Fitch: “Portugal has fiscal space to deal with Novo Banco”

The decrease in public debt and the budget surplus underpin Fitch’s optimism about Portugal. The agency currently gives the country a BBB rating (with a positive outlook), but acknowledges that its models already point to a higher financial rating and it could be the continued good performance of these two indicators that create the environment for further upgrades, as explained Michele Napolitano, senior sovereign director at Fitch Ratings.

In an interview with ECO from Lisbon, Napolitano nevertheless warned that negotiations on the State Budget for 2020 could be more difficult than in the last four years and preferred to wait to see what the budgetary impact of measures such as changes to the VAT on light or increased investment in health. As for the capital injections in the Novo Banco, they are also not a risk for Portugal’s first fiscal surplus.

How does the Portuguese rating is three notches below the rating indicated by the Fitch model?

Our ratings are based on a mix of qualitative and quantitative judgements, so our sovereign rating model is part of our overall methodology where it serves as a starting point for the ratings from which we apply what we call a qualitative overlay. This means we can then adjust the model output according to our judgements on factors that the model would not pick up.  For Portugal, it’s the growth potential. The growth potential is quite weak, affected by weak productivity growth and negative demographic trends. This explains why we have a one notch deduction for the macroeconomic situation.

Secondly, the public finances and the extremely high level of debt account for another notch. The level of debt is higher than other BBB countries and higher than the Euro Zone average and the European Union average. But it is coming down at a very fast pace, according to our projections, to a positive momentum. If things continue in the direction that we expect, there is a good momentum to potential remove that notch. That is partially why Portugal is on a positive outlook.

Then there is another notch deduction related to the very high level of external debt that Portugal has. External debt is a variable that is NOT in our model but it’s very important for sovereign credit worthiness. This explains why Portugal is a BBB, but the good dynamics of public finances explains the positive outlook.

The Portuguese Finance Minister Mário Centeno has been publicly vocal about wanting Portugal do have A rating. Is it possible?

It is possible. It is challenging, but not unrealistic.

Public debt is coming down at a quick pace. The macroeconomic outlook is conducive to debt reduction because we expect Portugal to grow above the Eurozone average.

Do you see a timeframe for it to happen?

No, it is very difficult to put a timeframe on that. The public finances are among the main rating drivers. If you look at the Eurozone, debt reduction is the most quoted rating sensitivity. So, reduction in debt is something important across almost every Euro Zone sovereigns. So, Portugal in this respect is doing well. Public debt is coming down at a quick pace. The macroeconomic outlook is conducive to debt reduction because we expect Portugal to grow above the Eurozone average. The interest rate environment is also conducive to debt reduction because interest rates will remain low. And then — maybe the more important for us and this is where Portugal really stands out relative to other countries — it has a government that openly targets enlarge primary surpluses and the reduction in public debt. If this trend continues and public debt continues to fall at a steady pace, the rating trajectory could continue to be positive, but it is difficult to put a timeframe around this.

We always talk about the reduction of the debt to GDP ratio, but now the Government is starting to talk about decreasing nominal debt as well. Is it something that matters to you?

If also the stock of nominal debt comes down, it would imply mathematically that the debt to GDP ratio would fall probably even faster so, yes, it would be something that we would probably see as positive.

But it is only important due to the impact on the ratio? Does it not matter in itself?

In our methodology, the factors that we look at are the ratio of debt to GDP and we also look at debt to revenue ratio, which is not as important as the first one. So our focus is the debt to GDP ratio, but we would say that if the nominal stock would come down and GDP increases (that is what we are expecting) that is clearly a very positive dynamic for the ratio. The two things are complementary in a way.

You said in your presentation that, on the last rating revision, you decided to wait and see the new government and that now you see difficulties in the budgetary discussions. Are you concerned?

I would not say that we are concerned. There is a new government with a different arrangement relatively to the previous government. There is a minority Government that has not a written agreement with other parties, so after the elections what we said is that we just wanted to wait and see how this new Government would play out and what will be the impact on policy making and on the budget negotiations. Now it seems to us the recent developments suggest that the negotiations around the budget under those new arrangements might be slightly more difficult than under the previous government when there was an agreement between parties.

There has been this proposal from the Social Democratic Party (PSD) to reduce the VAT rate on electricity. If we are not mistaken, the government might go ahead, but it will not adopt the original proposal. They will come up with their own proposal…

The government’s proposal is to differentiate VAT according to consumption, while the Social Democratic Party (PSD) wants to differentiate between companies and families…

The risk is that under this new government, fiscal policy making might be slightly less predictable given that the government would have to negotiate more than under the previous one. It’s a risk, but I wouldn’t say that we are extremely concerned because the government seems to be very committed and also the recent developments, the announcement by the minister of finance, suggest that there is still a lot of focus on maintaining a prudent fiscal stance. And obviously for us, as a rating agency, that is quite important. But policy making and budget negotiations might become slightly more difficult.

Regarding the proposal itself of changing electricity VAT, what do you think about it?

I want to be clear that, as a rating agency, we do not give policy advice. So what we do is that we really wait for the final proposal once it’s passed by the Parliament and then we will assess the fiscal and economic impact. So at this stage it would be premature to give a judgement or an opinion on a proposal that is still under discussion because we don’t want to enter the political debate. That is something for the government to decide.

But how would you see the Portuguese Government’s willingness to reduce taxes?

It depends on which taxes, on the fiscal cost, how it would be financed and also on the growth impact. The Portuguese government, in the past, has cut taxes, and the rating has moved up. Thus, the impact on growth and public finance has been positive. It really depends on the quality of the measures. In principle, from a sovereign credit perspective, we are not against cutting taxes. There are concrete examples, and Portugal is one, of rating upgrades despite rate cuts, but it really depends on the final design of the measures.

Still about the budgetary proposal, I would also want to ask what’s your opinion on the increase in health expenditure?

We are aware of the issues in the healthcare sector that have been building up for years. I don’t live here but there is anecdotal evidence that the quality of care has gone down over the years so clearly it is a political issue. In general, the fact that the Government is targeting health care to make it more efficient and possibly to avoid the creation of hospital arrears in the future is something that may be positive, but it depends on the whole design of the measures. How will it be financed? Are there cuts in other areas? Are there tax increases? We don’t know that yet. We need to wait for the final budget, but again, in principle, we don’t view that as negative.

You have said that the Portuguese banks are a concern…

Just to clarify, I didn’t say it is a concern, what I said is that we – in the sovereign ratings team  have a negative rating view on the banks. So – while it is not our expectation –  if something happened on the banking sector — basically if there was a shock in the banking sector that would require a sizeable intervention from the State, that would impact growth or that resulted in financial instability — that would be negative for the sovereign rating.. Our banking sector team has a fairly positive view of the Portuguese banking sector. The metrics are improving and the non-performing loans are coming down. If these dynamics continue, we are quite confident that our negative view will not materialize.

Are you fairly positive about all the banks?

What I can say as a sovereign rating analyst is that we are always concerned about banks in every country. In Portugal, the dynamic is positive, but non-performing loans are higher than the EU average. One comparison often made is between Portugal and Italy. Clearly Portugal looks much better on the public finances side — with public debt coming down, large primary surplus –, but on the banking sector side, Italy has been more successful at reducing its stock of non-performing loans. So now, Italy the non-performing loan ratio is lower than in Portugal. The fact that we still have in Portugal a fairly high level of non-performing loans is a concern for us because it something goes wrong, for example, if there is a very sharp growth slowdown for any reason, it’s better if the banking sector enters that phase with a very low level of non-performing loans. In that sense, we monitor the situation.

There is one bank that can have an important impact on public finance, which is Novo Banco. What will be the impact of another capital injection?

It would depend on the size of the injection. The government has always factored in injections of capital to Novo Banco in the budget. In that respect, the situation is quite transparent. We are not going to speculate on the likelihood of a more sizeable injection. I know that there are a lot of rumours about that… I would just point out that Portugal has some fiscal space to deal with the issue. The underlying situation of public finances is quite good. Public debt is high, it’s true, but it’s coming down very fast. The underlying budget is close to balance. So, hypothetically,  if there was a need for some more money for Novo Banco it probably wouldn’t concern us too much, it would not have a significant impact on our assessment of the rating. Obviously, it is also important to know how the money is used. If we were confident, the injection would improve the bank’s financial situation and reduce the need, in future years, for the State to intervene further, in that case the impact could be positive in our assessment. This is the framework on how we look at Novo Banco.

I know Luanda Leaks is not something that directly impacts Portugal, but it involves one bank and at least three important companies in the country. Is this case a risk for stability?

It’s too early to tell… What we can say is that it is something that we will look at, not only regarding the impact on companies and impact on banks, but also on the sovereign side whether there are any governance issues. Governance is a big factor in our rating assessment so when we understand a bit more about the implications of this scandal, we will need to see whether there are any governance shortcomings in the country but that’s the way we look at it. It is clearly something that we have to discuss at a sovereign level with our colleagues in corporate in financial institutions team. For now, there is no impact for the Portuguese sovereign rating.

What other external factors can impact the Portuguese rating?

Portugal has become a very open economy so, inevitably, it is more exposed than to what happens externally. So if there was a further slowdown in external growth or on the world trade growth, Portugal would be hit. But the important point is that Portugal would enter a period of slower growth with much stronger credit metrics, which should limit the Portuguese vulnerability to external shocks.

I wanted to clarify another point about your presentation, which is about the independence of central banks. Were you criticizing Christine Lagarde?

There was no criticism of Christine Lagarde at all. I just noted that central banks — not only the ECB, but also the Bank of England and other central banks around the world — speak more assertively about some areas that, at the moment, are not traditionally really part of their mandate. Fiscal policy, climate change, redistribution of income… We are not making a judgement on that, we don’t think it’s necessarily bad or good. We just say it is something different from the past. If these factors start to impact the way monetary policy is done, it will become more difficult to interpret the next moves in monetary policy. Those are areas that are under the control of the government, and central banks have always been independent. Their mandate has been to assure low inflation independently of the government. If the central bank mandate expands to these areas that require political guidance, there might be a bit of a clash. So, what does it mean for the independence of central banks? It’s a question mark. We don’t think it’s necessarily compromised, we just think it’s a doubt, it’s something new and it might make the life of analysts a bit harder. It’s a new paradigm and we need to wait for developments.