Rating Action: Moody's downgrades Portugal to Ba2 with a negative outlook from Baa1

Global Credit Research - 05 Jul 2011

London, 05 July 2011 -- Moody's nvestors Service has today downgraded Portugal's lo ng-term government bond ratings to Ba2
from Baa1 and assigned a negative outlook. Concurrently, Moody's has also downgradedthe government's short-term debt
rating to (P) Not-Prime from (P) Prime-2. Today's rating action concludes the reviewof Portugal's ratings initiated on 5 April 2011.
The following drivers prompted Moody's decision to downgrade and assign a negative outlook:
1. The growing risk that Portugal will require a second round of official financing before it can return to the private market, and
the increasing possibility that private sector creditor participation will be requir ed as a pre-condition.
2. Heightened concerns that Portugal will not be able to fully achieve the deficit r eduction and debt stabilisation targets set out in
its loan agreement with the European Union (EU) and nternational Monetary Fund (MF ) due to the formidable challenges the
country is facing in reducing spending, increasing tax compliance, achieving economi c growth and supporting the banking
system.
RATNGS RATONALE
The first driver informing today's downgrade of Portugal's sovereign rating is the i ncreasing probability that Portugal will not be
able to borrow at sustainable rates in the capital markets in the second half of 2013 and for some time thereafter. Such a
scenario would necessitate further rounds of official financing, and this may requir e the participation of existing investors in
proportion to the size of their holdings of debt that will become due.
Moody's notes that European policymakers have grown increasingly concerned about theshifting of Greek debt held by private
investors onto the balance sheets of the official sector. Should a Greek restructuri ng become necessary at some future date, a
shift from private to public financing would imply that an increasingly large share of the cost would need to be borne by public
sector creditors. To offset this risk, some policymakers have proposed that private sector participation should be a precondition
for additional rounds of official lending to Greece.
Although Portugal's Ba2 rating indicates a much lower risk of restructuring than Gre ece's Caa1 rating, the EU's evolving
approach to providing official support is an important factor for Portugal because i t implies a rising risk that private sector
participation could become a precondition for additional rounds of official lending to Portugal in the future as well. This
development is significant not only because it increases the economic risks facing c urrent investors, but also because it may
discourage new private sector lending going forward and reduce the likelihood that Portugal will soon be able to regain market
access on sustainable terms.
The second driver of today's rating action is Moody's concern that Portugal will notachieve the deficit reduction target -- to 3%
by 2013 from 9.1% last year as projected in the EU-MF programme -- due to the formi dable challenges the country is facing in
reducing spending, increasing tax compliance, achieving economic growth and supporti ng the banking system. As a result, the
country may be unable to stabilise its debt/GDP ratio by 2013. Specifically, Moody'sis concerned about the following sources of
risk to the budget deficit projections:
1) The government's plans to restrain its spending may prove difficult to implement in full in sectors such as healthcare,
state-owned enterprises and regional and local governments.
2) The government's plans to improve tax compliance (and, hence, generate the projec ted additional revenues) within the
timeframe of the loan programme and, in combination with the factor above, may hinde r the authorities' ability to reduce the
budget deficit as targeted.
3) Economic growth may turn out to be weaker than expected, which would compromise t he government's deficit reduction
targets. Moreover, the anticipated fiscal consolidation and bank deleveraging would further exacerbate this. Consensus growth
forecasts for the country have been revised downwards following the EU/MF loan agreement. Even after these downward
revisions, Moody's believes the risks to economic growth remain skewed to the downsi de.
4) There is a non-negligible possibility that Portugal's banking sector will requiresupport beyond what is currently envisaged in
the EU/MF loan agreement. Any capital infusion into the banking system from the gov ernment would add additional debt to its
balance sheet.
Moody's acknowledges that its earlier concerns about political uncertainty within Portugal itself have been largely resolved.
Portugal's national elections on 5 June led to the formation of a viable government, both components of which had campaigned
on the basis of supporting the EU-MF loan agreement negotiated by the previous gove rnment. Moody's also acknowledges the
policy initiatives announced at the end of June demonstrate the new Portuguese gover nment's commitment to the programme.
However, the downside risks (as detailed above) are such that Moody's now considers the government long-term bond rating to
be more appropriately positioned at Ba2. The negative outlook reflects the implement ation risks associated with the
government's ambitious plans.
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WHAT COULD CHANGE THE RATNG UP/DOWN
Developments that could stabilise the outlook or lead to an upgrade would be a reduc tion in the likelihood that private sector
participation might be required as precondition for future rounds of official suppor t or evidence that Portugal is likely to achieve or
exceed its deficit reduction targets.
A further downgrade could be triggered by a significant slippage in the execution of the government's fiscal consolidation
programme, a further downward revision of the country's economic growth prospects or an increased risk that further support
requires private sector participation.
PREVOUS RATNG ACTON AND THE METHODOLOGY
Moody's previous rating action on Portugal was implemented on 5 April 2011, when therating agency downgraded the
government's long-term debt rating by one notch to Baa1 and placed it on review for further possible downgrade. t also
downgraded the government's short-term debt rating to (P) Prime-2 from (P) Prime-1.
The principal methodology used in this rating was Sovereign Bond Ratings Methodologywas published in September 2008.
Please see the Credit Policy page on www.moodys.com for a copy of this methodology.
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Bart Oosterveld
MD - Sovereign Risk
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