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

DBRS Ratings GmbH (Morningstar DBRS) 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 remains at Positive.

KEY CREDIT RATING CONSIDERATIONS
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 (rated "A" with a Positive trend by Morningstar DBRS) to the regional government, which significantly reduces refinancing risks; and (3) Morningstar DBRS' view that the relationship between the regional government and the national government has slowly but steadily strengthened over recent 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, Morningstar DBRS takes the view that the economic and financial institutional relationship between these tiers of government will not deteriorate significantly.

The Positive trend continues to reflect Morningstar DBRS' view that the debt relief that the central government is likely to implement for Spanish autonomous communities as a consequence of the 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 return of the Budget Stability Law, Catalonia's fiscal and debt performance could substantially improve. The Positive trends also reflects the trend change to Positive from Stable on the Kingdom of Spain's Long-Term Foreign and Local Currency - Issuer Rating of "A" on 31 May 2024.

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 credit ratings could also be upgraded if: (1) the Kingdom of Spain's credit rating is upgraded; or (2) the region continues its fiscal consolidation towards a balanced budget position and improves its debt sustainability metrics.

The Positive trend on the credit ratings could return to Stable if debt relief is insufficient to allow for a rapid and substantial reduction of Catalonia's debt burden and the positive trend of the Kingdom of Spain is reverted to Stable. Catalonia's credit 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
PSC Wins the Elections But Regional Governability Remains Fragile And Timing For the Debt Relief Remains Uncertain

Regional snap elections took place in May 2024, stemming from political difficulties to approve the 2024 budget. Partit dels Socialistes de Catalunya (PSC) substantially improved its results compared to the 2021 elections and was the most voted party in the elections, with the control of 42 seats in the regional assembly (33 in 2021). However PSC is far from a majority at the regional assembly (68 seats) and governability is likely to remain challenging with the need to either form government or agreements to pass key legislation. For the first time in 20 years, pro-independence parties (Esquerra Republicana de Catalunya (ERC), Junts per Catalunya (JxC) and CUP) do not sum enough seats to form a government. Nonetheless, they are likely to remain a necessary partner to form a regional government.

Although there could be delays in public investment due to political uncertainty and the lack of a 2024 budget could weigh on the economic outlook, Morningstar DBRS considers that these election results are likely to point to an easier relationship between the central government and the regional government, at least for some time. Morningstar DBRS nonetheless expects the question of Catalonia's independence to remain a structural topic in the region over the medium to long term. Some of the agreements between the central government and the pro-independence parties (ERC and JxC), like the recently approved amnesty law, have already materialised. Morningstar DBRS is expecting the agreed debt relief for the Spanish Autonomous communities to take place, though the timing for its fulfillment has been delayed with no specific deadline agreed. In any case, the support from the Kingdom of Spain continues to be one of the strengths of Catalonia's credit rating.

Fiscal Improvement is Under Way, Though Balancing the Budget Remains A Challenge

In 2023, the budgetary result improved, resulting in a financing deficit estimated at 1.3% of GDP according to national accounting standards, from a deficit of 1.5% of GDP in 2022. The improvement was supported by a strong growth of revenues thanks to the growth of tax revenues and the positive settlement of the regional financing system, despite the winding down of exceptional support measures from the central government. The operating deficit decreased to EUR 1,463 million or 3.9% of operating revenues from EUR 1,935 million or 5.6% of operating revenues in 2022. At the same time investments remain relatively stable with the capital expenditure net of capital revenues at EUR 1.8 billion which resulted in a financing deficit of EUR 3.3 billion or 8.6% of operating revenues versus EUR 3.8 billion or 11.0% of operating revenues in 2022. Morningstar DBRS views positively the fiscal improvement recorded by the region in 2023. This fiscal improvement confirms that the deterioration seen in 2022 was mainly caused by the lack of extraordinary transfers received from the central government to alleviate the impact of the pandemic and headwinds from the regional financing system.

Fiscal challenges will remain significant in 2024 and 2025 because of the implementation of reforms supported by EU funds and the need to develop some fiscal space to meet ambitious expenditure targets and face medium-term challenges related to demographic and climate change, in combination with ambitious lower expenditure growth benchmarks. Morningstar DBRS understands that the return of state-decided fiscal rules in 2024 would leave a reduced fiscal margin for the regions to increase their expenditure significantly and expects the regions to keep the current track record of fiscal consolidation by reducing deficit levels. Catalonia went above the 0.3% deficit target in 2023, and the Independent Authority for Fiscal Responsibility (AIREF) expects a 2024 deficit of 0.2% of GDP, which is 0.3% weaker than AIREF's previous estimate. The targeted budgetary balance will likely not be achieved, though projected fiscal results should still help the region continue with its debt level decreasing trend.

Catalonia's Indebtedness Keeps Decreasing But Central Government Liquidity Support Remains Key

Despite the fiscal improvement seen during 2023, the persistence of financing deficits is causing Morningstar DBRS' adjusted debt to rise modestly to EUR 88.8 billion from EUR 86.6 billion at end-2022. However, both the economic growth and the recovery in revenues has positioned Catalonia's debt ratios on a downward trajectory. The adjusted debt-to operating revenues improved to 234% in 2023 from 250% in 2022 and also the adjusted debt-to-GDP has decreased to 32% from 34% in 2022, in line with the previous AIREF forecast. Going forward, Morningstar DBRS expects Catalonia's debt ratios to keep decreasing in the medium term, though the decreases could be less notable, given a reduced rate of nominal economic growth and normalised fiscal revenue flows as support measures wind down completely.

Moreover, the Catalan debt could potentially decrease even further than currently expected by AIREF if the central government's commitment for debt relief for autonomous communities materialises. For Catalonia, assuming all other factors remain stable, the adjusted debt to operating revenue could improve to the range 190%-200% from around 234% in 2023, according to Morningstar DBRS estimates. This ratio is a key financial metric and Morningstar DBRS expects simultaneous improvements in other key financial metrics such as the interest expenditure over operating revenue, or the short term debt to operating revenues.

Catalonia's debt and liquidity management practices are conservative; however, the region's relatively short weighted-average maturity of its debt stock produces sizeable debt amounts to be refinanced. The access to state financing mechanisms is mitigating this condition, as Catalonia has benefited from the financing support to the extent that it represented 86% of total regional debt or EUR 74.1 billion. Morningstar DBRS views this state financing as evidence of strong central government support when assessing regional governments' creditworthiness. Regarding liquidity, the region uses short-term loans and credit lines for a maximum of EUR 2.5 billion, which increases its ability to face further unplanned liquidity needs. Additionally, Morningstar DBRS understands that the region also benefits from long-term financing dedicated to specific investments available from multilateral institutions, which supports its liquidity position.

Economic Growth Remained Strong In Spite of High Interest Rates and Geopolitical Tensions

On the economic front, during 2022 and 2023 the service sector continued to drive growth, although there are signs of a better development on the industry sector for this year. In 2022, Catalonia's GDP grew by 6.0%, slightly above Spain's GDP growth (5.8%), and is expected to grow by 2.7% and 2.2% in 2023 and 2024 according to AIREF estimates; the regional economy has continued to grow after surpassing its pre-pandemic GDP level in the second quarter of 2022. In 2022, the services sector was driving growth whilst the industry sector was moderately weighing on economic performance as a result of the rapid increase in energy prices and the bottlenecks on world trade supply. However, thus far in 2024 there are visible signs of industry-led economic growth. Within the industrial sector, the automotive sector is the main driver of growth in exports and also economic growth. Additionally, industrial output seems to be very resilient to the last periods of droughts, a fact that shows the region's resilience in the face of a considerable economic challenge, which is indeed negatively affecting the agricultural sector whose share in regional GDP declined to 0.8% in 2023 from 1.2% in 2020.

The regional economy is expected to continue growing broadly in line with the national average. Morningstar DBRS expects a continuation of strong tourism performance and also a robust job market performance to support Spain's GDP growth, but increasing financing costs and a weaker global outlook are likely to somewhat weigh on growth in 2024. The European Commission (EC) expects the Spanish economy to expand by around 2.0% in each of the next two years, continuing its multiyear overperformance versus many of its EU peers.

The financial resources expected from the Next Generation EU (NGEU) programme, 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 has already been spent; for 2024 the expectation is to spend another 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 Morningstar DBRS to assess the full economic impact.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
General Considerations

ESG Considerations had a relevant effect on the credit analysis.

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 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

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 fiscal and financial impacts of the potential upgrade of Kingdom of Spain's rating, the financial impacts for Catalonia of the potential debt relief for Spanish autonomous communities, the elections and government formation possibilities, the institutional relationship between Catalonia and the central government, Catalonia's fiscal performance and debt evolution up to 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://dbrs.morningstar.com/research/433832.

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 (15 April 2024) https://dbrs.morningstar.com/research/431201/rating-european-sub-sovereign-governments In addition Morningstar DBRS uses 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 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 Morningstar, Inc. and company documents. Other sources include Autonomous Community of Catalonia for financial position, budgetary execution and debt structure for the 2017-23 period, Bank of Spain for the debt stock during the period between 2016 and 2023, Independent Authority for Fiscal Responsibility (AIREF) for its April 2024 report on Catalonia's Initial budget considerations, Instituto Nacional de Estatística (INE), Ministry of Finance, General State Comptroller (IGAE) and the Spring 2024 economic forecast from the European Commission. Morningstar DBRS considers the information available to it for the purposes of providing these credit ratings to be of satisfactory quality.

Morningstar DBRS 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. Morningstar DBRS's outlooks and credit 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://www.dbrsmorningstar.com/research/434517.

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

Lead Analyst: Jorge Espinosa, Assistant Vice President, Global Sovereign Ratings
Rating Committee Chair: Thomas R. Torgerson, Managing Director, Global Sovereign Ratings
Initial Rating Date: July 06, 2018
Last Rating Date: December 15, 2023

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