Moody's Investor Service warned on Tuesday it may downgrade debt-ridden Portugal's A1 rating by one or two notches after a review that will take up to three months, citing weak growth prospects and high borrowing costs.
Portugal has moved into the eye of the storm in Europe's debt crisis, with markets worried it will be next to take a bailout after Ireland and Greece, although Moody's said its solvency was not in question.
The cost of insuring Portuguese sovereign debt against default rose in response and the euro slipped a touch.
The premium investors demand to hold Portuguese 10-year bonds rather than safer German Bunds rose 9 basis points from Monday's settlement levels to 368 bps. Last month, the spread hit a euro lifetime record of over 481 bps, but has narrowed since thanks to bond buying by the European Central Bank.
The ratings agency said it had concerns about Portugal's ability to access capital markets at a sustainable price and cited uncertainties about Portugal's longer-term economic vitality, which will be exacerbated by the impact of fiscal austerity.
It said that if the government sought an international bailout, it would have a positive impact on short-term uncertainties, but would raise concerns about medium-term access to private market funding.
In Moody's opinion, Portugal's solvency is not in question, said Anthony Thomas, Moody's lead analyst for Portugal.
But the likely deterioration in debt affordability over the medium term and ongoing concerns about the economy's ability to withstand fiscal consolidation and private sector deleveraging mean its outlook may no longer be consistent with an A1 rating.
The agency also said it was concerned the government may need to support the banking sector for it to regain access to private capital markets, which may have an impact on the country's debt metrics.
Portugal's debt woes have shut the country's banks out of the interbank market for loans and they have been relying heavily on liquidity provided by the ECB. Nevertheless, Portugal's banks are considered solid and not representing any immediate problem as in Ireland.
Moody's rating for Portugal is two notches above that of Standard and Poor's, which put the Iberian country on negative credit watch on November 30, but a notch below that given to the country by Fitch.
The statement on Tuesday is the latest in a series of ratings-related jolts for the euro zone's most-indebted sovereigns after a five-notch cut by Moody's for Ireland last week.
Moody's analyst Kathrin Muehlbronner told Reuters the fact that Moody's had opted for a full-on review, rather than merely putting Portugal on negative outlook, meant there was a higher chance of a downgrade resulting.
She said there was a lot of work to be done, including analyzing potentially positive factors like exports growth, and did not expect a decision on ratings soon.
The export sector is doing surprisingly well so we have to see if we think this is sustainable and can counterweigh a very depressed internal demand, she said. There is also a fair chance of getting structural reforms through which is positive.
The government expects the economy to grow at least 1.3 percent this year after 2009's 2.6 percent contraction. It hopes exports growth will help it avoid a new recession predicted by many economists for next year, when it forecasts 0.2 percent growth despite austerity measures that include higher taxes.
The euro fell and German government bonds took some support from the news, but traders and analysts said there was only limited impact on Portuguese debt itself.
Really the rating agencies are playing catch up with events and arguably they've got a long way to go to get back up to speed -- they've been very much a lagging indicator throughout the crisis, said Chris Scicluna, deputy head of economic research at Daiwa Capital Markets.
From a fixed-income perspective this was fully expected and looking at where spreads are, they indicate much lower ratings.
(Reporting by Andrei Khalip; editing by Patrick Graham/Mike Peacock)