S&P warns of Portugal downgrade over euro bailout fund

(LISBON) - Standard & Poor's ratings agency said on Wednesday that the likely conditions attached to Europe's new bailout fund could force it to reduce its credit rating for Portugal by up to two notches.

S&P said it believed Portugal's government had made progress in its efforts to bring the eurozone country's public finances back into balance.

However, the ratings agency warned that "given Portugal's high external financing need and limited funding sources, we believe that Portugal could find itself forced to approach the EFSF and the IMF."

The European Union is currently finalising the details for the replacement in 2013 to its European Financial Stability Fund temporary bailout system.

S&P noted that recent statements by eurozone policymakers indicate that lending by the new fund, to be called the European Stability Mechanism, would be contingent on a restructuring of sovereign debt to ensure fiscal sustainability and that the ESM would receive payment before bondholders in case of a default.

"We view Portugal's potential exposure to such lending terms as the key near-term risk to its credit standing," the ratings agency said.

If such conditions are confirmed when European leaders meet later this month, S&P said it could lower Portugal's ratings.

"We would be unlikely to lower the ratings on Portugal by more than two notches," it added.

Lisbon currently has a long-term rating of A- and a two-notch downgrade would leave it at BBB-, S&P's lowest investment-grade rating.

Portugal has been under pressure from speculation that its eurozone peers want it to accept a bailout so as to avert a wider crisis that could drag down others, including neighbour Spain, after Greece and Ireland sought help in 2010.

Neither Greece nor Ireland was forced to restructure their debt and make investors accept losses on their bonds but some analysts said that possibility cannot be ruled out in future.

Lisbon is widely considered the next eurozone country at risk given its public deficit and debt coupled with anaemic growth, with investors demanding ever higher rates of return to provide fresh funds to the government.

Portugal has to cover 20 billion euros ($28 billion) in debt due by mid-2011 but has been able to sell bonds only at elevated yields, currently well above 7.0 percent on its benchmark 10-year paper, a level widely believed to be unsustainable for the longer term.

On Wednesday, Lisbon sold one billion euros in short term bonds, paying a yield of 4.057 percent on 12-month notes and 2.984 percent for six-month notes.

Portugal's public debt management agency also said it had retired early 110 million euros. This follows 190 million euros in debt retired early two weeks ago.

Analysts said few investors are taking up the offer to redeem their debt early at a discount, which shows markets expect that Portugal will continue to be able to honour its debts in full over the next few months.

"It's a sign of confidence," the Portuguese finance ministry said in a statement, adding over half of the debt sold on Wednesday had been bought by foreign investors.

However, Portuguese officials have repeatedly spoken out in public that they expect the European Union to take additional steps to help reassure capital markets, such as increasing the bailout fund to 500 billion euros and allowing it to buy debt of eurozone governments on the secondary market.

Germany has opposed such a move, but Portuguese Prime Minister Jose Socrates was due to hold talks with Chancellor Angela Merkel late on Wednesday in Berlin.

In addition to lobbying for expanding the tools available to the bailout fund, Socrates was expected to brief Merkel on his government's success in further reducing public expenses, Portuguese media reported.