Rating review puts Portugal on edge

Canadian rating agency DBRS is back at the top of investors’ watch lists ahead of its October 21 review of Portugal’s sovereign creditworthiness. DBRS is the smallest of the four ECB-recognised agencies and the only one to give Portugal an investment-grade rating, making it Lisbon’s last link to quantitative-easing liquidity. 

Despite European efforts to kill the bank-sovereign loop, speculation around a downgrade has risen, aggravating volatility in Portuguese government bonds, in part due to worries about the state’s banking sector contingent liabilities.

Concerns about Portugal and its banks have risen in tandem with similar concerns in Italy, where banks are also under pressure to crystallise loan losses and are struggling to raise much-needed capital privately. DBRS’s views, indeed, are in the spotlight there too, where it is the only one of the four to give Italy an A-rating. 

For Portugal, its decision is even more important, as a downgrade to junk would mean its government bonds would no longer be eligible for the ECB’s asset purchases, putting it in a similar category to Greece and Cyprus. “The market is hanging on DBRS’s lips,” says David Schnautz, interest rate analyst at Commerzbank.

David Schnautz, Commerzbank

Fergus McCormick, co-head of sovereign ratings at DBRS, says it focuses more on structural and institutional dynamics, and less on short-term indicators such as the quarterly deficit. As such, news in August of a largely government-backed €5 billion recapitalization of the country’s biggest bank, state-owned Caixa Geral de Depósitos, would not alone trigger a downgrade, as local banks’ poor profitability and non-performing loans must be tackled. 

But the proposed recapitalization, including a hoped-for €1 billion in private-sector subordinated debt, will add around 1.5 percentage points of GDP to Portugal’s stock of debt, bringing it over 130% (around €200 billion) when the ratio would otherwise have fallen, says McCormick. In the absence of new austerity measures in a new draft budget earlier in October, the rise above 130% could be even higher, he says, as growth has disappointed this year. 

McCormick thinks the debt ratio is stabilising, but the government has “not succeeded in putting the debt ratio on a firm downward path”. His worry is that uncertainties across the eurozone will mean growth continues to disappoint, dragging down not just tax revenues but also asset quality and capital at the banks, further hurting banks’ ability to support the economy. 

“It is encouraging that the [Portuguese governing] coalition is proving quite stable, but the contingent liability of the banking sector continues to be an issue,” he says. “We’re still to see a comprehensive plan for the banks.”

A DBRS downgrade would mean a big sell-off in Portuguese bonds, though the ECB might make an exception to the investment-grade rule, or find another way to maintain eligibility for QE, says Richard McGuire, head of rates strategy at Rabobank. He sees little appetite for another sovereign bail-out, which is officially the only other way the bonds would remain eligible. The EU might be more eager to maintain a benign image in the wake of the Brexit vote and given a surprisingly cooperative approach by the year-old left-wing government, he adds. 

Schnautz, however, says the government has “self inflicted problems” by reversing austerity measures of the 2010 to 2014 bailout programme. “Why should the ECB flinch?” he asks.

For DBRS, it is something of a chicken-and-egg situation.

“As long as ECB purchases continue, the flow [of debt] is less important,” says McCormick. “It’s more of a concern from a stock perspective.” Portugal benefits from “tremendous support” in the eurozone, he says, but the agency does not factor in the repercussions of its own actions. “We can’t work in a circle.” 

Whatever the decision, there is also a fear that Portugal is reaching its country ceiling for ECB support under the Public Sector Purchase Programme (PSPP). Strategists reckon the PSPP has fallen short of its target, based on Portugal’s share of the eurozone economy (the capital key) due to the ECB’s limit on purchases to one third of any issuer’s outstanding debt with residual maturities between one and 31 years. In other words, perhaps the ECB is slowing purchases now, rather than having to stop more abruptly later.

ING strategist Martin van Vliet says it will be a stretch for the ECB to continue purchasing Portuguese government bonds until the PSPP programme expires in March 2017, as the Eurosystem would already own around 27% of relevant Portuguese debt (above other small peripheral markets like Ireland). Even if the ECB looks at maturities of existing stock, purchases can only be made at the slower pace of recent weeks, he says.

Portugal is more likely to hit the country ceiling than Italy or Spain, as its bond market is so much smaller. Ironically, in one respect, it is not issuing enough debt. 

“Portugal’s bail-out loans crowd out the scope for quantitative easing,” says Schnautz. He adds that the ECB still has exposure to Portugal, unlike most other eurozone countries, under the earlier Securities Markets Programme, which also counts against the issuer limit.