TEXT-Fitch:Portugal bond issue is credit positive, challenges remain

Fri Jan 25, 2013 3:22am EST

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(The following statement was released by the rating agency)

Jan 25 - Portugal's return to the market with a EUR2.5bn five-year international bond is positive for its credit profile, but significant economic and political risks remain, Fitch Ratings says.

The deal completes a third stage in Portugal's preparation for regaining full market access, in terms of being able to meet all its fiscal funding needs in the bond or bill market by regularly issuing in a range of maturities. The first was increasing the size and maturity of its Treasury bill issue, which it did in April 2012. The second was an exchange to extend some bond maturities, which happened in September. There is a clear positive momentum, with 10-year yields at their lowest level in over two years. However we believe it remains challenging for Portugal to regain full market access because of large funding needs and the continuing high risk premium at the long end of the yield curve, which implies an unsustainably high cost of funding.

Our base case remains that Portugal will not gain full market access by the time the IMF-EU programme expires and, therefore, additional funding support and a new programme will be needed. Wednesday's bond issuance raises the possibility that Portugal will be supported through the ECB's Outright Monetary Transactions (OMT) once full market access is restored, although it remains unclear under what conditions the OMT would be deployed. EU Economic and Monetary Affairs Commissioner Olli Rehn said Tuesday that OMT purchases could be used to support Portugal's access to market funding alongside a precautionary programme. The ECB itself said in September that "a necessary condition" for OMT purchases is "strict and effective conditionality attached to an appropriate European Financial Stability/European Stability Mechanism programme."

The fall in Portuguese bond yields and successful bond issuance suggest that one of the positive rating triggers identified in our November review - a moderation of the eurozone crisis - is having a positive effect on Portugal's fiscal financing position.

The Portuguese economy still faces several challenges. The weak economic outlook is complicating the government's deficit reduction plan and Portugal is only part way through its adjustment. A large effort is still required to achieve sustainable public finances in the medium term.

To achieve this would involve additional fiscal measures, including cuts to government spending. Cross-party commitment to the programme is therefore likely to be tested further. Moreover, institutional constraints could limit the government's room for manoeuvre. Political risk remains significant.

Increased political uncertainty or material slippage in fiscal consolidation could put negative pressure on the ratings. Weaker-than-expected GDP growth, leading to a significantly higher peak in public debt, would also be a trigger for negative rating action. It could also dent investor sentiment towards Portuguese government debt. Further evidence that the internal adjustment is working as planned, with continued reduction in the current and fiscal deficits, would lead to the Outlook being revised to Stable from Negative. We affirmed Portugal's 'BB+' rating on 12 November.

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