DBRS Morningstar Confirms the Autonomous Community of Catalonia at BB (high), Stable Trend

DBRS Ratings GmbH (DBRS Morningstar) confirmed the Long-Term Issuer Rating of the Autonomous Community of Catalonia (Catalonia) at BB (high) and its Short-Term Issuer Rating at R-4. The trend on all ratings is Stable.

KEY RATING CONSIDERATIONS
The Stable trend reflects DBRS Morningstar’s assessment that the risks to the ratings remain broadly balanced. As a reminder, DBRS Morningstar deviated from its EU Calendar on June 5, 2020 to change the trend on Catalonia’s ratings to Stable from Positive to reflect the substantial shock from the Coronavirus Disease (COVID-19) on the Spanish and the regional economy. Catalonia's finances will be affected by a combination of higher healthcare-related expenditure and lower tax collection. Although DBRS Morningstar expects the national government to mitigate the impact on the region's financial performance in 2020, Catalonia's fiscal outcomes are likely to remain under pressure in 2021 and 2022.

Catalonia’s ratings remain underpinned by (1) the region’s robust economic indicators and its sound fiscal performance in recent years; and (2) the financing support provided by the Kingdom of Spain (A, Stable) to the regional government. While the political situation in the region remains a source of uncertainty, its impact on the regional economy or more generally on fiscal and financial management has thus far remained limited.

Catalonia’s Long-Term Issuer Rating currently remains at the BB (high) level given the region’s high debt metrics and a still challenging political environment. Although DBRS Morningstar expects the region’s debt reduction to be a slow and lengthy process and the political noise over independence to remain over the long-term, it considers that the region’s intrinsic performance had substantially improved between 2015 and 2019.

RATING DRIVERS
The ratings could be upgraded if: (1) the relationship between the region and the national government remains stable after the upcoming regional elections, with debt and fiscal management staying insulated from any potential rise in political tensions; (2) the region continues its fiscal consolidation towards a balanced budget position and improves its debt sustainability metrics; or (3) the Kingdom of Spain’s rating is upgraded.

The ratings could be downgraded if: (1) there is a material escalation of the political tensions between the region and the national government. Specifically, indications that the financing support received by the region may be reduced would have negative credit implications; or (2) there is a structural reversal in the region’s fiscal consolidation, leading fiscal deficits to widen over time.

RATING RATIONALE

The COVID-19 Outbreak Negatively Affects the Regional Economy

The COVID-19 outbreak has been taking its toll on the Spanish and the regional economy since March this year. Catalonia has been severely affected by the pandemic. The region, in line with the rest of the country, has been under one of the longest and strictest lockdowns in Europe. While the strict initial lockdown has helped reduce the transmission of the virus among the population, it also brought economic activity to an halt.

The regional gross domestic product (GDP) is estimated to have contracted by 22% in the second quarter (QoQ), by the Independent Authority for Spanish Fiscal Responsibility (AIReF). This result underperforms the GDP drop recorded in Spain (-18.5%) over the same period. Year-on-year, the regional GDP contraction is estimated at a staggering -26% compared with -22% for the country. While these results are very negative, DBRS Morningstar highlights the preliminary nature and the uncertainty surrounding these first estimates. The GDP drop largely reflected the extent of the healthcare crisis within the national and regional territories, the stringency of the lockdown that followed, and the higher concentration of economic activity in sectors severely affected such as tourism.

While a solid rebound is expected for the second part of 2020 and in 2021, uncertainty remains regarding its strength, given the resurgence in recent weeks of infections in the region and in Spain. DBRS Morningstar considers that the fiscal measures announced by the national government to mitigate the adverse consequences of the COVID-19 outbreak, as well as the resources expected from the Next Generation EU plan from 2021, should help alleviate the long-term impact of the pandemic. While DBRS Morningstar expects this shock to affect all Spanish regions, its overall impact on the region of Catalonia will depend in large part on how quickly economic activity normalises in coming quarters.

The Political Environment Remains a Key Rating Consideration

On the political front, while the regional pro-independence party, Esquerra Republicana de Catalunya (ERC), implicitly supported through its abstention the formation of a coalition government led by the Partido Socialista Obrero Español (PSOE) at the national level in January 2020, political uncertainty in the region remains. In particular, new regional elections, which could be held in coming months, could mean the resurgence of political tensions, as the outcome of the vote might bring ERC to reconsider its implicit support for Prime Minister Sanchez’s government and harden the pro-independence stance.

DBRS Morningstar believes that regional elections that would confirm a softer strategy on the independence question, such as the one currently followed by ERC, and reduce political tensions between both government tiers, would benefit its assessment of the region’s political risk and subsequently support Catalonia’s ratings.

Catalonia’s Fiscal Performance Will be Affected, but the National Government Will Limit the Negative Impact

On the fiscal front, Catalonia’s fiscal performance largely stabilised in 2019, with a deficit-to-gross domestic product (GDP) ratio at -0.56%. While the deficit slightly worsened compared to the -0.44% outcome in 2018, it was affected by one-offs, and remained in line with the -0.55% of regional peers. In 2020, further fiscal consolidation appears challenging given the rapid deterioration in economic indicators in the region and in Spain. DBRS Morningstar currently expects strong pressure on Spanish regions' operating expenditure, as regions directly manage healthcare related costs which are expected to increase. In addition, the anticipated drop in economic output in 2020 is likely to markedly affect the amount of regional taxes collected by the region.

On the other hand, Catalonia and other Spanish regions under the common regime will benefit from the automatic stabilisers built into the regional financing system. While the pandemic is likely to decrease substantially the level of taxes collected by the national government and in particular shared taxes such as value added tax and personal income tax, the regions should remain insulated from this drop in 2020. The national government has not revised down the level of transfers (entregas a cuenta) that it will make to regions this year. Transfers from the financing system will therefore continue to increase in 2020; by EUR 7.7 billion or 7.1% year-on-year compared with 2019.

The negative effect of the lower tax collection in 2020 will therefore be borne by the central government. While this will support regions in 2020, the regional financing system will prompt a negative settlement to be paid by regions in 2022, which is likely to be very substantial. However, DBRS Morningstar considers it likely that the national government will allow regions to repay this settlement over the long-term, as it did regarding the 2008 and 2009 negative settlements which are currently being repaid over 20 years.

DBRS Morningstar also highlights that the national government approved additional fiscal transfers to its regions (Fondo COVID-19) in 2020, totaling EUR 16 billion or 1.3% of national GDP. These correspond to one-off grants, aimed at supporting regional finances in the face of the COVID-19 crisis. These funds will be split between EUR 10 billion directed to healthcare expenditure, EUR 5 billion to compensate for lower regional revenues and EUR 1 billion for additional social costs borne by regions. Catalonia currently estimates that it could receive close to EUR 3.2 billion (1.4% of regional GDP) from the Fondo COVID-19, EUR 1.6 billion of which has already been confirmed for healthcare and education. Overall, the AIReF expects that Catalonia overall fiscal balance for 2020, taking into account these additional transfers, could range between a deficit of -0.2% and -0.6% of regional GDP.

DBRS Morningstar therefore anticipates that Catalonia and other Spanish regions' 2020 financial performance should be only partially affected by the COVID-19 crisis, as the central government finances take the hit. The situation is nevertheless likely to deteriorate rapidly in 2021 and 2022, with lower revenues from the regional financing system and still high expenditure increasing pressure on regional finances. While the national government is likely to continue supporting its regions, growing regional deficits and debt levels are likely to materialise. DBRS Morningstar will monitor the level of transfers (entregas a cuenta) to regions in 2021, as well as any potential additional measures taken by the national government to limit the impact of the crisis on regional finances over the medium-term.

The National Government’s Financing is Critical to the Region’s Creditworthiness

DBRS Morningstar expects Catalonia's financing needs to continue being covered by the national government. Such financing remains critical for the region's credit ratings. While Catalonia’s debt is very high at EUR 81.8 billion at the end of 2019, or 278% of its operating revenues, DBRS Morningstar gains comfort around its sustainability, given the support it receives from the national government. The Spanish Treasury currently holds about 75% of the regional debt stock (Banco de España figure) and Catalonia has benefited from very low funding rates in recent years. While the reduction in the region's debt-to-operating revenues ratio is now being challenged by the healthcare crisis, DBRS Morningstar continues to consider that Catalonia will remain committed to strengthen its debt metrics over the medium-term.

ESG CONSIDERATIONS

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

RATING COMMITTEE SUMMARY

The DBRS Morningstar European Sub-Sovereign Scorecard generates a result in the BBB (high) – BBB (low) range. Additional considerations factored into the Rating Committee decision included the uncertainty related to the political environment in the region and its potential impact on the region’s relationship with the national government as well as the region’s economic and fiscal prospects.

The main points discussed during the Rating Committee include: the region’s economic growth and the potential impact of the COVID-19 on its fiscal and debt trajectories. The relationship between the national government and the Autonomous Community of Catalonia and the political situation in the region and in the country.

For more information on the Key Indicators used for the Kingdom of Spain, please see the Sovereign Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/366403.

The national scorecard indicators were used for the sovereign rating. The Kingdom of Spain’s rating was an input to the credit analysis of the Autonomous Community of Catalonia.

Notes:
All figures are in euros (EUR) unless otherwise noted.

The principal methodology is the Global Methodology for Rating European Sub-Sovereign Governments (4 September 2020): https://www.dbrsmorningstar.com/research/366368/rating-european-sub-sovereign-governments.

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

The sources of information used for this rating include the Autonomous Community of Catalonia for financial position and debt structure for the 2014-19 period, Bank of Spain for the debt metrics during the 2014-19 period, Independent Authority for Fiscal Responsibility (AIReF) for its Report on the 2020 Budgetary Execution for the region of Catalonia and its quarterly estimate of the regional GDP growth (August 2020), Instituto Nacional de Estatística (INE), Ministry of Finance for the monthly budgetary execution. DBRS Morningstar considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

DBRS Morningstar does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.

Generally, the conditions that lead to the assignment of a Negative or Positive trend are resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are under regular surveillance.

For further information on DBRS Morningstar historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see:
http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/366631.

Ratings assigned by DBRS Ratings GmbH are subject to EU and U.S. regulations only.

Lead Analyst: Nicolas Fintzel, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global FIG and Sovereign Ratings
Initial Rating Date: July 6, 2018
Last Rating Date: June 5, 2020

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