Fitch downgraded Portugal's credit rating to junk status on Thursday, citing large fiscal imbalances, high debts and the risks to its EU-mandated austerity program from a worsening economic outlook.
The ratings agency cut Portugal to BB+ from BBB-, which is still one notch higher than Moody's rating of Ba2. S&P still rates Portugal investment grade.
Fitch said a deepening recession makes it much more challenging for the government to cut the budget deficit but it still expects fiscal goals to be met both this year and next.
However, the risk of slippage - either from worse macroeconomic outturns or insufficient expenditure controls - is large, Fitch said.
The challenging economic environment was clear in a Reuters poll on Thursday, where economists forecast Portugal's economy will contract by 2.9 percent next year, the deepest recession since the 1970s, and 1.6 percent this year, in line with the government's estimates.
Portugal's 10-year bond prices plunged, sending yields surging more than 100 basis points to 13.85 percent -- the second highest level in the euro zone after Greece. The spread to German Bunds also rose more than 100 basis points to 1,168.
The downgrade of Portugal came after the dramatic deterioration of the euro zone crisis in recent weeks as it spread to bigger countries like Italy and Spain.
The worsening regional outlook helped inform the downgrade (of Portugal), Rabobank said in an analyst note. This, in turn, underlines the mounting risk of systemic downgrades.
Portugal sought a 78-billion-euro bailout from the European Union and IMF earlier this year and has adopted sweeping austerity measures to bring public accounts under controls.
Under the loan program Portugal must cut the budget deficit to 5.9 percent of gross domestic product this year from around 10 percent in 2010. Next year it must cut the deficit further to 4.5 percent.
STATE COMPANIES A RISK
Fitch said the state-owned enterprise sector is another key source of fiscal risk and has caused a number of upward revisions to the country's debt and budget deficit figures this year. The government has said there was an unexpected fiscal shortfall of about 3 billion euros this year.
Given these downside risks, Fitch sees a significant likelihood that further consolidation measures will be needed through the course of 2012, Fitch said.
It sees Portugal total debt peaking at 116 percent of GDP in 2013 from 93.3 percent at the end of last year.
Filipe Garcia, an economist at Informacao de Mercados Financeiros, said that while the downgrade does not change the government's financing conditions as it is under a bailout, it could worsen the situation for companies.
Where (the downgrade) has an impact is on companies, such as banks and other issuers like EDP or Brisa, whose ratings are greatly influenced by the sovereign rating, leaving them in a more difficult situation, said Garcia.
The agency said Portugal's debt crisis poses big risks for the country's banks. Recapitalisation and increased emergency liquidity provision from the ECB to Portugal's banks will, in Fitch's view, be needed and provided, it said.
Under Portugal's bailout, 12 billion euros has been set aside for funding banks if necessary.
Fitch said a worsening fiscal or economic situation could lead to further downgrades. Furthermore, although Portugal is funded to end-2013, sovereign liquidity risk may increase materially toward the end of the program if adverse market conditions persist, Fitch said.
The government hopes to return raising debt in financial markets at the end of 2013.
(Additional reporting by Patricia Rua; Editing by Toby Chopra/Anna Willard)