DBRS Upgrades the Kingdom of Spain to A, Stable Trend

DBRS Ratings Limited (DBRS) upgraded the Kingdom of Spain’s Long-Term Foreign and Local Currency – Issuer Ratings to A from A (low) and maintained the Stable trend. DBRS also confirmed the Short-Term Foreign and Local Currency - Issuer Ratings at R-1 (low) and maintained the Stable trend.

KEY RATING CONSIDERATIONS

The rating upgrade reflects Spain’s strong economic recovery and progress reducing the fiscal deficit in recent years. Also, the upgrade reflects DBRS’s assessment that this strong economic and fiscal performance will continue largely unaffected by the political situation in Catalonia. DBRS considers that structural improvements in the Spanish economy have strengthened the prospects for sustainable growth. Against this background, DBRS anticipates that higher revenues and expenditure control will allow the Spanish government to continue to reduce its fiscal deficit in coming years. In our previous review, the institutional crisis in Catalonia necessitated caution in our rating action on Spain, but since then the associated economic and fiscal risks have decreased, DBRS assesses. The economic impact has been confined to the regional economy, and largely offset by stronger external demand. Improvements in the “Political Environment”, “Economic Structure and Performance”, and “Fiscal Management and Policy” building blocks of our analysis were key factors in the upgrade.

RATING DRIVERS

The Stable outlook reflects DBRS’s view that the risks to the ratings are balanced. Any of the following could lead to further positive rating action: (1) a faster than expected reduction of the fiscal deficit and the public debt ratio; or (2) a significant upward revision to the medium-term growth outlook, that may stem from less than currently considered constraints from structurally high unemployment. Downward rating drivers include one or a combination of the following: (1) a reversal in the fiscal consolidation path or the materialisation of sizable contingent liabilities; (2) a material downward revision to the growth path contributing to a reversal of the declining public debt ratio trajectory; or (3) disruptive political developments severe enough to derail the economic and fiscal outlook.

RATING RATIONALE

Uncertainty Over Catalonia Moderates But Will Persist In The Background

In DBRS’s view, the tensions and uncertainties associated with Catalonia’s bid for independence, which escalated around the vote on 1 October 2017, have eased. While support for Catalonia’s independence continues to be considerable in the region, DBRS considers that political confrontations are likely to be of lower level intensity going forward. This reduces the probability of a scenario of protracted and elevated tensions significantly impacting economic activity and fiscal accounts in Spain, which was a key limitation in DBRS’s previous rating review. Three developments support this view: (1) the pro-independence parties’ failed attempt to declare independence unilaterally, (2) the now tested and effective implementation of the measures under Article 155 of the Spanish Constitution; and (3) the lack of support from European institutions for resolution outside of the Spanish constitutional framework.

In line with other European democracies, the Spanish political picture has become more fragmented. Against this background, Partido Popular’s (PP) minority government has found it increasingly difficult to legislate during this political term. Instead, the PP has had to rely on ad-hoc support on a case-by-case basis to pass laws. The institutional crisis in Catalonia, especially the central government’s direct control over the region, has hindered Partido Popular’s ability to get sufficient backing in Congress due to divergent views on the treatment of the region. Thus, the formation of a regional government in Catalonia, that may lead to the withdrawal of Article 155, could help unblock support for Spain’s 2018 budgetary law. In the event that a budget is not passed, DBRS expects the continued roll-over of the 2017 budget to maintain a prudent fiscal stance. Although a failure to approve a budget for this year could increase the likelihood of early national elections, this is not DBRS’s baseline scenario. Strong electoral support for centrist political alternatives, as demonstrated in opinion polls, mitigates economic policy uncertainty.

Sustained Economic Growth And Job Creation Will Help Further Reduce Imbalances

Spain’s large and diversified economy, the fourth largest in the euro area, is a key credit strength. Spain continues to grow strongly and once again in 2017 outperformed the euro area average. Spain’s real gross domestic product (GDP) increased by 3.1% and full-time equivalent employment expanded by 2.8%. Underpinned by extremely favourable financing conditions, substantial employment gains and higher confidence levels, the recovery of domestic demand has led to a more balanced growth pattern compared with in the aftermath of the crisis. The economic impact of the political instability in Catalonia has been moderate, confined to the regional economy, and largely offset by stronger external demand. Upside surprises to growth among Spain’s trading partners provided an additional boost to Spanish exports, spurring manufacturing production and investment decisions. Given that these favourable conditions largely remain in place, DBRS anticipates another year of strong GDP growth at 2.7% in 2018. Stronger-than-expected external demand and fiscal impulse pose upside risks to this forecast.

After four consecutive years of growth, real GDP and non-construction investment surpassed their pre-crisis peaks. In DBRS’s view, the structural improvement in the Spanish economy will continue to support its performance, even as some of the tailwinds that facilitated the recovery gradually wane. Many factors, increased labour market flexibility, the private sector’s sharp deleveraging process, banks’ strengthened balance sheets, firms’ higher propensity to export and competitiveness gains, provide solid foundations for the expansion to continue. While unit labour costs are expected to increase in line with the higher utilisation of productive resources, Spain’s competitiveness is expected to continue unaltered or even improve relative to its European peers in coming years. These structural improvements have led to: (1) a rapid increase in GDP growth consistent with current account surpluses; (2) a shift of production and resources from the non-tradeable to the tradeable sector; and (3) a material increase of exports as a share of GDP. Key risks to the economic outlook in the medium-term stem from spiralling protectionist measures affecting world trade, unexpected contractionary impact from a disruptive Brexit or monetary policy normalisation, or a sharp escalation of tensions in Catalonia.

In the context of a favourable macroeconomic background, Spain’s external imbalances continue to unwind. From a flow perspective, Spain’s current account surplus has averaged 1.5% of GDP between 2013 and 2017 helped by competitiveness gains and by Spanish firms’ greater propensity to export. In DBRS’s view, wage moderation and productivity growth have restored the competitiveness of Spanish firms vis-à-vis their international peers, which will help Spain maintain current account balances in coming years. From a stock perspective, Spain’s negative net international investment position (NIIP) remains high at 80.8% of GDP end-2017, although slowly receding. This is a key credit weakness and leaves the country exposed to shocks or shifts in investor sentiment.

Fiscal Deficit Steadily Declines But The Debt Ratio Remains High And A Key Credit Weakness

Spain has undertaken an important structural fiscal adjustment, especially between 2009 and 2014, in response to the material deterioration during the crisis. Benefiting from a strong cyclical recovery that boosted revenues, the fiscal deficit continued to steadily decline. This occurred despite the impact of the tax reform in 2015-2016. In 2017, the fiscal deficit declined by 1.4 percentage points to 3.1% GDP in line with the target. Revenue growth accelerated to 4.6% in 2017, comfortably outpacing expenditure growth of 1.1%. The significant improvement in regional finances and the continuation of the local entities’ surplus position have compensated for the slippages at the central and social security system level.

DBRS anticipates that higher fiscal revenue and expenditure controls will allow the government to continue to reduce the fiscal deficit in coming years. The fiscal target of 2.2% of GDP is within reach for 2018, and would represent the first headline deficit below 3%, and primary surplus, since 2007. Taking advantage of the more favourable economic conditions, the government will try to pass some expansionary fiscal measures of around 0.3% of GDP in 2018. Although DBRS expects the fiscal deficit to continue declining, additional measures may be needed to comply with its fiscal targets in coming years. The past pension system reforms will be crucial in containing the ageing-related expenditure pressures. DBRS will continue to monitor ongoing discussions relative to the potential update to the regional financing system and reforms to the social security system. Progress on these fronts needs broad political agreement to advance further, and this has been difficult to achieve so far.

Although trending downward, the high public debt ratio at 98.3% of GDP in 2017 continues to be a key credit weakness, burdening the government, and reducing its room to respond to upcoming challenges. Spain’s gross financing needs to GDP ratio, at 19% in 2017, was one of the highest in the euro area. Sustained demand for Spanish securities, average maturity extension and declining fiscal deficits reduce refinancing or liquidity risks. The anticipated increase in funding cost in coming years is a source of risk given the high levels of indebtedness. Nonetheless, DBRS expects the debt-to-GDP ratio to drop below 95% by 2020, mostly driven by nominal GDP growth and a return to primary surpluses. Despite expected future increases of costs at issuance, the slowly declining debt ratio as well as the historically low starting point for the government’s funding costs should keep debt interest expenditures to GDP stable in coming years. However, the debt ratio could come under significant pressure in the unlikely event of a severe growth, fiscal or contingent liability shock.

Financial Stability Risks Are Contained And Legacy Issues Receding

Spain’s Eurozone membership is another credit strength, which has allowed Spain to benefit from the European Central Bank’s accommodative monetary policy and the European Stability Mechanism’s financial assistance to restructure and clean its financial system. The Spanish banking system continues to strengthen, although it still faces certain challenges. Benefitting from good economic and property market conditions, the asset quality of Spanish banks continued to improve in 2017, with some banks reporting large reductions in problem assets. Domestic non-performing loans (NPL) as a share of total loans stood at 7.8% of total loans at end 2017, 1.3 percentage points lower than a year earlier. At the same time, Spanish banks supervised by the European Banking Authority (EBA), including its international operations, reported a lower NPL ratio at 4.5%. Outstanding credit continued to contract in 2017, but new credit flows to small and medium-sized enterprises (SMEs) and consumer credit are increasingly offsetting this trend. Underlying profitability and capitalisation levels are improving despite the one-off impact from Banco Popular’s resolution in 2017. Improving asset quality, commissions and cost control have helped banks maintain profitability in a low interest rate environment. Spanish banks’ capital ratio remains comfortable with CET1 at 12.4% as of Q3 2017, although they are still below the euro area average.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the A (low) – A (high) range. The main points discussed during the Rating Committee include the economic structure and performance, fiscal policy, political developments, public debt, net external debt, and financial stability.

KEY INDICATORS
Fiscal Balance (% GDP): -3.1 (2017); -2.3 (2018F); -1.7 (2019F)
Gross Debt (% GDP): 98.3 (2017); 97.0 (2018F); 95.1 (2019F)
Nominal GDP (USD billions): 1,164 (2017); 1,209 (2018F); 1,256 (2019F)
GDP per capita (USD thousands): 25,026 (2017); 25,993 (2018F); 26,969 (2019F)
Real GDP growth (%): 3.1 (2017); 2.7 (2018F); 2.3 (2019F)
Consumer Price Inflation (%, avg): 2.0 (2017); 1.2 (2018F); 1.4 (2019F)
Domestic credit (% GDP): 207.3 (2016); 201.1 (Sep-2017)
Current Account (% GDP): 1.9 (2017); 1.8 (2018F); 1.8 (2019F)
International Investment Position (% GDP): -83.4 (2016); -80.8 (2017)
Gross External Debt (% GDP): 166.7 (2016); 164.8 (2017)
Governance Indicator (percentile rank): 83.2 (2016)
Human Development Index: 0.88 (2015)

Notes:
All figures are in EUR unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/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 at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The sources of information used for this rating include the Ministry of Economy and Competitiveness, Ministry of Finance, Bank of Spain, National Statistics Office (INE), General State Comptroller (IGAE), Spanish Treasury, European Central Bank (ECB), European Commission, Eurostat, European Banking Authority, AIReF, IMF, World Bank, UNDP, Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

DBRS does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period. DBRS’s outlooks and ratings are under regular surveillance.

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

Ratings assigned by DBRS Ratings Limited are subject to EU and US regulations only.

Lead Analyst: Javier Rouillet, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer – Global FIG and Sovereign Ratings
Initial Rating Date: 21 October 2010
Last Rating Date: 6 October 2017

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