Moody’s issued the following statement in downgrading Spain’s sovereign credit rating outlook to negative.
Moody’s Investors Service has today confirmed the Kingdom of Spain’s Baa3 government bond rating and assigned a negative outlook to the rating. In addition, Moody’s has confirmed Spain’s short-term rating at (P)Prime-3. Today’s rating action concludes the review for possible further downgrade of Spain’s rating that Moody’s had initiated on 13 June 2012.
The decision to confirm the Kingdom of Spain’s sovereign ratings reflects the following positive developments since June:
1.) Moody’s assessment that the risk of the Spanish sovereign losing market access has been materially reduced by the willingness of the European Central Bank (ECB) to undertake outright purchases of Spanish government bonds to contain their price volatility. The rating agency believes that Spain will likely apply for a precautionary credit line from the European Stability Mechanism (ESM). This should in turn help sustain demand for Spanish government bonds by allowing the ECB to activate its Outright Monetary Transactions (OMT) program of secondary market purchases. Entry into an ESM precautionary program would not in itself lead to a downgrade as long as the rating agency believes that the government is likely to retain access to private capital markets.
2.) Evidence of the Spanish government’s continued commitment to implement the fiscal and structural reform measures that are needed to stabilize its debt trajectory, as indicated by the package of fiscal measures announced in July, the changes to the institutional framework for regional government finances and, more recently, the announcement of further structural reforms to be implemented in the coming months. In this respect, Moody’s considers the external monitoring of the Spanish government’s implementation of its plans that would accompany an ESM precautionary credit line to be a positive factor. The rating agency’s base case assumes that the Spanish government will be successful in gradually reducing its large budget deficit and arresting the rise in its debt burden.
3.) The ongoing progress towards restructuring the Spanish banking sector and enhancing the solvency of the affected banks, which should help to restore market confidence in Spain’s banking system as a whole.
In summary, Moody’s believes that the combination of euro area and ECB support and the Spanish government’s own efforts should allow the government to maintain capital market access at reasonable rates, providing it with the time it needs to stabilise public debt over the next few years. In Moody’s view, the maintenance of market access is critical because the risk that some form of burden-sharing will be imposed on bondholders is material for those countries that rely entirely or to a very large extent on official-sector funding for an extended period of time.
The negative rating outlook reflects Moody’s assessment that the risks to its baseline scenario are high and skewed to the downside. In particular, Spain’s credit standing would be negatively affected by a lack of progress in placing the country’s public finances on a sustainable footing. Shocks at the euro area level could also have negative repercussions on Spain’s rating, for example in the absence of concrete progress in reforming the euro area’s fiscal, economic and regulatory institutions. The possibility of Greece exiting the euro area continues to constitute a major event risk for all the weaker euro area member states. Should any such factors lead the rating agency to conclude that the Spanish government had either lost, or was very likely to lose, access to private markets, then Moody’s would most likely implement a downgrade, potentially of multiple notches.
In addition to the confirmation of Spain’s sovereign ratings, the rating agency has today also confirmed the Baa3/Prime-3 ratings of the Fund for Orderly Bank Restructuring (Fondo de Reestructuración Ordenada Bancaria or FROB) and assigned a negative outlook. Spain’s local and foreign-currency bond and deposit ceilings remain unchanged at A3.
RATINGS RATIONALE
RATIONALE FOR CONFIRMING THE Baa3 RATING
Moody’s decision to confirm Spain’s Baa3 sovereign rating is primarily driven by the developments in the euro area policy framework since mid-June (when Moody’s initiated its review of Spain’s ratings), which support the Spanish government’s ability to refinance maturing debt with private investors. Specifically, Moody’s believes that the government will likely ask for an Enhanced Conditions Credit Line (ECCL) from the ESM as a prerequisite for the ECB activating its OMT program in relation to Spanish government debt. Moody’s believes the ECB’s willingness to act to contain volatility in Spanish government bond yields will reduce the risk of loss of market access for the Spanish sovereign for the foreseeable future. The rating agency places only limited weight on the ability of a backstop ESM facility — the size of which would, on its own, be insufficient to support debt issuance for a lengthy period — to sustain investor confidence. Moody’s views positively (i) the stricter and more timely surveillance of Spain’s program implementation that would accompany an ESM program, and (ii) the possible involvement of the International Monetary Fund (IMF) which would provide an independent assessment of program implementation. Moody’s would expect easier funding conditions to continue to filter through to other Spanish borrowers, thereby potentially easing the current lack of available credit that is hampering economic growth.
The second driver underlying today’s announcement is evidence of the Spanish government’s commitment to implement the fiscal and structural reform measures that are needed to reverse its debt trajectory. Ultimately, the Spanish government’s ability to refinance maturing debt will depend on the credibility of its efforts to reduce its large fiscal deficit and reverse the rising public debt trajectory. The government has taken significant fiscal measures since coming into office, including structural reforms in the areas of healthcare and education, as well as measures to reduce the public-sector wage bill and improvements in the budgetary framework for the regions. The unfavourable economic outlook constitutes the most significant risk to the government’s fiscal objectives and Moody’s continues to expect some, albeit relatively limited, deviation from the budget deficit plans. Nevertheless, the rating agency’s central expectation is that the government will succeed in gradually reducing the budget deficit over the coming years and begin the process of stabilising and eventually reversing the debt trajectory.
The third driver of the confirmation of Spain’s ratings is the progress being made towards the restructuring and recapitalisation of the banking system. While below the rating agency’s own estimate of a capital shortfall of EUR100 billion for the system, the more than EUR50 billion capital needs that resulted from the recent independent stress tests will enhance the solvency of the affected banks and should help to restore market confidence in Spain’s banking system as a whole.
RATIONALE FOR NEGATIVE OUTLOOK
The negative outlook on Spain’s confirmed Baa3 rating reflects Moody’s view that the risks to its baseline scenario are high and skewed to the downside. Risks to the economic outlook in Spain are significant, with repeated downward revisions of the country’s growth forecasts over the past year. Further downward revisions could have significant negative implications for the government’s ability to bring its public finances back onto a sustainable path and reverse its debt trajectory. Moody’s current baseline expectation is a resumption of growth in 2014, based mainly on the expectation of renewed growth in Spain’s core EU markets and hence continued positive export performance. Crucially, Moody’s fiscal forecasts of a gradual reduction in the general government’s budget deficit (to around 4.5% of GDP by 2014) are based on the expectation of a gradual and moderate recovery in economic growth. Should growth appear likely to weaken further still, Moody’s would need to reassess the government’s ability to achieve its fiscal objectives.
In addition, the central government continues to depend on the regional governments to contribute their part of the required fiscal consolidation. Despite measures to improve central control over the regions and the regions’ progress with implementing important measures to restrain their spending, Moody’s still expects some slippage from regional-level fiscal targets in aggregate. Should the measures taken prove less effective than intended, Moody’s would reassess the consequences for the central government’s programme.
Moody’s observes that the wider European environment remains fragile. The ECB’s OMT announcement has bought time for the euro area authorities to push forward the broader financial, fiscal and economic reforms that are needed to address the institutional flaws that led to the crisis and to avoid further shocks to the financial system. However, there is significant uncertainty around the limits on the ECB’s willingness to undertake debt purchase operations on a large scale. Moreover, while progress continues to be made, the future path of policy remains very unclear. For example, while the proposed euro-wide banking union is a potentially significant step toward integration of financial regulation, the continued clear tensions between member states have the potential to materially slow down the process. Also, the possible exit of Greece from the euro area remains a risk and further source of contagion.
Overall, Moody’s assessment assumes that the Spanish government will continue to be able to refinance its maturing debt at affordable rates. Should any of the factors listed above lead the rating agency to conclude that the Spanish government had either lost, or was very likely to lose, access to private markets, then Moody’s would need to reassess its debt rating.
WHAT COULD CHANGE THE RATING UP/DOWN
Moody’s would downgrade Spain’s rating if its current expectations regarding euro area and ECB support were to fail to materialise, or if the Spanish government failed to implement the necessary fiscal and other reform measures.
In view of the currently negative outlook on Spain’s sovereign rating, no upward rating movement is likely over the short term. However, Moody’s would consider returning the outlook on Spain’s rating to stable if the pace and strength of the country’s economic recovery were to exceed Moody’s current expectations.
The principal methodology used in these ratings was Sovereign Bond Ratings published in September 2008. Please see the Credit Policy page on www.moodys.com for a copy of this methodology.