DBRS Confirms Kingdom of Spain at A, Stable Trend

DBRS Ratings Limited (DBRS) confirmed the Kingdom of Spain’s Long-Term Foreign and Local Currency – Issuer Ratings at A and its Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (low). The trend on all ratings remains Stable.

KEY RATING CONSIDERATIONS

DBRS expects the Spanish economy to remain strong and to outperform the average growth of the euro area in coming years, despite gradually decelerating. DBRS expects a GDP growth rate of 2.6% in 2018, mostly driven by domestic demand, with downside risks stemming from external demand. DBRS expects the Socialist Party (PSOE) administration to remain committed to fiscal consolidation, albeit at a slower pace than initially foreseen. However, there is still some degree of uncertainty over the new government’s economic agenda, particularly regarding fiscal policy, and its ability to secure parliamentary approval.

Spain’s sovereign rating is supported by the country’s large and diversified economy, competitive export sector and eurozone membership. By contrast, the high public debt ratio remains a key consideration to the rating. Spain’s high reliance on foreign financing is also a source of vulnerability for the credit. Whilst a challenging political situation in Catalonia (Spanish region rated BB (high), Stable by DBRS) remains a concern, tension levels have eased over the last twelve months.

RATING DRIVERS

The Stable outlook reflects DBRS’s view that the risks to the ratings are balanced. Either of the following scenarios could put upward pressure on the ratings: (1) further progress in reducing Spain’s fiscal deficit and public debt ratio or (2) a significant upward revision to the medium-term growth outlook. Downward rating drivers include one or a combination of the following: (1) a reversal in the fiscal consolidation path or a deterioration in medium-term sustainability of public finances; (2) a downward revision to the growth path that contributes to a material reversal of the declining public debt ratio trajectory; or (3) disruptive political developments severe enough to derail the country’s economic and fiscal outlook.

RATING RATIONALE

Fiscal Deficit Steadily Declines but the Debt Ratio Remains High–A Key Credit Weakness

Spain has undergone a significant fiscal consolidation process to reverse the deterioration in public finances triggered by the crisis. The fiscal deficit stood at 3.1% of GDP in 2017 after peaking at 11.0% in 2009. This was attributed to a significant structural adjustment between 2010 and 2014, and since then, relying chiefly on cyclical momentum. DBRS now expects a 2018 fiscal deficit of 2.7% of GDP, falling short of the target of 2.2% of GDP, but still allowing Spain to exit the excessive deficit procedure in 2019. The reduction in the headline deficit relies on the tailwinds from the cyclical upswing, which should more than offset the deficit-widening measures from higher pensions, civil servants’ wages and personal income tax cuts introduced this year. A more pronounced economic growth deceleration could hamper public revenues growth in the second half of the year, but strong tax collection in the first half of the year mitigates this risk.

DBRS anticipates the fiscal deficit to continue declining in coming years, albeit at a slower pace. The new administration’s revised deficit targets imply an accumulated slippage of 1.6 percentage points between 2019-2021 compared with the previous objective. PSOE’s strategy may rely on measures to boost tax revenues to allow for a higher public spending ratio. The specific measures have not been fully unveiled, and it remains unclear whether the government will have enough backing to pass them through Congress. Social Security, which registered a deficit at 1.5% of GDP, will continue to be pressured by an ageing population and pension increases. Therefore, DBRS considers it important that changes that increase costs to the system are accompanied with offsetting measures to safeguard its sustainability.

Although trending downward, the high public debt ratio, which stood at 98.1% of GDP in 2017, continues to be a key credit weakness, burdening the government, and reducing its room to respond to upcoming challenges. Despite the slower fiscal consolidation path, DBRS continues to expect the debt-to-GDP ratio to drop below 95% by 2020, mostly driven by Spain’s nominal GDP growth and a return to primary surpluses. The anticipated funding cost increase is a source of risk given the high levels of indebtedness. However, changes in funding costs will only gradually impact the interest burden given the predominance of long-term and fixed-rate financing. The debt ratio could come under significant pressure in the unlikely event of a severe growth, fiscal or contingent liabilities shock.

Strong Cyclical Upswing to Continue Despite More Challenging External Environment

Spanish GDP growth remains strong and outperforms the euro area average. GDP growth averaged 3.3% during 2015-2017. Against a more challenging external environment, GDP growth is expected to decelerate to 2.6% in 2018 from 3.0% in 2017 but mostly driven by domestic demand. The effect of a weaker external environment and higher oil prices will be partially offset by the short-term impact of more expansionary fiscal policies in the second half of the year.
Private consumption growth, driven by employment gains, continues to underpin the expansion although decelerating as job creation slows, and household’s low savings rate and higher inflation limit its impulse. Business and construction investment remain high. Exports underperformed in the first half of the year under less favourable external conditions. DBRS attributes this to lower dynamism in Spanish export markets —especially in the euro area— and the lagged effect of a stronger euro.

Going forward, DBRS anticipates the cyclical upswing to continue albeit at a slower pace. Even as some of the tailwinds that facilitated the recovery gradually wane, the accumulated competitiveness gains will continue to support its performance. Downside risks to the outlook stem from spiralling protectionist measures affecting world trade, financial markets turmoil, political risks, and emerging markets contagion effects. An unexpected contractionary impact from a disruptive Brexit could disproportionally impact the Spanish tourism sector. On the domestic front, greater political instability at the national level, and its associated economic policy uncertainty, as well as an escalation of tension in Catalonia could weigh on the economy.

The Spanish economy continues to face significant challenges. Unfavourable demographics will weigh on long-term growth and call for productivity-enhancing measures and higher employment rates. The unemployment rate has declined dramatically to 15.3% in Q2 2018 from 26.9% in 2013-Q1, but still remains more than double the EU-average, with high levels of temporary and involuntary part-time employment. Labour market segmentation and regulatory hurdles, hindering competition among firms, act as a drag on productivity growth. DBRS considers that material changes to the labour market reform could hamper the pace of job creation and deteriorate the growth outlook.

External Accounts Continue to Improve Although Significant Imbalances Remain

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 Spanish firms’ greater propensity to export. In 2018, the current account surplus is expected to drop to 1.3% of GDP from 1.8% of GDP in 2017, reflecting costlier energy imports and lower external demand. In DBRS’s view, wage moderation and productivity growth have restored the competitiveness of Spanish firms, which will help Spain maintain current account balances in coming years. From a stock perspective, Spain’s negative net international investment position remains high at 81.3% of GDP in Q1 2018, although slowly receding. This is a key credit weakness and leaves the country exposed to shocks or shifts in investors sentiment.

Financial Stability Risks Are Contained with Significant Progress in Reducing Troubled Assets

The financial position of the Spanish banking system continues to strengthen. Banks’ disposal of troubled assets, amid more favourable economic and property market conditions, has led to a material improvement in asset quality. Domestic non-performing loans (NPL) as a share of total loans fell to 6.4% of total loans at end Q2 2018 from 8.4% a year earlier, with sharp improvements in construction and real estate NPL portfolios. Likewise, the level of foreclosed assets for the system will be substantially reduced in coming quarters with the completion of significant disposal transactions. Underlying profitability and capitalisation levels are improving year on year. Spanish banks’ capital ratio remains comfortable with a CET1 at 11.7% as of Q1 2018, although it remains below the euro area average (CET1 of 14.1%). Improving asset quality, higher commissions and costs control have helped banks maintain profitability in a low interest rate environment. Outstanding credit continued to contract in 2017, but new credit flows to small and medium-sized enterprises and consumer credit are increasingly offsetting this trend.

Change in Government but No Significant Change in Policies, Catalonia Remains a Challenge

The centre-left Socialist Party came into office in June 2018 following a vote of no-confidence that ousted the Partido Popular (PP), triggered by a corruption scandal involving former PP officials. The no-confidence vote initiated by PSOE advanced with the backing from heterogenous political forces including far-left Unidos Podemos, the Basque nationalist party, and Catalan pro-independence parties. PSOE’s weak position in Congress, where it only holds 84 out of 350 seats, and the need to reach consensus among diverse political parties hinders its ability to pass legislation and address the country’s medium-term challenges. The next general elections should take place no later than July 2020. However, a failure to pass a budget for 2019 could increase the likelihood of early national elections. Strong electoral support for centrist political alternatives, as demonstrated in opinion polls, mitigates economic policy uncertainty.

DBRS considers that the tensions and uncertainties associated with Catalonia’s bid for independence have eased since October 2017. The formation of a new regional government ending the central government intervention in Catalonia is a sign of institutional normalisation. The new regional government appears to be pursuing a medium-term strategy for independence, focusing on building popular support in the region. In turn, Pedro Sánchez’s administration is striking a more conciliatory approach to the region compared to his predecessor that could help defuse some of the tensions. DBRS considers that greater regional autonomy or an increase in resources devolved to the region could alleviate the pressures further. However, there is a risk of a renewed escalation of tensions with the central government, should support for independence in Catalonia markedly strengthen.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the A (high) – A (low) range. The main points discussed during the Rating Committee include Spain’s fiscal and debt metrics, economic performance and outlook, external environment, banking system developments, economic policies, and political developments.

KEY INDICATORS

Fiscal Balance (% GDP): -3.1 (2017); -2.7 (2018F); -2.3 (2019F)
Gross Debt (% GDP): 98.1 (2017); 97.4 (2018F); 96.0 (2019F)
Nominal GDP (EUR billions): 1,166 (2017); 1,209 (2018F); 1,256 (2019F)
GDP per Capita (EUR): 25,064 (2017); 25,887 (2018F); 2,6799 (2019F)
Real GDP growth (%): 3.0 (2017); 2.6 (2018F); 2.2 (2019F)
Consumer Price Inflation (%): 2.0 (2017); 1.8 (2018F); 1.7 (2019F)
Domestic Credit (% GDP): 208.1 (2016); 199.6 (2017); 197.5 (Mar-2018)
Current Account (% GDP): 1.8 (2017); 1.3 (2018F); 1.1 (2019F)
International Investment Position (% GDP): -85.3 (2016); -83.8 (2017); -82.6 (Jun-2018)
Gross External Debt (% GDP): 167.0 (2016); 166.6 (2017); 168.2 (Jun-2018)
Governance Indicator (percentile rank): 81.7 (2017)
Human Development Index: 0.89 (2017)

Notes:
All figures are in euros 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 Business, 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, and 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 April 2018

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