DBRS Morningstar Confirms Kingdom of Spain at “A”, Maintains Positive Trend

DBRS Ratings GmbH (DBRS Morningstar) confirmed the Kingdom of Spain’s Long-Term Foreign and Local Currency – Issuer Ratings at “A”. At the same time, DBRS Morningstar confirmed the Kingdom of Spain’s Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (low). The trend on all ratings remains Positive.

KEY RATING CONSIDERATIONS

The Positive trend reflects DBRS Morningstar’s view that the risks to the ratings continue to be tilted to the upside. Following a relatively strong last quarter, the Spanish full-year real GDP growth stood at 2.0% in 2019, substantially outperforming the 1.2% average of the euro area. DBRS Morningstar expects Spain’s economic expansion to continue at a more moderate pace with GDP growth hovering around 1.5-1.7% in coming years, although the external backdrop remains challenging. The potential economic and financial consequences from the rapidly evolving new Coronavirus Disease (COVID-19) remain unclear. Spain’s economy, especially tourism and the industrial sector, and its fiscal accounts might be impacted in the short-term by the coronavirus. However, DBRS Morningstar does not currently anticipate lasting effects to the Spanish economy or its creditworthiness.

The fiscal deficit for 2019 is currently estimated at around 2.2%-2.4% of GDP, only marginally decreasing from the -2.5% of GDP recorded in 2018. Although the economic cycle is maturing, the current economic outlook remains supportive of a small fiscal consolidation in coming years. In DBRS Morningstar’s view, however, the achievement of the revised deficit target path proposed by the government will remain contingent on additional fiscal measures being implemented. The potential passage of a 2020 budget, including revenue enhancing measures, could help in this regard. On the other hand, the political climate remains unconducive to the introduction of new structural reforms to substantially improve fiscal or economic outcomes. In this context, keeping the key aspects of previously implemented reforms will remain important.

Spain’s “A” rating is supported by the country’s large and diversified economy, competitive export sector, and euro zone membership. By contrast, the high public debt ratio remains an important consideration for the rating. Spain’s high reliance on foreign financing is also a source of credit vulnerability. Whilst the political situation in the Autonomous Community of Catalonia (rated BB (high) with a Positive trend by DBRS Morningstar) remains challenging, renewed dialogue between the central and regional government appears to be easing tensions thus far.

RATING DRIVERS

The ratings could be upgraded if one or a combination of the following occur: (1) Spain continues its fiscal consolidation, potentially reinforced by deficit-reducing measures; (2) Spanish authorities introduce economic reforms that improve the medium-term outlook; or (3) further evidence arises of the country’s improved economic resilience to shocks.

The trend could be changed to Stable if one or a combination of the following occur: (1) a reversal of the fiscal consolidation path; (2) a deterioration in growth prospects that contributes to a material reversal of the downward trajectory of the public debt ratio; or (3) the materialisation of a disruptive political developments that severely impair economic performance.

RATING RATIONALE

Political Fragmentation is Delaying Structural Measures, Catalonia Remains in the Backdrop

After four general elections in as many years, a minority coalition government composed of Partido Socialista Obrero Español (PSOE) and Unidas Podemos (UP) came into power on 13 January 2020. Prime Minister Sánchez won its investiture vote in Congress with the support of several smaller parties, including the abstention of the Catalan pro-independence Esquerra Republicana de Catalunya (ERC) party. This minority government will face a challenging balancing act to hold together as it will most likely need the support or abstention of the ERC to pass laws (for further details, please see DBRS Morningstar commentary entitled “Spain: Economy OK, but Politics are Challenging”, available at www.dbrs.com).

DBRS Morningstar considers that the government will continue to gradually improve the country’s fiscal position over time and opt for policy continuity. However, the political fragmentation in Congress, combined with increasing polarisation, could affect the government’s ability to pass ambitious reforms. DBRS Morningstar will also monitor the risk of undesired effects from a potential reversal of key aspects of the pension and labour market reforms, which DBRS Morningstar would view in a negative light.

Another source of uncertainty over the long-term remains the pro-independence movement in Catalonia. While DBRS Morningstar expects the Catalan question to remain in the background over the long-term, the renewed dialogue between the central government and the region on potential measures to address some of the underlying concerns in the region could help ease some of the tensions in the short to medium-term. The constraints imposed by the political climate on Spain’s capacity to address key economic challenges and the uncertainty over the situation in Catalonia continue to weigh on DBRS Morningstar’s assessment of the “Political Environment” building block.

Fiscal Deficit Likely to Continue Declining Although More Moderately than Previously Anticipated

Since 2012, Spain’s fiscal deficit-to-GDP ratio has been steadily declining, although the decline is primarily driven by cyclical conditions since 2015. In 2019, the fiscal deficit could end up around 2.3% of GDP as forecast by the European Commission, dropping only slightly compared with the 2.5% of GDP in 2018. This would miss both the government estimate and the approved deficit target of -2.0% and -1.3%, respectively. The underperformance was partially related to the failure to pass the 2019 draft budgetary plan and the ensuing political stalemate last year, that annulled the government’s plan to introduce deficit-reducing initiatives estimated at EUR 5.6 billion.

The government has approved a more gradual deficit path that targets a reduction of the deficit to 1.8% in 2020 and subsequently to 0.9% of GDP in 2023. The latest revisions, though less ambitious, remain consistent with a gradual improvement in debt and deficit metrics. Nevertheless, achievement of this new path will remain contingent on additional fiscal measures, yet to be outlined, being implemented. DBRS Morningstar introduced a positive qualitative assessment to the “Fiscal Management and Policy Management” building block to reflect its view that the fiscal outlook for Spain presents a brighter picture when compared with the performance over the last decade, dragged down by exceptionally high deficits during the crisis years, especially during 2009 and 2012.

Given Spain’s unfavourable demographics, pension and healthcare reforms in the future could help curb ageing-related spending pressures. While DBRS Morningstar considers that the short-term viability of the pension system is not threatened, rolling back key features of the previous pension reform without incorporating offsetting measures could undermine its long-term sustainability.

Lower Deficits and Economic Growth to Help Public Debt Reduction, But Still An Important Credit Weakness

Spain’s high public debt ratio, estimated at 95.5% of GDP at the end of 2019, continues to be a credit weakness, burdening the government and reducing its room to respond to potential challenges. However, DBRS Morningstar expects Spain´s debt-to-GDP ratio reduction process started in 2015 to continue in coming years. The public debt ratio, supported by some one-off factors, dropped 2.1 percentage points in 2019, more than doubling the average annual reduction pace between 2015 and 2018 of 0.8 percentage points. Going forward, a positive differential between nominal GDP growth and interest expenditure-to-GDP as well as improving primary balances are expected to drive lower debt ratio levels.

DBRS Morningstar considers that a combination of factors reduce the associated risks to Spain´s high public debt ratio. Over the last few years, Spain improving credit fundamentals has allowed it to tap into a more diversified investor base, including more stable long-term investors (e.g., pension funds). Furthermore, the Spanish Treasury has taken advantage of beneficial financing conditions since 2013 to improve its public debt profile by extending the average maturity to 7.62 years and reducing the average cost of debt at issuance to 2.15% . Importantly, the European Central Bank’s (ECB) accommodative monetary policy supports both extraordinary low funding costs and sovereign bonds liquidity, which in DBRS Morningstar view, helps ease debt sustainability concerns. These qualitative factors lend support to DBRS Morningstar’s assessment of the “Debt and Liquidity” building block.

The Spanish Economy Continues to Grow at a Relatively Strong Pace Despite A Challenging External Environment

The Spanish economic recovery has been solid with GDP growth averaging 2.6% over the last six years. Since 2014, domestic demand has been the primary growth driver on the back of a strong labour market, favourable financial conditions, and the recovery in the housing market. GDP growth stood at 2.0% in 2019, with a relatively strong Q4 leaving a carry-over effect of 0.7% for 2020. Going forward, DBRS Morningstar expects the economic growth to continue to decelerate towards potential growth as the cycle matures. A tighter labour market, with job growth slowing but real wages picking up, stronger household and firm’s balance sheets, and easy financial conditions are factors that will likely continue to support domestic demand. On the other hand, the deterioration of the global backdrop and intensifying external risks represent the main threats to the economic outlook. While Spain’s economic activity might be impacted in the short-term by COVID-19, especially the tourism and industrial sectors, DBRS Morningstar does not currently anticipate lasting effects to the Spanish economy.

Spain’s GDP per capita estimated at EUR 26,418 for 2019 remains below the European Union (EU) average, reflecting differences both in labour utilisation and productivity. Despite the substantial improvements in reducing unemployment, which stood at 13.8% in Q4 2019 down from 26.9% in Q1 2013, the still-high proportion of temporary workers at 26.1% of total employees leaves a significant portion of workers vulnerable and holds back human capital accumulation. Relatively high school dropout rates and the small size of Spanish companies also constrain productivity growth in Spain. Over the medium to long-term, Spain’s ageing population will increasingly weigh on growth prospects. Therefore, successfully addressing some of these hurdles and countering the effects of an ageing population could help lift potential growth and foster further income convergence towards its higher income EU partners.

External Accounts Continue to Improve Although Significant Imbalances Remain

Spain’s negative net international investment position (NIIP) remains high at 79.6% of GDP in Q3 2019. This is an important credit weakness, increasing the country’s vulnerability to sudden shifts in investor sentiment. However, the NIIP ratio has dropped 18.2 percentage points since Q2 2014 on the back of sustained current account surpluses and higher nominal GDP. The current account surplus averaged 2.2% of GDP between 2013 and 2019, helped by a sharp improvement in cost-competitiveness and Spanish firms’ greater propensity to export. Despite a potential erosion in coming years as the cycle matures and domestic demand strengthens further, DBRS Morningstar considers that the regained competitiveness will continue to support Spain’s net lending flows.

Spanish Banks in Good Shape but are Likely to Face an Increasingly Challenging Environment

DBRS Morningstar views the Spanish banking system as strong following the clean-up and restructuring in the aftermath of the financial crisis. Spanish banks’ capital ratios and asset quality has improved markedly over the last decade. Importantly, domestic nonperforming loans (NPLs) shrank to 4.8% of total loans by Q4 2019, well below their Q3 2013 13.6% peak, with sharp reductions in construction and real estate NPL portfolios. On the other hand, DBRS Morningstar expects banks’ profitability to remain under pressure as a result of the continued low interest rate environment and strong competition. Banks’ higher loan loss provisions and sluggish new mortgage flows in 2019 may signal the start of a turn in the credit cycle, although some one-off factors might be contributing to this. Given the potential drag from remaining legacy troubled assets, a still challenging operating environment, and risks of a slowdown increasing, DBRS Morningstar’s assessment of risks to financial stability has deteriorated marginally, lowering this building block assessment from ‘very strong’ to ‘strong.’ This reassessment does not, however, fully offset some of the ongoing material improvements in Spain’s credit fundamentals, and an upgrade remains relatively likely.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments.
http://www.dbrs.com/research/357700

EURO AREA RISK CATEGORY: LOW

Notes:

All figures are in euros (EUR) unless otherwise noted. Public finance statistics reported on a general government basis unless specified.

The principal methodology is the Global Methodology for Rating Sovereign Governments, which can be found on the DBRS Morningstar website www.dbrs.com at http://www.dbrs.com/about/methodologies. The principal rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The sources of information used for this rating include the Ministry of Economy and Business, Ministry of Finance, Bank of Spain (BdE), National Statistics Office (INE), General State Comptroller (IGAE), Spanish Treasury, European Central Bank (ECB), European Commission (EC), Eurostat, Bank for International Settlements (BIS), Organisation for Economic Co-operation and Development (OECD), International Monetary Fund (IMF), World Bank, United Nations Development Programme (UNDP), Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

This is an unsolicited rating. This credit rating was not initiated at the request of the issuer.

This rating included participation by the rated entity or any related third party. DBRS Morningstar had no access to relevant internal documents for the rated entity or a related third party.

DBRS Morningstar does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period. DBRS Morningstar’s outlooks and ratings are under regular surveillance.

For further information on DBRS Morningstar historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see:
http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Ratings assigned by DBRS Ratings GmbH are subject to EU and US regulations only.

Lead Analyst: Javier Rouillet, Vice President, Global Sovereign Ratings
Rating Committee Chair: Thomas R. Torgerson, Managing Director, Co-Head of Sovereign Ratings
Initial Rating Date: October 21, 2010
Last Rating Date: September 20, 2019

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