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It was just 6 months ago that Spain enjoyed a credit rating of AA. In early
October, 2011, S&P downgraded Spain to an AA- rating with a negative outlook (details below as to why) and then again in January, 2012 from AA- to A for failing to make much in the way of improvements. Then, just last week, having clearly forewarned Spain that it was at risk of having it’s credit rating even further downgraded with all the financial implications of such a move, S&P further reduced Spain’s credit rating by two levels to BBB+. When you read what S&P said back in October and again in January, Spain has only itself to blame for its amazing mismanagement and sorry state of affairs. Words: 2000
“We believe that the Kingdom of Spain’s budget trajectory will:
- likely deteriorate against a background of economic contraction in contrast with our previous projections.
At the same time, we see an increasing likelihood that:
- Spain’s government will need to provide further fiscal support to the banking sector.
As a consequence, we believe there are heightened risks that:
- Spain’s net general government debt could rise further.
We are therefore lowering our long- and short-term sovereign credit ratings on Spain to BBB+ from A.
The negative outlook on the long-term rating reflects our view of:
- the significant risks to Spain’s economic growth and budgetary performance, and
- the impact we believe this will likely have on the sovereign’s creditworthiness.“
The October, 2011 Downgrade: Interestingly, it was just 6 months ago that Spain enjoyed a credit rating of AA. In early October, 2011, S&P downgraded Spain to an AA- rating with a negative outlook. At that time S&P attributed the downgrade to, among other things:
- “Spain’s uncertain growth prospects…,
- the liklihood of a continuing deterioration in financial system asset quality… and
- the incomplete state of labor market reform, which we believe contributes to structurally high unemployment and which will likely remain a drag on economic recovery.“
S&P’s negative outlook for Spain was influenced by:
- “the possibility that the private sector’s protracted deleveraging process may accelerate due to a further tightening of credit conditions [which] could hinder any recovery in private investment…
- harsher repricing in the real estate market, particularly for new housing, to which the banking sector remains very exposed, which may result in a higher-tan-previously-expected accumulation of problematic assets in the financial system. This, in turn, could slow the flow of financial resources to more productive sectors of the economy and weigh on the recovery…
- high unemployment, expected at around 20-21% in 2011-12 [latest reported unemployment rate is 24% overall and 51% for youth] which remain a drag on private consumption. Although the government has implemented some labor market reform measures, their impact on reducing labor market rigidities remains to be seen.
- economic growth in Spain’s main trading partners could slow further or contract, which may result in more subdued external demand for Spanish exports…
S&P presented various scenarios as follows:
- “our revised base-case macroeconomic scenario, which we view as consistent with the downgrade and the negative outlook, expects GDP growth in 2011-13 will be weaker, with the stock of domestic credit to the private sector, estimated at around 165% of GDP in 2011, to decline somewhat faster…
- our downside scenario assumes a return to recession next year, partly as a result of weaker external and internal demand, with real GDP declining by 0.5% followed by a weak recovery thereafter. Under this downside scenario, the current account deficit would decline, but the general government deficit would remain above 5.5% of GDP which is at odds with the government’s fiscal consolidation targets…. “
The S&P report went on to say:
“Under our various scenarios we expect that Spain’s:
- high private sector debt, and in particular the high stock of external debt – largely euro-denominated – will remain the key rating constraint for the foreseeable future,
- narrow net external debt would range between 290% and 325% of current account receipts by 2014 [and, as such, under our sovereign criteria these
- values would continue to imply an initial score at the lowest possible level for a country with an actively traded currency, like Spain.
In the near term (and under our base-case scenario), we believe that:
- the government could miss its fiscal target date due to budgetary slippages at the local and regional government levels.”
The January 2012 Downgrade: In January S&P downgraded Spain, amongst a total of 16 countries, to indicate their belief that:
- “there is at least a one-in-three chance that the rating will be lowered in 2012 or 2013….driven by our assessment that the policy initiatives that have been taken by European policymakers in recent weeks may be insufficient to fully address ongoing systemic stresses in the eurozone.
In our view, these stresses include:
- tightening credit conditions,
- an increase in risk premiums for a widening group of eurozone issuers,
- a simultaneous attempt to delever by governments and households,
- weakening economic growth prospects, and
- an open and prolonged dispute among European policymakers over the proper approach to address challenges.
The outcomes from the EU summit on Dec. 9, 2011, and subsequent statements from policymakers, lead us to believe that the agreement reached:
- has not produced a breakthrough of sufficient size and scope to fully address the eurozone’s financial problems,
- does not supply sufficient additional resources or operational flexibility to bolster European rescue operations, and
- does not extend enough support for those eurozone sovereigns subjected to heightened market pressures.
We also believe that:
- the agreement is predicated on only a partial recognition of the source of the crisis: that the current financial turmoil stems primarily from fiscal profligacy at the periphery of the eurozone….
- the financial problems facing the eurozone are as much a consequence of rising external imbalances and divergences in competitiveness between the eurozone’s core and the so-called “periphery”….
- a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers’ rising concerns about job security and disposable incomes, eroding national tax revenues.
Accordingly, in line with our published sovereign criteria, we have adjusted downward our political scores (one of the five key factors in our criteria) for those eurozone sovereigns we had previously scored in our two highest categories. This reflects our view that the effectiveness, stability, and predictability of European policymaking and political institutions have not been as strong as we believe are called for by the severity of a broadening and deepening financial crisis in the eurozone.
In our view, it is increasingly likely that:
- refinancing costs for certain countries may remain elevated,
- credit availability and economic growth may further decelerate, and
- pressure on financing conditions may persist.
Accordingly, for those sovereigns we consider most at risk of an economic downturn and deteriorating funding conditions, for example due to their large cross-border financing needs, we have adjusted our external score downward.
We believe that downside risks persist and that a more adverse economic and financial environment could erode their relative strengths within the next year or two to a degree that in our view could warrant a further downward revision of their long-term ratings.
We believe that the main downside risks that could affect eurozone sovereigns to various degrees are:
- related to the possibility of further significant fiscal deterioration as a consequence of a more recessionary macroeconomic environment and/or
- vulnerabilities to further intensification and broadening of risk aversion among investors, jeopardizing funding access at sustainable rates.
A more severe financial and economic downturn than we currently envisage…could also lead to:
- rising stress levels in the European banking system, potentially leading to additional fiscal costs for the sovereigns through various bank workout or recapitalization programs.
Furthermore, we believe that:
- there is a risk that reform fatigue could be mounting, especially in those countries that have experienced deep recessions and where growth prospects remain bleak, which could eventually lead us to the view that lower levels of predictability exist in policy orientation, and thus to a further downward adjustment of our political score.
Finally, while we currently assess the monetary authorities’ response to the eurozone’s financial problems as broadly adequate, our view could change as the crisis and the response to it evolves….“
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The April 2012 Downgrade: The most recent downgrade is more or less an update of the October and January downgrades, reiterating their belief that:
“The downgrade reflects our view of mounting risks to Spain’s net general government debt as a share of GDP in light of the contracting economy, in particular due to:
- the deterioration in the budget deficit trajectory for 2011-2015, in contrast with our previous projections, and
- the increasing likelihood that the government will need to provide further fiscal support to the banking sector.
Consequently, we think risks are rising to:
- fiscal performance and flexibility, and to
- the sovereign debt burden, particularly in light of the increased contingent liabilities that could materialize on the government’s balance sheet….
Under our revised base-case macroeconomic scenario, which we view as consistent with the downgrade and the negative outlook, we have lowered our forecast for GDP, in real terms, anticipating that:
- GDP will contract by 1.5pc in 2012 and
- contract 0.5pc for 2013.
We had previously forecast real GDP growth of 0.3pc in 2012 and 1pc in 2013.
We believe that negative drags on GDP include:
- declining disposable incomes;
- private-sector deleveraging;
- implementation of the government’s front-loaded fiscal consolidation plan; and
- the uncertain outlook for external demand in many of Spain’s key trading partners.
In our opinion, the Spanish government has:
- taken measures that should facilitate the rebalancing of the economy….
- been front-loading and implementing a comprehensive set of structural reforms, which should support economic growth over the longer term….
- has implemented a comprehensive reform of the Spanish labor market, which we believe could significantly reduce many of the existing structural rigidities and improve the flexibility in wage setting…Although the reform is unlikely to eliminate the structural duality in the Spanish labor market, we believe it will ultimately benefit employment growth once a sustainable recovery sets in….At the same time, however, we do not believe the labor reform measures will create net employment in the near term. As a consequence, the already high unemployment rate – especially among the young – will likely worsen until a sustainable recovery sets in.
- undertaken financial sector reform, announced in February, which requires banks to allocate additional loan loss provisions and raise capital buffers on exposure to real estate developments and construction projects. We believe these sectors will continue to be the main sources of asset quality deterioration.
- brought about further banking sector consolidation…and asset protection schemes…Combined with embedded risks in the rest of the banking sector, public enterprises, and other state guarantees, we now estimate contingent fiscal risks to the sovereign as moderate, as defined in our criteria.
Furthermore, we believe the ECB’s recent long-term repurchase operations (LTROs) have:
- significantly reduced the risks the Spanish banking sector faced in refinancing its medium-term external debt and its short-term interbank liabilities maturing in the first half of 2012….and
- helped banks to finance their government debt portfolios cheaply.
Nevertheless, we do not view the provision of liquidity support by the monetary authorities as a substitute for financial sector restructuring and economic rebalancing. In our view, the strategy to manage the European sovereign debt crisis continues to lack effectiveness.
We think credit conditions, and hence the economic outlook for Spain, could now deteriorate further than we anticipated earlier this year unless offsetting eurozone policy measures are implemented to support investor confidence and stabilize capital flows with the rest of the world. Such measures at the eurozone level could include:
- a greater pooling of fiscal resources and obligations,
- possibly direct bank support mechanisms to weaken the sovereign-bank links, and
- a consolidation of banking supervision or
- a greater harmonization of labor and wage policies.
In light of the rapid rise in public debt since 2008, we expect the Spanish government to implement a sustained budgetary consolidation effort…but
- we believe front-loaded fiscal austerity in Spain will likely exacerbate the numerous risks to growth over the medium term, highlighting the importance of offsetting stimulus through labor market and structural reforms.
Following budgetary slippage of 2.5% of GDP in 2011 beyond the 6% target, the government has committed to a target of 5.3% of GDP in 2012 and 3% in 2013. In our opinion, these targets are currently unlikely to be met given the economic and financial environment. Instead,
- we forecast a budget deficit of 6.2% of GDP in 2012 and 4.8% in 2013 (our previous forecasts were 5.1% and 4.4%) and
- we also believe the delay to adopting the 2012 budget could reduce the government’s capacity to prevent deviations from its budget plans.
Given the significant and regular budgetary slippages at the regional level – the main contributor to the deviations from the government’s targets – the national government’s willingness to fully enforce its new budget will likely be tested…Because of higher-than-previously-expected deficit projections, and other debt-increasing items…
- we forecast net general government debt at 76.6pc of GDP in 2014, against our previous projection of 64.6pc of GDP…
In line with the increasing risks we see to Spain’s recovery, we have also considered a downside scenario that, if it were to eventuate, could lead us to lower the ratings again. This downside scenario assumes a deeper recession in Spain this year, as a result of weaker external and domestic demand, with real GDP declining by 4% in real terms, followed by a contraction of 1% in 2013 and a weak recovery thereafter. Under this downside scenario, the current account would adjust faster, but the general government deficit trajectory would deteriorate further. The net general government debt ratio would breach 80% of GDP.
The negative outlook reflects our view of the significant external and domestic risks to Spain’s economic growth and budgetary performance, and the impact we believe this may have on the sovereign’s creditworthiness.
- We could lower the ratings if we were to see a rise in net general government debt to above 80% of GDP during 2012-2014, reflecting fiscal deviations, weakening growth, or the crystallization of contingent liabilities on the government’s balance sheet beyond our current projections.
- We could also consider a downgrade if political support for the current reform agenda were to wane. Moreover,
- we could lower the ratings if we see that Spain’s external position worsens or its competitiveness does not continue to approach that of its trading partners, a key factor for Spain to return to sustainable economic and employment growth.
- We could revise the outlook to stable if we see that risks to external financing conditions subside and Spain’s economic growth prospects improve, enabling the net government debt ratio to stabilize below 80% of GDP.”
Editor’s Note: The above article may have been edited ([ ]), abridged (…), and reformatted (including the title, some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. The article’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article.
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