DBRS Morningstar Upgrades Autonomous Community of Catalonia to BBB (low), Stable Trend

DBRS Ratings GmbH (DBRS Morningstar) upgraded the Long-Term Issuer Rating of the Autonomous Community of Catalonia (Catalonia) to BBB (low) from BB (high) and Catalonia's Short-Term Issuer Rating to R-2 (low) from R-4. At the same time DBRS Morningstar changed the trend on all ratings to Stable from Positive.

KEY RATING CONSIDERATIONS
The upgrades of Catalonia’s ratings primarily reflect DBRS Morningstar's view that the relationship between the regional government and the national government has slowly but steadily strengthened over the last three years. While the independence question will remain a structural topic in the region over the medium-to-long-term and sporadic tensions could re-emerge, DBRS Morningstar takes the view that a relatively smooth economic and financial cooperation between both government tiers can now be expected and that a political escalation similar to the one that occurred in 2017 has now become very unlikely.

The Stable trend reflects DBRS Morningstar's assessment that the risks to Catalonia's ratings are now broadly balanced. The economic outlook remains clouded with uncertainties related to the healthcare situation and inflationary pressures, particularly energy prices. Nevertheless, Catalonia's finances have so far weathered relatively well the economic shock of the COVID-19 pandemic, supported by the extraordinary financial transfers provided by the national government to all Spanish regions.

Catalonia’s Long-Term Issuer Rating of BBB (low) reflects the improvement in the region's financial performance since 2015. While the region's debt stock has only marginally increased since 2017, Catalonia's debt metrics remain high by national and international standards and continue to weigh on its ratings. In addition, although it has improved, the political environment in the region is likely to remain a challenge for Catalonia's credit ratings over the long-term. Catalonia's ratings also reflect the financing support provided by the Kingdom of Spain (A, Stable) to the regional government which reduces significantly the refinancing risks for the region.

RATING DRIVERS
The ratings could be upgraded if: (1) the relationship between the region and the national government strengthens further, with a long-term solution preventing the emergence of political tensions between both government tiers; (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 are indications that a material escalation of the political tensions between both government tiers could 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

Recovery From the COVID-19 Shock is Ongoing but Some Uncertainties Remain

The COVID-19 outbreak has significantly affected the Spanish and the regional economies in 2020. Catalonia's gross domestic product (GDP) decreased by 11.5% in 2020, marginally worse than Spain's 10.8% decline, largely reflecting the extent of the healthcare crisis, the stringency of the lockdown that followed, and the high concentration of economic activity in sectors severely affected such as tourism. In 2021, economic output rebounded by 5% in Spain, largely driven by investments and domestic consumption. Real GDP in the region is expected to have slightly outgrown that of Spain last year. Economic recovery is currently expected to continue in the next two years, as the healthcare situation continues to normalise and activity resumes. The European Commission currently forecasts Spain's economy to grow by 5.6% in 2022 and 4.4% in 2023. These forecasts remain nevertheless subject to downside risks related to the pandemic and inflationary pressures.

Despite the strength of the COVID-19 shock, the supportive measures taken by the national government over the last 24 months as well as the financial resources expected from the Next Generation EU (NGEU, including the Recovery and Resilience Facility (RRF) and REACT-EU funds), should continue to alleviate the long-term impact of the pandemic and support the recovery. DBRS Morningstar therefore takes the view that long-term risks related to COVID-19 appear to have receded, as exemplified by the strong performance of the labour market in recent months. At the end of 2021, Catalonia's unemployment rate was already below its pre-pandemic level, standing at 10.2% compared with 10.5% at the end of 2019 and a peak of 13.9% in Q4 2020. Going forward, the impact of higher inflation on consumption and investment as well as the speed of absorption of EU funds will remain key areas of focus for DBRS Morningstar to assess the strength of the recovery within the region's territory.

Political Dialogue Between Region and National Government Strengthens their Relationship

On the political front, the regional government has been led by Pere Aragonès from Esquerra Republicana de Catalunya (ERC) since May 2021. Pro-independence parties including Junts Per Catalunya and CUP currently maintain a majority in the regional parliament with 74 seats out of 135. Although the independence question remains critical for the current government, DBRS Morningstar considers that the regional rhetoric on this topic has been more oriented towards political dialogue than direct confrontation. This has been confirmed over the last 10 months with the resumption of bilateral discussions between the region and the national government, either in the form of a purely political "mesa de dialogo" (dialogue table to discuss the independence question) or more technical ones, intended to making progress on economic and fiscal arrangements, such as the one that occurred on 2 March 2022 between finance ministers of the region and the Spanish government.

While the regional government has so far continued to voice its request to organise a formal referendum on independence, finding a short-term solution to this question appears unlikely. Over the medium-term, some political tensions are likely to re-emerge but DBRS Morningstar expects the tone of the political interaction between the regional and the national governments to remain less confrontational. DBRS Morningstar also notes that the region managed to approve its annual budget for 2022 before the end of the previous year for the first time since 2010. The budget was passed without the support from CUP but thanks to the abstention of En Comú Podem the regional party affiliated of the national far-left party Unidas Podemos. DBRS Morningstar will continue to monitor the political landscape in Catalonia, particularly the dynamic across political parties in the Catalan parliament, to evaluate for any impact on its assessment of the political environment in the region.

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

On the fiscal front, Catalonia’s performance has remained relatively stable in the last few years with the region recording a small but recurring fiscal deficit. When considering the deficit-to-GDP, which includes some European System of Accounts (ESA) accounting adjustments, consolidated accounts and excludes NGEU funds, the 2020 figure stood at -0.44%, marginal better than the -0.65% recorded in 2019. In 2021, the regional deficit is likely to marginally deteriorate, but remain below the reference rate set by the national government for Spanish regions of a deficit of 1.1% of GDP. Latest forecasts from the Independent Authority for Fiscal Responsibility (AIReF) estimate that Catalonia's deficit in 2021 could reach 0.6% of GDP.

While Catalonia's financial performance remains supported by the targeted budgetary support received from the national government, stabilising fiscal results will remain challenging, as government extraordinary measures are wound down and inflationary pressures linger. DBRS Morningstar will monitor the potential pass through of inflation to structural regional expenditure, such as personnel and healthcare related costs, as this may negatively affect regional finances, particularly if coupled with an increase in financing costs and a slowdown in economic growth.

In 2022, the national government is maintaining a high level of transfers (entregas a cuenta) to its regions. These transfers within the regional financing system will also be complemented with extraordinary transfers of EUR 7.0 billion meant to compensate regions for a negative fiscal settlement related to 2020 and a VAT payment shortfall from 2017. While these additional funds will continue to support regional finances in 2022, they represent a substantial decrease compared to the extraordinary COVID-related transfers received in 2020 and 2021 of EUR 16.0 billion and EUR 13.5 billion, respectively. As a result, addressing the share of new expenditure incurred during the pandemic, particularly healthcare related, that is likely to remain structurally higher, will remain critical for regions to maintain a sound budgetary position over the medium-term. The current reference rate for Spanish regions in 2022 is a deficit of 0.6% of GDP. Latest forecasts from AIReF estimate that Catalonia's deficit in 2022 could reach 0.8% of GDP, slightly underperforming the target.

As a result, DBRS Morningstar's analysis of the region's fiscal and economic performance will continue to focus on (1) the level of national government's transfers to its regions; (2) the effectiveness of the regional government's control over structural expenditure; and (3) the speed of absorption of EU funds.
The National Government’s Financing is Critical to the Region’s Creditworthiness

DBRS Morningstar expects Catalonia's financing needs to continue to benefit from the national government's support. Such financing is critical for the region's credit ratings. Catalonia’s debt is very high, at close to EUR 84 billion at the end of 2021. This represents around 232% of the region's operating revenues, decreasing from 277% in 2019, in part due to the substantial increase in transfers received from the national government in the last two years which inflated revenues; or around 37% of the region's GDP compared with 34% 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 more than 80% of the regional debt stock (Banco de España data) and Catalonia has benefited from very low funding costs in recent years. While the healthcare crisis has been challenging for regional finances, 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

DBRS Morningstar’s European Sub-Sovereign Governments Scorecard generates a result in the BBB (high) – BBB (low) range. The main points discussed during the Rating Committee include the political environment in the region and its impact on the region’s relationship with the national government; the region’s financial performance and the support received from the national government, the region’s high debt metrics and the medium-term economic and public finances prospects for the region, the region’s economic recovery including its tourism sector.

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/393251/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:
All figures are in euro (EUR) unless otherwise noted.

The principal methodology is the Rating European Sub-Sovereign Governments https://www.dbrsmorningstar.com/research/383672/rating-european-sub-sovereign-governments (September 1, 2021). 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, budgetary execution and debt structure for the 2015-21 period, Catalonia’s Investor Presentation, Bank of Spain for the debt stock during the period between 2015 and Q3 2021, Independent Authority for Fiscal Responsibility (AIReF) for its quarterly estimate of the regional GDP growth and its estimate of the 2021/2022 regional deficit, Instituto Nacional de Estatística (INE), Ministry of Finance; 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/393641.

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: September 10, 2021

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