DBRS Confirms the Kingdom of Spain at A (low), Negative Trend

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

The ratings incorporate recent evidence of macroeconomic stability. This includes more balanced economic activity, the stabilization of the financial sector, better financial market conditions, higher foreign capital inflows, and an ongoing forceful policy response to the crisis. The Negative trend on the long-term ratings reflects DBRS’ judgment that in spite of these positive signals, risks remain to the downside. First, the recovery is nascent and it is unclear whether price stability and the pace of economic growth are conducive to sustainable employment creation. Second, in spite of significant fiscal consolidation, the budget deficit remains high. A prolonged period of economic weakness combined with high fiscal deficits have contributed to a rising public debt burden, which is at least two years away from stabilizing as a share of GDP.

Factors that could change the trend on the long-term ratings from Negative to Stable include a lower fiscal deficit and a stronger recovery that steers the public debt ratio to a more sustainable path. Clearer signs over the coming six to 12 months that the debt ratio is on track to stabilize in 2016 would provide upward pressure on the trend. Structural reforms that boost employment, raise productivity and improve the sustainability of public finances – including a possible tax reform – would weigh positively on the ratings. Factors that could place downward pressure on the ratings are a weakening of the political commitment to fiscal adjustment, deterioration in funding conditions, or a material downward revision to the medium-term growth outlook that derails the expected stabilization of the debt ratio.

Spain’s ratings are underpinned by the size and diversity of its economy, which as the fourth largest in the Euro area returned to positive growth in the third quarter of 2013. GDP is expected to grow by 0.9% in 2014. Export-driven growth is leading the recovery, and is giving way to more balanced economic activity as domestic demand gains momentum. The return of confidence has materialized in better financing conditions and stronger consumer and business confidence indicators. Relative to other large Euro area countries, Spanish exports have performed well. Improved cost competitiveness, partly from declining unit labor costs in the manufacturing sector, appears to be responsible for this performance.

The recent labor market reform and other policy adjustments have contributed to wage flexibility, thereby supporting price competitiveness and export growth. External flow imbalances have been corrected, and this puts the economy in a better position to support growth in the future. Exports of goods and services surpassed their pre-crisis peak in late 2010. Exports and services surpluses, mainly tourism, have driven a sharp correction in the current account, which shifted from a deficit of 1.2% of GDP in 2012 to a surplus of 0.8% of GDP in 2013. Spain’s share of world goods exports has increased from a trough of 1.9% in 2012 to 2.0% in 2013, and this is partly due to rising auto and other manufacturing goods exports. This and other indicators suggest that Spanish firms have an increasing ability to compete in global markets of goods and services.

Spain’s policy response to the crisis has been forceful and effective, and the policy framework has strengthened. The restructuring and recapitalization of weaker banks and cajas under an EU financial assistance program has stabilized the financial sector and allowed a smooth exit from the program at the start of 2014. Systemic concerns over financial stability are receding. A comprehensive program of structural reforms, especially in the labor market, has largely been approved and is now being implemented. A sustained fiscal adjustment effort is underway, and fiscal institutions have been strengthened across the general government. The benefits of Euro area membership have helped to bolster investor and business confidence. The European Stability Mechanism (ESM) provided €41.4 billion in loans to help recapitalize the Spanish banking sector, and the ESM or European Central Bank could provide further support if necessary.

Despite this improving picture, high fiscal deficits, low GDP growth, and bank recapitalization costs have pushed up the public debt ratio from 37% of GDP in 2008 to 94% in 2013. Such a sharp increase, with expectations that it will continue to rise, exposes the real economy to shocks. This represents the greatest risk to the ratings. Under our baseline scenario, debt to GDP is expected to peak at 104% of GDP in 2016 and decline thereafter. However, this trajectory is contingent on a sustained fiscal adjustment, a steady economic recovery, and no additional fiscal costs stemming from bank recapitalization requirements.

Spain’s Stability Program involves lowering the deficit from 6.6% of GDP in 2013 to 5.8% of GDP in 2014, 4.2% in 2015, and 2.8% in 2016. If GDP does in fact grow by close to one percent this year, the 2014 target appears attainable. However, additional measures may be needed to reach the 2015 target, especially since 2015 is an election year.

Labor market dynamics are partly responsible for the deficit and low growth. High unemployment of 26% has put pressure on the budget in the form of benefits for job seekers. However, as the unemployment rate falls and cuts to benefits kick in, this will support the fiscal adjustment. The limited flexibility of firms to adjust to the difficult economic environment, combined with unresponsive wages, rigid collective bargaining agreements, high dismissal costs, the duality of the labor force between temporary and permanent workers’ contracts, and the shrinking of the labor-intensive construction sector have accelerated labor shedding. These factors serve as a drag on the economic recovery and could lead to a generation of underemployed youth, as well as lower Spain’s potential GDP growth. The labor reform has contributed to increasing the flexibility of firms and the responsiveness of wage bargaining to economic conditions. However, the effect of the reform on labor market duality is unclear, and firms continue to favor temporary employment. This is likely to slow the hiring of highly skilled workers and the training of low skilled workers.

Credit demand from households and firms has picked up. Nevertheless, high private sector debt serves as a further drag on the recovery. Following the restructuring and recapitalization of parts of the banking sector, and the exit of from the financial assistance program, the banking sector has stabilized, bank earnings are mainly positive and bank solvency has remained comfortable. The contraction of domestic private credit is slowing. However, the pending assessment of bank balance sheets by the European Central Bank and the European Banking Authority’s stress test poses some uncertainty over the level of capital adequacy, and this may be perpetuating poor financing conditions for small firms. Furthermore, high unemployment and a weak real estate market pose headwinds to bank profitability. Deleveraging by the non-financial private sector continues, but at 131% of GDP, the debt burden of firms remains high. Unemployment and declining incomes are slowing the pace of household deleveraging, whose debt burden is also high.

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

For further information on DBRS’ historic default rates published by the European Securities and Markets Administration (“ESMA”) in a central repository see http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period while reviews are generally resolved within 90 days. DBRS’s trends and ratings are under constant surveillance.

Lead Analyst: Fergus McCormick
Rating Committee Chair: Alan G. Reid
Initial Rating Date: 21 October 2010
Most Recent Rating Update: 8 March 2013

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