Friday, October 7, 2011

Fitch downgrades Spain

Fitch just downgraded Spain, from AA+ to AA-. Fitch's rating is now one notch below S&P's and Moody's. The outlook for the rating is negative, meaning that on its current path Spain would be downgraded again in the short to medium term (this interpretation of "negative outlook" is mine, not Fitch's).

(If you don't have an account at Fitch's website, you can read the press release below, which I pasted from the Wall Street Journal.)

Highlights from Fitch's report:

1) Two factors triggered the downgrade: intensification of the euro crisis, and the budget outlook for Spain's regions.

2) "A credible and comprehensive solution to the crisis is politically and technically complex and will take to put in place and to earn the trust of investors."

3) Spain is too large to fail, and will eventually be bailed out if necessary: "Spain’s ‘AA-’ rating incorporates Fitch’s judgement that as a solvent and systemically important sovereign, in extremis, the ECB and/or EFSF/IMF will provide support to prevent a self-fulfilling liquidity crisis."

4) The negative outlook reflects, among other things, contingent liabilities from the financial sector. 

The point that concerns me most is the fourth one. Spain has already spent about 17-18bn. euros in 2011 rescuing (or rather, nationalizing) financial institutions. Two more entities are expected to be nationalized within months. Fitch expects the additional cost of shoring up Spain's banks to be 30bn. euros. Other observers put the bill at 40-100bn, i.e. 4%-10% of Spain's GDP. 

Fitch's press release:
Fitch Ratings has downgraded Spain’s Long-term foreign and local currency Issuer Default Ratings (IDRs) to ‘AA-’ from ’AA+’. The rating Outlook is Negative. Fitch has simultaneously affirmed Spain’s Short-term rating at ‘F1+’ and the Country Ceiling at ‘AAA’.
The downgrade primarily reflects two factors: the intensification of the euro area crisis and secondly, risks to the fiscal consolidation effort arising from the budgetary performance of some regions and downward revision by Fitch of Spain’s medium-term growth prospects.
As Fitch has previously cautioned, a credible and comprehensive solution to the crisis is politically and technically complex and will take time to put in place and to earn the trust of investors. In the meantime, the crisis has adversely impacted financial stability and growth prospects across the region.
However, the still sizeable structural budget deficit, high level of net (although not gross) external debt and the fragility of the economic recovery as the process of deleveraging and rebalancing continues render Spain especially vulnerable to such an external shock.
While gross external debt (169% of GDP in 2010) is not high by euro area comparison, the net external debt of the economy (91% of GDP in 2010) is one of the highest in the world, reflecting a relative lack of Spanish foreign financial assets. This leaves the Spanish external finances sensitive to interest rate increases. While the current account adjustment has been significant, falling from 10% of GDP in 2007 to 4.5% of GDP in 2010 and a forecast 3.2% in 2011, further adjustment over the medium is necessary to improve the external balance sheet.
The intensification of the euro area crisis was identified as a negative rating trigger on 4 March 2011 when Spain’s rating Outlook was revised to Negative. With large fiscal and external financing needs, heightened volatility has adversely impacted market financing conditions for Spain as illustrated by the Eurosystem’s intervention in the secondary market. However, Spain’s ‘AA-’ rating incorporates Fitch’s judgement that as a solvent and systemically important sovereign, in extremis, the ECB and/or EFSF/IMF will provide support to prevent a self-fulfilling liquidity crisis.
The second principal driver of the downgrade of Spain’s sovereign ratings is the budgetary performance of some regional governments, which in Fitch’s opinion, poses a risk to fiscal consolidation. In September 2011, the agency downgraded five autonomous communities and maintains a Negative Outlook on the sector reflecting the still difficult fiscal and economic environment and the execution risks in implementing some of the cost cutting measures announced.
While the sub-national sector’s debt was only 11.1% of GDP in 2010, it accounts for roughly one-third of total expenditure, making it a vital part of the necessary correction in the public finances to restore confidence and public debt sustainability.
The process of rebalancing the Spanish economy is well underway but is not yet complete and Fitch expects it to weigh more heavily on economic growth over the medium term. The agency projects annual economic growth to remain below 2% through to 2015 and unemployment to remain high. Despite the important measures already adopted by the government, further structural reform will be necessary to further enhance the competitiveness and productivity of the economy. The fundamental weakness of the labour market, as underscored by an unemployment rate in excess of 20%, is a material rating weakness relative to European and high-grade peers. Nonetheless, while the recovery over the medium term will be lacklustre, Fitch expects the long-term (ie, post-2015) potential growth rate to exceed the average for the euro area as a whole.
Despite the weakened risk profile, Fitch views Spanish sovereign solvency as secure. Under the agency’s baseline scenario, the debt to GDP ratio will peak at 72% of GDP in 2013, well below the forecast euro area average of 89% in 2013.
Spain’s ‘AA-’ rating reflects strong fundamentals: a diversified, high-value-added economy and strong governance. The government’s policy response has been credible and aggressive.
The Negative Outlook reflects the risks associated with a further intensification of the euro area financial crisis, as well as possible material fiscal slippage and to a lesser extent contingent liabilities from the financial sector. A material deviation from the government’s fiscal targets and failure to stabilise the government debt to GDP ratio from 2013 would place negative pressure on the rating. Substantial progress has been made in the restructuring of the banking sector and Fitch has not revised its estimate of the ultimate fiscal cost which is moderate and is consistent with the current rating.
The amount disbursed by the Fund for Orderly Bank Restructuring (FROB) is estimated at EUR17.3bn by end-2011. Under Fitch’s baseline scenario, Fitch assumes that a further EUR30bn (2.8% of GDP) of capital is required from 2012 based on the agency’s stress-test exercise. This is to cover additional losses while maintaining a strong core capital ratio of 10% for the system. Fitch views the costs as manageable. Should recapitalisation costs be significantly higher than this figure, the rating could move into the ‘A’-range.
On a wide range of economic and fiscal indicators Spain has underlying fundamentals consistent with maintaining its sovereign rating in the ‘AA’ category. Success in meeting its fiscal targets and progress on structural reform that would further enhance competitiveness and growth prospects would stabilise the rating, as would resolution of the euro area crisis.

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