Scope revises the Outlook on Spain’s A- rating to Negative
|Deteriorating public finances and declining growth potential drive the Outlook change. Forceful European monetary and fiscal policies, and resilient debt profile support near-term debt sustainability and the rating.|
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Scope Ratings GmbH has today affirmed Spain’s A- long-term issuer and senior unsecured local- and foreign-currency ratings, with the Outlook revised to Negative. The agency has also affirmed the short-term issuer rating of S-1 in both local and foreign currency and revised the Outlook to Negative.
Summary and Outlook
The revision of the Outlook on Spain’s long-term sovereign ratings to Negative from Stable reflects the substantial deterioration in public finances and economic activity due to the Covid-19 pandemic. Specifically, the Negative Outlook reflects Scope’s view that:
The Outlook change to Negative reflects changes under Scope’s assessments in the ‘public finance risk’ and ‘domestic economic risk’ categories in its sovereign methodology. The affirmation of the A- rating reflects the significant support of the European institutions, in particular the European Central Bank’s (ECB) emergency actions and the European Commission’s (EC) recovery fund (Next Generation EU), which, together with Spain’s resilient debt profile, help absorb the financing of the immediate impact of the shock, critically supporting Spain’s debt sustainability in the near-term.
The ratings could be downgraded over the next 12-18 months if: i) the economic recovery is weaker than expected, ii) public finances are not placed on a firm downward trajectory once the recovery takes hold, and/or iii) reforms are introduced that adversely impact the economic and fiscal outlooks. Conversely, the Outlook could be reversed back to Stable if: i) the economy recovers faster than expected, and, in that context, a credible medium-term fiscal consolidation strategy is implemented, and/or ii) reforms are introduced to address labour market and productivity challenges, raising the country’s growth potential.
The first driver underlying Scope’s decision to revise the Outlook on Spain’s A- rating to Negative is the significant deterioration of the country’s public finances over the medium-term, which reflects Scope’s expectation of i) the depth of Spain’s 2020 recession following the Covid-19 shock, and ii) the challenge to stabilise, let alone reverse, Spain’s high and rising public debt-to-GDP ratio over the coming years.
Specifically, the Covid-19 shock has brought six consecutive years of average annual growth of 2.6% from 2013-19, compared to 1.9% for the euro area, 2.2% for Portugal and 0.8% of Italy over the same period, to an abrupt end with the biggest-ever output decline of 22.1% seasonally-adjusted in H1-2020. This is the most pronounced GDP contraction in the euro area, which reflects i) the strict lockdown measures in response to the severe health impact of the Covid-19 pandemic, ii) structural factors that expose the economy to such containment measures, with about 30% of economic activity and 40% of employment related to hard-hit sectors such as travel, tourism, hospitality and the arts, and iii) persistent labour market rigidities, resulting in high structural and cyclical unemployment, now exacerbating the risk of unemployment for about a fifth of the workforce with the associated economic, fiscal and social costs.
In line with other European sovereigns, Spain has gradually reopened its economy since May. It is Scope’s baseline that the -18.5% quarter-on-quarter GDP decline of Q2 2020 was the trough of this unprecedented recession and that Spain now faces a very gradual, sector-specific and highly uncertain recovery. However, the positive effect of the resumption of economic activity is somewhat offset by the advice of some governments not to travel to Spain this summer, which will result in important losses to the tourism sector. Balancing these effects, and mindful of the high uncertainty around the economic outlook, Scope expects for 2020 a moderate recovery in Q3 and Q4, resulting in an overall 2020 GDP decline of about 12.5%. This is the deepest recession in Spain’s history and compares to an expected decline of about 9% for the euro area and 10% for Italy and Portugal.
In this context, Scope notes that Spain’s public debt level was only on a very modest decreasing trajectory before the Covid-19 shock, having declined by around 5pp from 2014-19 to 95.5% of GDP by the end of last year, driven mostly by the favourable cyclical economic environment and falling interest payments. In fact, prior to the Covid-19 shock, Spain had the highest structural deficit among euro area member states at around 3% of potential GDP. The Covid-19 shock will now have a significant adverse impact on Spain’s public finances given the cyclical deterioration in the budget and the significant reduction in nominal GDP as well as the necessary direct fiscal stimulus implemented by the government (about 4% of GDP).
Specifically, it is Scope’s baseline that i) Spain’s economy will recover by around 7% in 2021 from a projected GDP decline of around 12.5% in 2020, with growth then gradually converging towards potential of about 1.5% over the coming years, and ii) Spain’s fiscal deficit will decline from about 13.5% of GDP this year to around 8% of GDP in 2021, and then improve gradually, but remain elevated at around 5% of GDP by 2024. Over the medium-term, Scope thus expects Spain’s gross financing needs to remain high but to decline from almost 30% of 2020-estimated GDP to around 25% of GDP in 2021 and then around 20-25% of GDP over the 2022-24 period.
On this basis, Scope expects Spain’s public debt ratio to jump to around 123% of GDP by the end of this year, and then reverse somewhat in 2021 to around 121% of GDP, driven mostly by the expected rebound in economic activity and the associated decline in the primary deficit. Still, even under this baseline scenario, which is subject to downside risks, Scope expects the debt-to-GDP ratio to stabilise at around 125% of GDP by 2024, about 30pp above the level prior to the Covid-19 shock. While Scope acknowledges that the financing of this debt stock has markedly improved over the past few years – and, given the ECB’s interventions, is expected to remain so – the public debt level will remain about twice as high as the 60% Maastricht criterion for the years to come. As highlighted by Spain’s independent fiscal council AIReF, it may take at least two decades to return to the debt level of 95.5% recorded at end-20191.
This expected higher debt level will structurally reduce Spain’s capacity to absorb future shocks and thus reduce the government’s fiscal space as more budgetary resources will be needed to finance larger debt amortisations, even if interest payments remain at the current low levels. This underscores the need for a credible, multi-year fiscal consolidation strategy, which, in the context of Spain’s moderate and declining growth potential – the second key driver for the Negative Outlook – constitutes a major rating constraint.
While Scope acknowledges the structural adjustments of the Spanish economy since the euro area crisis of 2010-12, which i) shifted resources towards the dynamic, export-oriented services sector, ii) markedly improved Spain’s cost competitiveness, iii) significantly deleveraged the private sector in line with the euro area average, and iv) restructured and recapitalised the banking sector, Scope highlights the need to raise Spain’s medium-term growth potential, which, already prior to the Covid-19 shock, was estimated between 1.0% and 1.7% by the Bank of Spain, the IMF and the European Commission. This moderate potential growth outlook is due to i) weak productivity growth, ii) unfavourable labour force demographics, and iii) a very weak labour market. Now the risk is that the Covid-19 shock may have permanently lowered the potential output of Spain given the great financial damage to companies, severing workers from their jobs to the extent that past productivity cannot be restored, placing a swifter economic recovery at risk.
The Covid-19 shock is thus further stressing Spain’s already weak labour market. While the unemployment rate declined from about 26% in 2013 to 14% in 2019, it remained around twice the euro area average prior to the pandemic, significantly above that of Italy (10%) and Portugal (6.5%). Scope now expects the unemployment rate to rise again to around 20% given that the sectors most affected by this crisis are also among the most employment-intensive ones. In fact, the reduction in the number of workers on furlough arrangements (ERTEs) since the April peak of around 3.4mn to 1.8mn in June has been very uneven across sectors, with almost half the workers on ERTEs in the retail and hospitality sectors2. Thus, in addition to the persistent duality of the labour market – evidenced via widespread use of temporary contracts (about 20% of all employed compared to less than 14% for the euro area), elevated youth and long-term unemployment rates – the key credit relevant risk now is that a more protracted recovery in these sectors may put people currently on ERTEs at risk of becoming permanently unemployed. This would adversely impact Spain’s growth and fiscal prospects, which Scope captures with the Negative Outlook.
Finally, Scope highlights that after four elections in as many years, Spain’s political landscape remains highly divided, due in part to the unresolved situation in Catalonia. Spain’s minority coalition government led by Pedro Sánchez of the Socialist Party (PSOE) together with the left-wing Unidas Podemos (UP) commands only 155 of 350 seats in the Congress of Deputies and was unable to pass a 2020 budget. Now, even if the minority government is able to adopt a 2021 budget, which is Scope’s baseline as the prospect of European grants from the EU’s recovery fund will likely create sufficient political pressure across party-lines to facilitate this decision, the risk is that passing the budget will entail meaningful additional fiscal costs to ensure cross-party support.
In addition, prior to the Covid-19 shock, a key risk was, and remains, the adoption of legislation that adversely affects Spain’s productivity and labour market inclusion. While the prospect of European grants may reduce the risk of passing legislation that adversely affects Spain’s growth potential, as this could result in a delay or even withholding of such funds, Spain’s track record in converting European funds into a favourable fiscal impulse is weak. In fact, at 39%, Spain has the second lowest cumulative 2014-20 absorption rate of European Structural and Investment Funds among the EU-28, in line with Italy but markedly below that of Portugal (54%)3. In this context, it is Scope’s opinion that the persistent political fragmentation could hinder the government’s ability to i) maximise the use of European grants to facilitate a swifter economic recovery, ii) formulate a credible medium-term fiscal consolidation plan once the recovery takes hold, and iii) introduce politically costly reforms to raise Spain’s growth potential.
Despite these challenges, Spain benefits from considerable credit strengths over the near-term:
The A- rating is supported by Spain’s European Union and euro area memberships, and in particular, the forceful European monetary and fiscal policy interventions to the Covid-19 shock. The ECB’s actions, including i) the Pandemic Emergency Purchase Programme (PEPP) currently worth EUR 1.35trn (11.3% of euro area GDP in 2019), which will last, at least, until June 2021, allowing the ECB to purchase sovereign bonds flexibly across time and jurisdictions, ii) highly accessible liquidity provision facilities to the banking sector, in terms both of cost and volume, and iii) relaxed requirements for assets pledged as collateral, have alleviated market pressures, eased banking system stresses and immediate increases in non-performing loans and defaults, and are critically supporting the government’s ability to finance high and rising fiscal deficits at very favourable market rates4.
While the ECB’s measures, and the PEPP in particular, are temporary in nature, it is Scope’s baseline that the weakness of aggregate euro area demand will continue exerting downward pressure on prices, and that consequently, the ECB will ensure a high degree of monetary accommodation over the coming years. This highly supportive monetary policy stance thus provides all euro area member states, including Spain, with excellent capital market access to finance a counter-cyclical fiscal stimulus on very favourable terms.
Scope estimates the ECB to purchase around EUR 120-130bn of Spanish government securities in 2020 and another EUR 50-60bn in 2021, under both the Asset Purchase Programme and PEPP for a total of around EUR 180bn this year and next, approximately in line with Spain’s share in the ECB’s capital key. For 2020, Scope estimates gross financing needs of around EUR 320bn, slightly above the government’s projections of EUR 297.4bn, given weaker growth and fiscal projections5. For 2021, Scope estimates gross financing needs of around EUR 280bn given a gradual recovery and resulting decline in the fiscal deficit.
Overall, compared to the 2019 level of EUR 192.8bn, this implies additional financing needs of around EUR 125bn in 2020 and EUR 90bn for 2021. Thus, the ECB’s government bond purchase programmes suffice to de facto cover the entire additional financing needs of the Spanish government this year and more than half of next year’s vis-à-vis the 2019 level. This ensures a stable and highly favourable market environment, with the 10-year bond yield currently at around 0.3%, significantly supporting Spain’s debt sustainability. Critically, the uncertainty and downside risks that still remain regarding the final volume of Spain’s gross financing needs is mitigated by the fact that, if needed, i) the ECB’s purchases of Spanish bonds under the PEPP could be higher given the flexibility to deviate from the capital key, ii) the ECB could again adjust the parameters of the PEPP, and finally, iii) following the European Council’s agreement to establish a recovery fund, financed by the European Commission (EC) for a maximum amount of EUR 750bn between 2021 and 20266, from 2021 onwards, Spain will be able to finance a part of its fiscal deficits via direct transfers and favourable loans from the EC, which constitutes an additional stable and favourable financing source.
Specifically, while the final allocation will only be known in the coming years, Spain is a key beneficiary of this instrument, entitled to receive about EUR 140bn, or about 11% of 2019 GDP, of which about EUR 71.3bn will be in direct transfers (about 6% of GDP). In absolute terms, this is the second highest expected allocation of grants after that of Italy (EUR 84.9bn) and the seventh highest among all EU-27 member states as a share of GDP, highlighting the funds’ macro-economic relevance7. It is Scope’s baseline that Spain could receive between EUR 10-30bn in transfers each year, starting from 2021 until 2026. This is about 1-2.5% of GDP in additional budgetary resources that will be, in principle, available to the Spanish government. Given a front-loading effort, Scope expects Spain to receive about EUR 25bn of grants in 2021, or about 2% of GDP. These direct grants provide a historic opportunity to facilitate a macro-economically relevant fiscal stimulus without directly impacting government finances.
In addition to the abovementioned grants, Spain will also receive a loan of about EUR 20bn, or 1.6% of GDP, from the EC’s unemployment insurance scheme (SURE) to cover parts of its elevated public expenditure related to its short-time work scheme (ERTE) and similar measures. While this loan – together with the additional loans Spain could receive from the recovery fund of almost EUR 70bn over the coming years – will increase the government debt stock, it will reduce the government’s recourse to capital markets, and improve Spain’s debt profile given the EC’s favourable lending conditions in terms of maturity and cost.
Overall, this forceful European policy effort is providing Spain with a benign financial market environment to absorb the Covid-19 shock and finance, on favourable terms, an economic recovery, which will also benefit from macro-economically relevant transfers that will not directly impact its public finances. This is critical to support Spain’s near-term debt sustainability as captured by Scope’s affirmation of the A- rating.
Sovereign rating scorecard (CVS) and Qualitative Scorecard (QS)
Scope’s Core Variable Scorecard (CVS), which is based on the relative rankings of key sovereign credit fundamentals, provides an indicative ‘bbb’ rating range for the Kingdom of Spain. This indicative rating range can be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative credit strengths or weaknesses versus peers based on qualitative analysis.
For the Kingdom of Spain, the following relative credit strengths have been identified: i) economic policy framework, ii) debt sustainability, iii) market access and funding sources, iv) current-account vulnerability, v) external debt sustainability, vi) vulnerability to short-term external shocks, vii) banking sector performance and viii) banking sector oversight and governance. Relative credit weaknesses are: i) recent events and policy decisions. The combined relative credit strengths and weaknesses generate a two-notch adjustment and indicate a sovereign rating of A- for the Kingdom of Spain. A rating committee has discussed and confirmed these results.
Factoring of Environment, Social and Governance (ESG)
Scope considers sustainability issues during the rating process as reflected in its sovereign methodology. Governance factors are explicitly captured in Scope’s assessment of ‘institutional and political risk’ under its methodology, in which Spain has high scores on a composite index of six World Bank Worldwide Governance Indicators. Social factors are reflected in Spain’s comparatively high GDP per capita, elevated rates of unemployment, and its high and rising old-age dependency ratio. Temporary contracts and high youth and structural unemployment remain key credit-relevant challenges. Finally, environmental factors were considered during the rating process but did not play a direct role in this rating action.
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Full nameThe Kingdom of Spain