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

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

KEY CREDIT RATING CONSIDERATIONS
The Stable trend reflects DBRS Morningstar’s view that the risks to the credit ratings are balanced. Spain’s economic growth is decelerating after two years of strong performance, but is holding up better than the euro area average. The recovery of purchasing power and the spending of European recovery funds should mitigate the effects of tight monetary policy and external headwinds next year. Public finance metrics are improving, driven by strong revenue growth and the removal of support measures after a sharp deterioration in 2020. The government projects a fiscal deficit of 3.9% of GDP in 2023 and a decline of the public debt ratio to 108.1% of GDP in 2023 from 120.3% in 2020. DBRS Morningstar expects the newly formed government led by Pedro Sánchez to pursue broad continuity in terms of fiscal policy and execution of Spain’s recovery plan. On the other hand, social and political tensions have increased in recent weeks response to the submission of the draft amnesty law to Congress and government stability might be tested, especially if pro-independence parties decide to withdraw their support.

Spain’s credit ratings remain supported by its large and diversified economy, competitive export sector, and euro-area membership. DBRS Morningstar expects these characteristics, coupled with the implementation of its recovery and resilience plan, to underpin the country’s economic performance. On the other hand, Spain’s high public debt ratio limits the government’s space to respond to shocks and weighs on fiscal accounts, especially in the context of higher funding costs and increasing age-related expenditures. Spain’s historically volatile employment dynamics, high structural unemployment, and sluggish labour productivity performance remain structural challenges. These limit the growth of income per capita and output potential, even though the new labour market reform is significantly reducing the share of temporary contracts in Spain. The institutional and territorial challenge posed by the pro-independence movement in the Autonomous Community of Catalonia (rated BBB (low) with a Stable trend by DBRS Morningstar) remains very limited although political tensions might resurface.

CREDIT RATING DRIVERS
The credit 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; or (2) further evidence of successful implementation of reforms that improve economic resilience and/or boost potential growth.

The credit ratings could be downgraded if one or a combination of the following occur: (1) a sustained increase in Spain’s already-high public debt ratio, which could result from a worsening medium-term growth outlook or weaker fiscal discipline; or (2) although unlikely at the moment, institutional and territorial challenges that would substantially erode the country’s economic and financial profile.

CREDIT RATING RATIONALE
New Government Expected to Pursue Policy Continuity but Its Stability Will Be Tested

Following Spain's inconclusive general election in July 2023, Pedro Sánchez was re-elected as Prime Minister backed by 179 votes out of 350 in the Spanish Congress on 16 November 2023 with the support of pro-independence Catalan parties (Esquerra Republicana de Catalunya and Junts per Catalunya) and other regional parties. Sánchez will lead a minority coalition government of the centre-left Partido Socialista Obrero Español (PSOE) and left Sumar parties. DBRS Morningstar takes the view that the newly formed government led by Sánchez will pursue broad continuity in terms of fiscal policy and execution of Spain’s recovery plan. However, the durability of the government will most likely face tests, especially if pro-independence parties decide to withdraw their support (see commentary “Spain: Government Formation Will End Deadlock Amid Political Turmoil, Credit Fundamentals Unlikely to Materially Change”).

Spain benefits from strong political institutions that support its economy. Spain’s percentile rank scores for Government Effectiveness (77.8), Voice and Accountability (79.7), and Rule of Law (77.4) are strong in the World Bank’s Worldwide Governance Indicators for 2022. Still, the agreements between PSOE and the Catalan pro-independence parties, and in particular the submission of the draft amnesty law to Congress, have led increased political and social tensions across Spain. The medium- to long-term political and social implications of the potential approval of the draft amnesty law are unclear at this stage. DBRS Morningstar considers that Spain's institutional checks and balances mitigate concerns over the rule of law. DBRS Morningstar will also monitor the potential impact of the different political agreements that led to Sánchez's investiture on the wider institutional and financial relationship between the central government and the autonomous communities, including the Autonomous Community of Catalonia.

The Economy Is Showing Resilience Amid Strong Headwinds

The Spanish economy recovered more quickly than previously estimated with real GDP surpassing its pre-pandemic peak already during 2022. After a sharp contraction of 11.2% in real GDP in 2020, the most pronounced in the EU-27, Spain’s real GDP grew by 6.4% in 2021 and by 5.8% in 2022. The return of foreign tourism, solid job gains, and the national and European policy responses have supported the post-pandemic recovery. The strength of the labour market and the speed of its recovery, in part due to the government’s support measures, are positive compared with previous crises. Both employment levels and unemployment rates are better than before the pandemic with a significant decline in temporary employment. While these are positive developments, Spain’s relatively low productivity and still-low employment rates have limited its ability to converge towards the euro area’s GDP-per-capita levels.

The European Commission (EC) projects real GDP growth in Spain to slow down to 2.4% in 2023 and to 1.7% in 2024, outperforming the euro-area average. Private consumption, after significantly lagging the pandemic recovery, revived this year as headline inflation eased and job creation remained strong in H1 2023. This, coupled with foreign tourism returning to pre-pandemic peaks, helped to offset the sharp contraction in good exports during Q2/Q3 2023 linked to the manufacturing weakness in Europe. For 2024, the expected recovery in purchasing power and the positive effects of implementing the NextGenerationEU (NGEU) funds on investment are expected to mitigate the impact of higher interest rates and the weak global backdrop. Still, a stronger-than-expected impact of higher rates, a more pronounced downturn in Europe, or further spikes in energy prices represent important downside risks to growth.

In DBRS Morningstar’s view, Spain’s ability to implement its committed reforms and fully absorb the NGEU funds will remain crucial to raise medium-term growth prospects and to deliver on its long-term investment plans, especially as fiscal deficits will need to be contained and high interest rates will likely weaken investments. The updated Spanish Recovery Plan, if fully implemented, will mobilise up to EUR 163 billion during 2021–26 (more than 12% of GDP). The country has made significant progress in its implementation, but the macroeconomic impact and effects on potential growth are difficult to estimate.

Gradual Reduction of the Fiscal Deficit Continues, EU Fiscal Rules Limit Future Slippage Risks

The pandemic and energy crises have heavily affected Spain’s fiscal performance. The collapse in output and the impact of coronavirus support led to a significant widening in the country’s fiscal deficit to 10.1% of GDP in 2020 from a deficit of 3.1% of GDP in 2019. Since then, the fiscal deficit narrowed to 4.7% of GDP in 2022 on the back of strong fiscal revenues as well as a reduction in the fiscal impact of coronavirus-related measures. Furthermore, the relative performance within the EU-27 is improving, with Spain's fiscal deficit ratio expected to go from being the largest in 2020 to the eleventh-largest in 2025, according to the latest estimates from the EC.

The fiscal deficit ratio is projected to decline in 2023 and 2024 related to the lower cost of energy measures this year and the majority of the measures will be phased out next year. The pace of reduction is expected to slow as revenue growth moderates after two years of very strong growth and high inflation. The 2024 Draft Budgetary Plan projects a deficit reduction to 3.0% of GDP in 2024 from 3.9% in 2023, assuming full expiration of energy crisis support and no policy changes. While the political agreements leading to the formation of a government could increase fiscal pressures during this legislature, the reactivation of EU fiscal rules and the previous government’s track record of gradual fiscal consolidation mitigate the risk. Spain is likely to rollover the 2023 budget law and approve a new budget for 2024 during the first months of the year.

Over the medium to long term, expenditure pressures that an ageing population places on pensions, healthcare, and long-term care as well as higher funding costs are expected to weigh on public finances. The Spanish independent fiscal institution (AIReF) estimates that the pension system reform during 2021–23 will result in an increase in the fiscal deficit of 1.1% of GDP by 2050. Therefore, new measures will most likely be needed to further shore up the financial sustainability of the system, potentially through the new automatic adjustment mechanism to be considered in 2025 and every three years thereafter.

Public Debt Ratio Is Falling but Remains High, Favourable Debt Structure Helps to Gradually Absorb Higher Interest Rates

Spain's public debt ratio, among the highest in the EU-27, remains an important credit challenge. High debt reduces the government’s fiscal space and increases its vulnerability to shocks. After peaking at 120.3% of GDP in 2020, the public debt ratio declined to 111.6% in 2022, mostly driven by high nominal GDP growth and a narrowing fiscal deficit. The government projects the debt ratio to continue declining to 108.1% of GDP in 2023 and to 106.3% of GDP in 2024, driven by a positive nominal interest-growth differential and lower deficits. As the tailwinds from nominal GDP growth lose strength and the fiscal pressures from an ageing population and higher interest burden increase, new structural adjustments might be needed to keep the public debt ratio on a firm downward trend.

On a positive note, Spain’s responsible debt management in anticipation of the end of the era of exceptionally low rates will help to smooth the impact of higher funding costs over time. The predominance of fixed-rate bonds, a relatively long average maturity of 7.8 years, and limited one-year refinancing risk of around 12.8% of the stock of debt as of Q2 2023 will delay the impact of higher costs of issuance on the total annual interest bill. The government projects the interest burden to remain unchanged at 2.4% of GDP in 2023 and to gradually increase to 2.5% of GDP in 2024. DBRS Morningstar notes that the higher yields mostly reflect an increase in benchmark rates and not the market’s perception of increased sovereign risks, as spreads have remained relatively stable. Furthermore, under its Transmission Protection Instrument, the European Central Bank (ECB) can purchase bonds of a sovereign that faces sharp interest rate increases that are not justified by fundamentals under certain conditions. Also, domestic financial institutions and increasing appetite from retail investors should help alleviate the impact of the ECB’s quantitative tightening since March 2023. The ECB’s financial backstop and Spain’s debt structure support DBRS Morningstar’s positive qualitative adjustment for the “Debt and Liquidity” building block assessment.

Spanish Banks Are Well Positioned to Benefit From Higher Rates and Weather a More Challenging Operating Environment

The Spanish banking system remains healthy and financial stability risks remain contained following a prolonged period of improvement in solvency, liquidity, and asset-quality metrics. According to the European Banking Authority, Spanish banks’ CET1 capital ratio stood at 12.7%, the loan-to-deposit ratio stood at 101.8%, the liquidity coverage ratio stood at 169.8%, and nonperforming loans stood at 2.8% of total loans in Q2 2023. Spanish banks’ profitability has increased substantially, mostly reflecting the improvement in net interest income as the loan book is repricing quickly given the predominance of variable-rate mortgages, while deposit rates have increased marginally. On the other hand, similar to euro-area trends, financing flows to households and firms have experienced a marked slowdown in 2023 as banks are tightening credit standards at a time where credit demand is declining.

While the higher interest rates and higher costs of living, amid a slowing economy, will test the most vulnerable borrowers’ capacity to repay their debt, DBRS Morningstar expects the potential deterioration in asset quality to remain manageable. Any increase in non-performing loans will be starting from a low base. Recovering purchasing power, households’ lower indebtedness levels than in the past, and the new package of relief measures for vulnerable borrowers support this view. DBRS Morningstar views limited risks from the housing market, despite the substantial drop in terms of new mortgage flows and transactions during 2023. Sluggish growth in supply of new housing units and higher construction costs mitigate the risks of a sharp correction in housing prices.

Spain’s External Accounts Continue to Improve in Spite of Successive External Shocks

Spain’s external accounts have improved significantly for more than a decade and there is no indication of imbalances building up, in contrast with the runup to the global financial crisis. Spain posted average current account surpluses of 1.6% of GDP between 2012 and 2022, reversing a period of current-account deficits averaging 5.6% of GDP between 2000 and 2011. Spain managed to maintain current account surpluses in spite of the pandemic and the sharp increase in energy import prices. The EC projects the current account to increase to 1.9% of GDP 2023 from 0.6% of GDP in 2022 thanks to the full recovery of tourism, energy prices retreating considerably, and the strong performance of non-tourism service exports. The accumulation of current-account surpluses, combined with an expanding nominal GDP, explain the improvement in Spain's net international investment position to -56.6% of GDP in Q2 2023 from -97.7% of GDP in Q2 2014. While Spain’s still-elevated net-external debtor position exposes the country to sudden changes in investor sentiment and capital flows, DBRS Morningstar considers that Eurosystem membership and Spain’s current account surpluses, which are expected to continue in the next couple of years, mitigate this risk.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

ESG Considerations had a significant effect on the credit analysis.

Environmental (E) Factors
There were no Environmental factors that had a relevant or significant effect on the credit analysis.

Social (S) Factors
The following Social factors had a significant effect on the credit analysis: Human Capital and Human Rights (S) affects the credit ratings assigned. Spain’s GDP per capita, estimated at USD 29,800 in 2022 to the International Monetary Fund (IMF), remains relatively low compared with its euro system peers. DBRS Morningstar has taken these considerations into account within the ”Economic Structure and Performance” building block.

Governance (G) Factors
There were no Governance factors that had a relevant or significant effect on the credit analysis.

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 (July 4, 2023) https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria:-approach-to-environmental,-social,-and-governance-risk-factors-in-credit-ratings.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments at: https://www.dbrsmorningstar.com/research/424856.

EURO AREA RISK CATEGORY: LOW

Notes:
All figures are in Euros 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 (October 6, 2023) https://www.dbrsmorningstar.com/research/421590/global-methodology-for-rating-sovereign-governments. In addition DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria:-approach-to-environmental,-social,-and-governance-risk-factors-in-credit-ratings in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

The sources of information used for these credit ratings include the Ministry of Economic Affairs (Recovery Plan Draft Addendum December 2022, Press Release – EC Approval of Addendum October 2023), Ministry of Finance (2024 Draft Budgetary Plan), Bank of Spain (Macroeconomic Projections 2023-2025, September 2023; Autumn 2023 Financial Stability Report), National Statistics Office, General State Comptroller (IGAE), Independent Authority for Fiscal Responsibility (Opinion on the Sustainability of Public Administration in the Long Term: the Incidence of Demographics; Report on the Main Budgetary Lines of the Public Administrations for 2024), Spanish Treasury (Treasury’s Presentation November 2023), State Official Gazette (Climate Change and Energy Transition Law, May 2021), EC (Autumn 2023 Economic Forecast; 2023 Country Report – Spain; Opinion on Draft Budgetary Plan 2024), EU’s Economic and Financial Committee's Sub-Committee on EU Sovereign Debt Markets (ESDM), ECB, European Banking Authority, Eurostat, Bank for International Settlements, Organisation for Economic Co-operation and Development, IMF (WEO and IFS), World Bank, the Social Progress Imperative (2022 Social Progress Index), and Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing these credit ratings to be of satisfactory quality.

With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, these are unsolicited credit ratings. These credit ratings were not initiated at the request of the issuer.

With Rated Entity or Related Third Party Participation: YES
With Access to Internal Documents: YES
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.

The conditions that lead to the assignment of a Negative or Positive trend are generally 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: https://registers.esma.europa.eu/cerep-publication. For further information on DBRS Morningstar historical default rates published by the Financial Conduct Authority (FCA) in a central repository, see https://data.fca.org.uk/#/ceres/craStats.

The sensitivity analysis of the relevant key credit rating assumptions can be found at: https://www.dbrsmorningstar.com/research/424858.

These credit ratings are endorsed by DBRS Ratings Limited for use in the United Kingdom.

Lead Analyst: Javier Rouillet, Vice President, Credit Ratings, Global Sovereign Ratings
Rating Committee Chair: Thomas R. Torgerson, Managing Director, Credit Ratings, Global Sovereign Ratings
Initial Rating Date: October 21, 2010
Last Rating Date: June 9, 2023

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