The key drivers of today's rating action on Spain are:

1.) The uncertainty over the prospects for institutional reform in the euro area and the weak macroeconomic outlook across the region, which will continue to weigh on already fragile market confidence.

2.) The country's challenging fiscal outlook is being exacerbated by the larger-than-expected fiscal slippage in 2011, mainly on account of budget overshoots by Spain's regional governments. Moody's is sceptical that the new government will be able to achieve the targeted reduction in the general government budget deficit, leading to a further increase in the rapidly rising public debt ratio.

3.) The pressures on the Spanish economy, which is close to entering a renewed recession, will be further increased by the need for even stronger action to achieve a deficit reduction. A renewed recession will also negatively affect the profitability of Spanish banks at a time when they are required to clean up their balance sheets.

Moody's is maintaining a negative outlook on Spain's sovereign ratings to reflect the potential for a further decline in economic and financing conditions as a result of a deterioration in the euro area debt crisis.


RATIONALE FOR DOWNGRADE


As indicated in the introduction of this press release, a contributing factor underlying Moody's two-notch downgrade of Spain's government bond rating is the uncertainty over the euro area's prospects for institutional reform of its fiscal and economic framework and over the resources that will be made available to deal with the crisis. Moreover, Europe's weak macroeconomic prospects complicate the implementation of domestic austerity programmes and the structural reforms that are needed to promote competitiveness. Moody's believes that these factors will continue to weigh on market confidence, which is likely to remain fragile. This will in turn mean a high potential for further shocks to funding conditions, which will affect weaker sovereigns like Spain first, increasing its susceptibility to other financial and macroeconomic shocks given the concerns identified below.


The second driver underpinning the downgrade of Spain's sovereign rating is Moody's expectation that the country's key credit metrics will continue to deteriorate. The larger-than-expected fiscal deviation reported for 2011 (with a general government deficit of around 8% of GDP vs. a target of 6%) make the country's fiscal outlook for 2012 even more challenging than Moody's anticipated at the time of its last rating action on Spain. Moody's acknowledges that the new government has taken timely action to compensate for a large part of last year's fiscal slippage, and has also taken steps to place the regional governments' finances under closer supervision. However, the effectiveness of these steps remains to be seen. Overall, the adjustment required to bring the public finances back onto the targeted path (a budget deficit target of 4.4% of GDP in 2012) is unprecedented. According to Moody's estimates, a total fiscal adjustment of approximately EUR40 billion (3.7% of GDP) will be needed, compared to a reduction in the deficit of around EUR28 billion in aggregate in 2010 and 2011.


Moody's is therefore sceptical that the target can be achieved and expects the general government budget deficit to remain between 5.5% and 6% of GDP. This in turn implies that the public debt ratio will continue to rise. Under Moody's base-case assumption, the debt ratio will be around 75% of GDP at the end of the year, more than double the trough reached in 2007, and will likely approach the 80% of GDP mark in the coming two years. One of Spain's key relative credit strengths -- its lower debt-to-GDP ratio compared to some of its closest peers in Europe -- is therefore eroding.


The third driver of today's rating action is the weakening Spanish economy, which is likely to come under even greater pressure because of the need for stronger action to achieve a deficit reduction. Spain recorded a contraction in real GDP of 0.3% quarter-on-quarter in Q4 of 2011 and Moody's expects Spain's GDP to contract by a further 1%-1.5% in 2012, compared to a forecast of low but positive growth of around 1% just a few months ago.


A renewed recession will further affect the profitability of Spanish banks at a time when they are expected to remove impaired real-estate-related assets from their balance sheets. Moody's views positively the new government's attempt to force the banking sector to increase provisioning against problematic assets related to banks' exposure to the real estate sector, thereby improving the transparency of banks' balance sheets and contributing to restoring market confidence. However, Moody's is doubtful that the government's plan to encourage stronger banks to merge with weaker ones will be achievable without further support from the public sector. The rating agency therefore continues to believe that the contingent risks arising from the banking sector are higher and more likely to crystallise in the case of Spain than among many of its peers. Moody's recognises that the labour market reforms, announced by the government on 10 February, are important steps to increase the flexibility in the labour market and should help foster faster employment growth once the economic recovery begins.


The decision to downgrade by two notches is explained by Moody's view that Spain's credit fundamentals and outlook are difficult to reconcile with a rating above the lower end of the "single-A" rating category. Indeed, peers at the top of the single-A category (like the Czech Republic and South Korea) as well as those in the middle of the category (like Poland), do not face Spain's fiscal and growth challenges, nor do they have banking systems with similar issues.