DBRS Assigns Stable Trend to Spain’s Sovereign Credit Ratings

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

The change in the trend from Negative to Stable reflects our view that the risks facing the Spanish economy are more balanced. The signs of macroeconomic and financial stability that we perceived in our last review have persisted. The recovery has benefited from the Spanish government’s forceful policy response to the crisis as well as monetary policy support from the European Central Bank, resulting in employment gains and moderate GDP growth. The recovery has supported deficit-reduction efforts. The deficit is on track to reach 5.5% of GDP this year, and 4.2% of GDP next year. The public debt burden continues to increase, but is within sight of stabilizing at close to 102% of GDP in 2016.

Factors that could change the trend to Positive include continued progress in reducing the fiscal deficit, as well as signs of a more sustainable economic recovery that can stabilize and eventually lower the public debt ratio. Longer term, fiscal and structural reforms that boost growth and employment, raise productivity and improve the sustainability of public finances could accelerate debt reduction and put upward pressure on the ratings. Factors that could place downward pressure on the ratings are a weakening of the political commitment to fiscal adjustment, or a material downward revision to the medium-term growth outlook that derails the expected stabilization of the debt ratio.

Sectors of the analysis that are mainly responsible for this rating action are Fiscal Management and Policy and Economic Structure and Performance. Spain’s ratings are underpinned by a series of reforms that have stabilized the banking sector, reduced the size of the public sector, contributed to wage flexibility, simplified licensing procedures, and increased education and job-search training programs. A sustained fiscal adjustment effort is underway, and fiscal institutions have been strengthened across the general government. Spain postponed the deadline for complying with the Maastricht criterion of a deficit of 3% of GDP or below by two years, to 2016. Nevertheless, greater oversight and transparency of regional governments have allowed regional administrations to accrue higher revenues, while 11 of 17 regional governments have complied with their 2013 deficit targets.

Improvements have also been made to expenditure polices, with lower spending on personnel across the public sector, as well as a program to improve efficiency in public administration. In July 2014, the Independent Authority for Fiscal Responsibility, an independent fiscal council, was established to enforce compliance with the fiscal framework and credibility of government targets. The fiscal council approved the Budget 2015 growth and fiscal targets to be credible.

Combined with the benefits of the EU financial assistance program and expansionary policy from the European Central Bank, these measures have helped restore investor and business confidence. This led to a sharp improvement in sovereign and bank financing conditions, which have lowered interest costs for the public and private sectors. This has also ushered in an improvement in competitiveness, partly from declining unit labor costs in the manufacturing sector. Goods and services export growth, combined with weak domestic demand, has driven a sharp correction in the current account, which shifted from a deficit of 4.3% of GDP in 2010 to 1.3% in the second quarter of 2014. Higher employment and positive growth since the third quarter of 2013. The Bank of Spain forecasts GDP growth at 1.3% in 2014 and 2.0% in 2015.

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 about 95.1% of GDP in mid-2014. Such a high debt burden exposes the real economy to shocks. Under our baseline scenario, debt-to-GDP is expected to peak at 101% of GDP in 2016. However, this trajectory is contingent on a sustained fiscal adjustment combined with a gradual economic recovery, and no additional fiscal costs from bank recapitalization requirements. Another concern is the inflation outlook. Weaker than expected price pressures in Spain present a headwind to public and private sector debt reduction. The election next year could also bring uncertainty.

In this environment, reducing unemployment from a current level of 24.5% will take time. As the unemployment rate falls and unemployment benefits expire, this should 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 from the financial assistance program, the banking sector has stabilized. Bank capital and liquidity positions have strengthened, bank earnings are mainly positive, and market funding costs have decreased. The contraction of domestic private credit is slowing. Spanish banks appear to be well-positioned for the pending asset quality review and stress tests by the European Central Bank and the European Banking Authority. Nevertheless, this poses some uncertainty over the level of capital adequacy, and may be perpetuating poor financing conditions for small firms. Furthermore, high unemployment and a weak real estate market pose headwinds to bank profitability.

Notes:
The main points of the rating committee discussion were: the financial sector and the fact that Spanish banks appear well-positioned for the ECB asset quality review and stress tests; the electoral outlook for 2015; contingent liabilities, which appear limited; and the outlook for the real estate market.

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 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 Ministry of Economy and Competitiveness, Bank of Spain, INE, AMECO, Eurostat, IMF, Haver Analytics, DBRS. 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: October 21, 2010
Most Recent Rating Update: April 11, 2014

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