Fitch Ratings is providing further comment on the rating actions it took earlier today on the Kingdom of Spain (Spain), where its long-term issuer default rating (IDR) was downgraded to 'A' from 'AA-'; Negative Outlook; and its short-term IDR was downgraded to 'F1' from 'F1+'.
The downgrade follows the Rating Watch Negative (RWN) placed on the sovereign ratings of Spain and five other Euro Area Member States (EAMS) on 16 December 2011. The RWN was initiated in response to concern over the lack of clarity on the ultimate structure of a fundamentally reformed Economic and Monetary Union; the risk of self-fulfilling liquidity and even solvency crises in the absence of a fully-credible financial 'firewall' against contagion; and the significant negative external shock to the region's economy from the prolonged nature of the Eurozone systemic crisis.
The two-notch downgrade to 'A' primarily reflects two factors:
- a re-assessment by Fitch of the potential financing and monetary shocks that members of the eurozone face in light of the increasing divergence in economic, monetary and credit conditions and prospects across the region, which is also a factor in the downgrades of some other eurozone sovereign governments.
- Spain's significant fiscal slippage in 2011 and deterioration in the macroeconomic outlook with adverse implications for the medium-term outlook for public finances.
The factors that have prompted the downgrade reflect the systemic nature of the eurozone crisis that Spain's high public deficit and net external debt rendered it especially vulnerable to. One notch of the two-notch downgrade of Spain reflects this systemic weakness that only more fundamental reform of Economic and Monetary Union can address.
Spain's rating of 'A' is supported by on-going correction of the macro-financial imbalances that were incurred during the pre-crisis boom as well as the sovereign's fundamental rating strengths: strong governance and institutions, and a high-value added and diversified economy compared with rating peers.
Since Fitch last reviewed the Spanish sovereign rating in October 2011, there has been a significant deterioration in the country's fiscal profile. The incoming government has announced that the general government deficit for 2011 will be around 8% of GDP, well above the official target of 6%. This material fiscal slippage primarily reflects an over-shoot at the regional government level and underscores a structural weakness in Spain's fiscal framework and has undermined the credibility of the fiscal consolidation programme.
The 2011 revision, as well as damaging Spain's fiscal credibility, also means that the medium-term deficit reduction path will be more drawn out than previously assumed. In Fitch's view, the official 2012 deficit target of 4.4% is now likely to prove unrealistic. The agency therefore assumes that this year's deficit will come in at 6%, and that the stated 3% target will now not be reached until 2014. The government has announced EUR8.9bn of spending cuts and EUR6bn of revenue-side measures with immediate effect to address this slippage, pending the 2012 budget later in Q112.
Most of last year's fiscal slippage was due to overruns at the regional government level (an estimated 1.4% of GDP). In response to weaknesses in regional expenditure control, Fitch views reform to the regional financing framework as likely in the near term. As stated in previous Fitch commentary, the existing system of withdrawing borrowing authorisation to recalcitrant regions has proven ineffective, incentivising the build-up of arrears and short-term borrowing rather than controlling expenditure.
In the interim to any reform, it is likely that the central government will take a more aggressive stance towards the regions by using their effective lack of market access as leverage to impose budgetary discipline. The fact that many of regional governments are run by the same party as that of the national government should help somewhat.
The necessary economic re-balancing in Spain is hindered by its rigid labour market, which has led to a significant destruction of human capital through the downturn. Unemployment rose to 22.8% in Q411. Until further reform is enacted, structural unemployment will remain very high compared with regional and rating peers.
The deterioration in the near-term economic outlook, combined with evidence of a continuing deterioration in asset quality, has heightened the risks to Fitch's assessment of the contingent liability to the state arising from the financial sector. The new government has also announced it will require the Spanish banks to increase their provisions by EUR50bn (EUR35bn net of tax). While full details have yet to be announced, Fitch assumes that banks could have a relatively short period of time in which to comply with this, and that they will still be required to meet the stricter capital requirements announced by the previous government in February 2011.
In Fitch's view, while stronger institutions will be able to offset this additional provisioning, either through their profit and loss statements or through excess reserves, the Spanish banking sector as a whole will likely need more capital support from the state. The agency notes, however, that the potential recapitalisation needed, relative to Spanish GDP, remains manageable.
The Negative Outlook primarily reflects the risks associated with a further intensification of the eurozone financial crisis, though today's action incorporates Fitch's expectation that the crisis will be prolonged and punctuated by further episodes of market volatility.
