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Rating action

Scope Ratings GmbH (Scope) has today affirmed the Kingdom of Spain’s A- long-term issuer and senior unsecured local- and foreign-currency ratings, along with its short-term issuer rating of S-1 in both local and foreign currency. All Outlooks remain Stable.

Summary and Outlook

Scope’s affirmation of Spain’s A- ratings is underpinned by the following credit strengths: i) a large and diversified economy, underpinned by high value-added activities; ii) a favourable public debt profile with long maturities; and iii) a strong institutional framework, bolstered by euro area membership that supports resilience to external shocks.

Rating challenges include: i) high public debt levels; ii) elevated structural unemployment and low productivity growth; and iii) rising structural budgetary pressures stemming from long-term spending trends, notably related to accelerated ageing dynamics, and the medium-term implications of current fiscal policies.

The Stable Outlook reflects Scope’s view that risks to the ratings are balanced over the next 12 to 18 months.

The A- ratings and Stable Outlooks could be upgraded if there was a notable improvement, individually or collectively, in: i) growth prospects, supported by, for example, structural reform progress; and/or ii) public finances, putting public debt on a firm downward trajectory.

Conversely, the ratings/Outlooks could be downgraded if: i) a weaker-than-expected economic recovery and/or protracted fiscal deterioration resulted in weaker debt sustainability; and/or ii) reforms were delayed, adversely impacting the economic and fiscal outlooks.

Rating rationale

Spain’s A- ratings are underpinned by the country’s large and diversified economy, which, compared to other European major economies, is less vulnerable to sharp energy supply restrictions due to the war in Ukraine.

The Spanish economy grew by 5.1% last year after one of the deepest contractions in the EU in 2020, during which GDP fell by 10.8%. The recovery continued into 2022, with strong growth of 6.7% year on year in the first half of the year, driven by recovering tourism receipts and household demand. Economic activity remained 2 pp below its pre-pandemic level at Q3 2022, in contrast with aggregate output in the euro area, which had overtaken the pre-pandemic level by 2.1 pp. The primary reason is Spain’s specialisation in sectors most impacted by the pandemic, tourism in particular, and in key industries affected by global supply chain disruptions, including automotive. Spain’s labour market remained strong, with unemployment standing close to multi-decades lows, at 12.7% at Q3 2022. Job creation remained robust, bringing persons employed and the employment rate to historical highs of respectively 20.5m and 64.8%. The quality of employment has also improved markedly as a result of the 2021 labour market reform, reflected in a steady decline of temporary hires.

Spain is less reliant on Russian gas than most other euro area peers, making it less vulnerable to sharp restrictions resulting from the war in Ukraine. This is underpinned by the country’s pipeline connections to North Africa and sizeable regasification capacities, the largest in Europe with six operational terminals. Even so, the Russia-Ukraine conflict represents a significant drag on Spain’s growth outlook as it has led to spiking energy prices and worsening economic outlooks for key trading partners. Despite a recent moderation of headline inflation to 7.3% YoY in October (from a peak of 10.8% in July), prices remain under pressure, with negative impacts on real incomes and private demand. Scope expects growth will remain strong this year at 4.5%, primarily reflecting a high carry-over effect, before moderating to 1.0-1.5% in 2023 due to weaker household consumption and business investment. It should then trend back to the medium-term potential, which Scope estimates at 1.5-2.0% per year. Growth prospects should be supported by high public investment fuelled by EU funds as well as the roll-out of Spain’s Recovery and Resilience Plan.

Spain’s A- ratings reflect its euro area membership, which confers strong institutional support in the form of EU monetary and fiscal policies. Support from the European Central Bank proved key throughout the Covid-19 crisis in anchoring market access for the EU’s most indebted member states, which includes Spain. The share of Spanish public debt held within the Eurosystem increased from 18% at end-2019 to 28% by end-2021, adding stability to the investor base. EU institutional support was reinforced by the inception of the EU Recovery and Resilience Facility. Spain is one of the largest beneficiaries of financial support under the new facility and is set to receive EUR 69.5bn in grants (5.6% of 2019 GDP) to be disbursed over 2021-26, supplemented by structural funds set out in the 2021-2027 Multiannual Financial Framework and EUR 12.4bn from the REACT-EU funds. These funds will add fiscal space to support growth while structural reforms are undertaken. Spain has a traditionally good absorption rate of European structural investment funds and sufficient capacity to channel large amounts of public investment.

Finally, the A- ratings are supported by a favourable debt profile and robust market access, mitigating risks stemming from tightening global funding conditions. The average life of debt outstanding stands at around eight years, up from 6.2 in 2013, with the Spanish treasury using the low interest rates to notably lengthen average repayment periods and reducing the share of short-term debt. This should allow for an only gradual feedthrough of higher interest rates to the government’s interest payments, which stood at 2% of GDP as of 2021. Similarly to peers, Spain’s debt issuance costs have increased markedly in recent months on the back of higher inflation expectations and tightening monetary policy. Debt issuance costs remain lower than the historical average, however, supported by a stable investor base, with more than 55% of total debt held by residents. Additionally, a moderate share of interest rate indexed-liabilities (around 6% of total) limit the near-term impact of higher inflation on debt servicing costs.

Despite these credit strengths, Spain’s ratings are challenged by several weaknesses.

First, Spain’s government debt-to-GDP ratio, at 116.1% as of Q2 2022, is among the highest in the euro area, behind that of Portugal (123.4%), Italy (150.2%) and Greece (182.1%). Despite having declined from pandemic peaks of 120% in 2020, the ratio remained nearly 18pp above its end-2019 levels, reflecting the spike in total debt resulting from measures to address the health crisis. Scope expects the debt-to-GDP ratio to decline moderately to 113% in 2023 before receding to 109% by 2027, more than 10 pp above its pre-pandemic level, as moderate nominal growth will only partially offset the impact of persistent, albeit declining, primary deficits.

Second, rising structural budgetary pressures stemming from long-term spending trends, notably related to accelerated ageing dynamics, and the medium-term implications of current fiscal policies are challenges.

For 2022, Scope expects Spain to reduce its general government deficit from 7% of GDP in 2021 to 4.5%, which would be 0.5 pp below the government’s forecast. However, the recent decline in the deficit and the likely better-than budgeted outcome in 2022 have relied on cyclical factors, which have included growing tax revenue in line with the economic recovery in 2022, the high allocations of Next Generation EU funds in form of grants and the gradual withdrawal of Covid-19 measures which offset the growing expenditure for the energy crisis.

For 2023, Scope forecasts an only gradual reduction of the general government deficit to 4.3% of GDP, which would be above the respective government reference rate of 3.9%, challenging consolidation efforts. This will be due to the likely extension beyond 2022 of measures to counteract the energy crisis. Another risk of a deviation from 2023 budgetary targets stems from potential revenue underperformance: the government’s assumption for real GDP growth of 2.1% in 2023 is higher than Scope’s forecast of 1.5%. In the absence of additional structural consolidation measures, Scope estimates Spain’s general government deficit to stabilise at 3.2-3.5% of GDP in the medium term, above the 3% limit set in the Stability and Growth Pact. This will be due to rising budgetary pressures given long-term spending trends, notably related to accelerated ageing dynamics, and the medium-term implications of current fiscal policies.

Spain’s demographic developments are among the worst in Europe, specifically, regarding the rapidly ageing and declining working population. This adds pressure on government expenditure and limits tax revenue growth. Amid high inflation, the government will increase pensions via automatic indexation clauses by around 8.5% in 2023, with the risk of adding inflationary pressure and reducing the state’s fiscal flexibility, already constrained by high public debt and rising interest rates. The recent pension reform included the cancellation of the previous sustainability mechanism and the relinking of pension payments to inflation, which makes financing the pension system even more challenging. The IMF estimates the net present value of healthcare spending changes over 2021-50 at 43.9% of GDP for Spain, well above that of Italy (25.5%), Portugal (34.9%) and France (36.2%). Spain’s improving fiscal position will be hindered by the revaluation of pensions in line with the consumer price index, adding EUR 17.3 bn of expenses (around 1.4% of GDP) unless compensated for by other savings. This will add pressure on fiscal sustainability, already burdened by a rapidly ageing population that will need more healthcare.

Finally, Spain is faced with long-standing labour market challenges, with high structural unemployment and weak productivity growth. Spain’s structural unemployment rate, as estimated by the European Commission, remains the highest in the euro area, at 12.4% as of last year. While the 2021 labour reform improved the quality of new jobs, high youth unemployment (34.8% against euro area’s 16.6%) and high long-term unemployment (6.2% against 2.8%) remain challenges. Productivity growth is also lacklustre, declining steadily relative to peers in recent years from 103% to 93% of the EU average over 2012-21. Recent regulatory developments, including the labour reform, and increased public investment from funds disbursed under the Recovery and Resilience Plan should support productivity gains in the medium term. However, further policy action will be needed to reverse the negative trend of productivity growth relative to peers, notably through reforms aimed at raising skill levels and accelerating digitalisation.

Core Variable 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 rating of ‘a’ for the Kingdom of Spain, after including an adjustment for the reserve currency under Scope’s methodology. As such, under Scope’s methodology, an ‘a’ indicative rating can be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative qualitative credit strengths or weaknesses against a peer group of countries.

For Spain, the following relative QS credit weaknesses have been identified: i) fiscal policy framework; and ii) social risks.

The QS generates one negative notch adjustment and indicates a sovereign credit rating of A- for 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 its rating process via the sovereign methodology’s stand-alone ESG sovereign risk pillar, with a 25% weighting under the quantitative model (CVS) as well as in the methodology’s qualitative overlay (QS).

Regarding environment risks, Spain scores well under the CVS on carbon emissions per unit of GDP and its exposure and vulnerability to natural disaster risk. Compared to European peers, Spain is among the most vulnerable to climate change. Spain scores weaker on resource risks, specifically for the ecological footprint of its consumption compared with the available biocapacity within its borders. Scope notes positively that the Spanish government moved its 2025 energy transition targets contained in its National Energy and Climate Plan forward to 2023. This should support investment for renewable energies, the renewal of housing stock, and infrastructure for electric mobility.

Socially related credit factors are similarly captured under Scope’s CVS. Moderate income inequality and increasing labour force participation rates are counterbalanced by significantly increasing old-age dependency ratios. Compared with peers, Spain also has a particularly high share of young people neither in employment nor in education and training, although the government has been addressing this, including as part of its Recovery and Resilience Plan.

Finally, governance factors are explicitly captured in Scope’s assessment of ‘institutional and political risk’ under its methodology, for which Spain scores strongly on a composite index of six World Bank Worldwide Governance Indicators, reflecting its mature and stable institutional framework. The ruling coalition, despite lacking an absolute parliamentary majority, passed several key legislations, including changes to the pension system and labour market as well as budget bills. However, some uncertainty remains regarding its ability to implement structural reforms ahead of the next general elections, scheduled in December 2023.

Rating Committee
The main points discussed by the rating committee were: i) domestic economic risk, including growth potential and resilience; ii) public finance risks, including fiscal framework and debt dynamics; iii) external risks; iv) financial stability risks; v) ESG considerations; and vi) peer developments.

Methodology
The methodology used for these Credit Ratings and Outlooks, (Sovereign Rating Methodology, 27 September 2022), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The model used for these Credit Ratings and Outlooks is (Sovereign CVS model version 2.1), available in Scope Ratings’ list of models, published under https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
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-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. 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-governance/definitions-and-scales. 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://scoperatings.com/governance-and-policies/rating-governance/methodologies.
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                                            YES
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 is/are UK-endorsed.
Lead analyst Jakob Suwalski, Director
Person responsible for approval of the Credit Ratings: Dr. Giacomo Barisone, Managing Director
The Credit Ratings/Outlooks were first released by Scope Ratings on 30 June 2017. The Credit Ratings/Outlooks were last updated on 27 May 2022.

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
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