DBRS Confirms Spain at A (low), Negative Trend

DBRS, Inc. (DBRS) has today confirmed the ratings on the Kingdom of Spain’s long-term foreign and local currency debt at A (low) with Negative trends, and the ratings on the short-term foreign and local currency debt at R-1 (low) with Stable trends.

The Negative trends on the long-term ratings reflect the fact that in spite of a forceful policy response to the crisis, improving external accounts, and more stable financial market conditions, the crisis remains in an acute phase. There are four factors that weigh on the credit: (1) the financial sector is weak and housing prices have yet to stabilize, with further impairment of bank balance sheets expected, (2) public finances remain under significant pressure and the public debt burden is increasing, (3) unemployment is very high and rising and the pace of economic growth is weak, and (4) a slow and incomplete wider European policy response to the Euro area crisis, and potential contagion from Italy or other distressed countries, risk a return to unstable market conditions and a protracted period of low growth.

Offsetting these concerns is the progress that Spain has made in confronting the crisis, and the benefit of European support. The new government led by the People’s Party (PP) confirmed DBRS’s expectations by continuing the previous Socialist government’s commitment to fiscal austerity and structural reforms. Despite fiscal slippage in 2011 and 2012, this commitment is strengthened by the PP’s outright majority in Congress, which has facilitated the passage of structural reform legislation. Among the major adjustments underway are a fiscal retrenchment program, labor reform and a restructuring of the financial sector.

The benefits of Euro area membership are apparent in the support Spain has received from European institutions. The European Stability Mechanism (ESM) has provided €41.4 billion so far in loans to recapitalize the Spanish banking sector, and the European Central Bank’s outright monetary transactions program promises to purchase bonds in the secondary market should Spain request a financial assistance program. This support has helped to calm investor fears.

Complementing these strengths is the size, diversity and dynamic export sector of the Spanish economy. Spain’s economy is the fourth largest in the Euro area and its share of world goods exports has been broadly steady at 1.8%. Recent policy adjustments in the labor market are promising. It is also promising that unit labor costs are declining, by 5.8% in the fourth quarter of 2012 compared to the same period a year earlier, and that labor productivity per worker is increasing, by 2.9% in the same period. Exports of goods and services have recovered, exceeding their pre-crisis peak and attenuating the contractionary effects of weak domestic demand. The improving trade balance has contributed to a sharp correction in the current account, which shifted from a deficit of 11.8% of GDP in the first quarter of 2008 to a surplus of 0.7% of GDP in the second half of 2012.

The rebalancing of the current account is important because at the root of Spain’s problems is a loss in competitiveness, combined with a 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 1.7 million of a total of 3.4 million jobs lost. Indebted households are deleveraging, unemployment has risen to 26%, and housing prices have fallen by 27.1% in real terms their peak. These factors are harmful to growth.

A large unlisted savings bank sector, accounting for 40% of banking assets, which lent heavily into real estate, revealed serious weaknesses in the financial sector. 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 10.4%, driven by exposures to construction and real estate activities. The government has made a concerted effort to clean up bank balance sheets, increase the coverage of exposures to residential real estate, and implement a recapitalization and restructuring of 30% of the financial sector. Four banks (18% of the system) and several smaller institutions have capital needs of €41.4 billion (3.9% of GDP), which Spain is borrowing from the ESM at a rate of less than 1%. These injections are being transferred to an asset management company for bank restructurings, or SAREB, and are added to the stock of public debt.

Spain aims to lower its budget deficit from 6.7% of GDP in 2012, to 4.5% of GDP in 2013 and 2.8% in 2014. The Stability Program envisions that this consolidation, combined with a return to growth in the second half of 2013, will stabilize the debt ratio by the end of 2014. The Bank of Spain registers the 2012 public debt stock at €882.3 billion, equivalent to 83.9% of GDP. However, achieving debt stabilization in an environment of risk aversion and with modest near-term growth prospects will require a persistent effort, especially with respect to potential further slippage by the autonomous communities or possible lower value-added tax receipts. A potential downward revision to the official 2013 GDP forecast, current estimated in the Stability Program to contract by 0.5%, could also delay debt stabilization. Despite the difficult environment, it is encouraging that the PP is in power at the regional level in most of the autonomous communities, since this facilitates the alignment of fiscal objectives between these two levels of government.

As concerns over debt, fiscal deficits and bank balance sheets persist, there is a risk of a return to market stress. Further market pressure on sovereign funding costs and domestic financing conditions could negatively affect the recovery. A second concern is potential market disruption caused by instability from outside Spain, including a worsening of the European economic outlook and uncertainty surrounding the Italian adjustment program.

DBRS could change the trend on the long-term ratings from Negative to Stable if there is a material reduction in the downside risks to the growth outlook of Spain and its main trading partners. The approval of additional structural reforms that aim to boost employment, improve the sustainability of public finances, raise competition and productivity, as well as the completion of the restructuring and resolution of the financial sector, would weigh positively on the ratings. However, downward rating actions could be triggered by significant delays in debt stabilization caused by fiscal slippage, higher bank recapitalization costs, deteriorating funding conditions, or a worsening of growth prospects.

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 principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website under Rating Scales.

The sources of information used for this rating include the Ministry of Economy and Competitiveness, Bank of Spain, 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 is an unsolicited credit rating. This credit rating was not initiated at the request of the issuer and did not include participation by the issuer or any related third party.

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

Lead Analyst: Fergus McCormick
Rating Committee Chair: Alan G. Reid
Initial Rating Date: 21 October 2010
Most Recent Rating Update: 16 November 2012

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