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

DBRS Ratings GmbH (DBRS Morningstar) confirmed the Kingdom of Spain’s (Spain) 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
The Stable trend reflects DBRS Morningstar’s expectation that Spain’s public finances will continue to gradually improve, despite a more challenging inflationary and external environment. DBRS Morningstar expects a strong tourism season this year to support activity through the summer but high energy prices, higher funding costs, and a weaker external backdrop will increasingly weigh on growth afterwards. Risks to Spain's energy supply are relatively limited, but a potential cut-off of Russian gas supply to Europe is a major risk to growth, mainly through higher energy prices and weaker external demand. Unless activity deteriorates sharply, Spain’s fiscal deficit ratio should continue to improve with the phaseout of Coronavirus Disease (COVID-19) support measures and buoyant tax revenues that are expected to offset the fiscal cost of the measures to mitigate the impact of higher energy prices. Spain’s high public debt ratio is projected to fall in coming years, mainly due to elevated nominal growth. As cyclical tailwinds fade and nominal growth decelerates, the implementation of a credible medium-term plan to consolidate public finances on a durable basis and to put the debt ratio on a firm downward trajectory will remain crucial to rebuilding fiscal space and to improving the country’s credit profile.

Spain’s “A” ratings remain supported by the country’s large and diversified economy, competitive export sector, and euro area membership. DBRS Morningstar expects these characteristics, coupled with the implementation of its recovery and resilience plan, to underpin the country’s recovery. By contrast, Spain’s high public debt ratio and its reliance on foreign financing are sources of credit vulnerability. Addressing Spain’s volatile employment dynamics, high temporality, and elevated structural unemployment pose another challenge; however, the recently passed labour reform seems to be producing encouraging results in this direction. The constraints imposed by the domestic political climate, which has challenged previous administrations’ stability and ability to pass legislation, have been alleviated in part by the incentives provided by European funds. While the pro-independence movement in the Autonomous Community of Catalonia (rated BBB (low) with a Stable trend by DBRS Morningstar) remains in the background, tensions between the two tiers of government have eased in recent years.

RATING DRIVERS
The ratings could be upgraded if one or a combination of the following occur: (1) successful implementation of a medium-term plan to rebalance public finances and place the debt-to-GDP ratio on a firm downward trend; or (2) further evidence of a strong recovery and successful implementation of economic reforms that improve economic resilience and/or boost potential growth.

The ratings could be downgraded if one or a combination of the following occur: (1) a sustained increase in Spain’s already high public debt ratio, which could result from a worsening of the medium-term growth outlook, a weaker fiscal discipline, and/or strong deterioration in the costs of funding; or (2) although unlikely at the moment, institutional and territorial challenges that would substantially erode the country’s economic and financial profile.

RATING RATIONALE

The Tourism Recovery Supports the Economy, but Headwinds are Intensifying

Before the start of the pandemic, Spain experienced a period of strong economic performance and job creation between 2014 and 2019, when GDP grew by 2.6% annually and 2.7 million jobs were created. Compared with the situation before the global financial crisis, Spain had improved its cost competitiveness, become more export-oriented, and experienced a strong deleveraging in the private sector. The pandemic halted this strong performance, heavily affecting its important tourism-related sector, and triggered a GDP contraction of 10.8% in 2020—the most pronounced in the EU 27. According to Spain’s statistical office, the tourism industry’s contribution to GDP plunged to 5.5% in 2020 from 12.4% in 2019.

In 2021, GDP rebounded 5.1%, benefitting from the reopening effects, although sluggish private consumption and foreign tourism recoveries kept output 3.8% below its pre-pandemic level by the end of 2021. On a positive note, the recovery in employment and machinery and equipment investment has been much faster than in previous crises, in part thanks to the massive income and liquidity support provided by the government. DBRS Morningstar views this as supporting evidence of limited long-term scarring from the pandemic thus far.

The repercussions of Russia’s invasion of Ukraine have dampened Spain’s near-term growth outlook and increased the risk of a recession in Europe. The impact of high inflation, increasing interest rates, and falling consumer confidence is expected to slow down the recovery in private consumption; however, the strength of the labour market and the substantial excess savings accumulated during the pandemic should cushion the impact. On the other hand, exports will likely continue to benefit from a strong comeback in foreign tourism in 2022 and investments from European funds over time. Against this background, the European Commission (EC) revised its growth projections for Spain downwards to 4.0% in 2022 and to 2.1% in 2023 in its Summer 2022 projections compared with the 5.6% and 4.4% released in February 2022, respectively. The main uncertainty is related to a possible cut in energy supply from Russia to Europe, which could affect Spain mainly through a slowdown in its main trading partners that are affected and higher energy prices. Spain benefits from a more geographically diversified supply of natural gas, with 10.5% of natural gas imports coming from Russia in 2020, and from its sizeable LNG regasification infrastructure, with around 38% (60.1 bcm) of the EU-27's total LNG operational capacity as of April 2022. CPI inflation reached 10.8% YoY in July, however, DBRS Morningstar expects the introduction of the natural gas price cap mechanism to shield households and firms from higher and more volatile natural gas prices in the coming months.

DBRS Morningstar will continue to assess the medium- to long-term effects of the reforms and investments included in Spain’s recovery plan. According to the newly calculated Recovery and Resilience Facility (“RRF”) figures, Spain could receive up to EUR 77.2 billion (or 6.9% of 2020 GDP) and could request up to EUR 70 billion of loans (or 6.2% of 2020 GDP). The government is in the process of preparing an addenda to access the additional EUR 7.0 billion of grants and request the loans. Spain has been a frontrunner in terms of achieving its milestones (83 certified out of 220 milestones), resulting in the disbursement of EUR 31 billion in grants (including pre-financing). While the EC estimates that Spain spent 0.2% of GDP in 2021, the execution is expected to speed up significantly starting in 2022. In terms of reforms, the labour market reform passed into law in December 2021, discouraging temporary contracts and enhancing firms’ internal flexibility, seems to be producing positive preliminary results thus far. During the first seven months of 2022, permanent contracts increased by 1.4 million (excluding fixed-discontinuous contracts) while temporary contracts dropped by 1.1 million. If sustained, the reduction of labour market duality should lead to lower procyclicality of employment dynamics, higher human capital investments, and lower structural unemployment over time.

Fiscal Position is Expected to Improve, Driven Principally by Cyclical Factors and the Removal of Coronavirus Support

The collapse in output and the measures to counter the pandemic’s effects led to a significant widening of Spain’s fiscal deficit to 10.3% of GDP in 2020 —the largest in the EU 27— from a deficit of 3.1% of GDP in 2019. The fiscal deficit ratio declined more quickly than expected in 2021 to 6.9% compared with the government’s original projection of 8.4%, driven by principally the good performance of tax receipts. DBRS Morningstar expects the fiscal repair to continue in 2022 as tax revenues continue to surprise on the upside and the phaseout of coronavirus support will overshadow the fiscal cost of the government’s response to the energy and inflation shock. The impact of the coronavirus-related support is expected to drop to 0.4% of GDP in 2022 from 3.0% of GDP in 2021 and 3.9% of GDP in 2020. On the other hand, the fiscal cost of the measures introduced and announced to ease the pressure of higher energy costs on households and firms in 2022 are estimated to be around EUR 12 billion, representing 0.9% of GDP, according to AIReF. The government plans to finance part of this with the introduction of two new temporary taxes, one on financial institutions and another on large energy companies, which it estimates could generate EUR 7 billion of additional revenues during 2023/2024.

The government projects the fiscal deficit ratio to drop to 5.0% of GDP in 2022, and to continue its decline towards a level below 3% of GDP by 2025. DBRS Morningstar notes that fiscal repair is relying mainly on cyclical factors and the phaseout of coronavirus measures. Given that the Spanish economy has not fully recovered, relying on cyclical forces to reduce the fiscal imbalance seems appropriate for now; however, tackling the post-pandemic structural deficit will require the implementation of a credible fiscal consolidation plan. The effects of an ageing population on pension and healthcare spending, especially with the re-indexation of pensions to CPI as of 2023, a renewed impetus to gradually increase defence spending towards 2% of GDP over time from 1.0% in 2021, and higher interest rates will increasingly weigh on public finances in coming years. The discussion around potential measures to strengthen the pension system’s sustainability and plans for comprehensive tax reform, both in the context of the NextGenerationEU (NGEU) milestones and targets, could present opportunities in this direction.

Public Debt Remains High but Affordability and Favourable Dynamics Mitigate Risks

Spain's high level of public debt, among the highest in the EU 27, remains an important credit challenge, reducing its fiscal space and increasing its vulnerability to shocks. The pandemic effect contributed to a sharp increase in Spain's public debt ratio to 120.0% of GDP in 2020 from 98.3% of GDP in 2019, which reversed only marginally in 2021 when the ratio fell to 118.4% of GDP. On a positive note and, despite higher levels of debt and significantly higher financing needs during 2020 and 2021, the Spanish Treasury continued to lengthen the average maturity of its debt, locked in historically low rates, and further diversified its investor base. The actions of European institutions, including the European Central Bank's (ECB) massive pandemic response and the various EU-backed financing lines, played a key role in allowing highly indebted sovereigns like Spain to comfortably finance their pandemic responses and mitigate any long-lasting implications on the economy.

In its Stability Programme Update 2022-2025, the government projects that its debt ratio will decline to 115.2% of GDP in 2022 and trend downwards to 109.7% of GDP by 2025. According to the government projections, the decline of 8.7 percentage points in the public debt ratio between 2022 and 2025 is principally explained by the nominal growth effect, which in isolation is expected to subtract around 25 percentage points from the debt ratio during this period, more than compensating for the effects of still-high but declining fiscal deficit ratios. DBRS Morningstar notes that the tailwinds from the nominal GDP growth will eventually lose strength and, therefore, keeping Spain’s debt ratio on a firm downward trend and rebuilding its countercyclical fiscal space will require a credible strategy to reduce the structural deficit over time.

Similar to other sovereigns, Spain has faced a rapid increase in nominal bond yields in recent months. The 10-year government bond increased by around 210 basis points this year to 2.6% by the end of August 2022 from 0.5% by the end of December 2021. Although a sustained rise in financing costs is likely to increase the interest burden over time, Spain's debt structure will help soften the impact. Spain’s debt stock is predominantly euro denominated and fixed rate which, combined with its relatively long average maturity of 8.0 years in 2021, will delay the impact of higher yields on the total interest bill paid annually. Furthermore, the Spanish authorities plans to request the loan portion of the NGEU, which could create interest savings in coming years. The ECB’s financial backstop and Spain’s debt structure support DBRS Morningstar’s positive qualitative factor for the “Debt and Liquidity” building block assessment.

Spanish Banks are Well Positioned to Benefit from Higher Rates and Weather a More Challenging Operating Environment

The Spanish banking system remains sound, benefiting from a prolonged period of improvement in its capital ratios and asset quality, including a large-scale restructuring and balance sheet clean-up in the aftermath of the global financial crisis. Despite the sharp deterioration in the operating environment due to the pandemic, Spanish banks’ credit quality and credit supply held up well, in part thanks to support measures introduced by the government and European institutions. Banks’ domestic nonperforming loans stood at 3.8% of total loans in Q2 2022, down from 4.8% in Q4 2019. Profitability, which deteriorated significantly in 2020, has strongly recovered partly because of a reduction in loan loss provisions. DBRS Morningstar notes that, after years of deleveraging, the total credit stock to the non-financial private sector began to increase again in 2020, first due to the boost of state-guaranteed loans to the corporate sector and then due to strong mortgage credit.

DBRS Morningstar considers that Spanish banks are generally well positioned to benefit from higher interest rates, provided that asset quality remains stable, as a large part of their loan book is referenced to variable rates and deposit rates expected to increase only slowly. On the other hand, DBRS Morningstar notes that Spanish banks’ domestic profits could be negatively affected by the deterioration in the Spanish economic outlook, which could translate into higher loan loss provisions as well as lower business volumes (please see: https://www.dbrsmorningstar.com/research/400833). On a positive note, loans exiting the loan moratoria and the state-guaranteed grace period have generally performed above expectations.

Spain Benefits from Strong Political Institutions and EU Funds Have Alleviated Constraints to Policy Making

Spain benefits from strong political institutions that support its economy. Before the pandemic, Spain experienced a period of political instability as reflected in four general elections in as many years during 2015–19, which complicated the introduction of meaningful economic or fiscal reforms and even prevented the approval of ordinary budgets in some instances. While the fragmented and polarised political landscape behind this instability remains broadly present, Spain has broken the reform impasse in part thanks to the NGEU incentives. DBRS Morningstar expects the implementation of its recovery plan to continue spurring policy making in coming years; however, passing controversial reforms could become more challenging as the next general election date approaches, no later than 10 December 2023.

Similarly, DBRS Morningstar acknowledges the slowly but steadily strengthening relationship between the central government and the Autonomous Community of Catalonia government over the last three years. While a long-standing solution remains elusive over the medium to long term and sporadic tensions could re-emerge, DBRS Morningstar takes the view that a relatively smooth economic and financial co-operation between both government tiers can now be expected and that a political escalation similar to what occurred in 2017 has now become unlikely.

The Recovery of Tourism Flows Helps to Mitigate the Effects of Higher Energy Prices and a Gloomier External Demand

Spain’s external accounts have strengthened considerably for more than a decade because of an improvement in cost competitiveness and Spanish companies’ greater propensity to export. Spain recorded ten consecutive years of current account surpluses between 2012 and 2021, reversing a period of current account deficits averaging 5.6% of GDP between 2000 and 2011. This sequence of current account surpluses, combined with growing nominal GDP, drove Spain's net international investment position to -66.8% of GDP in 2022Q1 from -95.9% of GDP in 2014Q4. While Spain’s still very elevated net debtor position exposes the country to sudden changes in investor sentiment and capital flows, DBRS Morningstar considers Spain’s net lending to the rest of the world over the last decade mitigates this risk.

The tourism industry appears to finally be recovering after two years of disruptions. After a dramatic collapse in 2020 and a partial recovery in 2021, international tourist arrivals and international tourist spending for January-July 2022 reached 82% and 91% of the levels for the same period in 2019, respectively. On the other hand, the material increase in energy prices, given Spain’s reliance on energy imports, and a weaker global backdrop will weigh on the country’s external imbalances. The trade energy deficit, which narrowed sharply in 2020, has been widening since last year.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
Social (S) Factors
The Human Capital and Human Rights factor affects the ratings. Spain’s GDP per capita, at USD 30,090 in 2021 according to the International Monetary Fund, remains relatively low compared with its European peers. This factor has been taken into account primarily in the “Economic Structure and Performance” building block.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/402337.

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/401817/global-methodology-for-rating-sovereign-governments (August 29, 2022). Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings, https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (May 17, 2022).

The sources of information used for this rating include the Ministry of Economic Affairs and Digital Transformation (Spain’s Stability Programme 2022–2025; Spain’s Recovery, Transformation and Resilience Plan), Ministry of Finance (Council of Minister Press Release 26 July 2022), Bank of Spain (Macroeconomic Projections 2022-2024; Economic Consequences of a Hypothetical Suspension of Russia-EU Trade May 2022), National Statistics Office (Satellite Account of Tourism of Spain, January 2022), General State Comptroller (IGAE), Independent Authority for Fiscal Responsibility (Report on Budgetary Execution, Public Debt and Spending Rule 2022), Spanish Treasury (Chart Pack June 2022), State Official Gazzette (Climate Change and Energy Transition Law, May 2021), ECB, European Banking Authority, EC (European Economic Forecast Summer 2022; Fiscal Statistical Tables providing background data relevant for the assessment of the 2022 Stability and Convergence Programmes May 2022; RRF: Update of the maximum financial contribution June 2022), Gas Infrastructure Europe (GIE LNG Database April 2022), Eurostat, Bank for International Settlements, Organisation for Economic Co-operation and Development, International Monetary Fund (IMF), World Bank, the Social Progress Imperative (2021 Social Progress Index), and Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, this is an unsolicited credit 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: YES
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.

The conditions that lead to the assignment of a Negative or Positive trend are generally 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: https://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. DBRS Morningstar understands further information on DBRS Morningstar historical default rates may be published by the Financial Conduct Authority (FCA) on its webpage: https://www.fca.org.uk/firms/credit-rating-agencies.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/402326.

This rating is endorsed by DBRS Ratings Limited for use in the United Kingdom.

Lead Analyst: Javier Rouillet, Vice President, Global Sovereign Ratings
Rating Committee Chair: Thomas R. Torgerson, Managing Director, Co-Head of Sovereign Ratings
Initial Rating Date: October 21, 2010
Last Rating Date: March 4, 2022

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