S&P Downgrades Portugal Again To BBB-/A-3, Outlook Negative, Still Somehow Investment Grade

Tyler Durden's picture

From S&P, although nothing new here. EURUSD does not even blink on the news:

Overview

  • The concluding statement of the European Council meeting of March 24-25, 2011, addressing the terms under which EU sovereigns may borrow from the European Stability Mechanism (ESM) confirms our previously published expectations that (i) sovereign debt restructuring is a potential pre-condition to borrowing from the ESM, and (ii) senior unsecured government debt will be subordinated to ESM loans.
  • Both features are, in our view, detrimental to the commercial creditors of EU sovereign ESM borrowers, and represent a major departure from the current European Financial Stability Facility (EFSF) regime whereby sovereign EFSF loans rank pari passu with a borrowing sovereign's commercial debt.
  • Given Portugal's weakened capital market access and its likely considerable external financing needs in the next few years, it is our view that Portugal will likely access the EFSF and thereafter the ESM.
  • While we believe Portugal's public sector debt trajectory could start to decline in 2013, thereby creating the possibility that Portugal may be able to obtain ESM funding without being required to restructure its debt (based in part upon our reading of the "sustainable path" language in the EC's concluding statement), the issue of subordination remains.
  • We are therefore lowering our sovereign credit ratings on Portugal to 'BBB-/A-3'.
  • The negative outlook reflects our view that the macroeconomic environment could weaken beyond our current expectations and that a political impasse could undermine the effective implementation of Portugal's adjustment program, leading to non-negligible policy slippages.

Rating Action

On March 29, 2011, Standard & Poor's Ratings Services lowered its sovereign credit ratings on the Republic of Portugal to 'BBB-/A-3' from 'BBB/A-2'. At the same time, the ratings on Portugal were removed from CreditWatch with negative implications, where they were placed on Nov. 30, 2010. The outlook is negative. The 'AAA' transfer and convertibility assessment is unchanged.

Standard & Poor's will hold a teleconference today to discuss the above rating actions. The call will begin at:

4:30 p.m. British Summer Time,

5:30 p.m. Central European Time, and

11:30 a.m. Eastern Time.

See section "Teleconference Information" toward the end of the text for access  details.

Rationale

The downgrade reflects our view of the concluding statement of the European Council (EC) meeting of March 24-25, 2011, that confirms our previously published expectations that (i) sovereign debt restructuring is a possible pre-condition to borrowing from the European Stability Mechanism (ESM), and (ii) senior unsecured government debt will be subordinated to ESM loans. Both features are, in our view, detrimental to the commercial creditors of EU sovereign ESM borrowers.

The EC's concluding statement addresses the issues of sovereign debt restructuring and government bond subordination in items 1 and 3 of the ESM's term sheet (see "European Council Conclusions" below).

According to the EC's concluding statement: "If, on the basis of a sustainability analysis, it is concluded that a macro-economic program cannot realistically restore the public debt to a sustainable path, the beneficiary Member State will be required to engage in active negotiations in good faith with its creditors to secure their direct involvement in restoring debt sustainability. The granting of the financial assistance will be contingent on the Member State having a credible plan and demonstrating sufficient commitment to ensure adequate and proportionate private sector involvement."

"Like the IMF, the ESM will provide financial assistance to a Member State when its regular access to market financing is impaired. Reflecting this, Heads of State or Government have stated that the ESM will enjoy preferred creditor status in a similar fashion to the IMF, while accepting preferred creditor status of IMF over ESM."

It is our view that high current account deficits accumulated over the past 10 years resulted in Portugal's substantial net external indebtedness, with gross external debt exceeding 500% of current account receipts (CARs), and gross financing requirements exceeding 200% of CARs annually in the whole forecast period until 2014. In our view, these financing requirements make it likely that Portugal will access the European Financial Stability Facility (EFSF; AAA/Stable) and, in 2013, ESM funding.

The outlook for Portugal's GDP performance is highly uncertain and will depend significantly on the capacity of the relatively small and closed Portuguese economy to build exports from the currently relatively low base of 30% of GDP. Following last week's resignation of Portugal's minority government, we assume that a new government will be formed by the end of the second quarter 2011. We expect the next government will agree to further fiscal and structural reforms
as part of an EU/IMF program. However, timing and implementation risks remain against the backdrop of an uncertain outlook for the economy and the financial sector.

Under current policies, Portugal's fiscal deficit is likely to exceed the targets established in the Stability and Growth Programme by around 3% of GDP in cumulative terms between 2011-2014; this would still imply that general government debt to GDP would begin to decline in 2013, based on our nominal GDP and interest rate assumptions. However, the uncertain outlook on the economy means that there are sizable downside risks to this relatively benign scenario, given the sensitivity of tax receipts to domestic demand and to imports, amid pressures on commercial banks to tighten credit.

If the government demonstrates that a macroeconomic program can realistically put the public debt trajectory onto a sustainable path, we are of the view, based on our reading of the concluding statement of the EC meeting, that Portugal may be able to obtain funding from the ESM without restructuring its existing debt in 2013, thus avoiding the timing disruption inherent in a restructuring. Nevertheless, any ESM borrowings would be senior to Portugal's government bonds. The seniority of ESM borrowings (and the consequent subordination of government bonds) in our view reduces the prospect of timely repayment to government bondholders, and likely also results in lower recovery values.

Outlook

The negative outlook reflects our view of the risks to Portugal's fiscal performance from a sustained weakening in domestic demand, as government austerity measures and weak credit stimulus weigh on incomes. Portugal still faces sizable twin deficits and their reduction will stress policymakers' resolve in the face of what we believe will become an increasingly hostile public opinion. Risks of a challenging economic and financial environment could negatively affect asset quality and profitability in the Portuguese financial system, potentially triggering the need for capital support from the
government.

If, contrary to our baseline assumption, the next government deviates from the current fiscal targets or if bank recapitalization cost exceeds 3% of GDP, we could lower the ratings further.

On the other hand, if Portugal achieves better-than-anticipated fiscal performance compared to our current forecast, achieves faster debt reduction by 2013, continues to implement growth-enhancing reforms, maintains its pace of strong export growth, and thus reduces its external financing gap, we could revise the outlook to stable.