DBRS Confirms Kingdom of Spain at A, Trend Changed to Positive

DBRS Ratings GmbH (DBRS) confirmed the Kingdom of Spain’s Long-Term Foreign and Local Currency – Issuer Ratings at A. At the same time, DBRS confirmed the Kingdom of Spain’s Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (low). The trend on all ratings has been changed to Positive.

KEY RATING CONSIDERATIONS

The change in trend to Positive reflects DBRS’s view that the risks to the ratings are now skewed to the upside. DBRS considers that the conditions that supported Spain’s solid economic growth and steady improvements in public finances in recent years should continue to underpin its credit metrics. Benefitting from the economic upswing, the general government fiscal deficit declined to 2.5% of GDP in 2018 from 3.1% of GDP in 2017, allowing Spain to formally exit its Excessive Deficit Procedure in June 2019 and post its first balanced primary accounts since 2007. DBRS expects the government’s debt ratio to continue to decline in coming years, helped by primary surpluses, the low interest rate environment and nominal GDP growth. DBRS does not expect the next national government to implement abrupt changes in policy that would challenge that assessment, although less popular measures that could structurally improve fiscal or economic outcomes could be delayed further.

Despite showing signs of deceleration, DBRS expects the Spanish economy to continue to grow at a healthy pace and outperform the euro area average growth in 2019-2020. A slowing but still dynamic labour market and monetary policy tailwinds will continue to support domestic demand. However, the deterioration of the global backdrop and intensifying external risks represent the main threats to the economic outlook.

Spain’s A rating is supported by the country’s large and diversified economy, competitive export sector and euro zone membership. By contrast, the high public debt ratio remains an important consideration for the rating. Spain’s high reliance on foreign financing is also a source of credit vulnerability. Whilst a challenging political situation in the Autonomous Community of Catalonia (rated BB (high) with a Positive trend by DBRS) remains ongoing, its economic impact has so far been relatively subdued.

RATING DRIVERS

The ratings could be upgraded if one or a combination of the following occur: (1) Spain continues its fiscal consolidation, potentially reinforced by deficit-reducing measures; (2) Spanish authorities introduce economic reforms that improve the medium-term outlook; or (3) further evidence arises of improved economic resilience to shocks.

The trend could return to Stable if one or a combination of the following occur: (1) a significant reversal of the fiscal consolidation path or a deterioration in the medium-term sustainability of public finances; (2) a downward revision to the growth path that contributes to a material reversal of the downward trajectory of the public debt ratio; or (3) the materialisation of a disruptive political developments that severely impair economic performance.

RATING RATIONALE

Fiscal Deficit to Continue Steadily Declining

Spain’s fiscal deficit-to-GDP ratio continues to steadily decline, primarily reflecting cyclical momentum since 2015. Last year, the fiscal deficit was 2.5% of GDP, 0.2 percentage points more favourable than DBRS originally anticipated, mostly because of higher than expected revenues. This year, despite the failure to implement the new revenue measures envisaged in the draft budgetary plan (DBP) for 2019 aimed at collecting an additional EUR 5.6 billion, tax-rich economic growth, lower interest costs, and new measures boosting social security revenues will more than compensate for the increases in the public sector wage bill and pension payments. In July, Spain’s Independent Authority for Fiscal Responsibility (AIReF) estimated that the general government deficit could drop to 2.0% of GDP in 2019, with an underlying fiscal deficit of 1.6% once non-recurring items are excluded.

DBRS considers that the fiscal outlook for Spain presents a brighter picture when compared to the performance over the last decade, dragged down by exceptionally high deficits during the crisis years. DBRS expects the fiscal deficit to continue gradually shrinking in coming years, although the government target of achieving a balanced budgetary position by 2022 may remain challenging. While a potential new administration led by the Partido Socialista Obrero Español (Spanish Socialist Workers' Party or PSOE), which seems the most likely scenario at the moment, could try to pass the new tax measures originally included in the DBP 2019, the measures underpinning the government´s planned 1% of GDP structural adjustment in 2021-2022 remain undefined. Given Spain’s unfavourable demographics, rolling back key features of the pension reform, such as potentially re-linking pensions to consumer price index inflation on a permanent basis, could put the long-term sustainability of the pensions system at risk if it is not compensated by offsetting measures.

Lower Deficits and Economic Growth to Help Public Debt Reduction, But Still An Important Credit Weakness

The high public debt ratio, at 97.6% of GDP at the end of 2018, continues to be a relevant credit weakness, burdening the government and reducing its room to respond to potential challenges. However, the debt-to-GDP ratio has been on a downward trend since 2014, with the International Monetary Fund (IMF) projecting the ratio to decline to 94.1% in 2021 on the back of primary surpluses, the low interest environment and nominal GDP growth. As part of the European Central Bank’s Public Sector Purchase Programme, the Bank of Spain held 21.5% of central government securities as of June 2019. Furthermore, the increasing demand for Spanish government securities, their average maturity extension and the country’s declining fiscal deficits have reduced Spain’s financing and refinancing needs. Spain has both managed to lengthen significantly the average maturity of its debt portfolio, to 7.5 years in 2019 from 6.2 years in 2013, and in recent years has diversified its investor base towards investors with longer-term horizons like pension funds. Finally, affirming the ECB’s role within Europe, the new monetary stimulus package, including the resumption of net asset purchases and deposit rate cut announced on 12 September 2019, further postpones concerns over Spain’s higher funding costs.

The Spanish Economy Continues to Grow at a Relatively Strong Rate Despite A Challenging External Environment

The Spanish economic recovery has been solid with GDP growth averaging 2.7% during 2014-2018. Spain’s growth pattern appears more sustainable than pre-crisis, with an economy significantly more competitive and more reliant on the export-oriented service sector, as well as non-financial private sector leverage now below the euro area average. Since 2014, domestic demand has been the primary growth driver on the back of significant job gains, favourable financial conditions, and the recent recovery in the housing market. These conditions are expected to continue to support aggregate demand. The IMF’s latest estimates point to GDP growth at 2.3% and 1.9% in 2019 and 2020, respectively. The main risks to this outlook stem from the external front: (1) a disorderly Brexit, given the commercial and financial ties that Spain has with the UK; (2) the indirect impact from existing protectionist measures and their potential escalation; (3) spill-overs from the manufacturing sector downturn in the euro area, especially in Germany; and (4) significantly and persistently higher crude oil prices.

Spain’s GDP per capita of EUR 25,854 in 2018 remains below the European Union (EU) average, reflecting differences both in labour utilisation and productivity. Despite the substantial improvements in reducing unemployment, which stood at 14.0% in Q2 2019 (down from 26.9% in Q1 2013), the still high proportion of temporary workers at 26.4% of total employees leaves a significant portion of workers vulnerable and holds back human capital accumulation. Relatively high school dropout rates and the small size of Spanish companies also constrain productivity growth in Spain. Over the medium to long term, Spain’s ageing population will increasingly weigh on growth prospects. Therefore, successfully addressing some of these hurdles and countering the effects of an ageing population could help lift potential growth and foster further income convergence towards its higher income EU partners.

Political Fragmentation is Delaying Structural Measures, Catalonia Remains in the Backdrop

In recent years, Spain’s growing political fragmentation and the main political parties’ inability to garner and sustain a majoritarian backing in Congress has led to less stable governments. Following the general elections in April, PSOE has failed to garner sufficient support in Congress to form a government, and therefore, Spain is now heading to new elections on 10 November 2019. While Spain benefits from strong institutions, this political climate raises questions regarding Spain’s capacity to address key economic challenges. Strong support for centrist political parties and pro-EU parties reduce the risks of extreme outcomes. DBRS believes that the next government will remain committed to fiscal consolidation. Nonetheless, the introduction of decisive measures to improve the medium-term sustainability of the pension system or push for ambitious economic reforms to lift potential growth appears unlikely.

DBRS expects the Catalan question to remain in the background in coming years. There is a risk that tensions with Catalonia escalate when the Supreme Court reaches a verdict —possibly in October— on the highly sensitive judicial process involving former Catalan government officials. Nevertheless, DBRS does not expect that a potential new stand-off between the central and the regional government would reach the levels seen at the end of 2017. Moreover, DBRS considers that the impact on the Spanish economy from the political situation in Catalonia has been relatively muted.

External Accounts Continue to Improve Although Significant Imbalances Remain

Spain’s negative net international investment position (NIIP) remains high at 78.0% of GDP in Q1 2019. This is an important credit weakness, increasing the country’s vulnerability to sudden shifts in investor sentiment. However, the NIIP ratio has dropped 22.2 percentage points since Q2 2014 on the back of sustained current account surpluses and higher nominal GDP. The current account surplus averaged 1.5% of GDP between 2013 and 2018, helped by a sharp improvement in cost-competitiveness and Spanish firms’ greater propensity to export. Despite a potential erosion in coming years as the cycle matures and domestic demand strengthens further, DBRS considers that the regained competitiveness will continue to support Spain’s net lending flows.

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, including non-performing loans (NPLs) and foreclosed assets, amid more favourable economic and property market conditions, has led to a material improvement in asset quality. Domestic NPLs shrank to 5.4% of total loans by Q2 2019, well below their Q3 2013 13.6% peak, with sharp reductions in construction and real estate NPL portfolios. Spanish banks’ average capital ratio is above regulatory requirements with a transitional CET1 at 11.8% as of Q1 2019, although it remains below the euro area average (CET1 of 14.3%). Improving asset quality, higher commissions and cost control have helped banks maintain profitability in a low interest rate environment. Nevertheless, DBRS expects profitability to remain subdued as the low interest rate environment is likely to limit further improvement, and litigation risks will remain in the background. New credit flows continue to improve but outstanding credit has not stabilized yet, declining 1.2% in June 2019, as loan repayments continue to surpass new lending flows.

For more information regarding the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments:
https://www.dbrs.com/research/350580/.

EURO AREA RISK CATEGORY: LOW

Notes:
All figures are in euros (EUR) unless otherwise noted. Public finance statistics reported on a general government basis unless specified.

The principal applicable methodology is Global Methodology for 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 (BdE), National Statistics Office (INE), General State Comptroller (IGAE), Spanish Treasury, Independent Authority for Fiscal Responsibility (AIReF), European Central Bank (ECB), European Commission (EC), Eurostat, European Banking Authority (EBA), Bank for International Settlements (BIS), Organisation for Economic Co-operation and Development (OECD), International Monetary Fund (IMF), World Bank, United Nations Development Programme (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 12-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 GmbH 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: October 21, 2010
Last Rating Date: March 22, 2019

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