DBRS Confirms Kingdom of Spain at A, Stable Trend

DBRS Ratings GmbH (DBRS) confirmed the Kingdom of Spain’s Long-Term Foreign and Local Currency – Issuer Ratings at A. At the same time, DBRS confirmed the Kingdom of Spain’s Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (low). The trend on all ratings is Stable.

KEY RATING CONSIDERATIONS

The Stable trend reflects DBRS’s view that the risks to the ratings are balanced. Benefiting from strong domestic demand, Spain’s GDP growth has been resilient in recent quarters to a weaker external environment. For 2019 and 2020, DBRS expects Spanish growth to continue to outperform the euro area average growth. The fiscal and debt ratios continue to decrease, primarily driven by the dynamism of the economy. However, expectations for a strong economic outlook for the next two years could be tempered by weaker external demand. DBRS does not expect any abrupt changes in policy following next month’s elections, although less popular structural fiscal measures could be delayed.

Spain’s A rating is supported by the country’s large and diversified economy, competitive export sector and eurozone membership. By contrast, the high public debt ratio remains a key consideration for the rating. Spain’s high reliance on foreign financing is also a source of credit vulnerability. Whilst a challenging political situation in the Autonomous Community of Catalonia (rated BB (high) with a Stable trend by DBRS) remains ongoing, its economic impact has been relatively subdued.

RATING DRIVERS

Upward rating drivers include one or a combination of the following: (1) further progress in reducing Spain’s fiscal deficit and public debt ratio; or (2) further evidence of improved resiliency of the economy to absorb shocks. Downward rating drivers include one or a combination of the following: (1) a reversal of the fiscal consolidation path or a deterioration in medium-term sustainability of public finances; (2) a downward revision to the growth path that contributes to a material reversal of the declining public debt ratio trajectory; or (3) disruptive political developments that severely impair economic performance.

RATING RATIONALE

Political Fragmentation is Delaying Structural Measures, Catalonia Remains in the Backdrop

In recent years, political fragmentation has resulted in less stable governments and has hindered stable policy making. In this context, after failing to gather enough parliamentary support to pass the 2019 budget, Prime Minister Pedro Sánchez called for early general elections to be held on 28 April 2019. With the potential breakthrough of the far-right Vox party at the national level, DBRS expects the next legislature to be even more fragmented than the current one.

While political uncertainty could remain elevated for months, DBRS does not expect abrupt shifts in economic or fiscal policy because of the need for multiparty agreements to pass legislation and the fact that there is still strong electoral support for centrist political alternatives. However, DBRS notes that, if the fiscal agenda is delayed after the elections and formation of a new government, this delay could hamper the ability of future administrations to implement the necessary measures to tackle Spain’s remaining imbalances and respond to potential adverse shocks.

DBRS considers that tensions between the national government and the pro-independence parties in Catalonia have eased since the end of 2017. There is a risk of a renewed escalation of tensions in coming months, especially under a conservative national government. However, the economic impact of the political situation in Catalonia has been relatively subdued.

Fiscal Deficit Steadily Declines but the Debt Ratio Remains High – A Key Credit Weakness

Spain’s fiscal deficit to GDP continues to decline. After a period of material structural adjustment between 2010 and 2014, the fiscal rebalancing has primarily relied on cyclical momentum. The fiscal deficit is estimated to have dropped from 3.1% of GDP in 2017 to 2.7% of GDP in 2018, allowing Spain to exit its excessive deficit procedure in 2019. The positive effect from the strong economic dynamism, enlarging tax bases and curbing unemployment benefits spending, more than compensated for the increase in pension, civil servants’ wages and personal income tax cuts introduced last year. Although there is some degree of divergence regarding structural balance estimates, the European Commission’s (EC) estimate of -3.1% of GDP for 2018 stands well above Spain’s MTO of -0.5%.

DBRS expects the fiscal deficit to continue gradually shrinking. In the absence of the revenue-enhancing measures envisaged in the 2019 budget, DBRS now expects the fiscal deficit to be close to 2.5% of GDP in 2019. Going forward, a maturing economic cycle and increasing pressures of an ageing population will demand new measures to be implemented to sustain the reduction in the fiscal deficit. Given Spain’s unfavourable demographics, rolling-back key features of the pension reform, such as potentially re-linking pensions to CPI inflation on a permanent basis, could put the long-term sustainability of the pensions system at risk, if it is not compensated by offsetting measures.

Although trending downwards, the high public debt ratio, which stood at an estimated 96.9% of GDP in 2018, continues to be a key credit weakness, burdening the government, and reducing its room to respond to potential challenges. Despite the slower fiscal consolidation path, DBRS continues to expect the debt-to-GDP ratio to drop below 95% by the end of 2020, mostly driven by Spain’s nominal GDP growth and a return to primary surpluses.

Given its high level of indebtedness, Spain is vulnerable to a large increase in the cost of funding, while unlikely, should risk premia be reassessed. However, higher funding costs for new debt issuances will only gradually affect the interest burden of the sovereign because of the predominance of long-term and fixed-rate financing. In recent years, Spain has both managed to lengthen significantly the average maturity of its debt portfolio and diversify its investor base towards more long-term investors. In addition, recent signals from the European Central Bank point towards a very slow normalisation of monetary policies going forward, a factor that should limit abrupt interest rate increases.

Spain Continues to Grow at Relatively Strong Rates Despite More Challenging External Environment

The Spanish economic recovery has been solid with GDP growth averaging 2.7% during 2014-2018, with real GDP exceeding its 2008 level by 4.3% in 2018. Spain’s growth pattern appears more sustainable than pre-crisis, more reliant on the export-oriented service sector and consistent with a deleveraging private sector. While the export sector has been crucial in the recovery, benefiting from significant competitiveness gains and a higher propensity to export, domestic demand has been the primary growth driver since 2014. On the back of strong employment creation, private consumption has roughly recovered to its pre-crisis levels. The construction sector has been recovering strongly since 2014, but remains well-below its pre-crisis levels. Machinery and equipment investment has surpassed its pre-crisis levels.

Despite losing strength, tailwinds from monetary policy, external demand and oil prices are still supportive for economic growth. Against this background, economic growth is projected to continue to decelerate gradually, with GDP growth forecast at an average of 2% for 2019-2020 as the economic cycle matures and tailwinds fade. The main source of risks to this outlook comes from the external side, although domestic political uncertainty could also weigh on activity.

Despite its recent robust economic performance, the Spanish economy continues to face significant challenges. Spain’s GDP per capita of EUR 25,825 in 2018 remains below the EU average, reflecting differences both in labour utilisation and productivity. Although it has declined substantially in recent years, the unemployment rate stood at 14.5% by end-2018. Also, temporary and involuntary part-time employment remains relatively high in Spain. While labour productivity has improved materially since 2008, the Organisation for Economic Co-operation and Development estimates multifactor productivity has remained sluggish. Importantly, Spain´s ageing population will increasingly weigh on long-term growth. Therefore, policies to reduce labour market segmentation and incentivise work, reduce regulatory hurdles hindering competition, and promote research and development investment could help boost growth potential.

External Accounts Continue to Improve Although Significant Imbalances Remain

Spain’s external imbalances remain high, but are steadily declining. Spain’s negative net international investment position (NIIP) remains high at 80.7% of GDP in Q3 2018. This is an important credit weakness, increasing the country’s vulnerability to sudden shifts in investor sentiment. However, the NIIP ratio has dropped 19 percentage points since Q2 2014 on the back of sustained current account surpluses and higher nominal GDP. The current account surplus averaged 1.5% of GDP between 2013 and 2018, helped by a sharp improvement in cost-competitiveness and Spanish firms’ greater propensity to export. Last year, the current account surplus stood at 0.8% of GDP, weighed by costlier energy imports and a normalisation of tourism flows, among other factors. Despite a potential erosion in coming years as the cycle matures, DBRS considers that the regained competitiveness will continue to support Spain’s net lending flows.

Financial Stability Risks Are Contained with Significant Progress in Reducing Troubled Assets

The financial position of the Spanish banking system continues to strengthen. Banks’ disposal of troubled assets, including non-performing loans (NPL) and foreclosed assets, amid more favourable economic and property market conditions, has led to a material improvement in asset quality. For instance, domestic NPL fell to 5.8% of total loans by end-2018 from 7.8% a year earlier, with sharp reductions in construction and real estate NPL portfolios. Underlying profitability and capitalisation levels are also improving. Spanish banks’ average capital ratio is above regulatory requirements with a CET1 at 11.3% as of Q3 2018, although it remains below the euro area average (CET1 of 14.2%). Improving asset quality, higher commissions and cost control have helped banks maintain profitability in a low interest rate environment. New credit flows continue to improve but outstanding credit declined by 2.6% in 2018 as loan repayments exceeded new lending with continued deleveraging by households and businesses.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the A (high) – A (low) range. The main points discussed during the Rating Committee include Spain’s fiscal performance, debt metrics, economic performance and outlook, external environment, banking system developments, and political developments.

KEY INDICATORS

Fiscal Balance (% GDP): -3.1 (2017); -2.7 (2018E); -2.5 (2019F)
Gross Debt (% GDP): 98.1 (2017); 96.9 (2018E); 96.0 (2019F)
Nominal GDP (EUR billions): 1,166.3 (2017); 1,206.9 (2018); 1,259.2 (2019F)
GDP per Capita (EUR): 25,064.4 (2017); 25,824.9 (2018E); 26,871.1 (2019F)
Real GDP growth (%): 3.0 (2017); 2.5 (2018); 2.2 (2019F)
Consumer Price Inflation (%): 2.0 (2017); 1.7 (2018); 1.7 (2019F)
Domestic Credit (% GDP): 207.9 (2016); 199.4 (2017); 194.9 (Sep-2018)
Current Account (% GDP): 1.8 (2017); 0.8 (2018); 0.8 (2019F)
International Investment Position (% GDP): -85.3 (2016); -83.8 (2017); -80.7 (Sep-2018)
Gross External Debt (% GDP): 167.0 (2016); 166.6 (2017); 167.5 (Sep-2018)
Governance Indicator (percentile rank): 81.7 (2017)
Human Development Index: 0.89 (2017)

EURO AREA RISK CATEGORY: LOW

Notes:
All figures are in euros (EUR) unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Fiscal balance (IGAE/INE/EC/BdE), Gross debt (BdE/INE/EC/DBRS), Nominal GDP (INE/EC), GDP per Capita (BdE/INE/EC), Real GDP Growth (INE/EC), Consumer Price Inflation (INE/EC), Domestic Credit (BdE/INE), Current Account (BdE/INE/DBRS), International Investment Position (BdE/INE), Gross External Debt (BdE/INE). Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The sources of information used for this rating include the Ministry of Economy and Business, Ministry of Finance, Bank of Spain (BdE), National Statistics Office (INE), General State Comptroller (IGAE), Spanish Treasury, Independent Authority for Fiscal Responsibility (AIReF), European Central Bank (ECB), European Commission (EC), Eurostat, European Banking Authority (EBA), Organisation for Economic Co-operation and Development, International Monetary Fund (IMF), World Bank, United Nations Development Programme (UNDP), Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

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.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period. DBRS’s outlooks and ratings are under regular surveillance.

For further information on DBRS historical default rates published by the European Securities and Markets Authority (“ESMA”) in a central repository, see:
http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Ratings assigned by DBRS Ratings GmbH are subject to EU and US regulations only.

Lead Analyst: Javier Rouillet, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer – Global FIG and Sovereign Ratings
Initial Rating Date: October 21, 2010
Last Rating Date: September 28, 2018

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