DBRS Morningstar Confirms Kingdom of Spain at “A”, Stable 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 Stable.

KEY RATING CONSIDERATIONS
The Stable trend reflects DBRS Morningstar’s assessment that the risks to the ratings remain broadly balanced. As a reminder, DBRS Morningstar changed the trend on Spain’s ratings to Stable from Positive on May 29, 2020 to reflect the substantial deterioration in the country’s economic, fiscal, and debt projections as a result of the Coronavirus Disease (COVID-19). Since then, the latest available figures have confirmed the scale of the impact on the Spanish economy, with the country’s gross domestic product (GDP) estimated to have declined by a very substantial 11% in 2020, and the overall fiscal balance estimated to have recorded a deficit close to 11% of GDP. Despite the magnitude of the COVID-19 shock on the Spanish economy, DBRS Morningstar highlights that preliminary 2020 outturns have marginally outperformed earlier projections. Going forward, the strength of the economic rebound will be critical for Spain to avoid long-term economic scarring effects from the pandemic.

A strong economic rebound should take place in the second half of 2021 on the back of an improving healthcare situation and fuller removal of restrictions. However, the risks associated with new COVID-19 variants as well as a still relatively slow vaccine rollout continue to cloud economic growth prospects with uncertainties. DBRS Morningstar, in its latest economic scenarios at the end of January 2021, estimated in its moderate scenario the Spanish GDP to pick up by 6.5% in 2021, a figure close to the Bank of Spain’s latest estimate of a 6.8% growth. Key to the country’s economic recovery in 2021 will be the timely implementation of the Next Generation EU (NGEU) plan, scheduled to provide some uplift to the country’s growth momentum and possibly help raise Spain’s medium-term potential growth.

While the country’s debt, in line with European peers, has increased substantially at the end of 2020 to 117.1% of GDP compared with 95.5% at the end of 2019, DBRS Morningstar positively note that (1) this increase is slightly lower than the rise above 120% initially foreseen; and (2) the financing cost associated with this new debt has continued to remain near historical low at the same time as the average life of debt increased throughout last year. Spain has continued to benefit from the European Central Bank (ECB) monetary policies and the country’s debt affordability has continued to strengthen in 2020, despite the increase in its debt stock. Looking ahead, as the economy recovers, stabilising and subsequently placing the debt-to-GDP ratio on a downward trend will remain critical for the country to limit lasting effects of the pandemic on its credit profile.

Spain’s “A” rating remains supported by the country’s large and diversified economy, competitive export sector, and eurozone membership. DBRS Morningstar expects these features to support the country’s recovery. By contrast, Spain’s high public debt ratio and its reliance on foreign financing are sources of credit vulnerability. Spain’s high structural unemployment and temporality underscore labour market shortcomings. The pro-independence movement in the Autonomous Community of Catalonia (rated BB (high) with a Stable trend by DBRS Morningstar) remains in the background, although tensions have eased.

RATING DRIVERS
The ratings could be upgraded if one or a combination of the following occur: (1) successful implementation of a medium-term plan to rebalance public finances and place the debt-to-GDP ratio on a firm downward trend; (2) evidence of a strong recovery reducing concerns over long-lasting economic scarring; or (3) the introduction of economic reforms to enhance potential growth, possibly improving labour market functioning and raising productivity.

The ratings could be downgraded if one or a combination of the following occur: (1) evidence that the economic damage from the coronavirus pandemic is substantially larger and more persistent than expected; (2) a deviation from prudent fiscal policy commitment that further deteriorates public finances over time; (3) a sustained increase in funding costs; or (4) a threat to the territorial unity of Spain that substantially erodes the country’s economic and financial profile.

RATING RATIONALE

The Pandemic Has Significantly Affected the Spanish Economy in 2020

The COVID-19 shock interrupted a prolonged period of overperformance by the Spanish economy compared to its European peers in the years leading to 2020. This growth, coupled with private sector deleveraging and restored competitiveness, allowed the country to enter the current crisis on a strong economic footing, contrasting with the credit-fuelled expansion that preceded the global financial crisis.

The Spanish economy was nevertheless one of the most affected by the pandemic. Spain’s real GDP decreased by a substantial 11% in 2020, compared with decline of 6.8% for the euro area. The economic contraction, concentrated in the first two quarters of the year, primarily reflected the higher number of COVID-19 cases registered in Spain during the first wave of contagions and the stringency of the containment measures taken by the Spanish authorities to limit the spread of the virus. In addition, the lower economic growth compared with European peers also reflected some structural features of the Spanish economy including (1) the large share of the tourism sector, which contributed to 12.4% of Spanish GDP in 2019 and 12.9% of employment; (2) the high level of temporality in the Spanish labour market, at 24.6% of employment at the end of 2020; and (3) the greater share of small and medium size enterprises (SMEs) in Spain –78% of all companies had less than 5 employees in 2019, nine percentage points above the euro area– less prepared than larger firms to sustain this shock.

Despite the strong decline recorded in the first two quarters of the year, Spain’s GDP rebounded substantially by 16.4% in Q3 (qoq), as the healthcare situation improved during the summer and grew by a limited 0.4% (qoq) during Q4, given the resurgence of COVID-19 cases at the end of last year. The first quarter of 2021 is likely to remain negatively affected by adverse weather conditions (snowstorm) and the high level of infections at the beginning of the year, which prompted Spanish authorities to implement additional movement restrictions. Nevertheless, DBRS Morningstar positively notes that Spain has managed to drastically reduce the level of infections in recent weeks, without having to implement lockdowns as stringent as in some neighbouring countries. In coming weeks and months, maintaining control over the spread of the virus will remain critical for the healthcare and economic situation to improve. The vaccination rollout, which is expected to pick-up in coming weeks, should help Spain and other countries to reduce the level of contagion further.

While heavily dependent on the healthcare situation, the macroeconomic situation is however set to substantially improve throughout the year, with most estimates anticipating a strong recovery in the second half of 2021. The Bank of Spain, in its December forecast, estimated the rebound in 2021 at 6.8% in its baseline scenario. While this level is markedly below the national government’s latest estimate of a 9.8% recovery in 2021, it appears to reflect more appropriately the protracted containment measures applied by the government in recent weeks. For 2022, the central bank currently anticipates GDP growth of 4.2%.

Over the medium-term, avoiding long-lasting economic damage will remain critical for the Spanish economy. In that regard, the temporary unemployment benefit scheme for workers, which has limited the rise in the unemployment rate to 16.1% at year-end from 13.8% at the end of 2019, is viewed positively, particularly when compared with the 26.9% rate reached at the end of Q1 2013. Similarly, liquidity support measures through government guaranteed loans representing more than EUR 87 billion in guarantees to close to 600,000 enterprises, have prevented an increase in firms’ bankruptcies.

DBRS Morningstar also considers that economic performance could surprise to the upside over the next two years, should the implementation and absorption of the NGEU funds prove faster than anticipated. Spain is expected to receive up to EUR 72 billion in grants under NGEU (7% of GDP) between 2021 and 2023, of which EUR 27 billion have been budgeted for 2021. The recovery plan represents an important opportunity to boost investment and to revive the stalled reform agenda. A successful implementation of the investments and reforms associated with these disbursements, could positively affect Spain’s long-term growth prospects, raising productivity and reducing structurally high unemployment.

Fiscal Position Has Deteriorated Substantially in 2020 But Should Start to Improve Gradually Thereafter

Spain’s fiscal deficit is expected to have deteriorated to a level close to 11% of GDP at the end of 2020, a level not seen since 2012. The 2020 deficit deterioration, from -2.9% of GDP at the end of 2019, reflected the economic recession as well as the country’s automatic stabilisers and the government’s targeted support measures implemented throughout the year. For 2021, the current estimate from the national government stands at a deficit of 7.7% of GDP. Given the relatively strong macroeconomic assumptions taken by the government, this forecast might be subject to downward revisions. The Independent Authority for Fiscal Responsibility (AIReF), under a somewhat milder growth assumption of 8.2% in 2021, expects for instance a deficit of 8.0% of GDP this year. Nevertheless, a potentially better than expected fiscal outturn in 2020 could support the government’s 2021 deficit scenario.

More than the exact deficit figure for 2020 or 2021, DBRS Morningstar’s focus in coming quarters will be on the effectiveness of the implementation of structural reforms via the absorption of NGEU grants, and on the commitment of the government to gradually rebalance its fiscal results over the medium-term. Nevertheless, while an emphasis on the type of expenditure that will ultimately be selected under the NGEU and the reforms implemented will be critical, DBRS Morningstar acknowledges that assessing their potential long-term effects is likely to take time. DBRS Morningstar also considers that Spain’s annual 2021 budget, approved before the start of the year for the first time since 2016 is a positive development. It should allow the government to implement its budgetary objectives more easily than in prior years, including the NGEU EUR 27 billion of spending.

The Pandemic Has Triggered a Rapid Rise in Public Debt but Funding Costs Remain Near an All Time Low

In line with other European peers, Spain’s public debt ratio has increased very substantially in 2020. Recently released figures by the Bank of Spain indicate a jump in the debt-to-GDP ratio to 117.1% at the end of 2020 from 95.5% at year-end 2019. The high public debt ratio, if persistent at this level, is likely to leave Spain more exposed to future shocks, as it would somewhat reduce the country’s scope for future countercyclical fiscal policy. Nevertheless, the debt increase, although significant, remains below earlier estimates of a rise of the debt above 120% of GDP. In 2021, pending updated government’s medium-term projections to be provided by the end of April to the European Commission, current forecasts anticipate a stabilisation of the debt ratio in 2021 before a reduction thereafter under a scenario of fiscal consolidation.

The ECB and the EU response to the pandemic underscores the considerable benefits associated with Spain’s membership of the euro area and of the EU. The ECB’s massive pandemic response and the various EU-backed financing facilities, including the grants under NGEU, are providing room for manoeuvre to European governments to appropriately respond to the pandemic and to accelerate structural reforms. The ECB’s stepped up sovereign debt purchases reduce the amount that the private sector has had to absorb. This has, so far, allowed Spain to continue to enjoy close to historically low funding costs. In this context, DBRS Morningstar expects the Spanish Treasury to continue to lower the average cost of its outstanding debt in the next couple of years. As of February 2021, the average cost at issuance for 2021 had for instance turned slightly negative, at -0.08%. At the same time, the average cost of outstanding debt stood at 1.84% in February 2021, well below the 4.53% recorded in 2007.

This overall decrease in funding costs materialised at the same time as the average life of debt outstanding increased to close to 8 years in February 2021 from 6.2 years in 2013, protecting the government from sudden increases in funding costs. The ECB’s financial backstop as well as Spain’s debt structure support DBRS Morningstar’s positive qualitative assessment of the “Debt and Liquidity” building block.

Spanish Banks Appear Better Prepared to Face an Increasingly Challenging Environment

The Spanish banking system entered the current economic crisis following a prolonged period of improvement in its capital ratios and asset quality. This happened following large-scale restructuring in the sector, tighter regulatory requirements, and the economic and housing market recovery in recent years. According to European Banking Authority data, the CET1 (fully loaded) capital ratio increased to 12.0% in Q3 2020 from 9.3% in Q3 2014, exceeding regulatory requirements. In the same period, the share of nonperforming loans shrank to 2.9% from 8.8%, to a level similar to that of the euro area average. In stark contrast with the previous crisis, Spanish households and firms have leaner balance sheets, with indebtedness levels below those of the euro area, and there is no significant evidence that there would be imbalances in the Spanish housing market.

DBRS Morningstar considers that the combination of the state-guaranteed loans scheme, loan moratoria, and the ECB’s extraordinary liquidity and regulatory relief measures have played a crucial role in sustaining a healthy supply of credit throughout 2020. Nevertheless, the current crisis is expected to weigh on banks’ asset quality, profitability, and capital ratios in coming quarters. Please see the Commentary “Spanish Banks: FY20 Earnings Significantly Down, but Credit Risk Still to Fully Materialise” for more information. This comes on top of the more structural profitability pressures resulting from the low interest rate environment and strong competition. The state-guaranteed loans are however expected to slow the pace of deterioration in credit quality from the pandemic shock going forward. Although the sovereign will bear between 70%-80% of the losses that might arise from these loans, the great majority of banks’ loan book is not covered by this programme, and loan loss provisions are likely to be needed to cover future defaults.

The Current Political Environment Continues to Represent a Challenge to Ambitious Reforms and Somewhat Weakens Political Stability

Spain benefits from strong political institutions underpinning its economy. However, an increasingly fragmented and polarised political landscape has complicated cooperation and undermined the stability of governments in the past five years. At times, this has resulted in rolled-over budgets, hindered faster fiscal consolidation, and stalled the reform agenda. Nevertheless, as previously mentioned, DBRS Morningstar considers that the 2021 budgetary process represents a move in the right direction, as it allowed for the more timely approval of a full-year budget for the first time since 2016. Despite this positive development, implementing key structural reforms, particularly under the NGEU programme, is likely to continue to prove challenging given the fragmented coalition government.

In addition, while the Catalan pro-independence movement has somewhat eased its stance since 2017, a long-lasting solution remains elusive and tensions might resurface. Recent regional elections have for instance confirmed the majority of pro-independence parties in the Catalan Parliament. The formation of a new regional government and gaining visibility over its political agenda might provide guidance on the future relationship between the region and the national government. The constraints imposed by the political climate on Spain’s capacity to address key economic challenges and the uncertainty over the long-term situation in Catalonia continue to weigh negatively on DBRS Morningstar’s qualitative assessment of the “Political Environment” building block.

Spain’s Balance of Payments is Expected to Withstand the COVID-19 Shock

The disruptive effects from the restrictions impacting trade and tourism flows have negatively affected external demand in 2020. Nevertheless, given the parallel decrease in imports, Spain has maintained, according to first available estimates, a positive current account balance last year, at 0.7% of GDP. The Spanish economy remains nevertheless reliant on foreign capital, increasing the country’s vulnerability to sudden shifts in investor sentiment. Spain’s negative net international investment position (NIIP), albeit having shrunk substantially since -97.7% of GDP at the end of Q2 2014, remained high at -73.9% of GDP at year-end 2019. While it is expected to worsen in 2020, reflecting the decline in the nominal GDP, it should restart its downward trajectory from 2021. Compared with the previous crisis, Spain remains in a much stronger external position thanks to a sharp improvement in cost-competitiveness and Spanish firms’ greater propensity to export.

ESG CONSIDERATIONS
Human Capital and Human Rights (S) were among the key ESG drivers behind this rating action. Spain’s per capita GDP was relatively low at USD 26,832 in 2020 compared with its euro area peers. This factor has been taken into account primarily in the “Economic Structure and Performance” building block.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessment: https://www.dbrsmorningstar.com/research/374875.

EURO AREA RISK CATEGORY: LOW

Notes:
For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883

All figures are in 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 https://www.dbrsmorningstar.com/research/364527/global-methodology-for-rating-sovereign-governments (July 27, 2020). Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/373262/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (February 3, 2021).

The sources of information used for this rating include the Ministry of Economy and Business, Ministry of Finance, Bank of Spain (Macroeconomic Projections 2020-2023, December 2020; Economic and financial developments in Spain over the COVID-19 crisis, February 2021), Ministry of Health (daily COVID-19 updates), National Statistics Office (INE), General State Comptroller (IGAE), Independent Authority for Fiscal Responsibility (Budget Execution, report on the main lines of the 2021 budgets of the general government, November 2020), Spanish Treasury (Presentation and Chart Pack, February 2021), European Central Bank, European Banking Authority, European Commission, Eurostat, Bank for International Settlements, Organisation for Economic Co-operation and Development, International Monetary Fund, World Bank, United Nations Development Programme and Haver Analytics. The Social Progress Imperative (2020 Social Progress Index) and the 2019 Global Competitiveness Report from the World Economic Forum were also used. 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.

With Rated Entity or Related Third Party Participation: YES
With Access to Internal Documents: NO
With Access to Management: NO

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 12-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. DBRS Morningstar understands further information on DBRS Morningstar historical default rates may be published by the Financial Conduct Authority (FCA) on its webpage: https://www.fca.org.uk/firms/credit-rating-agencies.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/374874.

This rating is endorsed by DBRS Ratings Limited for use in the United Kingdom.

Lead Analyst: Nicolas Fintzel, Senior Vice President, Global Sovereign Ratings
Rating Committee Chair: Thomas R. Torgerson; Managing Director, Co-Head Global Sovereign Ratings
Initial Rating Date: October 21, 2010
Last Rating Date: September 4, 2020

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