DBRS Morningstar Changes Trend on Autonomous Community of Catalonia to Positive, Confirms at BB (high)

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. At the same time DBRS Morningstar changed the trend on all ratings to Positive from Stable.

KEY RATING CONSIDERATIONS
DBRS Morningstar’s trend change to Positive from Stable on Catalonia’s BB (high) rating reflects a combination of (1) the resumption of the dialogue between the new regional government and the national government that could pave the way for smoother cooperation between both government tiers; (2) the expected recovery of the regional economy following the large shock related to the Coronavirus Disease (COVID-19); and (3) the likely stabilisation in the region’s fiscal performance over the next two years, supported by the national government's additional financial transfers to Spanish regions.

Catalonia’s ratings remain underpinned by (1) the region’s robust economic indicators prior to the pandemic 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 of BB (high) reflects the region’s high debt metrics, the remaining uncertainties regarding potential lasting economic effects from the COVID-19 pandemic and, although improving, a political environment that remains challenging. DBRS Morningstar expects the region’s debt reduction to be a slow and lengthy process and the political noise over the independence question to linger over the long-term. Nevertheless, the recent resumption of dialogue between the region and the national government, supported in part by the pardon in June this year of formerly imprisoned regional leaders over their failed bid for independence in 2017, could provide in the near term some additional information concerning the future relationship between both government tiers. DBRS Morningstar also considers that gaining some additional clarity around Catalonia's economic prospects will be key to conclude its trend on the region's credit ratings.

RATING DRIVERS
The ratings could be upgraded if: (1) the relationship between the region and the national government remains stable, 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 return to stable if the political environment deteriorates, leading to a substantial increase in tensions between the region and the national government. The ratings could be downgraded if: (1) there are indications that the material escalation of the political tensions between both government tiers would affect the financing support received by the region; or (2) there is a structural deterioration in the region’s fiscal performance, leading deficits to widen and placing debt metrics on a deteriorating trajectory.

RATING RATIONALE

Substantial Economic Impact From COVID-19 Last Year but Recovery is Expected in 2021 and 2022

Catalonia as well as Spain as a whole, have been severely affected by the pandemic. The latest figures available estimate that regional gross domestic product (GDP) decreased by 11.5% in 2020, marginally worse than Spain's 10.8% decline. The substantial GDP decrease largely reflected the extent of the healthcare crisis within the regional and national territories, the stringency of the lockdown that followed, and the high concentration of economic activity in sectors severely affected such as tourism.

For 2021, economic forecasts remain clouded with uncertainty given the risks related to the potential emergence of new virus variants and longer term efficacy of vaccines. Nonetheless, DBRS Morningstar views positively the recent improvement of the healthcare situation in Spain and in the region, supported by the strong vaccine rollout throughout the country. As of 3 September 2021, more than 77% of the Spanish population had received at least one dose of the vaccine while 71.5% had received two doses. The vaccination is expected to limit the introduction of new government restrictions and should, therefore, support the economic rebound. Current forecasts from the Spanish government anticipate an economic rebound of 6.5% in 2021 and 7.0% in 2022. Catalonia's economy is expected to perform more or less in line with the national average. Strong economic recovery will be key to limit the long-term scarring effects of the virus on the regional and the national economies in coming quarters.

Despite the strength of the COVID-19 shock, the fiscal measures taken by the national government over the last 18 months as well as the resources expected from the Next Generation EU (NGEU, including the Recovery and Resilience Facility (RFF) as well as REACT-EU funds), should help alleviate the long-term impact of the pandemic. DBRS Morningstar considers that the overall impact of the crisis on Catalonia will largely depend on how quickly economic activity resumes in coming quarters, particularly sectors substantially affected such as tourism, as well as on the effectiveness of the execution of projects related to EU funds.

On the Political Front, Dialogue with the National Government Resumes, but Challenges Remain

The new regional government, led by Pere Aragonès from Esquerra Republicana de Catalunya (ERC) was formed in May 2021, following the Catalan regional elections in February 2021. Pro-independence parties have slightly reinforced their majority in the regional parliament during these elections, obtaining 74 seats compared with 70 in the 2017 elections and obtained a slim majority of the votes (51% of the total). This is counterbalanced in DBRS Morningstar’s view, by (1) the strong results of the Socialist party (PSC-PSOE) which obtained the most votes – 23% of the total; and (2) the lead taken by ERC among pro-independence parties, which presents a rhetoric on the independence question more oriented towards political dialogue (please see DBRS Morningstar: Catalonia - COVID-19 Key Policy Focus For Now Even As Pro-Independence Parties Win Greater Parliamentary Representation).

This has been confirmed in recent months with the resumption of the dialogue between the region and the national government. Going forward further political discussions, starting with the "mesa de diálogo" (dialogue table) in September 2021, are expected to take place and touch on the independence question. The regional government has so far continued to voice its request to organise a formal referendum on independence, as well as obtain a full amnesty for the formerly imprisoned Catalan leaders. Although some degree of political tensions is likely, DBRS Morningstar expects the tone of the political interaction between the regional and the national governments to remain less confrontational.

Fiscal Performance Continues to be Supported by the National Government’s Financial Transfers

On the fiscal front, Catalonia’s fiscal performance deteriorated in 2020 (public accounting terms for the general administration), with a deficit-to-operating revenue ratio at -6.5% compared with -3.6% in 2019. When considering the deficit-to-GDP, which includes some European System of Accounts (ESA) accounting adjustments and consolidated accounts, the 2020 figure stands at -0.35%, which represents a marginal improvement compared to the -0.62% recorded in 2019. Catalonia's financial performance was supported by targeted budgetary support received from the national government. Spanish regions are responsible for their own healthcare and education. As a result, maintaining financial support as long as necessary for economic activity to recover will be key to avoid substantial deterioration in regional finances going forward.

In 2021, the national government is maintaining a high level of transfers (entregas a cuenta) to its regions. Regular transfers within the regional financing system will also be complemented with extraordinary transfers of EUR 13.5 billion, that will assist regions in covering the additional costs related to the pandemic. In addition, European Union transfers related to the NGEU programme should allow regions to increase their capital expenditure throughout the year and will likely support economic recovery.

While the regional deficit is currently expected to widen in 2021, to a level close to the reference rate set by the national government at -1.1% of GDP, it should subsequently decrease to a level close to the reference rate set for 2022 at -0.6% of GDP. Pressures on the region's fiscal performance will remain in 2022 and 2023, as these years are likely to be affected by negative settlements under the regional financing system, as well as a decrease in the amount of extraordinary transfers provided by the national government.

DBRS Morningstar acknowledges the national government's recent communication announcing EUR 7 billion of extraordinary transfers in 2022, part of which will be dedicated to absorbing the negative 2020 settlement, as well as the still high level of ordinary transfers scheduled under the regional financing system. These additional transfers should continue to support the financial performance of the region next year. Over the medium-term, as extraordinary transfers decrease further, addressing the share of new expenditure, particularly healthcare related, that is likely to remain structurally higher will remain critical to stabilise the regional finances.

Over the medium-term, DBRS Morningstar's analysis of the region's fiscal performance will focus on (1) the level of transfers to the regions; (2) the speed of absorption of EU funds; (3) the increase in the regions' structural expenditure; and (4) any potential additional measures taken by the national government to limit the future impact of the crisis on the regional finances.

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

DBRS Morningstar expects Catalonia's financing needs to remain supported by the national government. Such financing is critical for the region's credit ratings. Catalonia’s debt is very high, at close to EUR 82 billion at the end of 2020. This represents around 242% of the region's operating revenues, decreasing from 278% in 2019 due to the substantial increase in transfers received from the national government last year; or around 38% of the region's GDP compared with 35% in 2019. DBRS Morningstar gains comfort around the region's debt sustainability given the support it receives from the national government. The Spanish Treasury currently holds about 80% of the regional debt stock (Banco de España figure) and Catalonia has benefited from very low funding costs in recent years. While the healthcare crisis is challenging the positive track record of the region's fiscal and debt metrics, DBRS Morningstar continues to consider that Catalonia remains committed to strengthening its financial performance over the medium-term.

ESG CONSIDERATIONS

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.

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 remaining uncertainty related to the political environment in the region and its potential impact on the region’s relationship with the national government; the medium-term economic and fiscal risks related to the current pandemic.

The main points discussed during the Rating Committee include: the political situation in the region and Catalonia’s relationship with the national government, the region’s economic growth forecasts for 2021 and 2022; the impact of the COVID-19 pandemic on Catalonia’s fiscal and debt trajectories; the financial support provided by the national government to Spanish regions during the pandemic.

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/384029/spain-kingdom-of-scorecard-indicators-and-building-block-assessments

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:
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.

All figures are in EUR unless otherwise noted. Public finance statistics reported on a general government basis unless specified.

The principal methodology is the Rating European Sub-Sovereign Governments (September 1, 2021) https://www.dbrsmorningstar.com/research/383672/rating-european-sub-sovereign-governments. Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/373262/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (February 3, 2021).

The sources of information used for this rating include the Autonomous Community of Catalonia for financial position and debt structure for the 2014-21 period (end of July), Bank of Spain for the debt metrics during the period between 2015 and Q1 2021, Independent Authority for Fiscal Responsibility (AIReF) for its quarterly estimate of the regional GDP growth and its estimate of the 2021 regional deficit, Instituto Nacional de Estatística (INE), Ministry of Finance for the monthly budgetary execution; the 2020 European Social Progress Index from the European Commission. 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. DBRS Morningstar understands further information on DBRS Morningstar historical default rates may be published by the Financial Conduct Authority (FCA) on its webpage: https://www.fca.org.uk/firms/credit-rating-agencies.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/384284.

This rating is endorsed by DBRS Ratings Limited for use in the United Kingdom.
Lead Analyst: Nicolas Fintzel, Senior Vice President, Global Sovereign Ratings
Rating Committee Chair: Thomas R. Torgerson; Managing Director, Co-Head of Global Sovereign Ratings
Initial Rating Date: July 6, 2018
Last Rating Date: March 12, 2021

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