OREANDA-NEWS. Fitch Ratings has revised the Outlook on Portugal's Long-term foreign and local currency Issuer Default Ratings (IDR) to Stable from Positive and affirmed the IDRs at 'BB+'. The issue rating on Portugal's senior unsecured foreign and local currency bonds have also been affirmed at 'BB+'. Fitch has affirmed the Country Ceiling at 'A+' and the Short-term foreign-currency IDR at 'B'.

KEY RATING DRIVERS
The revision of the Outlook on Portugal's IDRs reflects the following key rating drivers and their relative weights:

MEDIUM
Fiscal performance was well off-target in 2015, with the general government deficit at an estimated 4.2% of GDP compared with the 2.7% initially expected. Excluding the EUR2.2bn one-off bailout of Banif agreed in late December, the official headline deficit could be above 3%. In view of this outcome, the country will not exit the EU's Excessive Deficit Procedure (EDP) this spring as originally scheduled. The narrowing of the deficit from 7.2% of GDP in 2014 (3.4% excluding all one-offs) was driven by modest growth rather than structural measures, as fiscal consolidation was halted ahead of parliamentary elections last October.

The government's plans for fiscal deficit reduction in 2016 are also at risk. In Fitch's view, the preliminary budget target of 2.2% of GDP is based on optimistic assumptions of economic growth and price developments. Moreover, there is some uncertainty as to how the new government will finance the gap stemming from the policy reversals announced for this year, as some of the proposed revenue measures could prove hard to implement in full. In this context, Fitch forecasts a headline deficit of 2.8% for 2016.

Fitch maintains its view that the government led by Antonio Costa will maintain the Socialist's long-standing pro-European stance. However, balancing the commitments under EU fiscal rules and the demands of the Leftist Bloc and Communist Party is proving challenging, raising considerable political risks in the near term. The need to implement further austerity measures during 2016 or in the 2017 budget, could prove a breaking point for the coalition. Renewed political uncertainty would increase fiscal and macroeconomic downside risks.

Underlying public debt dynamics remain weak. Gross general government debt fell to around 129% of GDP at end-2015 (from 130.2% in 2014), well above the original target of 124.2% and our previous estimate of 127.9%. This was partly the result of Banif's bail-out and the failure to sell Novo Banco, which limited positive stock-flow adjustments.

Our medium-term forecast for gross general government debt reduction has also deteriorated, reflecting a slowdown in fiscal consolidation. Fitch now expects GGGD/GDP to fall to 122% in 2020, compared with our March 2015 projection of 117.5%. Such an elevated debt level (BB and BBB medians are around 42% of GDP), leaves public finances with limited flexibility if faced with future shocks and exposed to the risk of deflation.

Portugal's 'BB+' IDRs also reflect the following key rating drivers:

Economic growth continues at a moderate pace. Although 2H15 saw a disappointing investment performance, GDP growth for the whole of 2015 reached 1.5% (in line with our expectations), underpinned by rising private consumption. The latter should continue to drive growth in 2016, helped by a further reduction in unemployment, lower energy costs and by higher fiscal transfers to low-income segments. That said, fiscal incentives are likely to have only a limited effect boosting growth, as they are likely to be offset by a weaker external environment and slow investment momentum. Fitch expects growth at 1.6% this year, with downside risks tied to domestic political developments.

Structural factors continue to weigh on potential growth, in particular the country's high public and private indebtedness, adverse demographic trends and low investment rates. There has been some progress in household and corporate deleveraging in recent years, but less so in raising the investment rate, which was 15% in Q315, the same as in 2014 and compared with 22% in 2007. Low levels of public expenditure are constraining the investment outlook. On the upside, the export sector has regained competitiveness and will help sustain GDP growth at around the eurozone average of 1.6% over the medium term.

The current account balance posted its third consecutive annual surplus in 2015, an unprecedented record in the last 40 years. The surplus was driven by a positive export performance, particularly in services such as tourism. Fitch expects this trend to continue in 2016-17, with the current account surplus averaging 0.7%. Downside risks include an upsurge in commodity prices or a rebound in investment growth, both of which would lead to higher imports. Although falling, the stock of net external debt is among the highest in the world, at over 115% of GDP in 2015 according to Fitch's estimates.

Portugal has put a number of reforms in place in recent years, including in pensions, meaning that the long-term fiscal cost of an ageing population is one of the most stable in the EU. Moreover, the country has a favourable business environment and benefits from high human development, governance and GDP per capita, well above those of the 'BB' and 'BBB' medians.

RATING SENSITIVITIES
Future developments that could individually or collectively result in negative rating action include:
- Failure to make progress in reducing general government debt/GDP ratios or unwinding external imbalances.
- Weaker economic growth prospects that could forestall corporate sector deleveraging or have a negative impact on the banking sector or public finances.

Future developments that could individually or collectively result in positive rating action include:
- Increased confidence in fiscal policy consistent with a downward trend in the general government debt/GDP levels.
- An improvement in medium term economic prospects, supporting gradual progress in private sector deleveraging.

KEY ASSUMPTIONS
In its debt sensitivity analysis Fitch assumes a primary surplus averaging 1.5% of GDP, trend real GDP growth averaging 1.5%, an average effective interest rate of 3.3% and deflator inflation of 1.7%. On the basis of these assumptions, the debt-to-GDP ratio would fall to 115.5% by 2024 from 130.2% in end 2014. Our debt dynamics do not include any government bank asset disposals as the timing and values of such operation remain uncertain.

The European Central Bank's asset purchase programme should help underpin inflation expectations, and supports our base case that the eurozone will avoid prolonged deflation.