WASHINGTON (MNI) – The following is the text of a statement by
rating agency Standard & Poor’s Thursday:

On Aug. 2, 2012, Standard & Poor’s Ratings Services affirmed its
‘BB/B’ long- and short-term sovereign credit ratings on the Republic of
Portugal. The outlook remains negative.

The recovery rating remains at ‘4’, indicating our expectation of
“average” (30%-50%) recovery for debt holders in the event of a debt
restructuring or payment default. The ‘AAA’ transfer and convertibility
assessment is unchanged.

Rationale

The ratings affirmation reflects our view of the significant
structural reforms the Portuguese government has undertaken in the past
12 months amid rapidly narrowing current account deficits, mostly
reflecting strong export performance. Although we consider that the
transition from a domestically-focused to an export-oriented economy has
increased near-term fiscal challenges, we expect Portugal will continue
to implement the EU/IMF program–including budgetary consolidation
measures–in a timely and rigorous manner. Despite its gradually
improving economic fundamentals, however, we are of the view that
Portugal’s exports-based recovery still faces significant headwinds from
potentially weaker economic and financial conditions in the eurozone,
particularly Spain; as its largest trade partner and external creditor,
Spain buys around a quarter of Portugal’s exports.

The risk of weaker export demand from Portugal’s traditional trade
partners could be offset by its increasing export receipts from markets
outside Europe, as well as from increasing market share in larger
eurozone economies such as France and Germany. Since 2010, Portuguese
exports have posted double-digit growth. We expect the current account
deficit (CAD) as a percentage of current account receipts (CARs) to
shrink below 10% in 2012 (just over 2% of GDP), from peaking at nearly
30% (12% of GDP) in 2008-2009.

Although the external adjustment has been more rapid, on a flow
basis, than we had expected, we observe that so far the narrowing of the
CAD has not been sufficient to reduce the country’s high external debt
stock; we believe external debt net of liquid assets will remain well
above 200% of CARs until 2015. Portugal’s external financing requirement
is mainly funded by the government’s borrowing from the official sector,
in particular the EU and IMF, as well as via ECB funding of the
redemptions of Portuguese banks commercial debt, and to a lesser extent
the partial rolling over of maturing private sector external debt. We
also expect increased net foreign direct investment and capital
transfers from the EU structural funds to provide some additional
external financing. It remains our baseline assumption that Portugal is
unlikely to regain full international capital market access in the next
12 months and we anticipate an extension of the official funding
program, likely mainly from the European Stability Mechanism (ESM).

The Portuguese government, elected after the EU/IMF program was
negotiated, has so far aligned its policies closely to the program
requirements and has achieved the key quantitative targets. Partly using
one-off measures of around 3.5% of GDP, it reduced the headline general
government deficit to 4.2% of GDP in 2011, below the program target of
5.9%. Over the last 12 months, the Portuguese government has enacted
numerous reforms to enhance the competitiveness of its economy and
attract foreign investment. It has amended the labor code to increase
working hours and wage flexibility, reduce the cost of redundancies, and
lessen the legal risk of objective dismissals. The government has
adopted a significant portion of the EU Services Directive and has
passed a new Competition Law. Several professions have been liberalized,
which we expect should reduce business transaction costs. The government
is also reforming the judiciary and is deregulating the rental market.
We believe that, taken together, these microeconomic reforms should
contribute to Portugal’s rebuilding economic flexibility, increasing the
probability that competitiveness improvements occur through rising
productivity rather than declining wages. On this point, we note that at
just over E12.10 per hour (Eurostat data), hourly wage costs in Portugal
at end-2011 were already 41% below those in Spain, 55% below those in
Italy, and 64% below those in France.

Factoring in the support the state provides to Portuguese banks and
state-owned entities, we expect general government debt to peak at
around 119% of GDP in 2013 before declining slowly. We also see the risk
that the scope of general government consolidation will expand to
include additional public sector entities that rely heavily on
government transfers, resulting in an upward revision of general
government debt. Public Private Partnership (PPP) contracts, mostly for
infrastructure projects, could also pose contingent liabilities. When we
also include the potential need for additional banking system support if
it comes under severe stress, we estimate the total contingent liability
to the government could exceed 30% of GDP.

The Portuguese financial system, which recently received a capital
injection of E7.2 billion (E6.2 billion from the state), faces continued
challenges to its domestic business, in our view. However, losses are
likely to be partly offset by profits from subsidiaries abroad. Retail
deposits are stable but credit losses are on the rise, a trend we expect
to continue. Portugal’s sixth-largest bank, Banif (not rated), is being
restructured and could soon need additional state support to strengthen
its capital base. In our view, Portuguese banks’ enhanced capital and
the remaining E7 billion available to the banks from the EU/IMF program
are sufficient to absorb potential losses under our base-case scenario.

We continue to view Portugal, and other eurozone governments
receiving official assistance, as vulnerable to delays or setbacks in
the eurozone’s plans to pool sufficient common resources to support
sovereign lending facilities; to create a banking union with a single
regulator and a common resolution framework by end-2012; and to move
toward closer fiscal integration. We agree with ECB president Mario
Draghi, who on July 26 said that financial fragmentation within the
eurozone is at the heart of the union’s broader economic problems. In
our view, if this fragmentation is not reversed, Portugal’s economy
could contract sharply, unemployment rise even further, social cohesion
fray, and reforms stall or reverse.

Outlook

The negative outlook on our rating on Portugal reflects our view of
the risks to the government’s progress on implementing fiscal and
structural reforms. The risks we see stem mainly from the possibility of
an even steeper-than-anticipated GDP contraction, connected to the
financial sector deleveraging and weakening external demand as a result
of worsening economic and financial problems in Spain. This could happen
if there were a delay or a reversal in eurozone fiscal and banking
integration. Further increases in unemployment could undermine the
government’s willingness to implement additional reforms. Among other
metrics, we would see significant deviations from Portugal’s fiscal
consolidation targets in 2012 and 2013. If a combination of these risks
materializes, we could lower the ratings.

Conversely, the ratings could stabilize at the current level if the
government’s budgetary performance and structural reform measures
continue as envisaged in the program, leading to not only improved
economic fundamentals, but also to either renewed access to commercial
markets or an extended program that sufficiently covers the large
external financing needs.

** MNI Washington Bureau: 202-371-2121 **

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