DBRS Downgrades Spain’s Rating to A (low) with Negative Trend

DBRS, Inc. (DBRS) has today downgraded the ratings on the Kingdom of Spain’s long-term foreign and local currency debt to A (low) from A (high), and assigned a Negative trend on both ratings. Today’s action concludes DBRS’s review of these ratings that commenced on 22 May 2012. As such, the ratings are no longer Under Review with Negative Implications.

The rating action reflects DBRS’s assessment that there has been a severe deterioration in Spain’s credit profile warranting the two-notch downgrade. The Negative trend reflects considerable downside risks to the economic growth outlook. Five factors are behind the downgrade: (1) the outlook for Spain’s economic growth has worsened as private sector deleveraging continues and fiscal austerity measures intensify; (2) Spain’s public debt dynamics have deteriorated from the capitalisation needs of the banking system; (3) reducing fiscal imbalances is increasingly difficult due to the weak economic environment; (4) stressed economy wide financing conditions are increasing downside risks to the growth outlook and prospects for public debt stabilisation; and (5) persistent doubts over the effectiveness of the policy response at the Euro area level appear to be contributing to investor uncertainty.

According to consensus forecasts, a contraction of 1.7% is expected for 2012. Projections for 2013 have been revised downward, with the IMF expecting a 1.2% contraction, below the government estimate of a 0.5% contraction. Of equal concern is that the unemployment rate is expected to remain above 20% through 2017, exceeding the previous longest spell of unemployment of more than 20% from 1993 to 1997. Compounding these estimates is the substantial uncertainty around the growth outlook, with downside risks emanating from the growth prospects for Spain’s main Euro area trading partners, a continuation of stressed economy-wide funding conditions, and the possibility of further adverse effects from the fiscal consolidation effort.

Spain’s public debt dynamics have also deteriorated. Uncertainty over Spain’s property values and the banking sector is adversely affecting investor confidence. To address this, the EFSF will provide a backstop for the sovereign up to a maximum of EUR 100 billion, or 9.3% of GDP, to recapitalise banks. This will result in a corresponding rise in Spain’s gross debt, the extent of which will depend on the final results of the overall exercise. If additional contingent liabilities do not materialise, the full use of the EUR 100 billion could help bring the debt-to GDP ratio to near 97% of GDP by 2015.

At present, DBRS’s baseline scenario assumes that the EUR 100 billion approved for Spanish banks will be sufficient to meet their capital needs. Individual bank capitalisation requirements will be published in the second half of September, providing clarity on the extent of the need for EFSF resources. This entails a bottom-up assessment conducted by four accounting firms (Deloitte, PwC, Ernst & Young and KPMG), and finalised by Oliver Wyman to produce a detailed review of bank by bank asset economic value and the ensuing capital requirements under a stressed scenario. Although this effort will strengthen bank balance sheets by separating legacy assets and recapitalising banks, its effect on restoring overall confidence is likely to be muted if concerns over sovereign debt dynamics and downside risks to growth persist.

On a gross basis, public debt could rise to near 97% of GDP by 2015, up from 68.9% of GDP in 2011. The deterioration in gross debt will depend on the use of the bank capital support facility, the pace of fiscal consolidation, and the depth and length of this second recession. However, the effect on Spain’s public debt, on a net basis, could be more modest if it is expected that there will be substantial recoveries. Furthermore, Spain’s gross debt could improve in the future if bank support from the sovereign is fully or partially replaced by direct capital injections by the EFSF/ESM, loosening the link between the sovereign and the banks.

Spain is also facing an increasingly difficult environment for reducing fiscal imbalances. The pace of correction of fiscal imbalances has slowed due to the weak economic environment. With the ongoing deleveraging of private sector balance sheets and the drop in fiscal revenues in 2011 to the low levels of 2009 in terms of percentage of GDP, achieving the 6.3% of GDP deficit target by year-end and 4.5% of GDP by the end of 2013 appears difficult. However, the recently announced fiscal measures increase the likelihood that this year’s 6.3% of GDP deficit target will be met. This fiscal package includes increasing the VAT from 18% to 21%, raising the reduced VAT from 8% to 10%, cancelling the 2012 additional December payment to civil servants, eliminating the mortgage tax deduction, and lowering the unemployment benefit replacement ratio after six months from 60% to 50%.

Stressed economy wide financing conditions also increase downside risks to the growth outlook and prospects for public debt stabilisation. DBRS believes that it is likely that stresses in economy-wide financing conditions will persist, increasing the likelihood of a negative feedback loop between stressed funding conditions, economic weakness, and deterioration in bank asset quality. However, lack of market access by Spanish banks has been mitigated by ECB lending, particularly through its three year LTRO programme. Net lending to Spanish banks by the Eurosystem jumped from EUR 76 billion in October 2011 to EUR 337 billion in June 2012. Furthermore, the bank recapitalisation effort could help stabilise Spanish banks.

The recent agreement to use EFSF/ESM sovereign funding up to EUR 100 billion to recognise banks asset quality deterioration, segregate impaired assets from bank balance sheets, and recapitalise banks with public funds may lead to a faster adjustment in the real estate market and lessen the funding stress for banks. Implementation of direct bank capital injections of Spanish banks by the EFSF/ESM could weaken the link between the banks and the sovereign. In addition, progress has been made in introducing greater flexibility in the labour market. This reform may make wages more responsive to economic conditions, although the strong duality of the labour market is likely to persist.

Spain is also suffering from persistent doubts over the effectiveness of the policy response at the Euro are level, which appear to be contributing to investor uncertainty. Furthermore, recent political developments have called into question the Greek government’s capacity to comply with its EU-IMF adjustment programme. DBRS believes that risks stemming from Greece will likely remain over the medium term given the scale of the macroeconomic adjustment required. Uncertainty over the future of Greece, combined with concerns over sovereign debt sustainability and financial sector fragility in the Euro area, have increased downside risks to growth in Spain and the Euro area, and contributed to market pressure on funding conditions for Spain. In addition, mitigation of the ongoing contraction in domestic demand in Spain is partly dependent on the performance of Spanish exports, particularly to its main trading partners in the Euro area.

DBRS acknowledges the progress achieved to date and the strong commitment of the government to fiscal consolidation. With the recently announced fiscal measures and budget plan for 2013-2014, the likelihood of meeting the revised fiscal targets for 2012 and 2013 has increased. It also appears that the tools to monitor and provide incentives for better compliance by the regions have improved, after the substantial regional fiscal slippages of 2011. Furthermore, the current account deficit moved from 9.6% of GDP in 2008 to 3.5% of GDP in 2011, and DBRS expects this to continue, buttressed by strong growth of net exports. The current ratings incorporate the assumption that in addition to the EUR 100 billion agreed for the Spanish banks, funding from the EFSF/ESM or the IMF would be available if needed.

Nevertheless, further downward rating action could be triggered by a significant worsening of Spain’s ability to stabilise its public debt. Substantial fiscal slippages with respect to programme targets, a significant increase in public debt from materialisation of contingent liabilities, or a deterioration of the growth outlook over the medium term in Spain or in the Euro area could place further downward pressure on the ratings.

DBRS will host a teleconference on 9 August 2012, which will focus on the review of DBRS’s sovereign ratings of: Italy, Ireland, and Spain.

Notes:
All figures are in Euros 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 and Competitiveness, Instituto Nacional de Estadística (INE), Eurostat, IMF and Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

This is an unsolicited credit rating. This credit rating was not initiated at the request of the issuer.

Lead Analyst: Pedro Auger
Rating Committee Chair: Alan G. Reid
Initial Rating Date: 21 October 2010
Most Recent Rating Update: 22 May 2012

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