Moody's May Downgrade Spain's Aaa Rating, Contagion Rules

There is another reason for the embattled euro to sell off. Moody’s says it may downgrade Spain’s debt which currently has an Aaa rating. The agency said,

“Moody’s decision to initiate this review was prompted by (1) the deteriorating (short-term and long-term) economic growth prospects; (2) the challenges the government faces in achieving its fiscal targets; and (3) concerns over the impact of rising funding costs over the medium term”

The news is likely to add to the near panic in the capital markets which have growing concerns about deficits and national debt in Spain, Portugal, Ireland, Greece. A large number of economists have said that Greece will not be able to avoid defaulting on its sovereign paper. Nouriel Roubini recently commented that the southern European nation would be best off to renegotiate its debt in an orderly fashion now.

Behind much of the concern about the financial future of the Eurozone and its weakest nations are 1)signs that banks in the region are starved for capital and that stress tests of many of the financial firms will show that they are in trouble and need capital, and 2) a realization that austerity measures may not work. Government decisions to cut costs and raise taxes could be undermined by the actions of powerful unions and angry voters.

The increase in taxes in the weakest economies may also prove to be regressive and could actually hurt the treasury receipts in each of the countries.

The entire Moody’s opinion:

London, 30 June 2010 — Moody’s Investors Service has today placed Spain’s Aaa local and foreign currency government bond ratings on review for possible downgrade.

Moody’s decision to initiate this review was prompted by (1) the deteriorating (short-term and long-term) economic growth prospects; (2) the challenges the government faces in achieving its fiscal targets; and (3) concerns over the impact of rising funding costs over the medium term.

If at the conclusion of the review, Spain’s ratings are lowered, it would most likely be by one, or at most two, notches, according to Moody’s. The rating agency intends to conclude its review within a three-month period.

The Spanish government’s Prime-1 short-term rating is not affected by this review. Spain’s falls under the Eurozone’s Aaa regional ceilings, which are not affected by the review of the Spanish government’s ratings.

RATIONALE FOR REVIEW

“Spain’s growth prospects are weaker than those of other Aaa-rated sovereigns,” says Kathrin Muehlbronner, a Moody’s Vice President — Senior Analyst and lead analyst for Spain. In the short term, the government’s accelerated fiscal consolidation combined with the higher borrowing costs currently facing the government, consumers, and businesses will likely depress growth.

From a longer-term perspective, it will take several years for the economy to adjust to the fallout from the collapse of the real-estate boom, to reduce the high level of private sector indebtedness to levels more in line with other EU countries, and to find new, internal sources of economic growth. Accordingly, Moody’s now expects GDP growth to average just slightly above 1% over the entire 2010-2014 period.

The weaker growth trajectory in turn complicates an already very challenging fiscal consolidation programme. “Moody’s believes that more fundamental adjustments to key spending items will be required in order to achieve the government’s budget deficit targets,” says Ms Muehlbronner. Moody’s own forecasts for Spain’s fiscal deficits are higher than the government’s targets. According to Moody’s projections, Spain’s debt-to-GDP ratio is likely to rise to about 80% by 2014.

Moody’s noted that the government’s efforts to put forward structural reforms — in the labour market, the banking sector and potentially also the pension system — are positive developments that could help revive Spain’s growth potential in the medium term. These proposals, however, have yet to restore investor confidence. As a result, the government’s funding costs remain elevated and its debt affordability ratio (the ratio of interest on the debt to government revenues) is likely to become increasingly out of line with those of other top-rated countries over time.

FACTORS TO BE CONSIDERED IN THE REVIEW

The review of Spain’s sovereign rating will assess the broader political commitment to structural reform and the likelihood that the reforms approved by parliament will be far-reaching enough to significantly stimulate long-term growth. Specifically, Moody’s will also review Spain’s upcoming 2011 budget plan, due to be presented in September, to assess whether the deficit target for 2011 can be achieved. The rating agency will also consider the contribution from the country’s regional and local governments towards the fiscal consolidation effort.

The outcome of the review could also be affected if the costs of recapitalizing Spain’s banking sector, which Moody’s currently believes to be manageable, were to turn out to be much larger than expected.

For further information, please see Moody’s Special Comment “Key Drivers of Decision to Review Spain’s Aaa for Possible Downgrade” available on www.moodys.com.

PREVIOUS RATING ACTION & METHODOLOGY

Moody’s last rating action affecting Spain was implemented on 29 July 2009, when the rating agency affirmed Spain’s Aaa local and foreign currency government bond ratings and their stable outlook. The last rating action on Spain prior to that was taken on 24 May 2006, when the rating agency affirmed the Aaa foreign and domestic currency country ceilings of the Eurozone. Prior to that, the last rating action on Spain was implemented on 13 December 2001, when Moody’s raised the government’s local and foreign currency bond ratings to Aaa with a stable outlook from Aa2/positive.

The principal methodology used in rating the government of Spain is “Moody’s Sovereign Bond Methodology”, published in 2008, which can be found at www.moodys.com in the Rating Methodologies sub-directory under the Research & Ratings tab. Other methodologies and factors that may have been considered in the process of rating this issuer can also be found in the Rating Methodologies sub-directory on Moody’s website.

Douglas A. McIntyre