Morningstar DBRS Changes Trends on Kingdom of Spain to Positive, Confirms Ratings at “A”

DBRS Ratings GmbH (Morningstar DBRS) changed the trend on the Kingdom of Spain's Long-Term Foreign and Local Currency - Issuer Ratings to Positive from Stable and confirmed the ratings at "A". At the same time, Morningstar DBRS changed the trend on Spain's Short-Term Foreign and Local Currency - Issuer Ratings to Positive from Stable and confirmed the ratings at R-1 (low).

KEY CREDIT RATING CONSIDERATIONS
The Positive trend reflects Morningstar DBRS' expectation that the consistently strong performance of the Spanish economy, continued reduction of external liabilities, and the steady improvement in public finances will over time reduce credit risk. There are many drivers of Spain's strong economic growth in recent years, including the investment of European recovery funds, the healthy performance of service exports, and the recovery of purchasing power. These forces are likely to endure over the next few years and should mitigate the adverse effects of restrictive monetary policy and downside risks from weaknesses among European peers. The fiscal deficit, having gradually improved in recent years from strong revenue growth, will benefit in the years to come from the complete removal of support measures. The government projects the fiscal deficit to reach 3.0% of GDP this year and for public debt to decline to 105.5% of GDP. While social and political tensions - now a persistent feature of Spain's political environment - could weaken the government's ability to legislate key policies, Morningstar DBRS expects the government to maintain its commitment to fiscal consolidation and to execute its recovery plan.

Spain's credit ratings remain supported by its large and diversified economy, competitive export sector, and euro area membership. Windfalls from EU transfers over the course of this decade will help underpin the country's economic performance. Conversely, Spain's high public debt ratio remains a credit weakness. High debt narrows the government's fiscal space to respond to shocks, accommodate higher funding costs, or address increasing age-related expenditures. Spain's historically volatile employment dynamics, high structural unemployment, and sluggish labour productivity growth remain structural challenges that limit a more meaningful advance of income per capita and output potential. Recent elections in the Autonomous Community of Catalonia appear to reduce the institutional and territorial challenges posed by the pro-independence movement, though political tensions might resurface.

CREDIT RATING DRIVERS
The credit ratings could be upgraded if authorities successfully implement a medium-term plan to rebalance public finances and place the debt-to-GDP ratio on a firm downward trend; or if there is further evidence of successful execution of reforms that improve economic resilience and/or boost potential growth.

The trends on the credit ratings could be returned to Stable if the government is unable to advance its spending plan for meaningful deficit reduction. The credit ratings could be downgraded if a worsening of the medium-term growth outlook or weaker fiscal discipline result in a sustained increase in Spain's already-high public debt ratio; or in the increasingly unlikely event that institutional and territorial challenges erode the country's economic and financial profile.

CREDIT RATING RATIONALE

Fiscal Deficit Reduction To Continue, Compliance With New EU Fiscal Rules Key To Contain Fiscal Slippage

The fiscal deficit is expected to return to its pre-pandemic level this year. From the 3.1% of GDP deficit in 2019, and following the accommodative fiscal policy response to the pandemic and energy crises, the fiscal deficit fell to 3.6% of GDP in 2023. That result was in line with the EU average deficit and down from the 10.1% of GDP deficit peak in 2020. The improvement in the fiscal imbalance stemmed primarily from revenue overperformance as a result of strong nominal GDP growth and gradual unwinding of support measures. Net of extraordinary energy measures, the general government balance was 2.5% of GDP last year. The government's fiscal objective is for a 3.0% of GDP deficit in 2024, as all energy support measures are wound down, and for a deficit of 2.5% in 2025. If the target is achieved next year, the outcome would result in the country's first primary fiscal surplus since 2007.

These more favorable government projections will be challenged by persistent spending demands and policy implementation risks. The government's reliance on support from Catalan pro-independence parties and the delays in the 2024 Budget discussions demonstrate the risk of effective and timely implementation of fiscal policies and reforms. Near-term expenditure pressures stem primarily from increased defense commitments, and over a longer time horizon, expenditure pressures mount on pensions, healthcare, long-term care from the ageing population, and from higher debt servicing costs. Additional measures will most likely be needed in the years to come to address these structural spending challenges. Yet, Morningstar DBRS is of the view that the reactivation of EU fiscal rules and the government's fiscal consolidation track record re-enforce its commitment to rebalancing public accounts.

Overperformance Of The Spanish Economy Has Been Broad-Based

Spain's economic recovery has been stronger than previously anticipated and supported across all GDP components. The return of tourism and non-tourism services boosted external demand, while lower inflation and improving purchasing power, the strength of the labour market, government support measures, healthy private sector finances, and absorption of EU investment funds propped up domestic demand. Real GDP expanded on average by 6.1% in 2021-2022 - following the sharp 11.2% contraction in 2020 - and the economy expanded by 2.5% last year, well above the euro area's average 0.5% growth rate. The EC expects the Spanish economy to expand by around 2.0% in each of the next two years, continuing its multiyear overperformance of many of its EU peers.

Downside risks to the near-term growth outlook stem from a more pronounced downturn in Europe, an escalation in geopolitical tensions across various fronts that once again drive up energy prices and the rate of inflation, and a stronger-than-expected impact of higher interest rates on domestic borrowers. Likewise, Morningstar DBRS considers medium-term growth prospects to be largely contingent on the government's ability to pass key reforms linked to the EU transfer grants and loans, including the NextGenerationEU (NGEU) funds, and effectively absorb structural funds from the Multiannual Financial Framework (MFF). The updated NGEU Spanish Recovery Plan alone, if fully implemented, is set to mobilise up to EUR 163 billion during 2021-26 (more than 12% of GDP). These long-term investments are critical for Spain to improve on its capital stock, its relatively low levels of productivity, and its ability to more rapidly converge towards the euro area's GDP-per-capita levels. The country has thus far made significant progress in the implementation of its recovery plan, but the macroeconomic effects on potential growth are difficult to estimate.

Spain's Public Debt Ratio Is Falling But Remains High
Spain's public debt ratio, still among the highest in the EU, remains an important credit challenge. High debt reduces the government's fiscal space and increases its vulnerability to shocks. After peaking at 120.3% of GDP in 2020, the public debt ratio declined to 107.7% in 2023. The positive nominal interest-rate GDP-growth differential and lower deficits are the main drivers of the downward debt trajectory. The government projects debt to reach 105.5% of GDP this year and 104.1% next year. If successful, this would constitute a 16 percentage points of GDP decline in the debt ratio from 2020-2025. For it to remain on a firm downward trend, Morningstar DBRS expects the government to remain committed to its objective to persistently consolidate its fiscal accounts over the medium-term.

The Spanish Treasury has successfully managed the shock associated with higher interest rates and funding costs. Effective debt management is characterised by the predominance of fixed-rate bonds and a relatively long average maturity profile (7.9 years). These features delay the impact of higher issuance and interest costs. The government projects the interest burden to remain unchanged at 2.5% of GDP in 2024-2025, up from 2.0% in 2021, but still below the 3.6% of GDP interest cost in 2013. The IMF expects the interest bill to stabilize at 2.7% over its forecast period. There has been a noticeable increase in the appetite from retail and institutional investors for Spanish bonds, helping to alleviate the impact of the European Central Bank's (ECB) quantitative tightening. Though not currently the case for Spain, the ECB can still under certain conditions purchase bonds of a sovereign that faces sharp interest rate increases not justified by fundamentals. This ECB financial backstop, Spain's favorable debt structure, and the downward sloping trajectory of the debt ratio all support the positive qualitative adjustment for the "Debt and Liquidity" building block assessment.

Spain's External Accounts Are Strong, Despite Successive External Shocks

Spain's external accounts have dramatically improved over the last decade. 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. In recent years, Spain's current account surpluses increased notwithstanding the pandemic and the sharp increase in energy import prices. The EC projects the current account to increase to 2.8% of GDP in 2024, from 2.5% in 2023, due to the strength of tourism and non-tourism service exports and lower energy prices. The accumulation of current account surpluses, combined with healthy nominal GDP growth, explain Spain's drastic improvement in its net international investment position. It narrowed to -52.8% of GDP in 2023 from -93.8% of GDP in 2014. The country's membership in the euro system, it's diversified export base, and its current account surpluses mitigate against Spain's still-elevated net external debtor position and support the positive qualitative adjustment for the "Balance of Payments "building block assessment.

Spanish Banks Are Benefiting From Higher Rates And The Resilient Economy

The Spanish banking system remains healthy and financial stability risks appear contained. The banks have strong liquidity, are well capitalized, and are profitable. Higher interest rates and the rapid repricing of variable-rate loans support strong bank earnings. Despite the rapid rise in interest rates, there has been no real deterioration in asset quality so far. Nonperforming loans as a share of total loans was 3.1% in 2023, up only slightly from 2.9% in 2020, according to the IMF. The full impact of tighter financing conditions in a context of higher costs of living is not yet clear, and Morningstar DBRS anticipates additional stress, especially among the most vulnerable households and firms. Yet, any deterioration in asset quality should remain manageable due to healthy macroeconomic conditions, including strong employment, steady wage growth, and lower private sector indebtedness. Lastly, there appears to be limited risks from the housing market, despite the substantial drop in terms of new mortgage flows and transactions during 2023. Sluggish growth in the supply of new housing and higher construction costs mitigate the risks of a sharp correction in housing prices.

The Government Faces Impediments To Implementing Its Policy Agenda

Though Spain's general election in July 2023 did not give any party a clear majority, Prime Minister Pedro Sánchez garnered sufficient support (in part from pro-independence Catalan parties Esquerra Republicana de Catalunya and Junts per Catalunya) to lead a coalition that includes the PM's centre-left Partido Socialista Obrero Español (PSOE) and the left Sumar parties. The country's healthy governance metrics support Morningstar DBRS' view that the government will continue to pursue its fiscal objectives and execute its recovery plan. The country's percentile rank scores of Worldwide Governance Indicators in 2022 for Government Effectiveness (77.8), Voice and Accountability (79.7), and Rule of Law (77.4), although having declined in recent years, remain strong.

The fractured nature of Spanish politics generates uncertainty, weakens government stability, and creates impediments to policy execution. Critically, the minority government's current mandate could be abruptly cut short if pro-independence parties decide to withdraw their support. It is unclear how the recent elections in Catalonia will affect the central government's governing coalition. Furthermore, the agreements made between PSOE and the Catalan pro-independence parties, and in particular the amnesty law, have resulted in increased political and social tensions across Spain. While the medium- to long-term legal, political and social implications of the amnesty law are unclear at this stage, Morningstar DBRS considers that Spain's institutional checks and balances alleviate concerns over any threats to the rule of law.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
ESG Considerations had a significant effect on the credit analysis.

Environmental (E) Factors
There were no Environmental factors that had a relevant or significant effect on the credit analysis.

Social (S) Factors
The following Social factors had a significant effect on the credit analysis: Human Capital and Human Rights (S) affects the credit ratings assigned. Spain's GDP per capita, estimated at USD 33,071 in 2023 to the International Monetary Fund (IMF), remains relatively low compared with its euro system peers. Morningstar DBRS has taken these considerations into account within the "Economic Structure and Performance" building block.

Governance (G) Factors
There were no Governance factors that had a relevant or significant effect on the credit analysis.

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (23 January 2024) https://dbrs.morningstar.com/research/427030/morningstar-dbrs-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://dbrs.morningstar.com/research/433832.

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 (06 October 2023) https://dbrs.morningstar.com/research/421590/global-methodology-for-rating-sovereign-governments. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://dbrs.morningstar.com/research/427030/morningstar-dbrs-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://dbrs.morningstar.com/about/methodologies.

The sources of information used for these credit ratings include the Ministry of Finance (2024 Draft Budgetary Plan, Macroeconomic and Fiscal Forecast Update), Bank of Spain (Macroeconomic Projections 2024-2026, March 2024; Spring 2024 Financial Stability Report), National Statistics Office, Independent Authority for Fiscal Responsibility (Opinion on the Sustainability of Public Administration in the Long Term: the Incidence of Demographics; Report on the Main Budgetary Lines of the Public Administrations for 2024), Spanish Treasury (Treasury's Presentation May 2024), State Official Gazette (Climate Change and Energy Transition Law, May 2021), EC (Spring 2024 Economic Forecast; 2023 Country Report - Spain; Opinion on Draft Budgetary Plan 2024), EU's Economic and Financial Committee's Sub-Committee on EU Sovereign Debt Markets (ESDM), ECB, European Banking Authority, Eurostat, Bank for International Settlements, Organisation for Economic Co-operation and Development, IMF (WEO and IFS), World Bank, the Social Progress Imperative (2024 Social Progress Index), and Haver Analytics. Morningstar DBRS considers the information available to it for the purposes of providing these credit ratings to be of satisfactory quality.

With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, these are unsolicited credit ratings. These credit ratings were 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

Morningstar DBRS 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. Morningstar DBRS' outlooks and ratings are under regular surveillance.

For further information on Morningstar DBRS 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 Morningstar DBRS 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://dbrs.morningstar.com/research/433833/.

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

Lead Analyst: Jason Graffam, Senior Vice President, Global Sovereign Ratings and Financial Institutions Group
Rating Committee Chair: Thomas R. Torgerson, Managing Director, Global Sovereign Ratings
Initial Rating Date: October 21, 2010
Last Rating Date: December 01, 2023

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