Costa’s Balancing Act Seen Letting Portugal Keep Crucial Rating

(Bloomberg) -- For Antonio Costa, it’s all about striking a fine balance.

The Portuguese Socialist prime minister’s ability to satisfy reform-driven European authorities while also appeasing his more radical backers at home may help his country keep its crucial investment-grade rating from DBRS Ltd.

“The government has criticized some austerity policies requested by the European Union, but they haven’t put in question Portugal’s membership of the euro zone or the application of the fiscal compact,” said Federico Santi, an analyst at Eurasia Group in London. “They definitely haven’t rolled back austerity. But they’ve given the impression that they’re doing so. Nothing has happened to justify a change in rating.”

Toronto-based DBRS on Friday will review Portugal’s only non-junk rating, critical because it makes the government’s debt eligible for the European Central Bank’s bond-purchase program. In April, DBRS kept the rating at BBB (low), its lowest investment grade, and maintained the stable trend. Portugal is rated junk by Fitch Ratings, Moody’s Investors Service and S&P Global Ratings.

Costa’s Socialists lost elections held a year ago but still formed a minority government by getting backing in parliament from the Communists and Left Bloc, an unprecedented political arrangement in 40 years of Portuguese democracy. The 55-year-old premier has been able to satisfy some demands of the two more radical parties while continuing to comply with European fiscal goals, in stark contrast with the confrontational approach taken last year by Alexis Tsipras’s Syriza government in Greece.

“There’s a lot of rhetoric and noise in the marketplace, but face-to-face it’s pretty clear that the authorities in Portugal are committed,” Fergus McCormick, co-head of sovereign ratings at DBRS, said on April 29, explaining the decision to keep the rating unchanged. “They’re making pretty significant fiscal adjustments in order to adhere to the Stability and Growth Pact targets and medium-term objectives.”

For his efforts, Costa has won the support of the likes of Francois Hollande, France’s president, who like him is from a traditional European Socialist party. Hollande put France’s weight behind Portugal to avoid EU penalties for breaching budget goals when he visited Costa in Lisbon on July 19, saying “one can’t inflict sanctions on a country that has worked to improve its budget, its competitiveness.”

Spending Freeze

Earlier this year Portugal pledged to freeze some spending and on July 27 it avoided a landmark penalty from EU authorities for missing budget targets in the past.

“The evolution of the financial situation in Portugal can only lead to a decision or an announcement that is positive,” Costa said in Brussels on Friday about the DBRS rating review.

For more on the importance of the DBRS rating, click here.

In an interview in London last month, McCormick of DBRS said “it’s looking fairly good politically,” even as he noted that financing costs had increased and growth was lower than expected.

Portugal’s 10-year bond yield is at 3.2 percent, about 80 basis points higher than 12 months ago. Even with the ECB’s purchases, Portugal is the euro region’s worst-performing sovereign-bond market this year through Wednesday, according to Bloomberg World Bond Indexes. The nation’s securities have lost 1 percent, compared with gains everywhere else in the bloc.

“If DBRS wants to downgrade, I think the ECB will still end up buying the paper,” David Owen, chief European economist at Jefferies International Ltd., said in a Bloomberg Television interview with Anna Edwards. “They can’t have a situation where Portugal starts selling off dramatically from here.”

Finance Minister Mario Centeno said in an interview in Washington on Oct. 7 after a lunch meeting with DBRS that “the position they have is that they feel very comfortable about our fiscal position, which they labeled ‘very strong.”’ Portugal’s 10-year yield has dropped 39 basis points since then.

“We expect DBRS to leave its rating for Portugal unchanged, as the variables that are closely watched by the agency for its assessment show no material change since DBRS’s last review in April,” Tullia Bucco, an economist at UniCredit SpA in Milan, said in a research note on Oct. 13. “This will most likely ease tensions on credit spreads.”

Growth, Debt

Portugal’s growth outlook was cut in the 2017 budget proposal released last Friday, when the government also said the budget deficit and debt ratio will be higher than previously forecast.

The economy will grow 1.2 percent in 2016 and the budget deficit will be 2.4 percent, which is still within a 2.5 percent limit set by the European Commission. Debt will rise to 129.7 percent of gross domestic product in 2016 as the government injects capital in state-owned bank Caixa Geral de Depositos SA, before falling to 128.3 percent in 2017.

While Costa has claimed he’s turning the page on austerity, he’s been increasing some indirect taxes and adding other levies while reversing state salary cuts faster than the previous administration proposed. Tax revenue will be 24.9 percent of GDP in 2017 compared with 25 percent in 2016. The government is also counting on a higher dividend from the central bank to narrow the deficit to 1.6 percent in 2017.

Assuncao Cristas, who leads the opposition conservative CDS party, says Costa’s government is applying austerity “a la gauche.”

That doesn’t appear to displease Costa’s backers, with a poll published on Oct. 14 by weekly Expresso showing the ruling Socialists with 36 percent support, widening the lead over the opposition Social Democrats to 5.6 percentage points.

“Despite pending challenges, fundamentals are better now than during the sovereign crisis, which underpins our view that DBRS will not downgrade Portugal below investment grade,” Bank of America Merrill Lynch economists Ruben Segura-Cayuela and Gilles Moec said in a note on Oct. 14. “The sustainability of public debt remains reliant on low interest rates. This leaves Portugal vulnerable to further negative confidence shocks. And without a broader strategy for fiscal adjustment, the fear of a DBRS downgrade will remain in the quarters to come.”

--With assistance from Anna Edwards and Henrique Almeida To contact the reporter on this story: Joao Lima in Lisbon at jlima1@bloomberg.net. To contact the editors responsible for this story: Vidya Root at vroot@bloomberg.net, Frank Connelly