NEW YORK/LISBON Fitch Ratings on Thursday downgraded Portugal, citing burgeoning debt levels and a tough financing environment, in a move which analysts said had been largely expected by markets.
Fitch downgraded Portugal's long-term and local currency ratings by one notch to A-plus, with a negative outlook, adding to a drumbeat of negative news on sovereign debt in Europe.
Portugal has moved into the eye of the storm in Europe's debt crisis on concerns about its public finances, with investors worried it will be next to take a bailout after Ireland and Greece.
"Failure to meet its 2011 budget headline and structural deficit targets would erode confidence in the medium-term sustainability of public finances that underpins Portugal's current sovereign ratings," Fitch said.
The downgrade puts Fitch's rating for Portugal on a par with Moody's A1 rating, but still two notches above that of Standard and Poor's A-minus and analysts said the move had been expected.
"This is not a surprise, though it is still bad news and will have impact, particularly on Portugal's financial sector. The market was already expecting this and the current interest rates had already priced in this downgrade," Joao Pereira Leite, an economist at Banco Carregosa in Lisbon, said.
The premium investors demand to hold Portuguese 10-year bonds rather than safer German Bunds fell two basis points to 377 bps on the downgrade but recovered quickly to 381 bps, just under Wednesday's settlement levels.
Last month, the spread hit a euro lifetime record of more than 481 bps but has narrowed since, thanks to bond buying by the European Central Bank.
The euro fell against the dollar and the Swiss franc after the downgrade.
The downgrade came just two days after Moody's Investor Service warned it may downgrade Portugal's A1 rating by one or two notches after a review that will take up to three months, citing high borrowing costs and weak growth prospects.
The Portuguese government has pledged to cut the budget deficit from a projected 7.3 percent of gross domestic product this year to 4.6 in 2011 by increasing taxes and cutting spending, including a 5 percent cut in civil servants' wages.
But Fitch warned the target will be "extremely challenging" especially if, as Fitch expects, the economy falls into recession next year.
"The scenario of a recession in 2011 is understandable, especially as the government's projection of 0.2 percent growth is based on exports, which is a pretty fragile and unpredictable base that does not depend only on Portugal itself," Pereira Leite said.
Fitch said, however, that it sees the Portuguese economy entering a sustainable recovery from 2012, which with fiscal adjustment and a smaller current account deficit "will place public and overall foreign debt in a sustainable path."
"They (Fitch) even say there is light at the end of the tunnel, which is something we haven't heard for a while about Portugal. So not everything was negative with this report," said Filipe Garcia, head of Informacao de Mercados Financeiros consultants in Porto.
Portuguese government officials were not immediately available for comment.
(Reporting by Shrikesh Laxmidas, Daniel Alvarenga and U.S. Treasury Desk; editing by Ron Askew)