DBRS Morningstar Confirms the Autonomous Community of Catalonia at BBB (low), Stable Trend

DBRS Ratings GmbH (DBRS Morningstar) confirmed the Long-Term Issuer Rating of the Autonomous Community of Catalonia (Catalonia) at BBB (low) and the Short-Term Issuer Rating at R-2 (low). The trend on all ratings remains stable.

KEY RATING CONSIDERATIONS

Catalonia's ratings are underpinned by (1) the region’s track record of improving its debt metrics since 2016; (2) the financing support provided by the Kingdom of Spain (A, Stable) to the regional government which reduces significantly refinancing risks; (3) DBRS Morningstar's view that the relationship between the regional government and the national government has slowly but steadily strengthened over the last years. While the independence question will remain a structural topic in the region over the medium-to-long-term and sporadic tensions could re-emerge, DBRS Morningstar currently expects a relatively smooth economic and financial cooperation between both government tiers and views a political escalation similar to the one that occurred in 2017 as unlikely.

The Stable trend reflects DBRS Morningstar's assessment that the risks to Catalonia's ratings are broadly balanced. The economic outlook remains clouded with uncertainties to inflationary pressures and the complete resolution of the healthcare situation. Nevertheless, Catalonia's finances have so far weathered relatively well the economic shock of the Coronavirus Disease (COVID-19) pandemic, supported by the extraordinary financial transfers provided by the national government to all Spanish regions.

While the region's debt metrics have improved since 2017, they remain high by national and international standards and continue to weigh on its ratings. In addition, although it has improved, the political environment in the region is likely to remain a challenge for Catalonia's credit ratings over the long-term.

RATING DRIVERS

The ratings could be upgraded if: (1) the relationship between the region and the national government strengthens further, with a long-term solution preventing the emergence of political tensions between both government tiers; (2) the region continues its fiscal consolidation towards a balanced budget position and improves its debt sustainability metrics; or (3) the Kingdom of Spain’s rating is upgraded.

The ratings could be downgraded if: (1) there are indications that a material escalation of the political tensions between both government tiers could affect the financing support received by the region; or (2) there is a structural deterioration in the region’s fiscal performance, leading deficits to widen and placing debt metrics on a deteriorating trajectory.

RATING RATIONALE

The Economic Recovery Is Under Way but Uncertainties Remain Given Inflationary Pressures in Europe

The COVID-19 outbreak significantly affected the Spanish and the regional economies in 2020. Catalonia's gross domestic product (GDP) decreased by 11.5%, marginally worse than Spain's 10.8% decline, largely reflecting the extent of the healthcare crisis, the stringency of the lockdown that followed, and the high concentration of economic activity in sectors severely affected such as tourism. Last year, Catalonia's GDP increased slightly faster than the national average, at 5.8% according to provisional estimates by the regional statistical institute Idescat, compared with 5.1% for the national average. The regional economy is expected to have continued to recover this year, broadly in line with the national average. DBRS Morningstar expects a strong tourism performance and solid job creation to support Spain's GDP, but inflationary pressures, particularly higher energy prices, increasing funding costs, and a weaker external backdrop are likely to weigh on growth afterwards. Amid this background, the European Commission revised its forecast for Spanish GDP growth to 4.0% in 2022 and 2.1% in 2023.

Despite the strength of the COVID-19 shock, the supportive measures taken by the national government during the pandemic, as well as the financial resources expected from the Next Generation EU (NGEU), including the Recovery and Resilience Facility (RRF) and REACT-EU funds, should continue to alleviate the long-term impact of the pandemic and support the recovery. DBRS Morningstar therefore takes the view that long-term risks related to COVID-19 appear to have receded, as exemplified by the strong performance of the labour market in recent months. As of Q2 2022, Catalonia's unemployment rate stood at 9.3%, the lowest rate since 2008, compared with 10.5% at the end of 2019 and a peak of 13.9% in Q4 2020. Going forward, the impact of higher inflation on consumption and investment as well as the speed of absorption of EU funds will remain key areas of focus for DBRS Morningstar to assess the strength of the recovery within the region's territory.

Political Dialogue Between Region and National Government Strengthens their Relationship

On the political front, the regional government has been led by Pere Aragonès from Esquerra Republicana de Catalunya (ERC) since May 2021. Pro-independence parties including Junts Per Catalunya and CUP currently maintain a majority in the regional parliament with 74 seats out of 135. Although the independence question remains critical for the current government, DBRS Morningstar considers that the regional rhetoric on this topic has been more oriented towards political dialogue than direct confrontation. This has been confirmed since Summer 2021 with the resumption of bilateral discussions between the region and the national government, either in the form of a purely political "mesa de dialogo", with the last one held in July 2022, or more technical ones, intended to making progress on economic and fiscal arrangements, such as the one that occurred in June 2022 ("Comisión Mixta de Asuntos Económicos y Fiscales Estado-Generalitat").

While the regional government has so far continued to voice its request to organise a formal referendum on independence, finding a short-term solution to this question appears unlikely. Over the medium-term, some political tensions are likely to re-emerge but DBRS Morningstar expects the tone of the political interaction between the regional and the national governments to remain less confrontational. DBRS Morningstar also notes that the region managed to approve its annual budget for 2022 before the end of the previous year for the first time since 2010. The budget was passed without the support from CUP but thanks to the abstention of En Comú Podem the regional party affiliated of the national far-left party Unidas Podemos. DBRS Morningstar will continue to monitor the political landscape in Catalonia, particularly the dynamic across political parties in the Catalan parliament, to evaluate for any impact on its assessment of the political environment in the region.

Fiscal Performance Continues to be Supported by the National Government’s Financial Transfers

On the fiscal front, Catalonia’s performance has remained relatively stable in the last few years with the region recording a small but recurring fiscal deficit. When considering the deficit-to-GDP ratio, which includes some European System of Accounts (ESA) accounting adjustments, consolidated accounts and excludes NGEU funds, the region is estimated to have reduced its deficit to 0.39% of GDP in 2021, supported by the economic recovery and the extraordinary transfers from the national government. This corresponds to an improvement from the deficit of 0.44% recorded in 2020 and the deficit of 0.65% of GDP in 2019. DBRS Morningstar views positively the fiscal improvement recorded by the region since 2016, but continues to consider that maintaining moderate deficits will remain challenging, as government extraordinary measures are wound down and inflationary pressures linger. DBRS Morningstar will monitor the potential pass through of inflation to structural regional expenditure, such as personnel and healthcare related costs, as this may negatively affect regional finances, particularly if coupled with an increase in financing costs and a slowdown in economic growth.

In 2022, the national government is maintaining a high level of transfers (entregas a cuenta) to its regions. These transfers within the regional financing system will also be complemented with extraordinary transfers of EUR 7.0 billion meant to compensate regions for a negative fiscal settlement related to 2020 and a VAT payment shortfall from 2017. While these additional funds will continue to support regional finances in 2022, they represent a substantial decrease compared to the extraordinary COVID-19-related transfers received in 2020 and 2021 of EUR 16.0 billion and EUR 13.5 billion, respectively. As a result, addressing the share of new expenditure incurred during the pandemic, particularly healthcare related, that is likely to remain structurally higher, will remain critical for regions to maintain a sound budgetary position over the medium-term. Latest forecasts from AIReF point to a deficit of 0.9% of GDP for the Spanish regional tier this year, versus a reference rate set at 0.6% for 2022, due to higher expenditure incurred and lower revenues related to European funds. According to those AIReF's forecasts, Catalonia's deficit in 2022 would reach 1.2% of GDP, versus 0.6% for the region's own deficit forecast.

As a result, DBRS Morningstar's analysis of the region's fiscal and economic performance will continue to focus on (1) the level of national government transfers to its regions; (2) the effectiveness of the regional government's control over structural expenditure; and (3) the speed of absorption of EU funds. Nevertheless, the sharp increase of the 2023 amounts related to the regional financing system announced by the national government in July 2022 (+ 24% on a consolidated basis for Spanish autonomous communities) should alleviate the budgetary pressure on autonomous communities in the short term.

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

DBRS Morningstar expects Catalonia's financing needs to continue to benefit from the national government's support. Such financing is critical for the region's credit ratings. DBRS Morningstar’s adjusted debt for Cataloniais very high, at close to EUR 85 billion at the end of 2021. This represents 232.5% of the region's operating revenues, decreasing from 277% in 2019, in part due to the substantial increase in transfers received from the national government in the last two years which inflated revenues; or around 37% of the region's GDP compared with 34% in 2019. DBRS Morningstar gains comfort around the region's debt sustainability given the support it receives from the national government. The Spanish Treasury currently holds more than 80% of Catalonia's debt stock (Banco de España data) and the region has benefited from very low funding costs in recent years. While the healthcare crisis has been challenging for regional finances, DBRS Morningstar continues to consider that Catalonia remains committed to strengthening its financial performance over the medium-term.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Social (S) Factors

The Passed-through Social credit considerations have a relevant effect on the ratings, as the social factors affecting the Kingdom of Spain’s ratings are passed-through to Catalonia.

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.

RATING COMMITTEE SUMMARY

DBRS Morningstar’s European Sub-Sovereign Governments Scorecard generates a result in the BBB (high) – BBB (low) range.

The main points discussed during the Rating Committee include the political environment in the region and its impact on the region’s relationship with the national government, the region’s financial performance and the support received from the national government, the region’s high debt metrics and the medium-term economic and public finances prospects for the region, the region’s economic recovery including its tourism sector.

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/402326/spain-kingdom-of-sensitivity-analysis-of-the-relevant-key-rating-assumptions

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 Rating European Sub-Sovereign Governments (August 12, 2022) https://www.dbrsmorningstar.com/research/401273/rating-european-sub-sovereign-governments. 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 Autonomous Community of Catalonia for financial position, budgetary execution and debt structure for the 2016-21 period, Catalonia’s Investor Presentation, Bank of Spain for the debt stock during the period between 2016 and Q1 2022, Independent Authority for Fiscal Responsibility (AIReF) for its July 2022 report on the 2022 budgetary execution, Instituto Nacional de Estatística (INE), Ministry of Finance; the 2020 European Social Progress Index from the European Commission. 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.

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/402452.

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

Lead Analyst: Mehdi Fadli, Vice President, Global Sovereign Ratings
Rating Committee Chair: Thomas R. Torgerson, Managing Director, Co-Head Global Sovereign Ratings
Initial Rating Date: February 1, 2019
Last Rating Date: March 11, 2022

DBRS Ratings GmbH, Sucursal en España
Paseo de la Castellana 81
Plantas 26 & 27
28046 Madrid, Spain
Tel. +34 (91) 903 6500

DBRS Ratings GmbH
Neue Mainzer Straße 75
60311 Frankfurt am Main Deutschland
Tel. +49 (69) 8088 3500
Geschäftsführer: Detlef Scholz
Amtsgericht Frankfurt am Main, HRB 110259

For more information on this credit or on this industry, visit www.dbrsmorningstar.com.