ARC Affirms Portugal s BBB- Rating, Outlook Positive

ARC Affirms Portugal s BBB- Rating, Outlook Positive ISSUER Republic of Portugal RATINGS DATE November 16,, 2018 ISSUER RATINGS - FOREIGN CURRENCY Medium and Long Term BBB- (BBB-,, with positive outlook) ISSUER RATINGS - LOCAL CURRENCY Medium and Long Term BBB- (BBB-,, with positive outlook) A-3 Short Term (A-3) A-3 Short Term (A-3) COUNTRY CEILING - FOREIGN CURRENCY Foreign Currency A (A) COUNTRY CEILING - LOCAL CURRENCY Local Currency A (A) London, November 16, 2018, ARC Ratings, S.A. (ARC) has affirmed Portugal s BBB- long-term foreign and local currency issuer ratings of the Republic of Portugal (Portugal). The outlook on both ratings is positive. In addition, the agency affirmed Portugal s foreign currency and local currency country ceilings of A and short-term sovereign ratings of "A-3. All ratings assigned are unsolicited. Portugal s credit ratings are based on ARC s sovereign methodologies as available on our website (www.arcratings.com). The methodologies utilized are ARC s Sovereign Rating Methodology dated July 13, 2018 and Criteria for Assessing Country Ceilings dated May 22, 2018. ARC s full credit analysis on Portugal is also available on the agency s website. RATING RATIONALE The key rating drivers supporting Portugal s ratings are: - Institutional strengths that have underpinned Portugal s crisis management successes in stabilizing its economy. - Continued commitment to fiscal consolidation. - Proactive debt management that contains the risks associated with Portugal s large government debt of around 125% of GDP. - A proven willingness and capacity to safeguard the stability of a financial system plagued by crisis and years of imprudent credit policies. - Improving economic performance with increased reliance on exports and investment - a healthier growth pattern -, but the recent convergence with Euro Area is at best modest and below peers. - Increased competitiveness that translated into the elimination of historically very high current account deficits. - Continued access to liquidity from the ECB and the financial markets. - A policy environment in the Eurozone that is cognizant of deflation risks. ARC Ratings, S.A. 1/6

- Eurozone membership that provides the institutional framework for economic management, and a proven source of emergency liquidity. The key constraints on Portugal s credit ratings are: - A large government debt that renders the country vulnerable to swings in market confidence. The combination of a large debt, exposure to this debt by resident banks and moderate growth prospects given the country s debt levels means Portugal s vulnerabilities are likely to remain high. - A history of lacklustre growth performance, plagued by many structural deterrents, and lack of competitiveness even in the pre-crisis period when liquidity (and borrowing) was buoyant. The post-crisis rebound was below peers and has already passed its peak. - An over-leveraged economy with high levels of corporate indebtedness and an historical bias towards debt accumulation rather than equity financing (albeit, slowly, this is changing). Corporate indebtedness and the high, although improving, level of NPLs limit prospects for investment and growth. - Effects of international trade policy disputes, Brexit, Catalonia secession crisis and contagion risks related to questions about the durability of the Eurozone project itself could exacerbate formidable liquidity pressures. At 2.8%, 2017 GDP growth, the best since 2000, should be the peak of the current economic cycle, with growth expected to moderate to levels around 2.2%/2.3% in 2018 (after printing 2.3% in the first half of the year and 2.1% in the third quarter) and even less in 2019, following Eurozone s growth moderation prospects, but still positioning the country at a GDP growth level that is more suitable with Portugal s ratings. Even more fundamental for ARC s assessment is the fact that investment and exports growth have been giving and are expected to continue to give (although at more moderate levels) very relevant contributions to the current improvement in growth and to the continuation of the reduction of unemployment. Recent economic recovery and improved prospects reduce the constraint of the country s low growth record and structural deterrents to growth on its rating. Still, while the recent economic performance and growth prospects are a positive evolution compared to the country s growth pattern since the beginning of the century, the muchneeded convergence with its Eurozone peers is, at best, very modest and hesitant, contrasting with much stronger performances from most of the EU convergence peers. Furthermore, the positive external environment that has been crucial for Portugal s recent performance is deteriorating significantly, with trade tensions already reflecting in growth moderation, delay in getting a Brexit withdrawal agreement and renewed risks related to questions about the durability of the Eurozone project itself following Italy s government defiant posture against European Commission rules, especially the Stability and Growth Pact rules, with the consequent unprecedented rejection by the European Commission of Italy s budget proposal. Italy s attitude of not respecting EU s rules and its past compromises, within the context of its public debt level above 130% of GDP (corresponding to almost a quarter of the Euro Area public debt) and at a time when the resources of European institutions and political conditions are limited to provide support, is particularly worrying. The populist stance of Italy s current government and nationalist / anti-eu posture of some of its most prominent members raises serious concerns that the defiant posture of the Italian Government towards the Euro Area will continue and broaden in scope. While improving both quantitatively and qualitatively Portugal s growth continues to be constrained by multiple structural factors. The economy s over indebtedness still above 360% of GDP, in spite of the private sector deleveraging effort of more than 60 pp since 2012 and weaknesses of the financial system plagued by weak, although improving, asset quality are amongst the most relevant deterrents to growth, with direct impact on the low level of investment (below 17% of GDP, even after the significant growth in 2017 and the first half of 2018). Portugal s ability to sustain a growth rate at least in the range of 1.5-2.0% is a key rating issue, critical to the country s ability to grow out of its large government ARC Ratings, S.A. 2/6

debt load, which stands around 125% of GDP. Portugal s large government debt and continuous budget deficits are its principal rating constraints. At 124.9% of GDP (115.2% net of deposits) at the end of the first half of 2018, Portugal s government debt is outsized compared to peers. This is the result of many years of slow (although improving) nominal growth, continuous (although decreasing) budget deficits and several negative surprises in the financial sector, which led to the postponement of the beginning of the downward trend in government debt. This downward trend began in 2017, with a 4.4 pp of GDP reduction (2.5 pp in net terms), the biggest reduction since 1995, and the Government inscribed in the 2018-2022 Stability Program, published in April, the goal of reducing the debt level to close to 100% of GDP in the horizon of the program (reaffirming this priority in the 2019 Budget Proposal with goals of 121.2% of GDP for 2018 and 118.5% of GDP for 2019). The improved economic and fiscal performance and prospects support the view that the debt reduction trend is in for the medium to long term, but the size of the drop forecasted by the government is probably too ambitious, especially if the external environment deterioration materializes further. Furthermore, even in the context of this downward trend, Portugal s government debt level is expected to remain at a very high level for a long period, acting as a constrain to the country s capacity of investment and credit rating and as a very relevant fragility factor, leaving the country very exposed to any deterioration of conditions. Portugal s fiscal consolidation efforts have been extremely vigorous. The country has narrowed its fiscal deficit to -2.0% of GDP in 2016 from -11.2% of GDP in 2010, reaching its lowest deficit in more than four decades, and the increase to -3.0% of GDP in 2017 was due to the -2.0% of GDP one-off effect of Caixa Geral de Depósitos capitalization. Excluding this one-off operation, whose impact in the Government debt was already incurred in 2016, the country s deficit was -0.9%. In the first half of 2018 the fiscal deficit reached -1.9% of GDP, less than a third of what was registered in the same period of 2017 (deeply marked by the one-off effect of Caixa Geral de Depósitos capitalization), and also reflecting significant one-off effects. Without one-off bank sector related effects, the evolution was from -2.0% of GDP in the first half of 2017 to -1.1% of GDP in the first half of 2018. The expectation of a seasonally better performance in the second half of 2018 and the dilution of the one-off effects for a longer period lead to expectations that the Government will be able to meet its -0.7% of GDP fiscal target for 2018 (-0.3% of GDP excluding the payment of the Resolution Fund to Novo Banco). This expectation is based on the same fundaments of 2017 positive economic performance, significant expenditure containment and improvement of financial market conditions and on the active management of debt done by the authorities. Primary surplus should return to growth, with expectation of 2.7% of GDP in 2018 versus the 0.9% of GDP in 2017 (ex-cgd recapitalization effects and payment of the Resolution Fund to Novo Banco the increase would be smoother, passing from 2.9% of GDP to 3.1% - an all time high, representing a very significant improvement on the 8.2% deficit from 2010, and one of the highest in the EU). Interest expenditure should also continue its declining trend (-0.3 pp, to 3.5% of GDP). The 2019 Budget Proposal, currently being discussed, reaffirms the country s priority on fiscal consolidation and follows the footsteps of the 2018 budget adding rigidity to expenditure while taking advantage of the current cyclical improvement. For 2019 the Government aims for a -0.2% of GDP budget deficit, in line with what was forecasted in the 2018-2022 Stability Programme, presented in April 2018. The structural consolidation effort is expected to reach 0.3% of GDP. Primary surplus is forecasted to maintain its positive trend, to 3.1% of GDP, even within the context of an expected increase of 3.4% of net primary government expenditure (clearly beating the European Recommendation of 0.7%). Interest expenditure is expected to continue its downward trend, to 3.3% of GDP. The budget macroeconomic ARC Ratings, S.A. 3/6

assumptions are optimistic and the continued emphasis on the increase in salaries and pensions, unfrozen of public servants careers and the recognition of part of the time that the teachers careers were frozen, adds to the budget rigidity. This increased rigidity is manageable within the current positive economic context and as long as the Government maintains fiscal consolidation, its main political achievement of the mandate, on top of its priorities, which makes the 2019 budget goals demanding but achievable targets. For the medium-term, the 2018-2022 Stability Program, published in April 2018, reaffirmed the country s priority on fiscal consolidation, establishing an ambitious goal of decreasing the Government debt level to close to 100% of GDP until 2022. The Government aims to achieve a budget surplus in 2020 (which would be the first since the instauration of democracy in the country, back in 1974), and expects this to continue to grow up to 1.3% of GDP in 2022, with increasing primary surplus (to close to 4.5% in 2022) and reduction of government debt to close to 100% of GDP by 2022. The government expects an improvement of 1.5 pp of potential GDP on the structural deficit, to a surplus of 0.9% of GDP, on the program horizon. The Government goal is to achieve this consolidation mostly through the moderation of expenditure growth. Public investment is expected to grow to 2.6% of GDP in 2022 (from a bottom of 1.5% of GDP in 2016) on the back of big railroad and subway projects. We reaffirm our opinion, published in our previous rating report, that these medium term goals are very ambitious and challenging (the recent evolution of economic prospects and risks further supports this opinion), and their materialization would demand the continuation of a positive macro-economic context for an extensive period and of a very strong prioritization by the government of the fiscal consolidation, the main political achievement of its mandate, in a context of increasing claims on the budget (a natural process in a context of economic improvement and entering into an election year). The options taken in the 2019 Budget Proposal prove fiscal consolidation is a priority but also prove the Government need to meet demands that increase the expenditure rigidity. Given this, in our view Portugal s fiscal consolidation will likely be slower and less smooth than forecasted by the government and will depend a lot on the government s willingness and ability to maintain an equilibrium between the fundamental fiscal and economic goals and the increasing claims for greater cuts in government s austerity. Portugal s almost decade long effort to regain financial sector stability has brought the sector close to normalization, but NPLs, in spite of the big improvement made in the last few years, and Novo Banco situation continue to be important achilles heals of the sector. Still, the significant progress in the restructuring processes, the completion of their recapitalization efforts and the return to profitability lead some of the biggest banks to consider returning to dividend distribution in 2019. Credit extension weaknesses are still significant, but improving both quantitatively and qualitatively, with credit allocation favouring tradable sectors. Private credit growth has returned to positive since June, after a very long period of contraction. Bank of Portugal has been acting proactively to support the sector in its return to normalization, to adjust to a more demanding regulatory context and to avoid the exposure to credit risks levels that are considered too high. The significant exposure to Portugal s sovereign debt a feature that is common to other European countries banking systems - constitutes a vulnerability that would exacerbate a crisis. ARC maintains Portugal s Positive rating outlook based on the maintenance of positive economic prospects for the country, and improvements on growth profile and unemployment levels; on the continued willingness and ability of the government to go beyond its own fiscal consolidation goals and on continued reaffirmation of its prioritization of fiscal consolidation and debt reduction; as well as on the improvement, although still with important fragilities, of the banking sector. It also takes into consideration overarching stability in the policy thrust and continuation of structural reform, even if at a slower pace. Besides the continued positive evolution of the factors listed before, the materialization of this positive ARC Ratings, S.A. 4/6

outlook into a rating upgrade will be very dependent on the government s ability to maintain an equilibrium between the fundamental fiscal and economic goals and the increasing claims for greater cuts in government s austerity, on the absence of negative surprises in the banking sector restructuring process and on the maintenance of a sound economic and political external environment, especially at the EU level. Rating Triggers The trigger for an upgrade would come from sharply improved competitiveness of the real economy, whereby much faster paced growth would be consistently achieved (>2% pa on average), also contributing to the rapid reduction in the country s government debt burden (<100% of GDP) and overall leverage in the economy. Such a scenario would likely involve a more rapid transformation of the structure of the economy, including corporate sector consolidation, as well as sharply improving prospects for investment. A faster paced fiscal consolidation, taking greater advantage of the current positive environment and reducing future risks, would also be a potential trigger for an upgrade. Triggers that could prompt a rating downgrade would include a deflationary environment, due to the importance of economic dynamism for growing out of the country s large debt burden (sustained GDP growth <1% pa and government deficit >3% of GDP). A political environment that would tangibly impede both the completion of the country s incomplete structural reform program and continued fiscal consolidation necessary to reduce the country s large government debt burden would also prompt downward ratings pressure. Significant impacts to Portugal s growth or EU support to the country due to the new Italian government policies, new policies from the USA administration, Brexit or Catalonia secession crisis could also impact ARC s assessment. In accordance with ESMA policies, ARC s next scheduled announcement on Portugal s sovereign ratings is 10 May 2019. ABOUT ARC RATINGS ARC is a global ratings agency based in London and Lisbon that was formerly known as Companhia Portuguesa de Rating, S.A.. ARC has partnered with rating agencies in India (CARE Ratings), Malaysia (MARC), Brazil (SR Ratings), and South Africa (GCR). ARC is focused on carving out a niche based on the local knowledge and expertise of its partners across the globe. ARC is registered with European Securities and Markets Authority (ESMA) and recognized as External Credit Assessment Institution (ECAI). Please visit www.arcratings.com for further details. THIS DISCLOSURE IS FOR INFORMATION PURPOSES ONLY AND DOES NOT DISPENSE THE READING OF THE RESPECTIVE RATING REPORT. ARC Ratings, S.A. 11 Hollingworth Court Turkey Mill, Ashford Road Maidstone, Kent ME14 5PP UNITED KINGDOM Phone: +44 (0) 1622 397350 E-mail: arcratings@arcratings.com Site: www.arcratings.com Key Contacts: Vítor Figueiredo Head of Sovereigns vitor.figueiredo@arcratings.com Emma-Jane Fulcher CRO and Panel Chairperson emma.fulcher@arcratings.com ARC Ratings, S.A. 5/6

Registered as a Credit Rating Agency with the European Securities and Markets Authority (ESMA), within the scope of the REGULATION (EC) Nº 1060/2009 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL, of 16 September, and recognised as External Credit Assessment Institution (ECAI). Ratings do not constitute a recommendation to buy or sell, but only one of the factors to be weighted by investors. ARC s Ratings are assigned based on information collected from a wide group of sources. ARC Ratings uses and treats this information with due care and attention. Although all due care was taken in the collection, cross-checking and processing of the information for the purposes of the rating analysis, ARC Ratings cannot be held liable for its truthfulness. ARC Ratings must make sure that the information has a minimum level of quality prior to assigning a rating based on such information. ARC Ratings, S.A. 6/6