Significance: Fitch downgraded Portugal's long-term rating one notch from AA- to A+, with a Negative outlook.

Implications: The downgrade was triggered by concerns about the government's ability to bring the fiscal deficit down and introduce structural reforms to make the economy more competitive, amid a very challenging financing environment.

Outlook: The Negative outlook suggests that a further downgrade is likely over the coming months.

Risk Ratings

Fitch's rating now matches the assessment given by Moody's (A1). However, it is still two notches above the rating given by IHS Global Insight and Standard and Poor's.

Fitch Ratings, the credit agency, downgraded Portugal's long-term rating one notch from AA to A+. The outlook has been kept as negative, suggesting that the rating is likely to be downgraded again over the coming months. Following this move, Fitch's rating is in line with the assessment given by Moody's (A1). However, it is still two notches above the rating given by Standard and Poor's. IHS Global Insight currently places Portugal's medium-term sovereign rating as 25 in our 0 to 100 scale, with a Negative outlook. This is equivalent to A- in the generic scale. This matches Standard and Poor's rating, but it is two notches below Fitch's and Moody's ratings.

Summary of Fitch's Statement

Fitch mentions that the downgrade reflects a "lower reduction in the current-account deficit and a much more difficult financing environment for the Portuguese government". More positively, their press statement also mentions that, if the government is successful in reducing the fiscal deficit to below 3% of GDP by 2012 as planned, the public-debt-to-GDP ratio would stabilise at 86% of GDP. Therefore, the adjustment necessary to bring it down to 60% would be relatively modest compared with the ones needed by other advanced economies. In Fitch's view, the 2011 state budget shows the determination of the government in achieving these targets. However, the margin for error is low, and the government should be prepared to introduce further austerity measures if needed. Fitch mentions that a "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".

The downgrade also reflects a sharp deterioration of the financial environment being faced by the government. The government has shown that it can still have access to market funding despite the crisis. However, access has come at a very high cost, as reflected by the sharp increases in bond yields in recent months. Fitch's rating assumes that the government will continue to have access to markets, but it does not seek external liquidity help. Nevertheless, Fitch acknowledges that the backstop facility put in place by the European Union (EU) and the International Monetary Fund (IMF) greatly reduces Portugal's liquidity risk.

Finally, Fitch also mentions that the rating is currently underpinned by the structural imbalances present in the economy. These will have to be overcome if the country is to raise potential growth. Although Fitch currently believes the economy will enter a sustainable recovery after 2012, the risk is that the fiscal adjustment put in place in 2011 could have a worse-than-expected impact on the economy, which would place an even greater pressure on public finances and bank asset quality.

Outlook and Implications

Despite Fitch's downgrade being highly expected, its effects are certainly being felt in markets. For example, yields on 10-year Portuguese government bonds increased sharply this morning to 6.840%, which is their highest level in almost a month. Moreover, five-year credit default swaps (CDS), which give an indication of how much it would cost to insure against a potential default, also rose sharply.

We certainly agree with many of the reasons given by Fitch in justifying its downgrade. These concerns are already incorporated in our current rating which is, as previously mentioned, two notches below Fitch's assessment. Over the medium term, future movements of our rating will mainly depend on the performance of the economy and the achievement of the fiscal target set by the government in its 2011 budget. Growth in 2010 was significantly higher than originally expected, but next year will be extremely challenging. Domestic demand is likely to be hit by significantly tighter fiscal policy, while a combination of weaker external demand and the low competitiveness of Portugal's export sector will limit export growth. On a more positive note, in addition to many structural reforms implemented since 2005, the government has continued with its efforts to improve the competitiveness of the economy. Their success will be key in ensuring Portugal's economic performance over the long term. Moreover, we believe that the fiscal plans put in place by the government are sound. However, their implementation will be key. Given the current negative sentiment towards peripheral Eurozone bonds in the markets, any slippage in this respect is likely to be severely punished.