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

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 remains Stable.

KEY RATING CONSIDERATIONS
The Stable trend reflects DBRS Morningstar’s assessment that the risks to the ratings remain broadly balanced. As a reminder, DBRS Morningstar deviated from its EU Calendar on May 29, 2020 to change the trend on Spain’s ratings to Stable from Positive to reflect the substantial deterioration of the economic, fiscal, and debt projections as a result of the Coronavirus Disease (COVID-19) shock. Since then, the latest national accounts figures have confirmed the massive toll on activity caused by the restrictions to contain the spread of the pandemic in the first half of the year. The recent resurgence of infections in Spain, and the measures needed to contain it, pose risks to the ongoing recovery and increase the likelihood of further output losses. On the other hand, a timely deployment of the financial resources from the Next Generation EU (NGEU) plan, reviving public investment and reforms, could provide much needed stimulus to support the recovery and to help raise Spain’s potential growth over time.

The measures to mitigate the economic fallout from the pandemic will result in a substantial deterioration of the fiscal deficit and the public debt ratios this year. A prolonged period of economic weakness could delay eventual fiscal rebalancing and debt ratio stabilisation. Despite the substantial increase expected in funding needs and debt levels, Spain continues to issue debt at near historically low funding costs and is reducing the average cost of its outstanding debt. DBRS Morningstar expects the financial backstop from the European Central Bank (ECB) and the various facilities at the European level to allow Spain to continue to support the economy through this crisis at very affordable funding costs. The implementation of a credible medium-term plan to put the debt ratio on a downward trend again will become increasingly important as the pandemic wanes.

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 in the Autonomous Community of Catalonia (rated BB (high) with a Stable 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 and raising productivity.

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 commitment that further deteriorates public finances over time; (3) a sustained increase in funding costs; or (4) a threat to the territorial unity of Spain that substantially erodes the country’s economic and financial profile.

RATING RATIONALE

The Pandemic Throws Spain into a Severe Recession in 2020

The pandemic shock interrupted a prolonged period of solid economic performance and strong job gains, which saw output expanding 2.6% annually over the past six years, consistently outpacing the euro area average. This period was marked by restored competitiveness, private sector deleveraging, and no evident imbalances. This contrasts with the unsustainable credit-fuelled expansion that preceded the previous crisis.

The partial shutdown of activity in Spain from mid-March until late June, combined with a sharp deterioration in the external background, has taken a heavy toll on activity in the first half of the year. According to the latest data, Spain’s GDP (SA/WDA) slumped 22.1% YOY in Q2, the sharpest contraction thus far in the euro area. This could be attributed mainly to the severity of the pandemic, the stringency of the lockdown, and the high weight of sectors more vulnerable to the suspension of activities, physical distancing and travel bans, for example like the tourism-related sectors in Spain. The tourism sector overall contributed around 12-13% to both GDP and to employment in 2018, including the indirect impact of tourism-related activities. In addition, one of the highest levels of temporality at 22.4% of total workers; a relatively smaller size of firms such that 78% of firms have less than five employees; and a smaller initial fiscal response announcement compared with other large European countries, might have played a role.

The recovery is expected to be uneven, with the manufacturing and services sectors that are less affected by physical distancing rules, potentially recovering faster. The rapid increase in infections in Spain in recent weeks, has been met mostly with localised restrictions, rather than a full lockdown, and with travel restrictions imposed by other European countries. This threatens the ongoing recovery and dashed hopes of a strong rebound in foreign tourism for the end of the summer, so far only partially compensated for by domestic tourism. The tourism sector could take years to return to pre-pandemic levels and likely needs to restructure in response to lower demand.

There is significant uncertainty surrounding the macroeconomic outlook in the near term, tightly linked to epidemiological developments. The Independent Authority for Spanish Fiscal Responsibility’s (AIReF) latest macroeconomic scenarios point to a massive GDP contraction of 10.1% this year and only a partial recovery of 5.2% in 2021 in the absence of new outbreaks, and to a slump of 12.4% in 2020 and a rebound of 5.8% in 2021 assuming a second wave forces an additional month of restrictions and a worsening of domestic and trade conditions. These scenarios already considered reduced tourism flows in 2020, and assumed a relatively weak recovery in private consumption in 2021, which could surprise on the upside if an effective medical solution is found. The IMF’s latest estimates for GDP performance, -12.8% in 2020 and 6.8% in 2021, are among the more conservative among international and official organisations.

Over the medium term, the main risk is that the pandemic causes long-lasting economic damage and slower economic rebalancing, leading to higher unemployment levels for a protracted period of time. The government has implemented several measures to prevent job losses (e.g., furlough-like schemes) and avoid otherwise solvent firms from closing through liquidity support. Since the reopening of the economy, the number of furlough workers has dropped by 76% to 0.8 million at the end of August from a peak of 3.4 million at the end of April. On the other hand, the NGEU recovery plan represents an important opportunity to boost investment in the medium term and revive the stalled reform agenda. A successful implementation of the EUR 140 billion (11.3% of 2019 GDP) funds in principle allocated to Spain, including EUR 72.7 billion in grants, over the next three years could help the country raise long-term growth and ease some of its structural weakness, such as relatively low productivity and high unemployment.

The Pandemic Shock Is Causing a Severe Fiscal Deterioration

Despite a substantial reduction since 2012, the fiscal deficit stood at 2.8% of GDP in 2019, still one of the highest among the EU member states. The fiscal deficit will deteriorate sharply in 2020 due to the deep economic recession, the automatic stabiliser effects, and the government’s stimulus measures. In July, AIReF estimated that the fiscal deficit ratio could reach between 11.9% and 14.4% in 2020, before shrinking gradually to a level between 8% and 10.3% in 2021, depending on the evolution of the pandemic. The IMF estimates the deficit ratio could reach 13.9% in 2020 and 8.3% in 2021, placing it again among the less optimistic of international and official organisations.

AIReF estimates that the fiscal impact of the pandemic response measures could amount to between 4.1% and 4.9% of GDP, mainly explained by the furlough-like schemes (ERTEs), self-employed income support, social contribution exemptions, and health system reinforcement. These measures are generally targeted to those affected by the pandemic and are so far limited to 2020. As a result, their fiscal impact should wane as Spain exits the peak of the healthcare emergency. Instead, the introduction of a means-tested minimum income scheme in July is expected to increase annual spending by around 0.2% of GDP. In addition, the government has adopted several measures that do not have an impact on the deficit in 2020. These are expected to help firms and the self-employed cope with the fall in revenues due to the pandemic and protect the Spanish economy’s productive capacity. They include State guarantees (over 11% of GDP), temporary tax deferrals, and other liquidity support.

Even if activity rebounds and temporary measures are phased out, below-potential GDP growth and higher unemployment levels could still continue to place a drag on fiscal accounts after the pandemic emergency ends. The need for additional support measures, the crystallisation of contingent liabilities, or protracted economic weakness are key risks to the fiscal outlook. On the other hand, a stronger-than-anticipated economic recovery could speed up the rebalancing process. Looking forward, sustained political commitment to prudent fiscal policies and controlling ageing-related spending pressures will remain crucial to re-build fiscal buffers.

The Pandemic Will Trigger a Rapid Rise in Public Debt but Funding Costs are Near an All Time Low

In line with other European peers, Spain’s public debt ratio is expected to increase considerably as a result of a sizable fiscal deficit and an unprecedented recession in 2020. The latest scenarios from AIReF suggest the debt ratio increasing to a level between 117.6% and 123.2% by the end of 2020 from 95.5% in 2019. In comparison, the IMF’s June debt ratio projection at 125% by end 2020 is on the pessimistic side of the range. This jump in the public debt ratio is likely to leave Spain more exposed to future shocks, burden its public finances, and reduce the scope for future countercyclical fiscal policy. Although the public debt ratio could drop in 2021 if there is strong growth rebound, stabilising or returning the debt ratio to a downward trajectory will require the implementation of a strong fiscal consolidation plan.

The ECB and the EU response to the pandemic underscores the considerable benefits associated with Spain’s membership of the euro area and of the EU. The ECB’s massive pandemic response and the various EU-backed financing facilities, including a significant portion of grants under NGEU, are expected to provide room for manoeuvre for European governments to respond to the pandemic. The ECB’s stepped up sovereign debt purchases and the EU funds will reduce the amount that the private sector will need to absorb. This should, therefore, allow Spain to continue to enjoy close to historically low funding costs. Furthermore, depending on the take up of the EU loans available for Spain, the country will be able to secure interest savings for the tenure of these loans. In this context, DBRS Morningstar expects the Spanish Treasury to continue to lower the average cost of its outstanding debt in the next couple of years. The average cost at issuance for 2020 thus far stood at 0.25% and the average cost of outstanding debt at 1.94%, well below the 4.53% recorded in 2007. The interest burden is expected to remain contained around 2.3% of GDP, compared with 3.5% in 2013.

The Spanish Treasury has taken advantage of the low interest rate environment and of its improving credit fundaments in recent years to lengthen the average maturity of its debt, lock-in lower rates, and broaden its investor base. The outstanding debt stock is predominantly euro-denominated and fixed-rate, and has a relatively long average maturity of 7.7 years, protecting the government from sudden increases in funding costs. The ECB’s financial backstop and Spain’s debt structure support DBRS Morningstar’s positive qualitative assessment of the “Debt and Liquidity” building block.

Spanish Banks Better Prepared to Face an Increasingly Challenging Environment

The Spanish banking system entered the current economic crisis following a prolonged period of improvement in its capital ratios and asset quality. This happened following large-scale restructuring in the sector, tighter regulatory requirements, and the economic and housing market recovery in recent years. According to European Banking Authority data, the CET1 (fully loaded) capital ratio increased to 11.5% in Q1 2020 from 9.3% in Q3 2014, exceeding regulatory requirements. In the same period, the share of nonperforming loans shrank to 3.1% from 8.8%, below the euro area average. In stark contrast with the previous crisis, Spanish households and firms have leaner balance sheets, and no significant evidence of imbalances in the housing market exist (please see Spanish Real Estate Market: More Balanced This Time: https://www.dbrsmorningstar.com/research/348394).

DBRS Morningstar sees positively the substantial increase in new lending to firms, which increased by 33.3% between March and July compared with the same period a year earlier. The combination of the state-guaranteed loans scheme and the ECB’s extraordinary liquidity and regulatory relief measures have played a crucial role in sustaining a healthy supply of credit. Nevertheless, the current crisis is expected to weigh on banks’ asset quality, profitability, and capital ratios in coming quarters (please see Spanish Banks: COVID-19 Crisis Starts to Impact H1 2020 Asset Quality; Earnings Under Pressure: https://www.dbrsmorningstar.com/research/365027). This comes on top of the more structural profitability pressures resulting from the low interest rate environment and strong competition. The loan moratoria and state-guaranteed loans are expected to slow the pace of deterioration in credit quality from the pandemic shock. Although the sovereign will bear between 70%-80% of the losses that might arise from the state-guaranteed loans, the great majority of their loan book is not covered by this programme, and significant loan loss provisions are expected to be needed to cover future defaults. An increasingly challenging operating environment and build-up of risks has weighed negatively on DBRS Morningstar’s “Monetary Policy and Financial Stability” building block qualitative assessment.

The Current Political Environment Presents a Challenge to Ambitious Reforms and Weakens Political Stability

Spain benefits from strong political institutions underpinning its economy. However, an increasingly fragmented and polarised political landscape has complicated cooperation and undermined the stability of governments in the past five years. At times, this has resulted in rolled-over budgets, hindered faster fiscal consolidation, and stalled the reform agenda. While the Catalan pro-independence movement appears to have eased its stance since 2017, a long-lasting solution remains elusive and tensions might resurface. 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 negatively on DBRS Morningstar’s qualitative assessment of the “Political Environment” building block.

On the other hand, the NGEU recovery plan presents an opportunity to implement a long-term investment and reform plan to tackle some of Spain medium term challenges in terms of productivity, environmental transition, and structural unemployment. This will require parties to break the political gridlock, which might prove challenging considering the recent past.

Spain’s Restored Competitiveness will Help Mitigate this Shock to the Balance of Payments

The disruptive effects from the restrictions impacting trade and tourism flows will negatively affect external demand this year. To some degree this will be compensated for by lower imports. 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), albeit having shrunk substantially, remained high at 74.4% of GDP in 2019. 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.

ESG CONSIDERATIONS
Human Rights and Human Capital (S) were among the key ESG drivers behind this rating action. Spain’s per capita GDP was relatively low at USD 29,961 in 2019 compared with its euro area peers. This factor has been taken into account in the “Economic Structure and Performance” building block.

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/366403.

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: https://www.dbrsmorningstar.com/research/364527/global-methodology-for-rating-sovereign-governments (July 27, 2020).

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, Ministry of Finance, Bank of Spain (Macroeconomic Projections 2020-2022, June 2020; Annual Report 2019, June 2020; Challenges for the Spanish economy in the face of the impact of the pandemic, July 2020), Ministry of Inclusion, Social Security and Migration (Affiliations Report, August 2020), Ministry of Health, National Statistics Office (INE), General State Comptroller (IGAE), Independent Authority for Fiscal Responsibility (Budget Execution, Public Debt and Expenditure Rule 2020 Report, July 2020), Spanish Treasury (Presentation, August 2020; Chart Pack, July 2020), European Central Bank, European Banking Authority, European Commission, Eurostat, Bank for International Settlements, Organisation for Economic Co-operation and Development, International Monetary Fund, World Bank, United Nations Development Programme, 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/366402.

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: May 29, 2020

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