DBRS Morningstar Confirms the Autonomous Community of Catalonia at BB (high), Trend Changed to Stable

DBRS Ratings GmbH (DBRS Morningstar) confirmed the Long-Term Issuer Rating of the Autonomous Community of Catalonia (Catalonia) at BB (high) and its Short-Term Issuer Rating at R-4. Simultaneously, DBRS Morningstar changed the trend on all ratings 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 11 September 2020. The credit rating considerations and rationale are presented below.

KEY RATING CONSIDERATIONS
The trend change on the region's ratings reflects the trend change to Stable from Positive on the Kingdom of Spain's Long-Term Foreign and Local Currency – Issuer Rating of "A" on 29 May 2020. Spain's ratings trend change reflected DBRS Morningstar’s view that the country's good economic performance and steady fiscal consolidation will be halted, at least in the near term, by the Coronavirus Disease (COVID-19) outbreak. Spain's output is now expected to fall sharply in 2020 and to recover only partially in 2021.

DBRS Morningstar considers that the factors underpinning the trend change of the sovereign ratings similarly affect its analysis of Catalonia’s creditworthiness and underpins the trend change to Stable on the region's ratings. Catalonia's finances will be affected by a combination of higher healthcare-related expenditure and lower tax collection. Although DBRS Morningstar expects the national government to mitigate the impact on the region's financial performance in 2020, Catalonia's fiscal outcomes are likely to remain under pressure in the next two-to-three years.

Catalonia’s ratings remain underpinned by (1) the region’s robust economic indicators and its sound fiscal performance in recent years; and (2) the financing support provided by the Kingdom of Spain to the regional government. While the political situation in the region remains a source of uncertainty, its impact on the regional economy or more generally on fiscal and financial management has remained limited.

Catalonia’s Long-Term Issuer Rating currently remains at the BB (high) level given the region’s high debt metrics and a still challenging political environment. Although DBRS Morningstar expects the region’s debt reduction to be a slow and lengthy process and the political noise over independence to remain over the long-term, it considers that the region’s intrinsic performance has improved in the last three years.

RATING DRIVERS
The ratings could be upgraded if: (1) the relationship between the region and the national government remains stable after the upcoming regional elections, with debt and fiscal management staying insulated from any potential rise in political tensions; (2) the region continues its fiscal consolidation towards a balanced budget position and improves its debt sustainability metrics further; or (3) the Kingdom of Spain’s rating is upgraded.

The ratings could be downgraded if: (1) there is a material escalation of the political tensions between the region and the national government. Specifically, indications that the financing support received by the region may be reduced would have negative credit implications; or (2) there is a structural reversal in the region’s fiscal consolidation, leading fiscal deficits to widen over time.

RATING RATIONALE

The COVID-19 Outbreak Negatively Affects the Regional Economy

The COVID-19 outbreak is taking its toll on the Spanish and regional economy. Catalonia has been severely affected by the pandemic. The region, in line with the rest of the country, has been under one of the longest and strictest lockdowns in Europe. This lockdown, aimed at slowing the transmission of the virus among the population has borne fruits, with the number of recorded cases recently dropping drastically. Nevertheless, the economic shock derived from this unprecedented lockdown will be very significant.

DBRS Morningstar considers that the fiscal measures announced by the central government to support the healthcare system –a responsibility of the Spanish regions– and to mitigate the long-term impact of the pandemic on the national economy should help alleviate the adverse consequences of the COVID-19 outbreak. However, a severe recession is now expected for 2020, with the national government forecasting the country's real GDP to decline by 9.2% before recovering partially with growth of 6.8% in 2021. While DBRS Morningstar expects this shock to affect all Spanish regions, its overall impact on the region of Catalonia will depend in large part on how quickly economic activity normalises. The recent announcement of a large automotive plant closure in the region is an early indication that the consequences of this crisis might be far reaching and possibly long lasting.

The Political Environment Remains a Key Rating Consideration

On the political front, while the regional pro-independence party, Esquerra Republicana de Catalunya (ERC), implicitly supported through its abstention the formation of a coalition government led by the Partido Socialista Obrero Español (PSOE) at the national level in January 2020, political uncertainty in the region remains. In particular, new regional elections, likely to be held by the end of 2020, could potentially mean the resurgence of political tensions, as the outcome of the vote might bring ERC to reconsider its implicit support for Prime Minister Sanchez’s government and harden the pro-independence stance.

DBRS Morningstar believes that regional elections that would confirm a softer strategy on the independence question, such as the one currently followed by ERC, and reduce political tensions between both government tiers, would benefit its assessment of the region’s political risk and subsequently support Catalonia’s ratings.

Catalonia’s Fiscal Performance Will be Affected, but the National Government Will Limit the Adverse Impact

On the fiscal front, Catalonia’s fiscal performance largely stabilised in 2019, with a deficit-to-gross domestic product (GDP) at -0.56%. While the deficit slightly worsened compared to the -0.44% recorded in 2018, it was affected by one-offs, and remained in line with the -0.55% of regional peers. In 2020, further fiscal consolidation appears challenging given the rapid deterioration in economic indicators in the region and in Spain. DBRS Morningstar currently expects strong pressure on Spanish regions' operating expenditure, as regions directly manage healthcare related costs which are expected to increase. In addition, the anticipated drop in economic output in 2020 is likely to markedly affect regional taxes collected by the region.

On the other hand, Catalonia and other Spanish regions under the common regime are likely to benefit from the automatic stabiliser built into the regional financing system. For example, while the pandemic is likely to decrease substantially the level of taxes collected by the central government and in particular shared taxes such as value added tax and personal income tax, the regions should remain insulated from this in 2020. The government has indeed not revised down the level of transfers (entregas a cuenta) that it will make to regions this year. Transfers for all regions from the financing system will continue to increase in 2020; by 7.3% year-on-year compared with 2019.

The negative effect of the lower tax collection in 2020 will therefore be borne by the central government. While this will support regions in 2020, the regional financing system will prompt a negative settlement to be paid by regions in 2022, which is likely to be very substantial. DBRS Morningstar considers however likely that the national government will allow regions to repay this settlement over the long-term, as it did regarding the 2008 and 2009 negative settlements which are currently being repaid over 20 years.

DBRS Morningstar also highlights that the national government recently approved additional fiscal transfers to its regions (Fondo No Reembolsable), totaling EUR 16 billion or 1.3% of national GDP for 2020. These correspond to one-off measures aimed at supporting regional finances on the face of the COVID-19 crisis. These funds will be split between EUR 10 billion directed to healthcare expenditure, EUR 5 billion to compensate for lower regional revenues and EUR 1 billion for additional social costs borne by regions. Overall, based on the Independent Authority for Fiscal Responsibility (AIReF), the additional deficit for all Spanish regions related to COVID-19 in 2020 is estimated between 1.2% and 1.7% of GDP. This additional deficit could therefore be in large part compensated by the extraordinary transfer from the national government of EUR 16 billion to the sector.

DBRS Morningstar therefore anticipates that Catalonia and other Spanish regions' 2020 financial performance should be only partially affected by the COVID-19 crisis, as the central government finances take the hit. The situation is nevertheless likely to deteriorate rapidly in 2021 and 2022, with lower revenues from the regional financing system and still high expenditure increasing pressure on regional finances. While the national government is likely to continue supporting its regions, growing regional deficits and debt levels are likely to materialise.

The National Government’s Financing is Critical to the Region’s Creditworthiness

DBRS Morningstar expects Catalonia's financing needs to continue being covered by the national government. Such financing remains critical for the region's credit ratings. While Catalonia’s debt is very high at EUR 81.8 billion at the end of 2019, or 278% of its operating revenues, DBRS Morningstar gains comfort on its sustainability, given the support it receives from the national government. The Spanish Treasury currently holds about 75% of the regional debt stock and Catalonia has benefited from very low funding rates in recent years. While the reduction in the region's debt-to-operating revenues ratio is now being challenged by the healthcare crisis, DBRS Morningstar continues to consider that Catalonia will remain committed to strengthen its debt metrics over the medium-term..

ESG CONSIDERATIONS

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.

RATING COMMITTEE SUMMARY

The DBRS Morningstar European Sub-Sovereign Scorecard generates a result in the BBB (high) – BBB (low) range. Additional considerations factored into the Rating Committee decision included the uncertainty related to the political environment in the region and its potential impact on the region’s relationship with the national government as well as the region’s economic and fiscal prospects.

The main points discussed during the Rating Committee include: the region’s economic growth and the potential impact of the COVID-19 on its fiscal and debt trajectories. The relationship between the national government and the Autonomous Community of Catalonia and the political situation in the region and in the country.

For more information on the Key Indicators used for the Kingdom of Spain, please see the Sovereign Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/361814/.

The national scorecard indicators were used for the sovereign rating. The Kingdom of Spain’s rating was an input to the credit analysis of the Autonomous Community of Catalonia.

Notes:
All figures are in euros (EUR) unless otherwise noted.

The principal methodology is the Global Methodology for Rating European Sub-Sovereign Governments (6 September 2019): https://www.dbrsmorningstar.com/research/350151/rating-european-sub-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 the Autonomous Community of Catalonia for financial position and debt structure for the 2014-19 period, Bank of Spain for the debt metrics during the 2014-19 period, Independent Authority for Fiscal Responsibility (AIReF) for its Report on the Stability Programme Update 2020-2021, Instituto Nacional de Estatística (INE), Ministry of Finance for the monthly budgetary execution. DBRS Morningstar considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

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/362094/.

Ratings assigned by DBRS Ratings GmbH are subject to EU and U.S. regulations only.

Lead Analyst: Nicolas Fintzel, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global Financial Institutions and Sovereign Ratings Group
Initial Rating Date: July 6, 2018
Last Rating Date: March 13, 2020

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This press release was amended on 16 June 2020 to fix the publication date of the "Global Methodology for Rating European Sub-Sovereign Governments" methodology.