the adjustment will have to be borne by weaker imports. The increase in savings needed to bring about the turnaround in imports will be difficult to achieve without a decline in domestic demand and consequently, a further weakening in the overall outlook for economic growth. Since the external adjustment is likely to take several years to complete, concerns about the growth outlook are likely to persist for some time.
Moreover, uncertainties in the global economy make Portugal's adjustment efforts more challenging. Rising inflationary pressures could lead to an increase in the ECB's policy rate, which could aggravate the Portuguese government's funding costs and put additional pressure on private sector borrowing costs. And should oil prices rise further and remain high for over a long period, external imbalances would worsen, given Portugal's dependence on imported energy.
That said, Moody's acknowledges the progress the Portuguese authorities have made and are continuing to make in reforming the economy, particularly its labor markets, social programs and the justice system, including the measures announced on 11 March. It is too soon, though, to estimate the impact such measures will have on the economy's medium- to long-term sustainable growth rate.
The second driver of Portugal's downgrade is the implementation risk surrounding the government's ambitious deficit reduction goals over the next two years. The government aims to reduce the deficit to 4.6% this year, which implies a substantially higher reduction in the underlying deficit than that achieved in 2010, and announced measures on 11 March to ensure it reaches its budget deficit targets for this year, 2012 and 2013. The commitment demonstrated by those measures is reflected in Moody's A3 rating assessment. Still, the government faces significant challenges, not least a less supportive economic environment: real GDP rose an estimated 1.4% in 2010 but is expected to decline this year and experience a weak recovery at best in 2012.
Moody's views positively the Portuguese government's proposed changes to its budgetary governance process, including the introduction of quarterly targets, corrective actions when deviations are detected and the amendment of the budgetary framework law aiming, amongst other things, to introduce fiscal rules and an independent council for public finances to ensure compliance with the multi-year fiscal plan set by the government. Indeed, if the reforms are successfully implemented, they would make a positive contribution towards a more sustainable fiscal situation.
The rating agency also notes that the commitment to fiscal consolidation shared by both leading political parties is an important reason why Portugal's rating remains within the A range, given the current government's minority composition and the possibility of early elections being called in the near future. In view of the political realities, an EFSF program could help to ensure that the targets are fulfilled.
Moody's third key concern is the possibility that the Portuguese government would have to intervene to provide capital to the country's banks and government-related issuers, leading to a potentially significant expansion of the government's balance sheet. The prospect itself and the uncertainty surrounding the size of any such increase are both factors in the rating agency's decision to implement today's rating action. This view would not change if the government sought support from the EFSF, since the banks and GRIs are unlikely to be able to re-enter the markets before the sovereign.
The background to this is that, although the government of Portugal is still able to access the market, the country's banks and GRIs have been shut out, the former for nearly a year. The banking system does not face solvency problems anywhere near as severe as those in Spain or Ireland, but the challenging operating environment increases downside risks for earnings and asset quality. Moody's notes that banks would need to rebuild their capital bases to regain access to the markets. GRIs will need to refinance maturing debt: Moody's estimates that the nine GRIs that it rates have total outstanding debt of around €35 billion (equivalent to roughly 20% of GDP) and around €14bn of this will mature by the end of 2013.
The fourth factor that drove today's rating action is the challenges the government faces in obtaining funding in the capital markets without paying elevated yields that would reduce its debt affordability over time. The cost of market funding is likely to remain high until the deficit has been reduced to a sustainable level and the prospects for economic growth have improved. If the government seeks funds from the EFSF rather than capital markets, Portugal would likely gain access to liquidity at lower cost than it currently faces in the capital markets and limit some of the potential increase in its debt servicing costs, but the path to regaining market access at favorable terms would remain challenging.