Moody’s Investors Service cut Portugal’s credit rating to below investment grade on concern the southern European country will need to follow Greece in seeking a second international bailout. The long-term government bond ratings were lowered from Baa1 to Ba2, and the outlook is negative. Moody’s said in a statement that discussions to involve private investors in a new rescue plan for Greece make it more likely that the European Union will require the same pre-conditions in the case of Portugal.
PAM Fixed Income Team View
The downgrade of the Portuguese government debt to below investment grade draws a number of parallels with the Greek situation. The Portuguese government debt, like its Greek counterpart has been removed by a number of market indices de facto reducing substantially the size of the market for Portugal from already very depressed levels. Hence the probability for Portugal to finance itself in the open market over the next few year is fairly low. In Portugal’s case like in the Greek case, the higher financing costs resulting from the downgrade should mean an increase in the debt of the country over the next few years as a percentage of GDP. Despite ambitious fiscal consolidation programs Portugal is unlikely to return to investment grade in the near term. In Portugal like in Greece the political split between the people supporting the austerity packages and the people who oppose them is fairly balanced making the local social environment difficult to predict.
Yet we would argue that the parallels stop there. The starting point for Portugal is a debt to GDP ratio expected to be around 85% at the end of this year compared with 140% expected for Greece. Portugal’s fiscal deficit to GDP is expected to be around 4.6% compared with Greece’s 7.4% in 2011. For Portugal to achieve its deficit reduction program to 3% of GDP in 2013 we calculate that the impact to GDP growth will be in the area of 1% per year over the next couple of years taking Portuguese real growth to -1% this year, -2% in 2012 and flat afterwards. This is in contrast with the - 4.4% GDP growth from Greece in 2010 and the -3% expected for this year. As a result of lower growth and higher financing costs, Portugal’s Debt to GDP is expected to grow to around 95% in 2013 compared to the 160% expected for Greece. The EUR 78 bln IMF and EU package approved for Portugal covers all of Portugal’s debt servicing for the next 4 years yet Greece’s initial package in 2010 only covered about 2 years and a half of Greece’s debt servicing.
Given these differences we do not believe that a Portuguese debt restructuring is imminent but the downgrade definitely makes a Greek restructuring more necessary to relieve the systemic pressures on the Eurozone. The “kicking the can down the road” option for Greece seems less and less plausible as the number of potential bail-outs would continue to cumulate with Portugal and Ireland next and the threat of Spain always lurking in the background.
In this context we should focus on the potential systemic threat for the Eurozone of a Greek debt restructuring. Needless to say that the pressure point of all this is the Greek banks and their capacity to pledge Greek government as collateral for loans at the ECB. There is a significant amount of Greek debt outstanding held by French and German banks, which would see their capital ratios significantly affected by a Greek default. The rating agencies have already reaffirmed their view that the publicised “French voluntary debt restructuring plan” would constitute a credit event forcing them to rate Greek government debt as default (D). All eyes are then on the ECB who has so far opposed a restructuring as it would almost force the ECB into the awkward situation of accepting D rated paper as collateral for their repo operations. The alternative is for most the of the Greek banking sector to declare insolvency. The ECB also already owns about EUR 50bln of Greek government bonds and the Greek banking sector owns about EUR 45bln which is consistently pledged as collateral at the ECB to obtain fresh financing. A Greek debt restructuring would generate significant losses for the ECB.
We believe that the ECB will continue to accept Greek and Portuguese debt as collateral to keep the banking system afloat. We also believe that a restructuring of Greek debt is more and more likely and probably necessary to alleviate the pressure on other countries like Portugal which has better fundamentals.
In that context, we continue to be underweight in Portugal as we believe that investor´s appetite for peripheral debt has structurally been reduced given the volatility in the spread relative to Germany arguing for smaller exposures to peripheral Europe.
Pictet Fixed Income Funds
As we changed in July 2010 the benchmark for Pictet-EUR Short Mid Term Bonds as well as Pictet-EUR Government Bonds and opted for an Investment Grade series, Portugal will exit the universe starting September 1st, 2011.
