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 Spain’s gradually improving public finance metrics against a more challenging macroeconomic environment. Despite the headwinds from Russia’s invasion of Ukraine, Spain’s GDP grew by 5.5% in 2022, helped by the strong recovery in foreign tourism and the government’s measures to shelter the private sector from the energy and inflation shock. Spain’s growth outlook remains moderate in 2023 as sticky inflation and higher interest rates, in a context of weaker external demand, will likely make a larger dent on consumption and investment. However, the resilience of the labour market, the execution of the European Union (EU) funds, and the government’s support help offset these risks. On the fiscal front, another year of strong revenue growth and an accelerated withdrawal of Coronavirus Disease (COVID-19) support should compensate for the fiscal costs related to the government’s response to the inflation shock. The fiscal deficit is expected to drop below 5% of GDP in 2022 and this ratio, along with the public debt ratio, will likely decline further in 2023. However, 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 its 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 economic performance. By contrast, Spain’s high public debt ratio limits the government’s space to respond to shocks and weighs on fiscal accounts. Spain’s volatile employment dynamics, high structural unemployment, and sluggish labour productivity performance remain structural challenges, limiting income per capita and potential growth. The incentives provided by European funds have partly alleviated the constraints imposed by the domestic political climate, which has challenged previous administrations’ stability and ability to pass legislation. 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 medium-term growth outlook, 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 Recovery in Tourism Helped Growth in 2022, but a Slowdown is Underway in 2023

During 2014–19, Spain experienced a period of strong economic performance and job creation when GDP grew by 2.6% annually and 2.7 million jobs were created. The pandemic halted this progress as it heavily affected Spain’s significant tourism-related sector and triggered a GDP contraction of 11.3% in 2020, the most pronounced in the EU-27. The reopening effects, including the return of foreign tourism, and the government’s support measures in response to the pandemic and energy crises have supported the post-pandemic recovery with GDP growing by 5.5% both in 2021 and 2022. A stronger labour market and the excess savings accumulated during the pandemic also helped absorb the rapid surge in costs of living. Employment stood over 20 million and the unemployment rate at 13.0% in Q4 2022, marking an improvement from pre-pandemic levels and with a significant decline in temporality. On the other hand, the Spanish GDP recovery has lagged that of the euro zone, partly because of a sluggish recovery in private consumption and construction investment. According to INE’s flash estimates, as of Q4 2022, GDP was still 0.9% below its pre-pandemic peak. Headline inflation has receded and stood at 5.9% YoY in January 2023 driven by lower energy prices and public intervention. It is expected to remain sticky as core inflation remains very high in part driven by food inflation and the past increases in energy costs have not been fully passed-through. On a positive note, wage growth has remained moderate, reducing the risks of a second round effects.

While the impact of the conflict in Ukraine has so far been far less damaging than anticipated, the slowdown in activity has been increasingly visible as reflected by the quarter-on-quarter contraction in private consumption, investment, and exports during Q4 2022, according to flash estimates. The impact of sticky inflation, higher rates, and weaker external demand is expected to take a more significant toll on private consumption and investment during the first half of 2023, although the risks of energy rationing in Europe and energy prices have receded this winter. The International Monetary Fund (IMF) projects growth of 1.1% in 2023 before firming up to 2.4% in 2024. The strength of the labour market and some firepower from the pandemic-related excess savings should help to at least partially absorb the higher costs of living while the EU funds support investment dynamics. The main downside risks are linked to the evolution and the ramifications from the conflict in Ukraine, a more aggressive monetary policy response if inflation is more persistent than anticipated, and a more pronounced global slowdown.

DBRS Morningstar will continue to assess the medium- to long-term effects of the reforms and investments included in Spain’s recovery plan. Spain was the first Member State to request the third disbursement in November 2022 that if approved would mean 30% of the milestones and targets would have been achieved and the country would have received 50% of the EUR 70.0 billion in grants originally estimated under the European Commission’s (EC) Recovery and Resilience Facility (RRF). Also, the government will soon submit an addendum to request access to an additional EUR 7.7 billion in grants and EUR 84.0 billion in loans that if approved could help avoid the cliff-effect for investment after 2023. In terms of execution, the government projects expenditures of 2.0% of GDP in 2022 and 1.7% of GDP in 2023 to be financed with RRF grants, although the actual macroeconomic impact is more difficult to estimate. In terms of reforms, the labour market reform passed into law in December 2021 has yielded positive results, reducing Spain’s temporality rate by 7.5 percentage points by end-2022.

The Fiscal Position Improved Driven by Strong Revenue Growth and the Removal of Coronavirus Support

The pandemic and energy crises have heavily affected Spain’s fiscal performance. The collapse in output and the impact of coronavirus support led to a significant widening in Spain’s fiscal deficit to 10.1% of GDP in 2020—the largest in the EU-27—from a deficit of 3.1% of GDP in 2019. Since then, the fiscal deficit narrowed to 6.9% of GDP in 2021 on the back of strong fiscal revenues in the context of high nominal growth and employment gains as well as a reduction in the fiscal impact of coronavirus-related measures from to 3.0% of GDP in 2021 3.9% of GDP in 2020. The accelerated withdrawal of coronavirus support, which is estimated to have represented only 0.3% of GDP in 2022, combined with another year of strong revenue growth should compensate for the fiscal cost related to the government’s response to the inflation shock. According to the Independent Authority for Spanish Fiscal Responsibility’s latest estimates, the fiscal deficit will narrow to 4.5% of GDP in 2022. The cost of the energy measures is estimated to have reached EUR 22.8 billion in 2022 (1.6% of GDP), including tax cuts on electricity and gas, a fuel rebate, and several subsidies to vulnerable households and the economic sectors affected by the energy shock. The government approved a new package for EUR 12.3 billion (0.9% of 2022’s GDP), extending the bulk of the measures until the end of June 2023 (with the exception of the fuel rebate) and adding tax cuts on basic foods. New temporary taxes on energy companies, banks, and high-net-worth individuals partially offset the cost of these measures. The government estimates that these new taxes could generate around EUR 5.0 billion annually (0.4% of 2022’s GDP) in 2023 and 2024, although they are subject to litigation risk.

The government projects the fiscal deficit to narrow to 3.9% of GDP in 2023, 3.4% of GDP in 2024, and 2.9% of GDP in 2025. The fiscal deficit declines related to cyclical factors. Therefore, tackling the post-pandemic structural deficit will require the implementation of a credible fiscal consolidation plan. The main near-term risks to fiscal improvement are linked to the evolution of the economy and the energy crisis, potentially weighing on revenues and/or triggering the need for additional support. Over the medium term, the expenditure pressures from an ageing population (please see: Spain: Pension Indexation Reduces Fiscal Flexibility, https://www.dbrsmorningstar.com/research/406038), defence commitments, and higher interest rates will increasingly weigh on public finances. The discussion around potential measures to strengthen the pension system’s sustainability and plans for comprehensive tax reform could present opportunities in this direction.

Public Debt Remains High, but Affordability and Favourable Dynamics Mitigate Risks

Spain's public debt ratio, among the highest in the EU-27, remains an important credit challenge, reducing its fiscal space and increasing its vulnerability to shocks. The pandemic contributed to a sharp increase in Spain's public debt ratio to 120.4% of GDP at the end of 2020 from 98.3% of GDP at the end of 2019. After a small drop in 2021, the IMF projects that the debt ratio declined to 112.8% in 2022 driven by high nominal GDP growth and a narrowing fiscal deficit ratio. Going forward, the IMF expects the debt ratio to decline only gradually to 109.0% by 2025, similar to the government’s projected levels in its Stability Programme Update 2022–2025. As the tailwinds from nominal GDP growth lose strength, 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.

Amid high inflation and the European Central Bank’s (ECB) monetary policy tightening, the average Spanish 10-year government bond yield rose to 3.2% in January 2023 from 0.4% in December 2021. While the average cost of new issuances rose to 1.35% in 2022 from -0.04% in 2021, the average cost of outstanding debt only increased to 1.73% in 2022 from 1.64% in 2021. Indeed, Spain’s favourable debt profile will help to smooth out the impact of higher rates on public finances over time. 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 annual interest bill. The government projects that the interest burden as a percentage of GDP will increase to 2.4% of GDP in 2023 from 2.2% in 2021 and 2022. DBRS Morningstar continues to view the euro-area membership as an important safeguard. While the ECB has tightened monetary policy to combat elevated inflation in the euro area, under its Transmission Protection Instrument, the ECB can purchase bonds of a sovereign that faces sharp interest rate increases that are not justified by fundamentals under certain conditions. Furthermore, domestic financial institutions and increasing appetite from retail investors should alleviate the impact of the ECB’s quantitative tightening starting in March 2023. 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

In general, Spanish banks have weathered the pandemic-related shock well and will face the current more challenging macroeconomic environment with higher solvency levels and lower nonperforming loan (NPL) ratios than before the pandemic. According to the European Banking Authority, Spanish banks’ CET1 capital ratio stood at 12.5% and NPLs stood at 2.7% of total loans in Q3 2022. Spanish banks’ credit quality and credit supply held up well during the pandemic, in part thanks to support measures introduced by the government and European institutions. Spanish banks are generally well positioned to benefit from higher interest rates as a large portion of their loan book is referenced to variable rates and deposit rates should increase to a lesser extent (please see: Spanish Banks' Profitability to Benefit from Higher Interest Rates, https://www.dbrsmorningstar.com/research/409685). While the higher prices and interest rates will weigh on borrowers’ capacity to repay their debt, the potential deterioration in asset quality should remain manageable and start from a low base. The risks of a disorderly downturn in the housing market affecting the overall economy appear to be limited. Spain’s housing market dynamics have been more moderate since the pandemic compared with other developed markets. DBRS Morningstar considers a strong labour market, lower debt levels, the new package of relief measures for vulnerable borrowers, and the increasing use of fixed-rate mortgages in recent years to be mitigants against asset quality and housing market risks.

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. After a period of political instability and no meaningful progress on reforms, the minority government lead by the Spanish Socialist Workers' Party mustered sufficient support in parliament to push through reforms, helped by the momentum from the NextGenerationEU funds. Going forward, DBRS Morningstar expects the implementation of Spain’s 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. The pro-independence movement continues in Catalonia; however, tensions have eased significantly in recent years. DBRS Morningstar takes the view that the economic and financial institutional relationship between these tiers of government will not deteriorate significantly even if tensions escalate in the future.

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

Spain’s external accounts have improved significantly for more than a decade and there is no indication of imbalances building up, in contrast with the runup to the global financial crisis. Between 2012 and 2021, Spain posted ten consecutive years of current account surpluses averaging 1.7% of GDP, reversing a period of current account deficits averaging 5.6% of GDP between 2000 and 2011. Despite the surge in energy prices and Spain’s reliance on energy imports, the strong recovery in tourism exports will most likely keep the current account in balance or slightly positive. After two years of disruptions, international tourist arrivals and international tourist spending in 2022 reached 85.7% and 94.7% of the levels in 2019, respectively. This sequence of current account surpluses, combined with growing nominal GDP, drove the improvement in Spain's net international investment position to -59.4% of GDP in Q3 2022 from -97.7% of GDP in Q2 2014. While Spain’s still-elevated net debtor position exposes the country to sudden changes in investor sentiment and capital flows, DBRS Morningstar considers that Spain’s net lending to the rest of the world over the last decade mitigates this risk.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Social (S) Factors
The Human Capital and Human Rights factor affects the ratings. DBRS Morningstar considers this factor significant and has taken it into account within the Economic Structure and Performance building block. Spain’s GDP per capita, estimated at USD 29,198 in 2022 according to the IMF, remains relatively low compared with its European peers.

There were no Environmental or Governance factors that had a significant or relevant effect on the credit analysis.

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 (May 17, 2022).

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/410073.

EURO AREA RISK CATEGORY: LOW

Notes:
All figures are in euros 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). In addition, DBRS Morningstar uses 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-andgovernance-risk-factors-in-credit-ratings (May 17, 2022) in its consideration of ESG factors.

The sources of information used for this rating include the Ministry of Economic Affairs and Digital Transformation (Draft Budgetary Plan 2023; Recovery Plan Draft Addendum December 2022), Ministry of Finance (MoF’s Presentation January 2023), Bank of Spain (Macroeconomic Projections 2022-2025), National Statistics Office, General State Comptroller (IGAE), Independent Authority for Fiscal Responsibility (Monthly Monitoring of the Stability Objective 2022), Spanish Treasury (Treasury’s Presentation January 2023), State Official Gazzette (Climate Change and Energy Transition Law, May 2021), ECB, European Banking Authority, EC, Politico Poll of Polls, Eurostat, Bank for International Settlements, Organisation for Economic Co-operation and Development, International Monetary Fund (WEO October 2022 and January 2023 and IFS), World Bank, the Social Progress Imperative (2022 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/410069.

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: September 2, 2022

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