DBRS Confirms AA Ratings of Spain, Changes Trends to Negative on Increased Downside Risks

DBRS Inc. (DBRS) has today confirmed the ratings of the Kingdom of Spain’s long-term foreign and local currency debt at AA and changed the trends from Stable to Negative.

The ratings balance Spain’s relatively low public-sector indebtedness and its progress in achieving its fiscal targets with high fiscal deficits, high unemployment, a fragile recovery and a weakened financial sector. The Negative trends reflect the potentially adverse effects of the sharp rise in uncertainty in financial markets on economy-wide funding conditions and the increased risks to the growth outlook of the United States that could affect both Europe and Spain’s export-based recovery.

DBRS recognises the progress achieved to date, with a fiscal adjustment program that has been on track, the ongoing extensive reform of the savings bank sector and the narrowing of the current account deficit. Furthermore, Spain’s general government indebtedness is comparatively low. The European Commission forecast that the debt-to-GDP ratio will rise to 68.1% by the end of 2011, about 15% of GDP below its forecasts for the three largest AAA-rated European economies, namely, France, Germany and the United Kingdom.

As concerns over debt and fiscal deficits appear to continue in financial markets, Spain and Italy have come under renewed market stress, although reported European Central Bank (ECB) purchases in secondary bond markets seem to have lowered yields significantly. If these support measures by the ECB, or later by the EFSF, continue, it could ease recent market pressure on sovereign funding costs and on domestic financing conditions. However, the recent sharp rise in financial market uncertainty could have a negative impact on economy-wide funding conditions. Furthermore, increased downward risks to the U.S. economic outlook could add downside risks to Spain’s weak recovery given its reliance on exports. This, in turn, could potentially make the achievement of Spain’s ambitious fiscal targets more difficult.

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, accounting for 40% of banking assets, which lent heavily into real estate, coupled with a labour market that performed poorly with losses of almost 11% of employment since the peak in the second quarter of 2008, revealed serious weaknesses. As a result, the unemployment rate has reached 20.9%, the highest among advanced economies. Banking sector-wide non-performing loans have climbed to 6%, driven by exposures to construction and real estate activities, which are responsible for 57% of these. The savings banks have also about EUR 44 billion, or 4.1% of GDP, in foreclosed assets. Still, there has been a substantial recognition of impairment losses in commercial and savings banks, amounting to 9% of GDP.

In spite of these shortcomings, the unwinding of economy-wide imbalances is proceeding at varying speeds. The current account balance narrowed from a deficit of 10% of GDP in 2007 to a deficit of 4.5% of GDP in 2010, as investment in residential housing declined, helping reduce the trade deficit. The contraction in construction employment has been fast and deep, accounting for 1.24 million of a total of 2.12 million jobs lost. Indebted households increased their savings rates from 10.7% of disposable income to 18% in 2009 and has fallen to 13.1% in 2010. Correction of house prices has reached almost 17% in nominal terms and 22% in real terms, as reported by official data since the housing peak of the first quarter of 2008, and the drop is likely to continue.

For first quarter of 2011 quarter growth was 0.3% over the previous quarter, and the contraction in quarterly GDP since its peak in the first quarter of 2008 is about 4%. Recent estimates place growth in 2011 at a modest pace of 0.8%, driven by exports. With the unemployment rate at 20.9%, the depth of the recession suggests that many of the jobs lost were low productivity jobs, especially in construction. In spite of some progress in reforming labour market policies, structural unemployment is likely to have increased and, at this growth rate, it is expected that cyclical unemployment will fall slowly.

Credible debt stabilisation by 2013, in an environment of increased risk aversion and with modest near-term growth prospects, will continue to require a persistent effort, especially with respect to potential slippages by some Autonomous Communities. President Rodriguez Zapatero has called early elections for November 20th 2011 and opinion polls give the opposition People’s Party a substantial lead over the ruling Socialist Party. Regardless of the outcome, there is a widespread political consensus on the need for fiscal consolidation and DBRS expects that the firm commitment to the fiscal adjustment programme will continue.

The trend could be changed from Negative to Stable if there is a material reduction of the downside risks to the growth outlook of advanced economies alongside substantially more stable financial markets or if Spain’s growth outlook improves. However, possible downward rating actions could be triggered by significant fiscal slippage, a worsening of Spain’s growth prospects, or if access to funding were to deteriorate materially.

Notes:
All figures are in Euros (EUR) unless otherwise noted.

The principal applicable methodology is Rating Sovereign Governments, which can be found on our website under Methodologies.

The sources of information used for this rating include the National Statistical Institute, The Bank of Spain, Eurostat and the International Monetary Fund. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This is an unsolicited rating. This rating is based solely on publicly available information.

Lead Analyst: Pedro Auger
Rating Committee Chair: Alan G. Reid
Initial Rating Date: 21 October 2010
Most Recent Rating Update: 21 October 2010

For additional information on this rating please refer to the linking document under Related Research.