Research Update:

Portugal 'BB/B' Ratings Affirmed; Outlook Negative On Policy Uncertainty

Primary Credit Analyst: Eileen X Zhang, CFA, London (44) 20-7176-7105; eileen.zhang@standardandpoors.com Secondary Contact: Benjamin J Young, London (44) 20-7176-3574; benjamin.young@standardandpoors.com Analytical Group Contact: SovereignEurope; SovereignEurope@standardandpoors.com

Table Of Contents
Overview Rating Action Rationale Outlook Key Statistics Related Criteria And Research Ratings List

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Research Update:

Portugal 'BB/B' Ratings Affirmed; Outlook Negative On Policy Uncertainty

Overview
We expect Portugal to achieve its program fiscal deficit target of 5.5% of GDP in 2013 as the economy stabilizes. In our view, the coalition government remains committed to the EU/IMF program. We are therefore removing our long-term sovereign credit rating on Portugal from CreditWatch with negative implications, and affirming the ratings at 'BB/B'. The outlook is negative, reflecting what we view as ongoing social and political risks associated with deleveraging efforts by Portugal's highly indebted private and public sectors, as well as financing uncertainties related to Portugal's exit from the EU/IMF program, expected in May 2014.

Rating Action
On Jan. 17, 2014, Standard & Poor's Ratings Services affirmed its 'BB/B' longand short-term foreign and local currency sovereign credit ratings on the Republic of Portugal. At the same time, we removed the long-term ratings from CreditWatch where they were placed with negative implications on Sept. 19, 2013. The outlook is negative.

Rationale
The affirmation and removal from CreditWatch reflect our expectation that, despite potential legal and political impediments, Portugal should achieve its fiscal targets of 5.5% of GDP in 2013 and approach its 4.0% target in 2014. We base this expectation partly on indications that the economy has been showing signs of stabilization since mid-2013, after 10 consecutive quarters of contraction. Stronger-than-expected export performance, and an expected bottoming-out of private consumption, amid a modest decline in unemployment, should support Portugal's fiscal performance in 2014. Portugal's economic outlook continues to depend on competitiveness and external demand for Portuguese goods and services, in our opinion. Domestic demand components are likely to remain subdued as both the private and public sectors continue efforts to reduce high debt burdens. The Portuguese central bank estimates nonfinancial private-sector debt at 284% of GDP in September 2013, marginally down from the peak in December 2012 (287%). Under our current growth and deficit assumptions, we expect Portugal's net

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Research Update: Portugal 'BB/B' Ratings Affirmed; Outlook Negative On Policy Uncertainty

general government debt to peak in 2014 at around 122% of GDP, and to decline only gradually to below 120% by 2016. The trajectory of debt to GDP will depend heavily on real and nominal GDP performance. We project the Portuguese net general government debt-to-GDP ratio will remain one of the highest of all rated sovereigns in 2014. We forecast that the effective nominal interest rate of the central government will fall to 3.5% in 2014, from around 4.5% during the 2008-2009 crisis, partly supported by considerable interest-rate reduction and maturity extension to the Portuguese government via the European Financial Stability Facility (EFSF) and the European Financial Stabilisation Mechanism (EFSM). Risks to our baseline projections for net government borrowing requirements--and hence debt sustainability--remain material. Constitutional Court rulings have added further uncertainty by forcing the government to adjust elements of its fiscal consolidation plan for both 2013 and 2014. Most recently, in December 2013, the Court rejected the pension alignment of public sector workers with private sector workers (worth 0.2% of GDP in 2014 budget, but another significant setback in public administration reform). In August 2013, the Court rejected a key government reform: the termination of permanent contracts for public-sector workers with contracts agreed before 2008. This followed the Court's April 2013 rejection of fiscal measures amounting to 0.8% of GDP. Opposition members of parliament have also challenged some of the government's 2014 budgetary measures on constitutional grounds, leading to an extended period of fiscal policy uncertainty. We expect the government to find alternative measures to offset any fiscal gaps created by potential adverse rulings, as it has done in the past. Continued renegotiation of fiscal and structural measures could also damage political stability, as we saw in July 2013 when ministerial resignations delayed program reviews. We believe this is symptomatic of diminishing political backing for further fiscal and structural reforms. The Constitutional Court's deliberations over further fiscal measures could coincide with Portugal's planned EU/IMF program exit in the second quarter of 2014. We also anticipate that political tensions could increase in the run-up to 2015 parliamentary elections. We assess contingent liabilities to the Portuguese government as "moderate," as defined in our criteria. We believe these contingent liabilities stem from potential capital needs from the banking system in a stressed scenario, public enterprise debt that is not yet consolidated in the general government, and net charges related to public-private partnership projects. Standard & Poor's Banking Industry Country Risk Assessment (BICRA) ranks Portugal's banking system in group 7 on a scale from 1 (strongest) to 10 (weakest), with negative risk trends related to both the industry and economic risk components of the BICRA. On the financing side, the recent debt exchange and issuance of a 3.25 billion five-year bond will address part of the government's borrowing requirements in 2014. We expect the government's gross financing requirement (including short-term debt) for 2014 to be 45.5 billion (28% of GDP), of

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Research Update: Portugal 'BB/B' Ratings Affirmed; Outlook Negative On Policy Uncertainty

which 7.9 billion will likely be provided by the EFSF, EFSM, and IMF. We expect that the remainder of the requirement will be covered by domestic debt issuance targeted to the retail sector and the purchase of government debt by social security funds, as well as by the 100% rollover of outstanding treasury bills. We also believe the central government's single treasury account cash deposits, estimated at about 15 billion at end-2013 (9% of GDP), will likely reduce in 2014 to fulfil financing needs. Portuguese banks are deleveraging (loans to residents excluding the public sector contracted by 6.1% year-on-year in October 2013, having fallen by 13.7% from their peak in second-quarter 2011) and asset quality continues to deteriorate. Banco de Portugal reported a broad definition of nonperforming loans ("credit at risk") at 10.6% of the banks' loan book at June 30, 2013, up from 9.8% at end-2012. At Oct. 31, 2013, private sector customer deposits were flat, compared with end-2012, with household deposits increasing slightly. Other nonbank private sector deposits have continued to shrink. As banks continue to delever, we expect depository corporation claims on the resident nongovernment sector to decrease further in 2013 and 2014, to reach about 140% of GDP by 2017, from the 175% peak in 2009. The European regulator has already approved the restructuring plans of all other banks apart from Banif, which received a capital injection from the government of about 0.7% of GDP early in 2013. We believe banks are deleveraging because loan demand is weak and banks' management is husbanding capital. Asset quality has suffered, in our view, partly from an impaired transmission mechanism within the eurozone. We believe this is the result of the disintegration of financing flows between eurozone countries since 2010. Despite low European Central Bank (ECB) base rates, Portuguese entities face higher interest rates compared to most other eurozone countries. According to ECB data, Portuguese corporate borrowers pay about 200 basis points more on new loans than the eurozone average. We believe external financing risks remain a key ratings constraint for Portugal, despite a faster-than-anticipated turn around in its current account. We estimate external debt, net of liquid assets, at about 300% of current account receipts (CARs) at the end of 2013. Public sector external financing has been almost entirely met by official lending over the past few years, but is likely to move toward market funding during 2014 as Portugal exits its EU/IMF program. Portugal's large banks will also likely try to increase their borrowing in the international capital markets. Banco de Portugal's Target2 balances with the Eurosystem have remained almost unchanged (around 40% of GDP) since the ECB's announcement of Outright Monetary Transactions, while other peripheral central banks have been able to markedly reduce their balances. However, we view both public- and private-sector access to the markets as vulnerable to domestic shocks and to an external downturn. Portugal's creditworthiness appears to us, therefore, to continue to depend on the

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Research Update: Portugal 'BB/B' Ratings Affirmed; Outlook Negative On Policy Uncertainty

support and flexibility of its official creditors. Under our current baseline assumptions, we forecast that the government will exit its EU/IMF program in mid-2014, perhaps with a contingent line of credit provided by the European Stability Mechanism.

Outlook
We removed our ratings on Portugal from CreditWatch negative because the risks that could have led us to downgrade Portugal did not materialize in the fourth quarter of 2013. However, the negative outlook reflects our opinion that there is at least a one-in-three possibility that we could lower our ratings on Portugal during 2014. We could lower the ratings if factors affecting Portugal's government debt sustainability markedly worsen due to lower-than-expected growth, slippage in the primary fiscal balance, or the materialization of contingent liabilities. These outcomes could be prompted, for example, by judicial or opposition challenges to the 2014 budget, political tension within the coalition, a noticeable weakening of the institutional and governance environment or social contract, as well as renewed turmoil in the eurozone. We could also lower the ratings if we observe that official support is waning. We could lower our ratings on Portugal by more than one notch if we perceive--contrary to our current expectations--that the prospect of private sector involvement via debt restructuring has increased. On the other hand, the ratings could stabilize at the current level if the government maintains key program commitments in a timely and predictable manner, such that it can exit its current program and continue to refinance its government debt in the market, with or without continued official support.

Key Statistics
Table 1

Republic of Portugal - Selected Indicators

2006 Nominal GDP (US$ bil) GDP per capita (US$) Real GDP growth (%) Real GDP per capita growth (%) Change in general government debt/GDP (%) General government balance/GDP (%) General government debt/GDP (%) 202 19,196 1.4 1.3 4.5 2007 232 22,002 2.4 2.2 2.4 2008 252 23,872 0.0 (0.2) 4.4 2009 234 22,164 (2.9) (3.0) 10.5 2010 229 21,652 1.9 1.8 12.4 2011 238 22,499 (1.3) (1.2) 13.3 2012 212 20,122 (3.2) (3.0) 11.8 2013e 216 20,567 (1.9) (1.7) 1.9 2014f 216 20,526 0.5 0.5 0.7 2015f 222 21,104 1.6 1.4 2.9 2016f 231 21,870 2.2 2.0 2.0 2017f 240 22,707 2.4 2.2 2.0

(4.6) 69.4

(3.1) 68.4

(3.6) 71.7

(10.2) 83.7

(11.3) 94.0

(7.8) 108.2

(6.4) 124.0

(5.5) 128.0

(4.3) 126.7

(3.0) 125.9

(2.0) 123.2

(2.0) 120.5

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Research Update: Portugal 'BB/B' Ratings Affirmed; Outlook Negative On Policy Uncertainty

Table 1

Republic of Portugal - Selected Indicators (cont.)

Net general government debt/GDP (%) General government interest expenditure/revenues (%) Oth dc claims on resident non-govt. sector/GDP (%) CPI growth (%) Gross external financing needs/CARs +use. res (%) Current account balance/GDP (%) Current account balance/CARs (%) Narrow net external debt/CARs (%) Net external liabilities/CARs (%) 64.6 6.9 63.8 7.3 67.6 7.5 80.2 7.2 90.1 7.0 98.8 9.7 114.2 10.6 118.8 10.4 122.5 10.4 121.8 10.6 119.3 10.8 116.6 10.8

147.1 3.0 263.4 (10.7) (25.5) 308.7 197.7

156.1 2.4 270.3 (10.1) (23.2) 315.8 218.8

167.4 2.7 293.1 (12.7) (28.7) 289.9 207.2

174.6 (0.9) 295.4 (10.9) (29.2) 407.6 306.6

169.8 1.4 288.5 (10.6) (25.0) 347.0 256.3

168.6 3.6 257.8 (7.0) (15.0) 285.4 209.2

162.6 2.8 241.2 (2.0) (4.2) 338.1 246.7

156.4 0.4 222.2 0.8 1.5 308.0 216.4

150.8 1.0 207.6 1.7 3.1 273.3 200.2

146.4 1.5 194.6 2.4 4.1 247.2 181.7

142.4 1.5 185.3 2.9 4.9 224.0 164.2

139.6 1.6 175.6 4.3 7.2 202.0 145.4

Other depository corporations (dc) are financial corporations (other than the central bank) whose liabilities are included in the national definition of broad money. Gross external financing needs are defined as current account payments plus short-term external debt at the end of the prior year plus nonresident deposits at the end of the prior year plus long-term external debt maturing within the year. Narrow net external debt is defined as the stock of foreign and local currency public- and private- sector borrowings from nonresidents minus official reserves minus public-sector liquid assets held by nonresidents minus financial sector loans to, deposits with, or investments in nonresident entities. A negative number indicates net external lending. CARs--Current account receipts. The data and ratios above result from S&Ps own calculations, drawing on national as well as international sources, reflecting S&Ps independent view on the timeliness, coverage, accuracy, credibility, and usability of available information.

Related Criteria And Research

Related Criteria
Sovereign Government Rating Methodology And Assumptions, June 24, 2013 Methodology For Linking Short-Term And Long-Term Ratings For Corporate, Insurance, And Sovereign Issuers, May 7, 2013 Criteria For Determining Transfer And Convertibility Assessments, May 18, 2009

Related Research
Sovereign Defaults And Rating Transition Data, 2012 Update, March 29, 2013 Banking Industry Country Risk Assessment Update: January 2014, Jan. 8, 2014

In accordance with our relevant policies and procedures, the Rating Committee was composed of analysts that are qualified to vote in the committee, with sufficient experience to convey the appropriate level of knowledge and understanding of the methodology applicable (see 'Related Criteria And Research'). At the onset of the committee, the chair confirmed that the information provided to the Rating Committee by the primary analyst had been

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Research Update: Portugal 'BB/B' Ratings Affirmed; Outlook Negative On Policy Uncertainty

distributed in a timely manner and was sufficient for Committee members to make an informed decision. After the primary analyst gave opening remarks and explained the recommendation, the Committee discussed key rating factors and critical issues in accordance with the relevant criteria. Qualitative and quantitative risk factors were considered and discussed, looking at track-record and forecasts. The chair ensured every voting member was given the opportunity to articulate his/her opinion. The chair or designee reviewed the draft report to ensure consistency with the Committee decision. The views and the decision of the rating committee are summarized in the above rationale and outlook.

Ratings List
Ratings Affirmed; CreditWatch/Outlook Action To Portugal (Republic of) Sovereign Credit Rating BB/Negative/B Senior Unsecured BB Transfer & Convertibility Assessment AAA Short-Term Debt B Commercial Paper B

From BB/Watch Neg/B BB/Watch Neg

BANIF Banco Internacional do Funchal S.A. Senior Unsecured* BB Comboios de Portugal E.P.E Senior Unsecured* Metropolitano de Lisboa E.P. Senior Unsecured* Caixa Geral de Depositos S.A. Senior Unsecured* Banco Espirito Santo S.A. Senior Unsecured* *Guaranteed by the Republic of Portugal.

BB/Watch Neg

BB

BB/Watch Neg

BB

BB/Watch Neg

BB

BB/Watch Neg

BB

BB/Watch Neg

Complete ratings information is available to subscribers of RatingsDirect at www.globalcreditportal.com and at spcapitaliq.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. Use the Ratings search box located in the left column. Alternatively, call one of the following Standard & Poor's numbers:

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Research Update: Portugal 'BB/B' Ratings Affirmed; Outlook Negative On Policy Uncertainty

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