Morningstar DBRS Upgrades the Autonomous Community of Catalonia to BBB, Trend Remains Positive

DBRS Ratings GmbH (Morningstar DBRS) upgraded the Long-Term Issuer Rating of the Autonomous Community of Catalonia (Catalonia) to "BBB" from BBB (low) and upgraded the Short-Term Issuer Rating to R-2 (middle) from R-2 (low). The trends on all ratings remain Positive.

KEY CREDIT RATING CONSIDERATIONS
The upgrade reflects the upgrade of Kingdom of Spain's Long-Term Foreign and Local Currency - Issuer Ratings to A (high) from "A" on 29 November 2024, and the financing support provided by the Kingdom of Spain to the regional government, which significantly reduces refinancing risks. The upgrade also reflects Catalonia's improvement of its fiscal performance and debt metrics. In Morningstar DBRS' view, the relationship between the regional government and the national government has slowly but steadily strengthened over the recent years. While the independence question is likely to 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 is likely to continue to normalize.

The Positive trend reflects Morningstar DBRS' view that Catalonia's fiscal and debt performance could improve further, supported by the return of the Budget Stability Law. Particularly, if combined with the debt relief that the central government has committed to implement for the autonomous communities, this could rapidly alleviate Catalonia's very high debt burden.

CREDIT RATING DRIVERS
The credit ratings could be upgraded if (1) the region continues its fiscal consolidation towards a balanced budget position and improves its debt sustainability metrics; or (2) the debt relief mechanism is implemented and allows for a rapid and substantial reduction of Catalonia's debt burden.

The Positive trend on the credit ratings could return to Stable if there is a structural deterioration in the region's fiscal performance, leading to a wider deficit and reducing the current improvement of debt metrics and the debt relief is insufficient to allow for a rapid and substantial reduction of Catalonia's debt burden. Catalonia's credit ratings could be downgraded if: (1) there is a structural deterioration in the region's fiscal performance, leading to a wider deficit and placing debt metrics on a deteriorating trajectory; or (2) the Kingdom of Spain's credit rating is downgraded; or (3), although unlikely, if there are indications that a material escalation of the political tensions between both government tiers could affect the financing support received by the region.

CREDIT RATING RATIONALE

Catalonia's Strong Fiscal Improvement in 2024 Will Be Difficult to Replicate in 2025

In 2024, the Independent Authority for Fiscal Responsibility (AIREF) expects Catalonia to continue improving its budgetary performance, with a financing deficit of 0.4% of GDP. In 2023, the financing deficit stabilized around 1.4% of GDP according to national accounting standards. In 2024, operating revenues are expected to strongly increase. There are also this year some one-off items such as the sale of public companies for around EUR 500 million, but overall the main driver of revenue growth is rising employment and growth in internal demand. In 2023, the operating deficit decreased to 3.9% of operating revenues from 5.6% of operating revenues in 2022.

Morningstar DBRS view positively the fiscal improvement recorded by the region in 2024, though it may not represent a structural fiscal improvement. Morningstar DBRS continues to take the view that maintaining this strong performance in the near term will remain challenging since the settlement of the regional financing system will decrease for next year and the economic prospects are weaker. For 2025, there could be a budget approved by the regional parliament, on contrary to the 2024 budget that was not approved. However, the lack of budget has resulted in the region modifying some budgetary allocations to use increased revenue expectations into outsourced services impacted by inflation. If the budget is ultimately not passed, part of the increased revenues will be used to provide delayed health services. On investments, the budget roll-over is likely to slow down investment implementation, but this condition does not prevent the government from allocating investments with EU funds.

Despite of the strong improvement expected in 2024, AIREF expects the region's financing deficit to deteriorate slightly to 0.6% of GDP in 2025. Fiscal challenges will remain significant in 2025, with weaker economic prospects, 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 after a slight deterioration in 2025.

Still Growing Debt, But Towards Much Affordable Debt Levels, Debt Relief Would Accelerate the Path

Despite the fiscal improvement in 2023 and 2024, the persistence of financing deficits has caused Morningstar DBRS' adjusted debt stock to rise modestly, increasing to EUR 91.3 billion at end of June 2024 from EUR 88.8 billion at end-2023. However, economic growth has put Catalonia's debt-to-GDP ratio on a downward trajectory. The adjusted debt-to operating revenues improved to 234% in 2023, from 250% in 2022 and is expected to keep decreasing in 2024. As well, the direct debt-to-GDP has decreased to 30.4% at June 2024 from 31.3% in 2023 and AIREF expects this ratio to decrease towards 28.7% in 2025. Going forward, Morningstar DBRS expects Catalonia's debt ratios to keep decreasing in the medium term, though we expect the decreases to be less notable given a reduced rate of nominal economic growth and normalised fiscal revenue flows.

Moreover, the Catalan debt could potentially decrease even further than currently expected if there is a materialisation of the political commitment for debt relief to the autonomous communities (excluding Basque Country and Navarre). There is still uncertainty on the timing and form of this debt relief. However, Morningstar DBRS understands that it is likely that the central government would take over part of the debt accumulated by the autonomous communities since 2012. For Catalonia, assuming all other factors remain stable, its adjusted debt to operating revenue could improve to the range 190%-200% from around 234% in 2023. In addition, debt relief would boost other key financial metrics such as interest expenditure over operating revenue, and short-term debt to operating revenues.

Catalonia's debt and liquidity management practices are conservative. At the end of June 2024, almost 97% of Catalonia's debt was at fixed interest rates. The region's relatively short weighted-average maturity of its debt stock, standing at 5.3 years at the end of 2023, is likely to translate into higher interest rates following refinancing. Nonetheless, access to state financing mechanisms is mitigating this risk, as 85% of Catalonia's debt (EUR 75.8 billion) has benefited from this financing support. 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 meet 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.

Strong Tourism Performance Combined with Strength of Labour Market Continues to Lift the Economy Against Weaker External Demand

In 2022, Catalonia's GDP grew by 6.0%, slightly above the growth rate of Spain (5.8%), and is estimated to have grown by 2.7% and 3% in 2023 and 2024 according to AIREF; the regional economy has continued to grow after surpassing its pre-pandemic GDP level (seen in the fourth quarter of 2019) in the second quarter of 2022. The economy is showing resilient growth thanks to domestic demand and investment.

The services sector continues to be the main driver of growth and while tourism is growing satisfactorily, its potential growth is now limited. The industrial sector is also contributing to regional economic growth, but the weaker stance of trading partners (such as France or Switzerland) could weigh on growth prospects. Within the industrial sector the production of chemicals has led growth in this sector, from January to September 2024, followed by the automotive sector which also has a significant share of total exports. Additionally, industrial output seems to be very resilient to the periods of droughts, a fact that shows the region's resilience in the face of a considerable economic challenge. For instance the last accused drought took place in 2023 with just negative implications into 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 weaker external demand is likely to somewhat weigh on growth in 2025. The positive trend in job performance that started at the end of the pandemic has continued so far, with the employment level reaching 56% in 2023, improving from 54% in 2021, and higher than the national average of 52% in 2023. Employment enjoyed particular strong growth in the public administration, in education, and in information and technology services up to Q3 2024 compared with the same period of 2023. Simultaneously, unemployment has been on a downtrend, decreasing to 8.8% at the end of Q3-2024 from 10% at the end of 2022.

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 5.6 billion up to the end of 2024 and EUR 4.6 billion has already been spent; for 2025 the expectation is to implement EUR 0.9 billion. Going forward, the the speed of absorption of EU funds will remain a key area of focus for us to assess the full economic impact.

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

Social (S) Factors

The following Social factor had a relevant effect on the credit analysis: Passed-through Social considerations.

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

There were no Environmental or Governance factors that had a significant or relevant effect on the credit analysis.

Credit rating actions on Kingdom of Spain are likely to have an impact on this credit rating. ESG factors that have a significant or relevant effect on the credit analysis of Autonomous Community of Catalonia are discussed separately at https://dbrs.morningstar.com/issuers/15664.

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.

RATING COMMITTEE SUMMARY
Morningstar DBRS' European Sub-Sovereign Scorecard generates a result in the A (low) - "BBB" range. The main points discussed during the Rating Committee included the fiscal and financial impacts of the upgrade of Kingdom of Spain's rating, the fiscal and debt evolution in 2024, the economic situation in the region and its outlook, and its financial forecasts.

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/444000.

The national scorecard indicators were used for the sovereign rating. The Kingdom of Spain 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 (09 August 2024) https://dbrs.morningstar.com/research/437618. 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 Autonomous Community of Catalonia for financial position, budgetary execution and debt structure for the 2017-24 period, Bank of Spain for the debt stock during the period between 2016 and 2024, Independent Authority for Fiscal Responsibility (AIREF) for its November 2024 report on Catalonia's Budget Fundamental Lines for 2025, and for its November 2024 Macroeconomic Forecasts for Catalonia, Instituto Nacional de Estatística (INE), Ministry of Finance, General State Comptroller (IGAE). national statistical agency, central bank, Ministry of Finance, IMF, World Bank, Haver Analytics. 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' 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://dbrs.morningstar.com/research/444608.

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: 6 July 2018
Last Rating Date: 14 June 2024

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