DBRS Assigns AA Ratings to Spain on Strong Fiscal Adjustment

DBRS has today assigned ratings to the Kingdom of Spain’s long-term foreign and local currency debt of AA with Stable trends.

The ratings balance Spain’s relatively low pre-crisis public-sector indebtedness and its progress in adjusting its external and internal imbalances with high fiscal deficits, high unemployment and a weakened financial sector. The Stable trends reflect the resilience of the public-sector balance sheet, improved credibility in the government’s fiscal policy response, lower uncertainty regarding the state of unlisted savings banks and progress in the correction of external imbalances.

“The quality of the fiscal retrenchment has enhanced the credibility of the government’s fiscal targets,” says Pedro Auger, DBRS’s Spain analyst.

Furthermore, the results from the banking stress test implemented by the Bank of Spain have dissipated much of the uncertainty surrounding the fiscal costs of repairing savings banks’ balance sheets. Mr. Auger adds, “Restoring confidence is essential, and although we are seeing a decoupling of Spain’s government bond yields from other stressed euro zone countries, ultimate success in stabilizing public debt ratios will hinge on a sustained fiscal effort.”

On May 20, 2010, the government adopted a set of measures to consolidate public finances, seeking to front-load the fiscal adjustment required to reduce the fiscal deficit to 3% by 2013. The brunt of the adjustment falls in 2011 as the government aims to reduce the deficit by 3.3% of gross domestic product (GDP), down from this year’s deficit of 9.3% of GDP. Consolidating public finances in 2011 in the face of continuing weak private-sector demand will be challenging. Still, DBRS is reassured by the fiscal retrenchment measures, the additional adjustments contained in the 2011 budget proposal and the progress achieved in reforming the unlisted savings banks.

At the root of Spain’s problems are losses in competitiveness, combined with the rapid rise in leverage, which fuelled Spain’s residential property boom. A large unlisted savings banking sector that lent heavily into real estate, coupled with a labor market that resulted in losses of 9.5% of employment, have revealed serious weaknesses.

In spite of these shortcomings, the unwinding of economy-wide imbalances is proceeding. The current account balance has been improving steadily, from 10% of GDP in 2007 to an estimated 4.6% of GDP in 2010, as investment in residential housing has declined, helping reduce the trade deficit. The contraction in construction activity alone is responsible for one million of a total of two million jobs lost. Indebted households have sharply increased their savings rates from 10.7 % of disposable income to 18.8% in 2009, albeit weakening domestic demand.

Banks, especially unlisted savings banks, which account for 40% of banking assets, have largely withstood the stress from their overexposure to residential housing. Savings banks have shored up their balance sheets through consolidation and the use of the government’s recapitalization facility. Critically, it is expected that with the new savings bank law, savings banks will, for the first time, raise private capital. Residential housing prices have fallen modestly, although the estimated stock of unsold units is still high, at approximately one million.

At the end of 2010, it is expected that the accumulated contraction in GDP since the start of the crisis will be close to 4%, with growth likely resuming in 2011 at a modest pace. With unemployment at 20%, the depth of the recession suggests that many of the jobs lost were low productivity jobs, especially in construction. The ensuing erosion of the tax base, the stimulus package and automatic stabilizers have given rise to high fiscal deficits and rising public debt, which is likely to reach 64% of GDP in 2010, up from 36% of GDP in 2007.

The overriding objective behind the fiscal austerity program is credible debt stabilization by 2013. Difficult spending decisions will likely be required on an ongoing basis to meet this objective, especially if the economy underperforms GDP budget estimates. As some of this effort falls on decentralized autonomous regional governments, there are risks to the implementation of the plan. However, the quality of the spending reductions that have been approved signals strong government commitment to stabilizing public debt ratios. This has been further strengthened by an agreement reached between the ruling Socialist government, the Basque Nationalist Party and the Canarian Coalition, providing the government stable political support for its fiscal policies.

Strong political commitment and support for the fiscal austerity plan underpin DBRS’s Stable trends. Nevertheless, the trends could be changed to Negative if the fiscal measures required are not forthcoming or if weak economic conditions significantly impair the achievement of the fiscal targets.

Note:
The applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website under Methodologies.

These ratings did not include issuer participation and are based solely on publicly available information.