DBRS Downgrades Spain to AA (low) on Funding Stress and Growth Outlook

DBRS, Inc. (DBRS) has downgraded the ratings on the Kingdom of Spain’s long-term foreign and local currency debt to AA (low) from AA. The trends remain Negative. The downgrade reflects the intensification of funding pressures for the sovereign, which will likely make it harder to achieve Spain’s ambitious fiscal targets and negatively affect domestic credit conditions. Furthermore, downward revisions in expected growth in 2012 for Spain’s major trading partners in Europe add downside risks to Spain’s weak export-based recovery. The Negative trends reflect continuing uncertainty in financial markets, as well as downside risks to the European and Spanish growth outlooks.

DBRS recognises the progress achieved by Spain to date, and expects the incoming government led by the People’s Party to continue with a strong commitment to achieving fiscal targets. On 20 November 2011, the People’s Party won an outright majority in Congress, which may make it less difficult to pass additional structural reforms. Among the major adjustments realised to date are a fiscal retrenchment programme that has been on track and the ongoing reform of the savings bank sector. Furthermore, Spain’s general government indebtedness is comparatively low, and the current account deficit is narrowing. The ratings balance these positive factors with elevated fiscal deficits, very high unemployment, a fragile recovery and a weakened financial sector.

As concerns over debt, fiscal deficits and bank balance sheets persist in financial markets, sovereigns, including Spain, have come under renewed market stress. If secondary market bond purchases by the European Central Bank (ECB) and support by a revamped European response, including the recently approved measures that seek to leverage the European Financial Stability Facility (EFSF), are implemented effectively, it could ease market pressure on sovereign funding costs and on domestic financing conditions.

However, the worsening European economic outlook, combined with the sharp rise in volatility in financial markets and the uncertainty surrounding the Greek adjustment programme, is stressing financing conditions for some sovereigns – including Spain – and could negatively affect their recovery.

Spain’s economy is the fourth largest in the Euro area. It is well diversified and its share of world goods exports has been broadly steady at 1.9%. Exports of goods and services have recovered, exceeding their pre-crisis peak, attenuating the contractionary effects of weak domestic demand. Although productivity growth has been stagnant, Spain’s income per capita on a purchasing power parity (ppp) basis has risen relative to the three largest Euro area economies over the last decade. In 2010, income per capita on a ppp basis stood at 94% of France’s, 85% of Germany’s and at par with Italy’s.

Another strength is Spain’s comparatively low level of public debt. The European Commission forecasts that the country’s debt-to-GDP ratio will rise to 69.6% by the end of 2011, close to 14% of GDP below its forecasts for the three largest European economies with a AAA rating – France, Germany and the United Kingdom. Furthermore, the fiscal adjustment has been on track. In 2010, the government achieved its fiscal deficit target of 9.3% of GDP. However, complying with this year’s ambitious target of 6% of GDP, given the difficulties that some of the country’s regions, or Autonomous Communities, are facing, may prove more difficult. Consensus estimates place the fiscal deficit at 6.5% of GDP. It is likely that the central government will over perform to try to compensate for fiscal slippages in certain Autonomous Communities. Nevertheless, despite tepid growth, the improvement in the deficit will likely be significant. Furthermore, the balance of the proposed fiscal measures has fallen more on the spending side, enhancing the likelihood of success in delivering a durable adjustment.

The national savings rate has been high, averaging 21.5% of GDP from 1999 through 2010. Although this helps support a high level of investment, it has not been sufficient to fully cover requirements. As investment peaked near 30% of GDP, this required substantial external financing, generating a current account deficit of 10% of GDP in 2007. Nevertheless, the current account balance narrowed to a more sustainable 4.6% of GDP by 2010, an adjustment driven by the fall in residential investment and which is likely made easier by the high level of savings.

At the root of Spain’s problems are losses in competitiveness, combined with the rapid rise in leverage that fuelled Spain’s residential property boom. The correction underway has resulted in a contraction in construction employment that has been fast and deep, accounting for 1.34 million of a total of 2.34 million jobs lost. With unemployment at 21.5% and housing prices that have fallen by 23% in real terms since their peak, indebted households are deleveraging, increasing their savings rates from 10.4% of disposable income in 2007, to 18.5% in 2009 and to 13.9% in 2010.

A large unlisted savings bank sector, accounting for 40% of banking assets, which lent heavily into real estate, has revealed serious weaknesses. Outstanding loans to construction firms and real estate promoters rose from 17.7% of GDP in 2003 to 42.2% of GDP in 2007. Bank-wide non-performing loans have climbed to 6.7%, driven by exposures to construction and real estate activities, which are responsible for 59% of the total. The savings banks also have approximately EUR 44 billion, or 4.1% of GDP, in repossessed assets. Still, there has been a substantial recognition of impairment losses in commercial and savings banks, amounting to 10% of GDP. The additional capital required by the European Banking Authority to raise capital ratios to 9% with capital of the highest quality will likely not require support from the public-sector balance sheet.

Credible debt stabilisation by 2013 in an environment of increased risk aversion and with modest near-term growth prospects, will certainly require a persistent effort, especially with respect to potential slippages by the Autonomous Communities. The recently elected People’s Party is also in power at the regional level in most of the Autonomous Communities, which should make it easier to align fiscal objectives between these two levels of government.

The trend on the ratings could be changed from Negative to Stable if there is a material reduction of the downside risks to the growth outlook of advanced economies, in conjunction with more stable financial markets. However, possible downward rating actions could be triggered by significant fiscal slippages, a worsening of Spain’s growth prospects, or if funding conditions deteriorate.

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

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

The sources of information used for this rating include the Bank of Spain, Ministry of Economy, European Commission Autumn 2011 forecast, Spain Stability Programme 2011-2014, INE, Eurostat, Haver Analytics and IMF. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This credit rating has been issued outside the European Union (EU) and may be used for regulatory purposes by financial institutions in the EU.

This is an unsolicited rating. This rating did not include participation by the rated entity or any related third party, and 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: 17 August 2011

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