DBRS Morningstar Changes Trend on Autonomous Community of Catalonia to Positive, Confirms at BBB (low)

DBRS Ratings GmbH (DBRS Morningstar) confirmed the Long-Term Issuer Rating of the Autonomous Community of Catalonia (Catalonia) at BBB (low) and Short-Term Issuer Rating at R-2 (low). The trend on all ratings has been changed to Positive from Stable.

KEY CREDIT RATING CONSIDERATIONS
The Positive trend reflects DBRS Morningstar's view that the debt relief that the central government is likely to implement for Spanish autonomous communities as a consequence of the recent political agreement between the centre-left Partido Socialista Obrero Español (PSOE) and the pro-independence Catalan party Esquerra Republicana de Catalunya (ERC), is likely to alleviate Catalonia's very high debt burden. Combined with the more favorable fiscal outlook, supported by the expected return of the applicable Budget Stability Law, Catalonia's fiscal and debt performance could substantially improve. Despite some headwinds for the Catalan economy mainly caused by the higher-for-longer interest rate environment and weak external demand, DBRS Morningstar expects lower but steady economic growth in the region, that will enable the fiscal results to be sustainably improved.

Catalonia's credit ratings remain 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 significantly reduces 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 takes the view that the economic and financial institutional relationship between these tiers of government will not deteriorate significantly.

CREDIT RATING DRIVERS
The credit ratings could be upgraded if the debt relief mechanism is implemented and allows for a rapid and substantial reduction of Catalonia's debt burden and, at the same time, the political and institutional relationship between Catalonia and the central government continues towards normalization. Catalonia's ratings could also be upgraded if: (1) the region continues its fiscal consolidation towards a balanced budget position and improves its debt sustainability metrics; or (2) the Kingdom of Spain’s rating is upgraded.

The Positive trend on the ratings could return to Stable if the debt relief is not implemented or its characteristics, including its magnitude, are insufficient to allow for a rapid and substantial reduction of Catalonia's debt burden. Catalonia's 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 to a wider deficit and placing debt metrics on a deteriorating trajectory.

CREDIT RATING RATIONALE
Central Government To Assume Part of Catalonia’s Debt Within Normalized Relationship And Changes to the Regional Framework May Arise From Latest Political Agreements

In November, 2023, a coalition government was formed by the center-left Partido Socialista Obrero Español (PSOE) and left Sumar parties in the Kingdom of Spain. PSOE gained support from Sumar parties and from pro-independence Catalan parties (Esquerra Republicana de Catalunya (ERC) and Junts per Catalunya) along with other regional parties. In order to gain enough support, several political agreements were reached, which include the reform of the financing system for the regions with Sumar, institutional and law arrangements with both ERC and Junts per Catalunya, agreements related to the broadening of responsibilities of Catalonia, and to a debt relief for the regions. Few details on the form, date and magnitude of these commitments is made available. Therefore, DBRS Morningstar will continue to monitor the progress of these potential changes to assess any financial impact or influence on the institutional framework and/or to the financial stance of the regions.

Specifically in relation to the political agreement between PSOE and ERC, there is a commitment to debt relief for Catalonia that is expected to be extended to all the autonomous communities except Basque Country and Navarre. Despite the uncertainty, DBRS Morningstar understands that it is likely that the central government would take over part of the debt accumulated by the autonomous communities since 2012 and considers that such a mechanism would likely improve the financial metrics of the regions, although the magnitude of this improvement is likely to vary from one region to the other. Specifically for Catalonia, the measure is meant to reduce its debt by around EUR 15 billion or 17%, out of a total of EUR 86.5 billion of debt at the end-2022. Assuming all other factors remain stable, adjusted debt to operating revenue could improve to the range 200%-210% from around 250% in 2022 according to DBRS Morningstar estimates. This would mean a substantial decrease of Catalonia's high debt level and DBRS Morningstar understands that Catalonia's ability to pay their financial commitments will be enhanced if this commitment is materialized.

The relationship between the two governments, that serve as the link for the effectiveness of the institutional framework, have improved in recent years and this relationship remains a key credit rating factor. However, particularly in Catalonia, there is a pro independence movement that has previously caused some uncertainty of the overall effectiveness of the system under a low level of collaboration. While the independence question will remain over the long-term and potential political tensions could re-emerge sporadically even if the aforementioned institutional and law arrangements materialise, DBRS Morningstar takes the view that the economic and financial institutional relationship between these tiers of government will not deteriorate significantly. Still, remaining uncertainties regarding the evolution of the political environment continues to weigh on DBRS Morningstar’s assessment of the overall relationship between the region and the national government compared with its national peers, but to a lesser extent than in the past. DBRS Morningstar will continue to monitor the political landscape in Catalonia, particularly the dynamic across political parties in the Catalan and National parliament, to evaluate for any impact on its assessment of the political environment in the region.

Catalonia’s Indebtedness Returned to a Decreasing Path Over the Last Years But Central Government Liquidity Support Remains Key

Despite the higher 2022 deficit, during the last five years the deficit reduction trend has contributed to containing the debt stock increase. DBRS Morningstar’s adjusted debt for Catalonia amounted to EUR 86.6 billion at the end of 2022, moderately increasing from EUR 81.1 billion at the end of 2017. However, its indebtedness, as a percentage of GDP, has decreased to 33.8% of GDP at the end of 2022, versus 36.9% of GDP in 2021. The Independent Authority for Fiscal Responsibility (AIREF) expects the debt ratio to decrease to 31.1% at the end of 2023, in 2024 it should keep decreasing to 30.1% and AIREF expects that trend to continue over the medium term. Moreover, the Catalan debt could potentially decrease even further than currently expected by AIREF if the debt relief agreed between PSOE and ERC materialises.

Catalonia's debt and liquidity management practices are conservative and largely follow the guidelines provided by the central government, thus Catalonia's debt structure is conservative. At the end of June 2023, most of Catalonia's debt is at fixed interest rates, amounting to 97% of debt stock. However, the region's relatively short weighted average maturity of its debt stock, standing at 4.97 years at the end of June 2023, is likely to translate into higher interest rates following refinancing. However, access to state financing mechanisms is mitigating this condition, as Catalonia has largely benefited from the financing support to the extent that it represented 84% of total regional debt or EUR 73.1 billion. While this support was originally designed to be exceptional, largely to support the Spanish regions’ liquidity, DBRS Morningstar now views it as an ongoing critical credit feature when assessing regional governments’ creditworthiness. At the same time, DBRS Morningstar considers that the debt relief commitment is unlikely to influence the region's debt strategy since the central government is likely to take over debt from the regions regardless of the source of funding used, including either banking, intergovernmental or bond debt.

Favorable Fiscal Prospects Confirmed By Preliminary Budget Data And Management Behaviour to Be Constraint by Fiscal Rules Return

In 2022, the budgetary result deteriorated, resulting in a national accounting standards' financing deficit estimated at 1.5% of GDP from a deficit of 0.4% of GDP in 2021. The deterioration stemmed mainly from lower revenues and increased capital investments. Despite a contraction of operating expenditures, the reduced operating revenues as a consequence of lower extraordinary transfers received from the central government meant that the region increased its operating deficit to EUR 1,968 million (from EUR 1,354 million in 2021). The net capital investment position increased to EUR 1,885 million from EUR 493 million in 2021, increasing the financing deficit to EUR 3,845 million (EUR 1,841 million in 2021).

Despite the recent deterioration of financial performance, DBRS Morningstar takes the view that some exceptional factors affected the 2022 performance and the overall financial performance has not structurally changed. Additionally the likely return of full capabilities of the Budget Stability Law (BSL) would further strengthen fiscal management after the ending of the general escape clause at EU level. AIREF has estimated a deficit at 0.9% of GDP for Catalonia in 2023 and a further improvement of the financing result to a surplus at 0.1% of GDP in 2024, although the Catalan government estimates a deficit at 0.3% of GDP. Up to the end of August 2023, Catalonia's revenues grew by 15% over the same period in 2022 and the region increased operating expenditure by 9%, resulting in an improvement of the operating balance to EUR 2 billion. This fiscal improvement confirms that the 2022 fiscal deterioration was mainly caused by the lack of extraordinary transfers received from the central government to alleviate the impact of the pandemic. Regarding the potential effects that the debt relief may have on the region’s fiscal behaviour, DBRS Morningstar understands that the likely return of fiscal rules in 2024 would leave a reduced fiscal margin for the regions to increase their expenditure significantly and expects the regions keep the current track record of fiscal consolidation by reducing deficit levels.

Continuation of Economic Recovery Benefiting from EU Funds, in Line with the Sovereign, but Still Challenged by the Potential Effects of High Interest Rates and Increased Geopolitical Tensions

During 2022, Catalonia's GDP grew by 5.8%, in line with the growth rate for Spain, and in the second quarter of 2022, the region surpassed its pre-pandemic GDP level reached in the fourth quarter of 2019. During 2022, the services sector was driving growth, whilst the industry sector was moderately weighing on performance as a result of the rapid increase in energy prices and the bottlenecks on world trade supply. For 2024, AIREF's expectation aligns with the region’s growth assumption at 1.8% in its budget estimations. The regional economy is expected to continue growing broadly in line with the national average. DBRS Morningstar expects a continuation of strong tourism performance and robust job market performance to support Spain's GDP growth, but increasing financing costs, and a weaker global economic growth momentum are likely to somewhat weigh on growth in 2023 and 2024.

The European Commission (EC) revised its growth projections for Spain upwards to 2.4% in 2023 and downwards in 2024 to 1.7% growth, in its Autumn 2023 economic forecast, from 2.2% for 2023, and 1.9% for 2024 at Summer. The downside risks relate to the prolonged impact on demand of the tightening financial conditions ,notably due to elevated external public and private debt. Although the increase in households purchasing power combined with the liquidity accumulated over the last years could partly mitigate the headwinds on consumption and investment.

The financial resources expected from the Next Generation EU (NGEU), including the Recovery and Resilience Facility (RRF) and REACT-EU funds, should continue to support reforms and investments. The region estimates revenue received related to these funds at around EUR 4.3 billion up to the end of 2023 and EUR 4.1 billion is already spent while for 2024 the expectation is to implement EUR 0.9 billion. Going forward, the impact of 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 full economic impact.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Social (S) Factors

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

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 (04 July 2023) https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria:-approach-to-environmental,-social,-and-governance-risk-factors-in-credit-ratings

RATING COMMITTEE SUMMARY
DBRS Morningstar’s European Sub-Sovereign Scorecard generates a result in the BBB (high) – BBB (low) range. The main points discussed during the Rating Committee included the financial impacts for Catalonia of the potential debt relief for Spanish autonomous communities, the institutional relationship between Catalonia and the central government, Catalonia's fiscal performance and debt evolution in 2023, financial forecasts and the situation of the regional economy.

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/424856.

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 unless otherwise noted.

The principal methodology is the Rating European Sub-Sovereign Governments (11 August 2023) https://www.dbrsmorningstar.com/research/419048/rating-european-sub-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/416784/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 these credit ratings include Autonomous Community of Catalonia for financial position, budgetary execution and debt structure for the 2016-22 period and preliminary budget execution up to the end of August 2023, Bank of Spain for the debt stock during the period between 2016 and 2022, Independent Authority for Fiscal Responsibility (AIREF) for its October 2023 Budget fundamental lines report, for its April 2022 report on Catalonia’s Initial budget considerations, and for its economic and financial information observatory of Autonomous Communities, Instituto Nacional de Estatística (INE), Ministry of Finance, General State Comptroller (IGAE) and the Autumn 2023 economic forecast 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 credit 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 credit 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://registers.esma.europa.eu/cerep-publication. 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 credit rating assumptions can be found at https://www.dbrsmorningstar.com/research/425382.

These credit ratings are endorsed by DBRS Ratings Limited for use in the United Kingdom.

Lead Analyst: Jorge Espinosa, Assistant Vice President, Credit Ratings, Global Sovereign Ratings
Rating Committee Chair: Thomas R. Torgerson, Managing Director, Credit Ratings, Global Sovereign Ratings
Initial Rating Date: July 06, 2018
Last Rating Date: June 16, 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.