DBRS Morningstar Confirms Kingdom of Spain at “A”, Trend Changed to Stable

DBRS Ratings GmbH (DBRS Morningstar) confirmed the Kingdom of Spain’s Long-Term Foreign and Local Currency – Issuer Ratings at “A”. At the same time, DBRS Morningstar 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 revised to Stable from Positive.

DEVIATION FROM DBRS MORNINGSTAR’S EU CALENDAR
This is a deviation from DBRS Morningstar’s EU Sovereign, Sub-Sovereign, and Supranational Calendar due to new information becoming available on the creditworthiness of the issuer related to the Coronavirus Disease (COVID-19). DBRS Morningstar believes that this new information makes it inappropriate to wait until the next scheduled review of the issuer on 4 September 2020. The credit rating considerations and rationale are presented below.

KEY RATING CONSIDERATIONS
The trend change to Stable from Positive reflects the fact that Spain’s good economic performance and steady fiscal consolidation have been reversed at least in the near term by the coronavirus outbreak. Despite starting the year carrying positive growth momentum and a sizable fiscal response, Spain´s output is expected to fall sharply in 2020, and to recover partially in 2021. Spain is expected to be one of the European countries most affected by the pandemic in 2020. Given the severity of the health crisis, Spain imposed one of the longest and strictest lockdowns in Europe, taking a very heavy toll on activity in the first half of this year. Furthermore, Spain´s higher reliance on sectors hard hit by the lockdown, such as hospitality, trade, and transport, and possible affected by lingering weakness of the tourism sector after most restrictions are lifted, contribute towards explaining this underperformance. Any medium-term implications will most likely depend on the effectiveness of the policy response in avoiding the temporary shock becoming more entrenched.

The government’s efforts to mitigate the impact of the crisis, coupled with lower revenues, will lead to a material deterioration in the fiscal and debt ratios in 2020. Despite the higher public debt ratio, DBRS Morningstar considers that Spain’s debt sustainability remains strong as funding costs remain very low thanks to the ECB’s massive monetary response. The uncertainty surrounding the duration of this extraordinary support highlights the importance of the implementation of a credible medium-term plan to rebalance the fiscal accounts once the emergency subsides and growth resumes. The deterioration in DBRS Morningstar’s assessment of the “Fiscal Management and Policy” and “Debt and Liquidity” building blocks were the key factors for the trend change.

Spain’s “A” rating is supported by the country’s large and diversified economy, competitive export sector, and eurozone membership. DBRS Morningstar expects these features to underpin the country’s recovery. By contrast, Spain’s high public debt ratio and high reliance on foreign financing are sources of credit vulnerability. Spain's high structural unemployment and temporality underscore labour market shortcomings. The pro-independence movement push in the Autonomous Community of Catalonia (rated BB (high) with a Positive trend by DBRS Morningstar) remains in the background, although tensions have eased.

RATING DRIVERS
The ratings could be upgraded if one or a combination of the following occur: (1) implementation of a medium-term plan to rebalance public finances and place the debt-to-GDP ratio on a firm downward trend; (2) evidence of a strong recovery reducing concerns over long-lasting economic drag; or (3) the introduction of economic reforms to enhance potential growth, possibly improving labour market functioning.

The ratings could be downgraded if one or a combination of the following occur: (1) evidence that the economic damage from coronavirus is substantially larger and more persistent than expected; (2) a deviation from prudent fiscal policy that further deteriorates public finances over time; (3) a sustained increase in funding costs; or (4) a threat to the territorial unity of the country that substantially erodes Spain’s economic and financial profile.

RATING RATIONALE

The Pandemic Throws Spain into a Severe Recession in 2020

Prior to this crisis, Spain’s annual GDP growth averaged 2.6% over the last six years, consistently outpacing the euro area. Despite the positive inertia at the start of this year and no evidence of the sectoral or external imbalances of the past, the Spanish economy is expected to be one of the European countries most hit in 2020. The severity of the health crisis, being one of the most affected nations, and some features of the Spanish economy may explain this underperformance.

To contain the spread of the virus and to avoid the healthcare system being particularly overwhelmed, the government imposed one of the strictest lockdowns in Europe from 14 March 2020 and temporarily suspended non-essential activities. The sectors most affected by the suspension of activities and travel bans, such as retail trade, hospitality, and transport services, represent a higher portion of gross value added, 23.8% in Spain compared with the EU average of 19.3%. These sectors are closely linked to foreign tourism. The construction sector, and to a lesser extent, manufacturing industry, have also been significantly affected.

Since 11 May, authorities have been lifting restrictions for each province in a staggered fashion, depending on their respective health situations. Following a likely sharp contraction in the first half of the year, the lifting of restrictions should allow for an uneven recovery. While the industrial sector could normalise gradually, the outlook for foreign tourism is more uncertain due to the potentially slow removal of international travel bans and travellers’ aversion to going abroad only partially offset by domestic tourism. The tourism sector overall contributed around 12-13% to both GDP and to employment in 2018, including the indirect impact of tourism-related activities.

Despite government support to prevent job losses, supplement household incomes, and ease firms´ liquidity strains, the partial shutdown of the economy will take its toll on activity and employment. The high share of temporality, at 25% of total workers and one of the highest in the euro area, as well as the relatively small size of its firms might amplify the risk of job losses and business closures. In its Stability Programme Update 2020-2021 (SPU 2020), the government expects real GDP to contract by 9.2% in 2020 and to partially recover by 6.8% in 2021. The unemployment rate is expected to rise to 19% in 2020 from 14.1% in 2019, and to decline to 17.2% in 2021. Over the medium-term, the potential impact on economic performance will hinge on the health developments and the authorities` effectiveness in supporting jobs and business activity.

A Surge in the Fiscal Deficit Will Need Growth and Discipline to Rebalance

In 2012 to 2018, the fiscal deficit-to-GDP ratio narrowed by 8.2% percentage points, although the improvement was mostly cyclical in the more recent years. In 2019, the fiscal deficit widened to 2.8% of GDP from 2.5% of GDP in 2018, driven by higher spending on public sector wages, pensions, and other social benefits outpacing revenue growth with a rolled-over budget. This represented the first increase in the deficit ratio since 2012 and was slightly higher than DBRS Morningstar previously anticipated.

The healthcare crisis has swiftly worsened the fiscal outlook in the near term. The effects of sharp recession in 2020 (shrinking tax bases and materially higher unemployment benefit payments), increased healthcare costs and the economic measures to support the private sector will hit public coffers in 2020. The government in its SPU 2020 projects the fiscal deficit to reach 10.3% of GDP in 2020, while the Independent Authority for Fiscal Responsibility`s (AIReF) scenarios place the deficit ratio within a range of 10.9%-13.8%. AIReF estimates that 95% of the measures included in the SPU 2020 are temporary; however, a potentially slow reabsorption of labour market slack could present a drag on public finances for longer.

The government has put in place a fiscal aid package amounting to EUR 138.9 billion (12.2% of GDP), including state guarantees, to support the economy in the near term and to step up the healthcare response. However, the impact of the discretionary measures on the deficit could reach 3.1% of GDP in 2020, with the short-time work schemes (ERTEs) and extraordinary support for self-employed people as key measures. The ultimate impact on the deficit could be higher in light of the likely extension of the short-term layoff scheme and plans to introduce a minimum income programme. The state guarantees, which are worth EUR 104.4 billion and mainly reinforce credit supply to small and medium-size enterprises (SMEs) and the self-employed, will only affect the deficit and the debt in the event that potential losses on the underlying loans materialise. The temporary postponement of taxes to support firms’ liquidity should not affect the deficit, as long as deferrals do not translate into cancellations.

Once the emergency subsides, reversing the fiscal damage from the pandemic will not only depend on a return of growth, but also on a sustained political commitment to rebalance public finances. Given Spain’s unfavourable demographics, curbing ageing-related spending pressures will also remain challenging. In this regard, rolling back key features of the previous pension reform without incorporating offsetting measures could undermine the pension system’s long-term sustainability.

The Pandemic Will Trigger a Rapid Rise in Public Debt But Funding Costs Are Low

The coronavirus outbreak has abruptly halted Spain´s debt-to-GDP ratio reduction. The sharp increase in funding requirements and the contraction in output will lead to a large jump in the debt ratio in 2020. In its Stability Programme, the government projects the debt ratio to reach 115.5% in 2020 compared with AIReF’s view of 117% to 122%, from 95.5% in 2019. Spain’s high public debt ratio, an important credit weakness, will burden the government finances and constrain its capacity to forcefully respond to potential challenges.

Despite this anticipated hefty deterioration, the massive support from the European Central Bank has limited any potential stress for now. Together with the ECB’s Public Sector Purchase Programme (EUR 360 billion in 2020), its EUR 750 billion Pandemic Extraordinary Purchase Programme has played a crucial role in this regard. Spain’s cost of funding remains near historically low levels, with the Spanish 10 year bond yield at 0.69% on May 26, and still strong investor demand. On top of this, the additional resources agreed at the EU level provide further support. Finally, the Spanish Treasury took advantage of favourable conditions and its improving credit fundaments in recent years to lengthen the average maturity of debt and to broaden its investor base. These qualitative factors lend some support to DBRS Morningstar’s qualitative assessment of the “Debt and Liquidity” building block, even though the scorecard deterioration means that the overall building block assessment has worsened.

Spain’s Restored Competitiveness and Rebalancing will Help Mitigate this Shock for the Balance of Payments

The global contraction and temporary restrictions will negatively affect external demand. Travel restrictions and heightened health precautions might significantly impair tourism flows to Spain this year. It remains unclear whether a more lasting impact on tourism demand will remain. However, compared with the previous crisis, Spain is in a much stronger external position thanks to a sharp improvement in cost-competitiveness and Spanish firms’ greater propensity to export. The annual current account surplus averaged 2.2% of GDP between 2013 and 2019. Despite the significant improvement during the last decade, the Spanish economy remains reliant on foreign capital, increasing the country’s vulnerability to sudden shifts in investor sentiment. Spain’s negative net international investment position (NIIP), which has shrunk substantially, remained high at 74.0% of GDP in 2019.

Spanish Banks are in Good Shape to Face an Increasingly Challenging Environment

The sharp economic deterioration will likely negatively impact banks’ profitability and asset quality. Spanish banks’ higher loan loss provisions and weaker new lending volumes will come on top of the more structural profitability pressures resulting from the low interest rate environment and strong competition. However, the government’s support measures, state guarantees, and mortgage payment moratoriums could partially offset this impact and distribute it over several quarters. Similarly, the extraordinary liquidity and capital relief measures taken by euro area supervisors could help sustain a healthy credit supply in Spain.

Spanish households and firms entered this crisis with leaner balance sheets after years of deleveraging and no significant evidence exists of imbalances in the housing market. The banking system has undergone a large scale clean-up and consolidation process since the housing market bubble burst, showing a significant improvement in capital ratios and asset quality. Domestic nonperforming loans (NPLs) shrank to 4.8% of total loans in Q4 2019, well below their Q3 2013 13.6% peak, with sharp reductions in construction and real estate NPL portfolios. However, the potential drag from the remaining legacy troubled assets and challenging operating environment has weighed on DBRS Morningstar’s “Monetary Policy and Financial Stability” building block qualitative assessment.

The Current Political Environment Inhibits Ambitious Reforms and Weakens Political Stability

Spain benefits from strong political institutions. However, an increasingly fragmented and polarised political landscape, coupled with longstanding separatist and small regionalist parties, have complicated cooperation and undermined the stability of governments in the last five years. The left-wing minority coalition government that came into power earlier this year needs the support of other parties in parliament to pass legislation. Dealing with the healthcare emergency has been the main priority thus far this year, placing discussions on major reforms, or potential rollback, to the background. The constraints imposed by the political climate on Spain’s capacity to address key economic challenges and the uncertainty over the long-term situation in Catalonia continue to weigh on DBRS Morningstar’s qualitative assessment of the “Political Environment” building block.

ESG CONSIDERATIONS
Human Rights and Human Capital (S) were among the key ESG drivers behind this rating action. Spain’s per capita GDP is relatively low at USD 29,961 in 2019 compared with its euro system peers. A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/361814/.

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 methodology is the Global Methodology for Rating Sovereign Governments (17, September, 2019):
https://www.dbrsmorningstar.com/research/350410/global-methodology-for-rating-sovereign-governments.

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

The sources of information used for this rating include Ministry of Economy and Business (Stability Programme Update 2020-2021), Ministry of Finance, Bank of Spain (BdE), National Statistics Office (INE), General State Comptroller (IGAE), Independent Authority for Fiscal Responsibility (Report on the Stability Programme Update 2020-2021), Spanish Treasury, European Central Bank (ECB), European Commission (Spring 2020 Economic Forecast), Eurostat, Bank for International Settlements (BIS), Organisation for Economic Co-operation and Development (OECD), International Monetary Fund (World Economic Outlook October 2019 and April 2020, Fiscal Monitor April 2020), World Bank, United Nations Development Programme (UNDP), and Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

This is an unsolicited rating. This credit rating was not initiated at the request of the issuer.

With Rated Entity or Related Third Party Participation: YES
With Access to Internal Documents: NO
With Access to Management: NO

DBRS Morningstar 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 Morningstar’s outlooks and ratings are under regular surveillance.

For further information on DBRS Morningstar 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.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/361813/.

Ratings assigned by DBRS Ratings GmbH are subject to EU and U.S. 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 6, 2020

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