LONDON (MNI) – Fitch Ratings downgraded Portugal’s sovereign rating
by one notch from BBB- to BB+ on Thursday and changed the outlook to
negative, citing the country’s “large fiscal imbalances, high
indebtedness across all sectors, and adverse macroeconomic outlook.”

The downgrade was expected by the markets and concludes Fitch’s
review of Portugal’s sovereign rating, resolving the “ratings watch
negative” in place since April 2011.

Portuguese bonds came under pressure following the downgrade
announcement, with the 10-year yield spread reversing earlier tightening
versus German Bunds. The 10-year OT yield spread was last 1 basis point
wider at +1018bps.

The full text of the report follows:

Fitch Ratings has downgraded Portugal’s Long term foreign and local
currency Issuer Default Ratings (IDR) to ‘BB+’ from ‘BBB-‘ and
Short-term IDR to ‘B’ from ‘F3′. The Rating Watch Negative (RWN) on the
long-and short-term ratings has been removed. The Outlook is Negative.
The agency has also affirmed its Country Ceiling at ‘AAA’. Fitch has
also downgraded Portugal’s senior unsecured debt to ‘BB+’ and commercial
paper to ‘B’, and removed both from RWN.

Fitch has concluded its fourth-quarter review of Portugal’s
sovereign rating, resolving the RWN in place since April 2011. The
country’s large fiscal imbalances, high indebtedness across all sectors,
and adverse macroeconomic outlook mean the sovereign’s credit profile is
no longer consistent with an investment-grade rating.

Fitch has lowered Portugal’s growth forecasts in light of the
worsened European outlook. The agency now expects GDP to contract by 3%
in 2012. Significant structural reforms expected under the programme
should leave Portugal in a more competitive position in the long term.

Over the next two years, the recession makes the government’s
deficit-reduction plan much more challenging and will negatively impact
bank asset quality. However, Fitch judges the government’s commitment to
the programme to be strong.

Fitch expects the official deficit target of 5.9% to be met this
year, albeit with significant recourse to one-off measures. The most
significant of these will be the transfer of bank pension schemes to the
public sector, booking an upfront gain of up to 1.7% of GDP.

The 2012 budget contains significant expenditure reductions, mainly
on pensions and civil service pay. The budget is well-designed and is
based on reasonable GDP assumptions. Fitch therefore expects the 4.5%
deficit target for 2012 to be met. However, the risk of slippage –
either from worse macroeconomic outturns or insufficient expenditure
control – is large. Fitch’s base case is that general government debt
will increase from 93.3% of GDP at end-2010 to around 110% at end-2011
and peak at around 116% at end-2013.

The state-owned enterprise sector is another key source of fiscal
risk and has been responsible for several upward revisions to the
general government debt and deficit figures over the past year. Given
these downside risks, Fitch sees a significant likelihood that further
consolidation measures will be needed through the course of 2012.

The current account deficit (CAD) was 9.9% of GDP in 2010, near its
(exceptionally high) 10-year average, and net external debt was 78% of
GDP. The return to recession in 2011 marks the start of a long-delayed
external adjustment, with resources shifting away from consumption
towards exports. Fitch expects the CAD to narrow to 7.5% in 2011.

The sovereign crisis poses significant risks to the banking system,
which lends to one of the most indebted private sectors in Europe and is
highly reliant on wholesale financing (access to which is now closed
off). Recapitalisation and increased emergency liquidity provision from
the ECB to Portugal’s banks will, in Fitch’s view, be needed and
provided.

A worse economic and/or fiscal performance than forecast could lead
to a further downgrade. Furthermore, although Portugal is funded to
end-2013, sovereign liquidity risk may increase materially towards the
end of the programme if adverse market conditions persist.

Successful economic and fiscal rebalancing under the IMF/EU
programme would ease downward pressure on the rating. Improvement in
Portugal’s potential growth rate would improve the sovereign’s credit
profile over the long term.

–London Bureau; Tel: +442078627492; email: ukeditorial@marketnews.com

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