Spain Upgraded to 'BBB+' by S&P; Outlook Stable (FXE)

(Updated - October 2, 2015 11:43 AM EDT)

RATING ACTION

On Oct. 2, 2015, Standard & Poor's Ratings Services raised its long-term sovereign credit rating on the Kingdom of Spain to 'BBB+' from 'BBB'. The outlook is stable.

At the same time, we affirmed our 'A-2' short-term sovereign credit rating on Spain.

RATIONALE

The upgrade reflects our view of Spain's strong, balanced economic performance over the past four years, which is gradually benefiting public finances. We now expect real GDP growth to average 2.7% over 2015-2017 versus our previous forecast of 2.2% after our review in April this year. Combined with our projection of the GDP deflator at about 0.6% this year, this implies nominal GDP growth of 3.8% in 2015 and more than 4% for the next three years, compared with average nominal GDP contraction of about 0.9% from 2011-2014. A shift toward consistently higher real and nominal growth would benefit Spain's debt dynamics, given that the Spanish Treasury refinances central government and regional debt at an average cost of less than 1%.

Some of Spain's growth drivers--including front-loaded tax cuts, lower oil prices, and a weaker exchange rate--are likely to fade. Others--including labor and other structural reforms, as well as easier financing conditions--will, in our view, contribute permanently to Spain's more dynamic recovery than peers'. One key change is that the Spanish economy is more open than it was seven years ago. Although external risks continue to overshadow any growth model based on net exports, Spain has a strong track record of gaining international market share in goods and services. By the end of 2015, we expect exports to represent about 34% of Spain's GDP versus 25% in 2008.

Export growth in Spain accelerated in real terms to 6% year over year in the second quarter of 2015. While this pace could be interrupted by a cooling of demand in the eurozone and emerging markets, we project Spain's current account surplus will improve to 1.5% of GDP this year as terms of trade remain favorable. For the past two years, Spain’s services surplus has averaged 4.7% of GDP. Further contributing to the improvement in the current account has been the gradual decline in the cost of servicing Spain's net external liabilities. Seven years ago, Spain's net income deficit peaked at 3.2% of GDP, but last year it was 0.4% of GDP, the lowest since 2002, when Spain joined the eurozone. The European Central Bank (ECB)'s highly accommodative monetary stance explains the lower external financing costs for Spain, and we expect this will continue.

A corollary to these lower external funding costs is improved market access for Spain's banks and corporations. In particular, we believe the rapid external deleveraging of Spain's financial institutions has eased. The financial sector's net external debt (including net eurosystem lending to Spanish credit institutions) has declined to an estimated 75% of current account receipts (CARs) this year versus a peak of 136% in 2009. Spain's external debt, net of public and financial system external assets, remains high, however, at about 261% of CARs in 2014, as does its net external liability position.

Since 2014, the ECB’s more accommodative policy, including its quantitative easing program, has helped unblock credit channels. In particular, small and midsize enterprises (SMEs), which contribute about two-thirds of Spain's GDP, have better access to funding at lower interest rates, supporting their profitability and willingness to hire. Much of the employment growth in Spain during the first half of 2015, which averaged 3% year on year, was in the SME sector, but overall salary growth was only about 0.2%, according to National Accounting Statistics published by the Instituto Nacional de Estadistica.

Our base-case assumption is that in 2015-2018, as private-sector spending increases, the next elected government will take further steps to reduce the high public-sector debt, which has increased nearly as much as private debt has declined over the past five years. We expect the flow of general government debt (as opposed to the overall ratio of general government debt to GDP) to increase by about 5% of GDP in 2015, the fastest relative rise in public debt of all eurozone sovereigns.

Most of the projected fiscal improvement for 2016-2018 will likely stem from further job creation, lower average interest costs, and the flattering denominator effect of rising nominal GDP. Employment growth should continue to support consumer spending, and hence tax receipts, while also lowering social expenditure, according to our estimates. The current government's proposed budget implies a more neutral fiscal position compared with this year's modest stimulus. In our view, further budgetary tightening will likely be necessary if Spain is to meet its stability program target of an almost balanced general government account, with a deficit of 0.3% of GDP, by 2018. We anticipate considerably slower consolidation, with the deficit at 2.7% of GDP in 2018, also reflecting slow progress on closing the social security deficit. Our relatively conservative forecasts reflect the lack of detailed information on possible spending cuts over the next three years, and the difficulty in assessing the government's fiscal plans in light of this year's heavy electoral calendar before the elections in December. The current stability program includes a target to reduce general government expenditure by about 5% of GDP between year-end 2014 and year-end 2018. Our projections partly reflect the possibility of a policy shift to a more relaxed pace of fiscal consolidation.

For 2015, we project the general government fiscal deficit at 4.5% of GDP versus Spain's 4.2% target, reflecting weaker performance on social security goals and regional governments' inability to meet their ambitious deficit target of 0.7% of GDP; we estimate that the regions' overall deficit will be 1.3%. We think the central government's budgetary position will outperform its2.9% of GDP deficit target in light of strong revenues. During the first eight months of 2015 (in cash terms), the central government's revenue performance was positive. Value-added tax receipts were up by 7.7% year on year; personal income tax receipts increased by more than 1%, despite a cut in personal tax rates and an increase in the income threshold for exemption; and corporate tax receipts rose by about 29% year on year, although they remain a small part of the tax base. Overall, we continue to project general government deficits of 4.5% of GDP in 2015 and 3.5% in 2016, versus official targets of 4.2% and 2.8%, respectively.

One significant uncertainty we see is whether subsequent governments will be able to preserve or even extend the strong track record of competitiveness-enhancing reforms. It is unclear what a possible future policy shift might imply for Spain's main economic weakness, its seasonally adjusted unemployment rate. At 22.2% as of August 2015 (the seasonally adjusted rate published by Eurostat), it is the second highest in the EU. We still see ample indications that Spain has a two-tiered labor market, with some workers on temporary contracts and others on indefinite contracts. Despite the recent introduction of incentives to hire permanent employees, Spanish employers' cost of employment remains above the average for countries in the Organisation for Economic Cooperation and Development, with social security contributions exceeding 20% of total labor costs. We consider this to be a constraint on economic flexibility.

Spain's medium- to long-term economic growth prospects will, in our view, be constrained by still high net external debt, high unemployment, an aging population, and lower investment in education, research, and development than Spain's eurozone peers.

The potential for a fragmented political environment following this year's elections may also lead to fiscal and structural policy slippages, which could jeopardize Spain's medium-term government deficit and economic growth targets. That said, one of our key assumptions is that tensions between the central government and regional authorities will gradually subside, and that the
region of Catalonia will remain part of Spain. If Catalonia were no longer part of Spain, we believe that elements of Spain's credit metrics, including the average per capita GDP, external accounts, and government finance position, would weaken, as would its creditworthiness.

We do not expect the Spanish government will incur additional significant fiscal costs linked to commercial banks' recapitalization. Since the fourth quarter of 2013, Spain's banking system has posted positive net income. Taking into account the improved resilience we see in the banking sector and signs of stabilization in Spain's real estate market, we see a limited risk that further contingent liabilities of the banks could crystallize on the public-sector balance sheet. Banks' nonperforming loans had declined to 10.9% of total loans as of June 30, 2015 (according to Banco de Espana data), versus the 13.6% peak at year-end 2013, despite the unflattering denominator effect from still-declining total loans. This also reflects an important reduction in doubtful loans. Low interest rates and the ECB's quantitative easing program should, we expect, help asset prices to recover, reducing the state's financial-sector contingent liabilities. We do not consider the Spanish government's stakes in financial institutions to be liquid assets, and we do not subtract them from gross general government debt when calculating Spain's net general government debt ratio. We rank Spain's banking sector in group '5' under our Banking Industry Country Risk Assessment (on a scale of '1' to '10', with group '1' denoting the lowest risk banking industry).

OUTLOOK

The stable outlook on Spain reflects our view that, over the next two years, the broad-based economic recovery we anticipate, and gradual budgetary consolidation, will likely balance risks connected to Spain's large net external liabilities and potentially weak external demand. We assume general continuity in policymaking with the next government and that political developments in Catalonia will not weaken investor confidence.

We could consider raising the ratings if Spain posts sustained and higher-than-projected GDP growth without sliding into a current account deficit, if the budget deficit narrows materially more than we currently expect, or if the monetary transmission channel strengthens further.

We could consider lowering our ratings on Spain if economic growth fell short of our projections; eurozone monetary policy failed to prevent deflationary pressures from eroding Spain's fiscal and growth performance; if net general government debt were to overshoot 100% of GDP, contrary to our expectations and regardless of the reason; or if Spain's current account balance were to weaken once again.

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