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Rating action

Scope Ratings GmbH (Scope) has today affirmed Spain’s A- long-term issuer and senior unsecured local- and foreign-currency ratings, with the Outlook revised to Stable from 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 Stable from Negative.

Summary and Outlook

The revision of the Outlook on Spain’s long-term sovereign ratings to Stable from Negative reflects an improving economic outlook and reform momentum, driven by the country’s recovery and resilience plan. Specifically, the Outlook revision reflects Scope’s view that

1. the front-loaded investments over the H2-2021 to 2023 period, together with reforms aimed at addressing long-standing labour market and productivity challenges, should facilitate the economic recovery and raise the country’s growth potential over the coming years; and
    
2. ithe improved economic outlook, in the context of continued European monetary and fiscal support and relative government stability, should facilitate the gradual consolidation of public finances, resulting in a modestly declining debt trajectory over the coming years.

The Outlook change to Stable reflects changes under Scope’s assessments in the ‘domestic economic risk’ and ‘public finance risk’ categories under its sovereign methodology. The affirmation of the A- rating reflects the country’s medium-term credit challenges, including high public and external debt levels as well as increasing economic and fiscal pressures from an ageing population.

The rating/Outlook could be downgraded over the next 12-18 months if: i) the economic outlook is weaker than expected; ii) public finances deteriorate further; and/or iii) reforms are delayed or introduced adversely impacting the economic and fiscal outlook. Conversely, the rating/Outlook could be upgraded if: i) reforms are introduced that further raise the country’s growth potential; and/or ii) public finances improve meaningfully.

Rating rationale

The first driver underlying the revision of the Outlook relates to the country’s recovery and resilience plan, which, in Scope’s opinion, makes a significant contribution to the country’s economic rebound and modernisation by addressing key structural challenges. The plan, worth EUR 69.5bn (or 6.2% of GDP), is set to provide momentum to the economy in the short term and facilitate a structural transformation towards more sustainable and resilient growth. The plan is centred around 10 policy areas and contains 102 reforms and 109 investments aimed at driving activity and employment via substantial allocations for the green (EUR 27.6bn; 39.7% of total) and digital transitions (EUR 19.6bn; 28.2%). The plan is set to mobilise both public and private investment over the coming years¹.

Of the numerous reforms accompanying the plan, Scope highlights as the most critical those targeting the labour market. This is a long-standing and highly credit-relevant issue: Spain’s unemployment rate, (around 16% as of end-2020) is around twice the euro area average and significantly above that of Italy (9%) and Portugal (7%). Further, Spain’s structural unemployment rate (around 14%) is among the highest in the euro area. At the same time, the persistent duality of the labour market, with a widespread use of temporary contracts (about 25% of all employed, against 14% for the euro area) and elevated youth and long-term unemployment rates, adversely impacts the country’s growth potential and public finances. Given this context, Scope views as credit positive the reforms seeking to reduce the high share of temporary contracts, by lowering the number of contract types to three (i.e. open-ended, temporary and training) and making it more difficult for employers to use temporary contracts. In addition, active labour market policies, including for older workers as well as planned reforms to enhance the skill level of the workforce, should boost employment levels and thus reduce structural unemployment. The successful implementation of these reforms should thus not only reduce the unemployment rate to around 13% over the coming years but would have a lasting effect on the economy’s growth potential².

Additional reforms of the recovery plan should contribute to a better business environment. These aim to reduce market fragmentation and improve regulation to boost economic productivity and competitiveness. The combination of substantial, front-loaded investments and growth-enhancing reforms should improve total factor productivity and labour market efficiency. The full impact on GDP and employment will ultimately depend on the timing and sequencing of these investments and reforms as well as associated fiscal multipliers, which are difficult to estimate given Spain’s large, negative output gap. Nonetheless, Scope expects these measures to boost GDP and employment over the coming years.

Specifically, the Spanish government estimates the plan will increase potential growth by 0.4% yearly over the medium term to above 2%, above the pre-crisis estimates of the Bank of Spain, the IMF and the European Commission, which range from 1.0% to 1.7%. While the European Commission considers Spain’s estimates of cumulative increases in GDP (by 4.2%) and employment (3.1%) for the plan’s first three years to be optimistic, the plan will still provide a noticeable boost to economic growth, particularly between 2022 and 2023. This will be driven by strong demand, given the front-loaded absorption of the funds, the potential crowding-in effect on private investment, and the gradual normalisation of the household savings rate. The European Commission projects the plan’s full implementation to result in GDP increases of between 1.8% and 2.5% by 2024, similar to Spain’s independent fiscal council (AIReF), which also projects a positive impact on GDP of between 1.5% and 2.5% until 2024, facilitating a return to pre-Covid levels by 2022^2,3.

The second driver underpinning the revision of the Outlook to Stable is Scope’s expectation of a faster-than-previously expected improvement in Spain’s public debt trajectory. This view is underpinned by the improved economic outlook combined with the continued accommodative monetary policy stance of the European Central Bank, with the 10-year government bond yield of around 0.4% significantly supporting Spain’s debt sustainability. Following the conclusion of the ECB’s strategic review and the adoption of a revised symmetric inflation target of 2%, Scope expects this highly favourable market environment to continue over the medium-term, facilitating the gradual consolidation of Spain’s public finances^4,5.

With growth and employment rising faster, the deficit should also narrow more quickly, placing the debt-to-GDP ratio on a downward trajectory that outpaces Scope’s previous expectation (i.e. stabilising at around 125% of GDP by 2024). Scope’s adjusted baseline is that i) Spain’s economy will recover by around 6% in 2021 and 2022 from a GDP decline of 10.8% in 2020, after which growth converges towards a slightly revised potential of about 1.75% over the coming years; and ii) Spain’s fiscal deficit will decline to around 8% of GDP in 2021 from about 11% in 2020 followed by a gradual improvement by 2026 but at an elevated level of around 3%. Over the medium term, Scope thus expects gross financing needs to remain high but to decline to around 25% of GDP in 2021, from almost 30% in 2020, and then reduce to just below 20% over 2022-25. On this basis, Scope expects the public debt-to-GDP ratio to decline from around 120% by the end of this year to around 113% by 2026 in line with Portugal but markedly better than Italy (160%), to be driven mostly by sustained economic activity and the associated decline in the primary balance. The declining trajectory contrasts with Scope’s previous expectations of around 125% by 2024, supporting the revision of the Outlook back to Stable.

In addition, Scope notes positively that in addition to the recovery funds, Spain has also received a loan of EUR 21.3bn, or 1.6% of GDP, from the European Commission’s unemployment insurance scheme, SURE. The loan covers parts of Spain’s elevated public expenditure related to its short-time work scheme (ERTE) and similar measures. While this loan increases the debt stock (along with additional loans Spain could still receive from the recovery fund of almost EUR 70bn over the coming years), it reduces recourse to capital markets, improving Spain’s debt profile given the favourable maturities and interest costs offered by the European Commission.

The success of Spain’s recovery and resilience plan will depend on a stable government and on the ability of Prime Minister Pedro Sánchez to rapidly implement reforms with continued support from the regional parties. This highlights that the government’s recent decision to partially pardon nine Catalan politicians and officials who were imprisoned following an illegal consultation on Catalan independence in 2017 should facilitate more conciliatory relations between central and regional governments. Scope expects that this improved dialogue will ensure that the Catalan pro-independence party, ERC, will continue to support Spain’s minority coalition government (led by the Socialist Party and left-wing Unidas Podemos) in passing critical legislation, including the 2022 budget. As a result, Scope now expects relative political stability, even with the fragmented parliament, until the next elections scheduled by December 2023. This is important because the success of forthcoming reforms as well as the implementation and absorption of investments under the recovery and resilience plan depend on cooperation with regional governments.

Despite these improvements, several credit challenges remain, anchoring Spain’s credit ratings at A-:

First, public debt will remain elevated for the years to come, at about 15-20pp above pre-Covid levels, even with Scope’s expectation of a continued accommodative monetary policy stance easing the financing of the public debt stock. The downward trajectory of public debt was already only very modest before the Covid-19 shock, by around 5pp from 2014-19 to 95.5% of GDP, 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 members, at around 3% of potential GDP. The higher public debt will continue to structurally reduce Spain’s capacity to absorb future shocks and thus reduce fiscal space as the larger debt amortisations will require more budgetary resources, even with interest payments remaining low. The elevated public debt stock thus constitutes a major rating constraint and underscores the need for a credible, multi-year fiscal consolidation strategy once the recovery takes hold. In this context, reforms related to tax reforms, including via raising VAT and environmental taxes as proposed by the OECD, could help contribute to Spain’s medium-term fiscal consolidation⁶.

Second, Spain’s external position remains a credit weakness, also compared to Italy’s. Spain’s still-negative net international investment position is high at around 84% of GDP as of end-2020, significantly below that of Italy (+1.2%), after having deteriorated by about 10pp last year. This exposes Spain to shocks and sudden shifts in market sentiment. However, this increase was mostly driven by the Bank of Spain, while external debt levels from the private sector have remained largely unchanged over the past few years. In addition, the deterioration in the net international investment position has been amplified by the increased market value of portfolio debt securities issued by Spanish residents, contributing almost -50pp since 1996. Still, while external risks are clearly mitigated by having the euro as a reserve currency, a sustained period of current account surpluses will be needed to unwind Spain’s external imbalance⁷.

Finally, Spain’s demographic developments are among the most adverse in Europe, specifically, regarding the rapidly ageing and declining working population. The EC projects Spain’s working-age population (aged 20-64) to decrease by about 16% by 2070, less than Italy (-23%) and Portugal (-31%), but well above the 6-8% decline expected for higher-rated sovereigns such as Belgium and France. As a result, the old-age dependency ratio is set to increase to around 63 by 2070 from 32 in 2019, in line with that of Italy (66) and Portugal (67), but above France’s (57) and Belgium’s (53). In Scope’s opinion, this will have a significant impact on the financing of Spain’s pension system and likely limit growth potential, complicating the consolidation of public finances over the medium term⁸.

In this context, the final design of the pension reform is critical. While the reform as proposed would increase pension expenditure, by permanently relinking pensions to the consumer price index and delinking initial pensions from life expectancy, other measures may mitigate the impact on fiscal sustainability. These include raising the effective retirement age, changing the contribution base for the self-employed and increasing the contribution period for the calculation of pension benefits.

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 a first indicative rating of ‘bbb+’ for the Kingdom of Spain. The Kingdom of Spain receives a one-notch uplift to this indicative rating via the reserve currency adjustment under the methodology. As such, the ‘a-’ indicative ratings 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 analysts’ qualitative analysis.

For the Kingdom of Spain, the following relative credit strengths have been identified: i) monetary policy framework, and ii) market access and funding sources. The relative credit weakness is: i) social risks. The combined relative credit strengths and weaknesses do not result in a qualitative 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 explicitly factors in ESG sustainability issues during the ratings process via the sovereign methodology’s stand-alone ESG sovereign risk pillar, with a 20% weighting under the quantitative model (CVS) as well as in the qualitative overlay (QS).

Governance factors are explicitly captured in Scope’s assessment of ‘institutional and political risk’ under its methodology, in which Spain has relatively high scores on a composite index of six World Bank Worldwide Governance Indicators. Socially related credit factors are similarly captured under Scope’s CVS. Increasing labour force participation rates are counterbalanced by high income-inequality and significantly increasing old-age dependency ratios, which are also driving Scope’s qualitative assessment in this evaluation category of the QS, under which Spain is assessed as ‘weak’ compared with sovereign peers.

In respect to environment risks, Spain scores relatively well under the CVS on carbon emissions per unit of GDP and its exposure and vulnerability to natural disaster risk metrics. However, the sovereign scores weaker on resource risks, specifically for the ecological footprint of its consumption compared with the available biocapacity within its borders. Also, among European peers, Spain is among the most vulnerable countries to the adverse effects of climate change. Scope notes positively that the Spanish government moved its 2025 energy transition targets contained in its National Energy and Climate Plan forward to 2023 to boost the country’s economic recovery. This should foster investment for renewable energies, the renewal of housing stock and infrastructure for electric mobility.

Rating committee
The main points discussed by the rating committee were: i) Spain’s recession, recovery and growth potential; ii) the recovery and resilience plan; iii) Europe’s monetary and fiscal support measures; iv) labour market developments; iv) fiscal outlook, market access and public debt sustainability; v) banking sector performance; vi) political developments and fragmentation; and vii) peers.

Rating driver references
1. Spain’s recovery and resilience plan
2. European Commission, Analysis of the recovery and resilience plan of Spain, June 2021
3. AIReF Presentation June 2021
4. Tesoro Recent Developments June 2021
5. ECB monetary policy review
6. OECD Fostering the recovery, May 2021
7. Tesoro Chart Pack June 2021
8. EC 2021 Ageing Report

Methodology
The methodology used for these Credit Ratings and/or Outlooks, (Rating Methodology: Sovereign Ratings, 9 October 2020) is available on https://www.scoperatings.com/#!methodology/list.
Scope Ratings GmbH and Scope Ratings UK Limited apply the same methodologies/models and key rating assumptions for their credit rating services, while Scope Hamburg GmbH’s methodologies/models and key rating assumptions are different from those of Scope Ratings GmbH and Scope Ratings UK Limited.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/#!governance-and-policies/rating-scale. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. Also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/#governance-and-policies/rating-scale. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://www.scoperatings.com/#!methodology/list.
The Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The Credit Ratings were not requested by the Rated Entity or its Related Third Parties. The Credit Rating process was conducted:
With Rated Entity or Related Third Party Participation    YES
With Access to Internal Documents                                 NO
With Access to Management                                           NO
The following substantially material sources of information were used to prepare the Credit Ratings: the Rated Entity and public domain.
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting these Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data. Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and/or Outlooks and the principal grounds on which the Credit Ratings and/or Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.

Regulatory disclosures
These Credit Ratings and/or Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and/or Outlooks are UK-endorsed.
Lead analyst: Alvise Lennkh, Executive Director
Person responsible for approval of the Credit Ratings: Dr Giacomo Barisone, Managing Director
The Credit Ratings/Outlook were first released by Scope Ratings in January 2003. The Credit Ratings/Outlook were last updated on 21 August 2020.

Potential conflicts
See www.scoperatings.com under Governance & Policies/EU Regulation/Disclosures for a list of potential conflicts of interest related to the issuance of Credit Ratings.

Conditions of use / exclusion of liability
© 2021 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Ratings UK Limited, Scope Analysis GmbH, Scope Investor Services GmbH, and Scope ESG Analysis GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data. Scope’s ratings, rating reports, rating opinions, or related research and credit opinions are provided ‘as is’ without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or other damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party as, opinions on relative credit risk and not a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings GmbH at Lennéstraße 5 D-10785 Berlin.