By Marc Jones
LONDON (Reuters) - Pressures are building on Portugal's creditworthiness as its low-growth economy battles to contain high levels of government and corporate debt and amid banking sector strains, the head of sovereign ratings at credit agency DBRS said.
DBRS's BBB (low) rating has been a vital prop for Portugal, allowing its bonds to remain part of the European Central Bank's 1.7 trillion euro buying program and as eligible collateral for the Bank's unlimited and now free bank funding.
The rating, next due for review on October 21, carries a 'stable' outlook, giving Lisbon some breathing space, but Fergus McCormick told Reuters that the picture was deteriorating.
"Friday's Q2 GDP release (which showed growth at just 0.2 percent) raised our concerns about growth prospects, which appear to be slowing into the third quarter," he told Reuters in an interview.
"Therefore, the outlook remains stable, but pressures appear to be mounting from these various fronts," he added, also citing European Commission demands that an unwilling Lisbon implement more spending cuts.
DBRS's October review will come just a week after Portugal is scheduled to provide the Commission with a list of those new cuts to get its budget deficit back under 3 percent of GDP.
Uncertainties over the make-up of those measures and their impact on the delicate political balance were a concern McCormick said, as was the possibility that more taxpayer money may be needed to prop up banks including Caixa Geral de Depositos and BCP.
"Will the far-left parties support these two initiatives? This is unclear."
DBRS's view is closely watched because it is the only one of the four ratings agencies recognized by the ECB to have an investment grade rank for Portugal.
It needs a rating of that category to qualify for the central bank's quantitative easing program and for the ECB to accept Portugal's bonds as loan collateral.
A downgrade could therefore cause havoc for Portugal's borrowing costs and its banks which rely heavily on the ECB's funding, and analysts warn it would almost inevitably trigger a significant market selloff.
NEXT BIG TEST
For Europe as a whole the next crucial test after the Brexit vote will be an upcoming constitutional referendum in Italy, McCormick said.
DBRS put Italy's A (low) rating on downgrade warning earlier this month, and if the agency pulls the trigger that would also have major ramifications.
Italian government bonds would be hit with as much as an 8 percent bigger 'haircut' in ECB lending operations, meaning they would have to find other ways to get the money that some need to stay afloat.
While Italy faces similar problems to Portugal in terms of meager growth, high debt and problem banks, McCormick said Prime Minister Matteo Renzi's decision to call a public referendum on political reform plans was a key trigger for the review.
With the vote set to determine Renzi's political future, it represents "the next big test for the euro zone".
"It is also the next test, following the UK referendum, of popular support for the EU," McCormick said, referring to Britain's vote to leave the European Union in June.
It was likely to result in either greater political stability and better governance, or more uncertainty and lower growth, he added.
And like in Portugal, low growth is already making it harder for Italy's banks to deal with bad loans on their books.
S&P's head of sovereign ratings told Reuters last week its BBB- rating on Italy could handle the potential costs of a government bailout but for DBRS's A (low) grade it may not be so digestible.
"If in the future an injection of public money is necessary to support bank balance sheets, this would translate into an increase in government debt. This contingent liability risk is a cause for concern," McCormick said.
(Additional reporting by John Geddie; editing by John Stonestreet)