Morningstar DBRS Upgrades Kingdom of Spain to A (high), Changes Trend to Stable

DBRS Ratings GmbH (Morningstar DBRS) upgraded the Kingdom of Spain's Long-Term Foreign and Local Currency - Issuer Ratings to A (high) from "A". At the same time, Morningstar DBRS upgraded Spain's Short-Term Foreign and Local Currency - Issuer Ratings to R-1 (middle) from R-1 (low). The trends on all ratings have returned to Stable from Positive.

KEY CREDIT RATING CONSIDERATIONS
The upgrade reflects Morningstar DBRS' view that Spain's credit quality is enhanced by strong economic performance, a reduction of net external liabilities, and steady improvement in public finances. Healthy performance of service exports has powered Spain's recent economic growth, and in the coming years we expect favourable labour market conditions, falling interest rates, the recovery of purchasing power, and the deployment of EU investment funds to support domestic demand. We also expect these forces to mitigate the adverse effects from heightened external risks and weaknesses among European peers. On public finance, the IMF expects the fiscal deficit to reach 3.0% of GDP this year and for public debt to decline to 100% of GDP by 2026. The government's medium term fiscal plan projects gradual fiscal consolidation and persistent debt reduction over the course of the decade. 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.

The Stable trend reflects our view that medium-term risks to the outlook are balanced. 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 and high unemployment, while improving, remain structural challenges that limit a more meaningful productivity convergence with the euro area average. The institutional and territorial challenges posed by the pro-independence movement in the Autonomous Community of Catalonia appear to have reduced, especially since the May 2024 Catalan regional elections, though political tensions might resurface.

CREDIT RATING DRIVERS
The credit ratings could be upgraded if authorities significantly reduce the debt-to-GDP ratio, and if there is persistent evidence that reforms improve economic resilience and boost potential growth. 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.

CREDIT RATING RATIONALE

Strong Performance of the Spanish Economy has been Broad-Based

Spain's economic recovery has been stronger than previously anticipated and supported across various GDP components. The return of tourism and non-tourism services boosted external demand, while lower inflation and improved consumer 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 in Spain expanded by 2.7% last year, well above the euro area's average 0.5% growth rate, and is on pace to grow by around 3.0 % this year. The IMF expects growth of the Spanish economy to average 2.0% between 2025-2027, continuing its multiyear overperformance of its EU peers. Downside risks to the near-term growth outlook stem from a more pronounced downturn in Europe or an escalation in geopolitical tensions across various fronts that could once again drive-up energy prices and the rate of inflation.

Morningstar DBRS considers medium-term growth prospects to be contingent on persistent strength of the labour market and the government's ability to manage EU transfer grants and loans, including from the NextGenerationEU (NGEU) funds and the Multiannual Financial Framework (MFF). Employment growth in Spain has been steady, growing roughly 2% per year over the last five years, in part supported by large net inflows of migrants. The immigration windfall has been accompanied by a gradual decline in the unemployment rate (still high at 11.2% in September 2024) and a gradual increase in labour productivity per hour worked. On EU funds, Spain's NGEU Recovery Plan, if fully implemented, is set to mobilise up to EUR 163 billion by 2026 or roughly 11% of GDP in grants and loans. The amount increases to 13% of GDP by 2030 including the MFF. These investments are critical for Spain to improve on its capital stock 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.

Near-Term Fiscal Deficit Reduction to Continue; Medium-Term Fiscal Pressures Remain

The fiscal deficit is expected to return to its pre-pandemic level this year. The deficit peaked at 10.1% of GDP in 2020 and the government expects it to reach 3.0% in 2024, roughly the pre-pandemic result and in line with the euro zone average. The improvement in the fiscal imbalance stemmed primarily from revenue overperformance from strong nominal GDP growth and gradual unwinding of support measures. The government's medium term structural deficit plan expects a 2.5% of GDP deficit in 2025. If achieved, the outcome would result in the country's first primary fiscal surplus since 2007. The plan targets a gradual reduction in the deficit to 1.5% of GDP by 2029. Spain's independent fiscal authority (AIReF) nonetheless considers the current medium-term targets unachievable in the absence of additional adjustments to public finances and expects a 2.9% of GDP deficit by 2029.

Persistent spending demands and policy implementation risks will likely challenge the government's more favourable fiscal projections. The governing coalition consists of many parties with disparate preferences, and the delays in passing the 2025 Budget demonstrate for the second consecutive year the risk to effective and timely implementation of fiscal policies and reforms. That said, this government in November 2024 rallied sufficient support for a tax reform that among other objectives sets a global minimum tax on corporates and extends the taxes on energy companies and on banking income. More details of the energy component are forthcoming. Damages linked to recent extreme weather events, in Valencia and other regions, will require unforeseen public spending, though costs will likely be shared at the regional, federal, and supranational levels, and we do not expect this to materially alter immediate fiscal outcomes. Expenditure pressures in the coming years stem from increased defence commitments and possibly from reform to regional government financing. Over a longer time horizon, spending pressures mount on pensions, healthcare, and long-term care from the ageing population, and from higher debt servicing costs. Despite the uncertain path, Morningstar DBRS is of the view that Spain's fiscal consolidation track record re-enforce its commitment to EU fiscal rules and to rebalancing public accounts.

Spain's Public Debt Ratio Is Falling but Remains High

Spain's high public debt ratio remains an important credit challenge. High debt reduces the government's fiscal space and increases its vulnerability to shocks. The path of debt reduction is nonetheless favourable. After peaking at 120.3% of GDP in 2020, the government expects public debt to reach 102.5% of GDP in 2024. The positive nominal interest-rate to GDP-growth differential and lower deficits are the drivers of the downward debt trend. The government's medium-term plan targets debt falling to 92.8% of GDP by 2030. While public debt remains high and above the euro area average, the Spanish Treasury has successfully managed the shocks associated with higher interest rates and funding costs. The predominance of fixed-rate bonds and a relatively long average maturity profile (7.9 years) delay the impact of higher issuance and interest costs. The government projects the interest burden to remain unchanged at 2.4% of GDP in 2024-2025, up from 2.0% in 2021, but still below the 3.6% of GDP interest cost in 2013. It is worth mentioning that market spreads on Spain's benchmark 10-year bond against comparable German bunds has narrowed to around 70 bps, a slightly tighter spread over bunds than equivalent French bonds. Morningstar DBRS makes a positive qualitative adjustment for the "Debt and Liquidity" building block assessment to reflect Spain's favourable debt structure, a large share of debt is held by the euro system and European authorities, and the downward sloping trajectory of the debt ratio.

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

Spain's external accounts have significantly 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 surplus declined towards balance during 2020-22 because of the pandemic's effect on export volume and the sharp increase in energy import prices. The IMF projects the current account surplus to reach 3.4% of GDP in 2024 from 2.7% 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 large improvement in its net international investment position. It narrowed to -51.7% 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 reporting record profits. 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. Nonperforming loans as a share of total loans was 3.4% in the first half of 2024, according to the Banco de España, down from 4.8% at end 2019. Furthermore, there appears to be limited risks from the housing market, despite the slow recovery in terms of new mortgage flows and transactions. 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 Persistent Impediments to Implementing Its Policy Agenda

Spain's general election in July 2023 did not give any party a clear majority, yet Prime Minister Pedro Sánchez garnered sufficient support to lead a coalition that includes the PM's centre-left Partido Socialista Obrero Español (PSOE) and the left-of-centre Sumar parties. The country's healthy governance metrics support Morningstar DBRS' view that the government will continue to pursue its fiscal objectives and to execute its recovery plan. The country's percentile rank scores of Worldwide Governance Indicators in 2023 for Government Effectiveness (76.9), Voice and Accountability (87.7), and Rule of Law (78.3) 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 implicit support. The agreements made between PSOE and the Catalan pro-independence parties, and particularly the amnesty law, have resulted in increased political and social tensions across Spain. The government's inability to satisfy political commitments or additional financial accommodations to the autonomous communities are also potential flashpoints, including the possible reforms to regional government financing and debt relief.

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

Social (S) Factors
The following Social factor had a significant effect on the credit analysis: Human Rights and Human Capital. Spain's GDP per capita, at USD 33,896 in 2023, remains relatively low compared with its European peers most likely reflecting still a higher structural unemployment rate and lower productivity. Nonetheless, respect for human rights is high. Morningstar DBRS has taken this factor into account in the Economic Structure and Performance building block.

There were no Environmental or 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 Factors in Credit Ratings (13 August 2024) https://dbrs.morningstar.com/research/437781.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments at: https://dbrs.morningstar.com/research/444000

EURO AREA RISK CATEGORY: LOW

Morningstar DBRS notes that this Press Release was amended on 6 February, 2025 to update the title of the ESG methodology.

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 (15 July 2024) https://dbrs.morningstar.com/research/436000. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings https://dbrs.morningstar.com/research/437781 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 (2025 Draft Budgetary Plan, Macroeconomic and Fiscal Forecast Update), Bank of Spain (Quarterly Report and Macroeconomic Projections for the Spanish Economy; 2024 Financial Stability Report), National Statistics Office, Independent Authority for Fiscal Responsibility, Spanish Treasury (Treasury's Presentation November 2024), State Official Gazette (Climate Change and Energy Transition Law, May 2021), EC (Summer 2024 Economic Forecast; 2024 Country Report - Spain; Opinion on Draft Budgetary Plan 2025), 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), Macrobond, 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/443997

This credit rating is 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: May 31, 2024

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