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 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 view that the risks to the ratings are balanced. The next general election to take place on July 23, 2023 increases policy uncertainty for the upcoming legislature. Nevertheless, DBRS Morningstar expects continuity on the implementation of the Spain’s recovery plan and committed fiscal path. Spain’s economic growth is expected to remain solid albeit decelerating after two years of strong recovery. The risks from the energy crisis receded and headline inflation eased significantly in Spain in recent months. However, stubbornly elevated core inflation and uncertainty about the lagged effects from the rapid monetary policy tightening remain a source of risk to growth. Against this background, Spain continued repairing its public-sector balance in 2022 whilst introducing temporary measures to counter the effects of the energy and inflation shock. The fiscal deficit narrowed to 4.8% of GDP in 2022, driven by strong revenue growth and shrinking fiscal impact of the Coronavirus Disease (COVID-19) support measures. Public debt declined significantly to 113.2% of GDP in 2022 from 120.4% of GDP in 2020 but remains well above pre-pandemic levels. The effects from nominal growth and narrowing fiscal deficits bode well for public debt reduction in the next couple of years; however, keeping public debt on a more permanent downward trend will most likely require new measures going forward.

Spain’s 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. The external sector was an important contributor to growth in 2022, helped by the recovery in foreign tourism, and the current account remained in surplus in spite of the sharp increase in energy import prices. On the other hand, Spain’s high public debt ratio limits the government’s space to respond to shocks and weighs on fiscal accounts, especially in the context of higher funding costs and increasing age-related expenditures. Spain’s historically volatile employment dynamics, high structural unemployment, and sluggish labour productivity performance remain structural challenges. These limit the growth of income per capita and output potential, even though the new labour market reform is significantly reducing the share of temporary contracts in Spain. The institutional and territorial challenge posed by the pro-independence movement in the Autonomous Community of Catalonia (rated BBB (low) with a Stable trend by DBRS Morningstar) remains very limited although political tensions might resurface after the next general elections.

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 or weaker fiscal discipline; or (2) although unlikely at the moment, institutional and territorial challenges that would substantially erode the country’s economic and financial profile.

RATING RATIONALE
This Year’s General Elections Raise Policy Uncertainty; DBRS Morningstar Expects Broad Policy Continuity on Reforms and Fiscal Path

Spain benefits from strong political institutions that support its economy. The centre-left minority government led by the Spanish Socialist Workers' Party, with the left-wing United Podemos party as a junior coalition partner and the support of smaller regional and nationalist parties, has made good progress in implementing Spain's recovery plan and in the gradual reduction of the fiscal deficit since the pandemic. Following an electoral defeat in the regional and municipal elections that took place on May 28, 2023, Prime Minister Pedro Sánchez decided to call snap elections for July 23, 2023. While the centre-right Partido Popular party emerges stronger from the recent sub-national elections and is leading the opinion polls, the potential composition and policies of the next administration remain unclear. A fragmented and polarised political backdrop might complicate and reduce the chances of broad political alliances, elevating the risk of a hung parliament if there is no clear political mandate for any of the political blocs. However, DBRS Morningstar sees limited risks of a reversal on key reforms and commitments outlined in Spain’s Recovery Plan that could complicate future disbursements, although some delays might occur. From a public finance perspective, the expected reactivation of EU fiscal rules in 2024 will limit the fiscal space for the next administration and the risks of deviation from the currently projected fiscal path.

The pro-independence movement continues in Catalonia, though tensions have eased significantly in recent years. This might be challenged after the next general elections. However, DBRS Morningstar considers that the economic and financial institutional relationship between these tiers of government will not deteriorate significantly even if tensions escalate in the future.

Spain’s Economic Growth to Slow Down In 2023 But To Remain Robust Over Time

The Spanish economy recovered strongly over the past two years and was nearing its pre-pandemic real GDP by Q1 2023, but is still lagging behind the euro-area post-pandemic recovery. After a sharp contraction of 11.3% in real GDP in 2020, the most pronounced in the EU-27, Spain grew by 5.5% both in 2021 and 2022. The return of foreign tourism, solid job gains, and the fiscal impulse have supported the post-pandemic recovery. The strength of the labour market and the speed of its recovery, in part due to the government’s support measures, are positive compared with previous crises. Both employment levels and unemployment rates are better than before the pandemic with a significant decline in temporality. While these are positive developments, Spain’s relatively low productivity and still-low employment rates have limited its ability to converge towards the euro area’s GDP-per-capita levels.

The risks associated with the energy crisis receded this past winter. Seasonally adjusted real GDP grew by 0.5% quarter over quarter in Q1 2023, driven by the external sector’s strong performance and the recovery in investments after a decline in the second half of last year. The negative effects of inflation and tighter financial conditions have dented private consumption, which contracted by 2.9% during the last two quarters. Conversely, the dynamism in the labour market, expected recovery in purchasing power, and the execution of EU funds should lend support to growth in coming quarters. Furthermore, if competitiveness is preserved, the external sector’s good performance bodes well in coming years. The European Commission (EC) expects real GDP growth of 1.9% in 2022 and 2.0% in 2023. The main downside risks are linked to the effects of tighter financial conditions on investment and consumption dynamics, especially in a scenario where the European Central Bank (ECB) needs to tighten monetary policy further or for longer than expected in response to stubbornly high core inflation in the euro area.

DBRS Morningstar will continue to assess the medium- to long-term effects of the reforms and investments included in Spain’s recovery plan. The country has made significant progress in its implementation, but the macroeconomic impact and effects on potential growth are more difficult to estimate. Spain has already received more than 50% of the EUR 70.0 billion in grants originally estimated under the EC’s Recovery and Resilience Facility. At the start of June 2023, the government approved and submitted to the European Commission an addendum to request access to an additional EUR 7.7 billion in grants and EUR 84.0 billion in loans which, if approved, could help to avoid the cliff effect for investment after 2023.

The Fiscal Position Improves 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 the country’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 and 4.8% of GDP in 2022 on the back of strong fiscal revenues as well as a reduction in the fiscal impact of coronavirus-related measures. Public revenues grew at 12.9% in 2021 and 8.1% in 2022 driven by economic growth, job gains, and higher inflation. Coronavirus support represented only 0.4% of GDP in 2022 and was completely phased out by the end of the year. The pace of deficit reduction was slowed down by the fiscal costs associated with measures to counter the effects of the energy crisis and high inflation, which the government estimates at 1.7% of GDP in 2022 and 1.2% of GDP in 2023. These measures are expected to be fully phased out by the end of 2023 and will only be partially compensated by temporary levies on energy companies, banks, and high-net-worth individuals that the government estimates could generate around EUR 4.5 billion annually in 2023 and 2024.

In its Updated Stability Programme 2023-2026 (USP), the government expects that the fiscal deficit will narrow to 3.9% of GDP in 2023. The fiscal deficit ratio reduction in 2023 is mostly driven by the absence of coronavirus measures, continued dynamism of revenues, and moderate spending growth. Deficit projections over the forecast horizon improve when compared with previous stability programmes. The USP projects a deficit of 3.0% of GDP in 2024 and further declines to 2.7% of GDP in 2025 and 2.5% of GDP in 2026. The expected re-activation of the fiscal rules in 2024 will limit the room for manoeuvre for the next administration. DBRS Morningstar considers the main risks are on the revenue side in light of the very strong performance in recent years, especially if the economic deceleration is more pronounced than anticipated.

Over the medium to long term, expenditure pressures that an ageing population places on pensions, healthcare, and long-term care as well as higher funding costs are expected to weigh on public finances. The Spanish independent fiscal institution (AIReF) estimates that the pension system reform during 2021–23 will result in an increase in the fiscal deficit of 1.1% of GDP by 2050 as the additional expenditure due to the re-indexation of pensions to CPI and the elimination of the sustainability factor (3.5% of GDP) is not totally compensated by the corrective measures adopted (2.5% of GDP). Therefore, new measures will most likely be needed to further shore up the financial sustainability of the system, potentially through the new automatic adjustment mechanism to be considered in 2025 and every three years thereafter.

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. High debt reduces the government’s fiscal space and increases its vulnerability to shocks. After peaking at 120.4% of GDP in 2020, the public debt ratio declined to 113.2% in 2022, mostly driven by high nominal GDP growth and a narrowing fiscal deficit. DBRS Morningstar expects the debt ratio to continue declining more gradually in the next few years. As the tailwinds from nominal GDP growth lose strength and the fiscal pressures from an ageing population and higher interest burden increase, new structural adjustments might be needed to keep the public debt ratio on a firm downward trend. In its USP, the government projects that the debt ratio will continue declining to 106.8% by 2026, driven by a return to primary surpluses by 2025 and a still positive nominal interest- growth differential.

On a positive note, Spain’s responsible debt management in anticipation of the end of the era of exceptionally low rates will help to smooth the inevitable impact of higher funding costs over time. The predominance of fixed-rate bonds, a relatively long average maturity of 7.9 years in 2022, and limited 1-yr refinancing risk of around 13.1% of the stock of debt will delay the impact of higher costs of issuance on the total annual interest bill. The government projects the interest burden to remain unchanged at 2.4% of GDP in 2023 and gradually increase to 2.9% of GDP in 2026. DBRS Morningstar notes that the higher yields mostly reflects an increase in benchmark rates and not the market’s perception of increased sovereign risks as spreads have remained relatively stable. Furthermore, 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. Also, domestic financial institutions and increasing appetite from retail investors should help alleviate the impact of the ECB’s quantitative tightening since 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

The Spanish banking system remains healthy and financial stability risks remain contained following a prolonged period of improvements in its solvency, liquidity, and asset-quality metrics. According to the European Banking Authority, Spanish banks’ CET1 capital ratio stood at 12.6%, loan-to-deposit ratio stood at 99.8%, liquidity coverage ratio stood at 171.1%, and nonperforming loans stood at 2.8% of total loans in Q4 2022. The Spanish banking system has weathered a series of shocks well, including the pandemic, the energy crisis, and the recent financial turbulences. Spanish banks’ fundamentals remained unscathed from the recent banking turmoil, partly reflecting their comfortable liquidity levels, relatively sticky depositor base with a strong retail bias, and diversified balance sheets. Profitability has recovered from the pandemic and Spanish banks are generally well positioned to benefit from higher interest rates, given that more than 70% of the outstanding mortgage stock has been referenced to variable and mixed rates as of December 2022. Regarding deposit costs, rates are slowly starting to increase but to a lesser extent than the banks’ loan book repricing. On the other hand, similar to euro-area trends, financing flows to households and firms have experienced a marked slowdown in 2023 as both banks are tightening credit standards at a time where credit demand is declining.

Higher interest rates are driving up households’ and firms’ debt burdens and have already dampened private consumption and investment dynamics in recent quarters. While this, coupled with the impact of inflation and higher energy costs, will test the most vulnerable borrowers’ capacity to repay their debt, DBRS Morningstar expects the potential deterioration in asset quality to remain manageable and start from a low base. Strong labour market dynamics, households’ lower indebtedness levels than in the past, and the new package of relief measures for vulnerable borrowers support this view. Also, households have increasingly used fixed rates for new mortgages since 2016, which became the predominant mode since 2021. From a housing market perspective, new mortgage flows have declined significantly in 2023 and will most likely lead to a sharp drop in transactions. However, sluggish supply of new housing units and the higher construction costs mitigate the risks of a sharp correction in housing prices.

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. Spain posted average current account surpluses of 1.6% of GDP between 2012 and 2022, reversing a period of current-account deficits averaging 5.6% of GDP between 2000 and 2011. Despite the surge in global energy commodity prices and Spain’s reliance on energy imports, the good performance of service exports, in particular of tourism exports, resulted in a current account surplus of 0.6% of GDP last year. After two years of disruptions, international tourist arrivals and international tourist spending in 2022 reached 85.8% and 94.8% of the levels in 2019, respectively. This sequence of current-account surpluses, combined with a growing nominal GDP, drove the improvement in Spain's net international investment position to -60.5% of GDP in Q4 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 29,421 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 (May 17, 2022) 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/415602.

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 (August 29, 2022), https://www.dbrsmorningstar.com/research/401817/global-methodology-for-rating-sovereign-governments. 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-and-governance-risk-factors-in-credit-ratings, in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at:
https://www.dbrsmorningstar.com/about/methodologies.

The sources of information used for this rating include the Ministry of Economic Affairs and Digital Transformation (Update of Stability Programme 2023-2026; Recovery Plan Draft Addendum December 2022), Ministry of Finance (MoF’s Presentation May 2023), Bank of Spain (Macroeconomic Projections 2023-2025; Annual Report 2022; Spring 2023 Financial Stability Report), National Statistics Office, General State Comptroller (IGAE), Independent Authority for Fiscal Responsibility (Opinion on the Sustainability of Public Administration in the Long Term: the Incidence of Demographics; Report on the Update of Stability Programme 2023-2026), Spanish Treasury (Treasury’s Presentation May 2023), State Official Gazette (Climate Change and Energy Transition Law, May 2021), EC (Spring 2023 Economic Forecast, 2023 Country Report - Spain), EU’s Economic and Financial Committee's Sub-Committee on EU Sovereign Debt Markets (ESDM), ECB, European Banking Authority, Politico Poll of Polls, Eurostat, Bank for International Settlements, Organisation for Economic Co-operation and Development, IMF (WEO 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. For further information on DBRS Morningstar historical default rates published by the Financial Conduct Authority (FCA) in a central repository, see https://data.fca.org.uk/#/ceres/craStats.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/415603.

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: February 17, 2023

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.