OREANDA-NEWS.  Fitch Ratings has affirmed Spain's Long-term foreign and local currency IDRs at 'BBB+'. The Outlooks are Stable. The issue ratings on Spain's senior unsecured foreign and local currency bonds have also been affirmed at 'BBB+'. The Country Ceiling has been affirmed at 'AA+' and the Short-term foreign currency IDR at 'F2'.

KEY RATING DRIVERS 
The Spanish economy is recovering strongly, enhancing confidence in its successful adjustment within the eurozone. Growth accelerated further since the last rating review in October 2014 and reached 2% in 4Q14, over-performing not only the eurozone, but also Germany. Fitch forecasts GDP growth, driven predominantly by domestic demand, to reach 2.5% this year and 2.3% in 2016, an upward revision of 0.8pp and 0.4pp, respectively.

Both external and domestic factors support the recovery. In particular, a positive feedback loop has evolved between improving confidence, fuelled by easing financial conditions, higher employment, benefiting from earlier labour market reforms, and growing household consumption. Unemployment is forecast to decline to 21% in 2016 from 24.4% in 2014 and a peak of 26.1% in 2013. 

The very low eurozone inflation will constrain relative price adjustment for a longer period in Spain as well as many other member states. Both headline and core HICP inflation were negative in Spain from mid-2014 until March 2015. Despite the strengthening recovery, Fitch forecasts inflation to remain below the eurozone average in 2015 and 2016.

The strong recovery and the easing financial conditions have a favourable impact on the budget deficit. The headline budget deficit declined to 5.8% of GDP in 2014 and Fitch forecast 4.5% in 2015 and 3.4% in 2016. However, the improvement is estimated to be purely cyclical and Fitch does not expect any further fiscal consolidation measure until 2016. Nevertheless, real-time measures of the output gap and structural position are inherently uncertain. A larger negative output gap and better short-term growth prospects would imply a larger cyclical improvement of the fiscal position in the coming years and less need for further structural adjustment.

Public debt is very high. Gross general government debt (GGGD) reached 97.7% of GDP in 2014 compared with the 'BBB' median of 40% and is still increasing. Fitch forecasts the GGGD to GDP ratio to peak at 101% in 2016 and to decline to 91% by 2024 according to our baseline scenario.

The ECB's monetary easing has led to further improvement in financing conditions. Yields of 10-year sovereign bonds declined below 1.5% in 1Q15 and the short end of the curve is close to 0%. The prolonged period of low yields combined with the 6.5 year average life of GGGD will lead to a steady declining trend in interest expenditure over the next years.

The economic recovery is changing the dynamics of the external adjustment. The balance of payment adjustment is slowing down as the recovery of domestic demand boosts imports. After Spain registered the first current account (CA) surplus (1.4% of GDP) in 2013 in nearly three decades, the CA narrowed to 0.8% of GDP in 2014 due to a surge in imports and is forecast to remain below 1% of GDP in 2015-16.

Notwithstanding the large CA adjustment over the past years, high external indebtedness and reliance on intra-eurozone capital flows will remain a key vulnerability of the Spanish economy for a prolonged period. Net external debt is estimated at 80% of GDP in 2015, significantly above the 7% 'BBB' median.

The ECB's comprehensive assessment confirmed the progress with banking sector restructuring. The strong recovery and the declining unemployment had a positive impact on asset quality, reducing the risk of systemic state support to the financial sector.

RATING SENSITIVITIES 
The Stable Outlook reflects Fitch's assessment that upside and downside risks to the rating are currently balanced.

The following risk factors may, individually or collectively, result in positive rating action:
- Further progress in shrinking the budget deficit, particularly if based on structural measures, leading to a firm downward trend in public debt/GDP ratio. 
- Sustained economic recovery leading to further improvement of the labour market while maintaining a CA surplus.
- Improvement in Spain's external balance sheet.

The following risk factors may, individually or collectively, result in negative rating action:
- Lower nominal GDP growth and/or crystallisation of contingent liabilities, leading to public debt/GDP ratio to peak higher and later than forecast.
- Reversal of Spain's economic and fiscal policy stance (eg weakening commitment to fiscal consolidation).
- Emergence of a large CA deficit.

KEY ASSUMPTIONS
We assume no additional bank capital injections will be required from the Spanish sovereign. Nonetheless, further state support for Spanish banks cannot be ruled out completely, especially if deflation risks intensify and lead to deteriorating asset quality of the highly indebted domestic sectors. We assume no official debt relief on Spain's existing EUR38.2bn loan from the European Stability Mechanism.

The ratings are based on the assumption that the current fiscal policy stance will be broadly maintained after the general elections; that there will be no constitutional crisis in Spain; and that future governments will keep public debt/GDP on a declining path in the latter half of the decade.

The debt dynamics calculation is based on the assumption of real GDP growth converging to its 1.5% medium term growth potential, GDP deflator reaching 2% by 2018 from its trough of -0.5% in 2014 and a permanent primary surplus of 0.4% from 2018 onwards. In light of no further structural consolidation measures since 2013, Fitch does not expect additional fiscal tightening measures over the forecast horizon.

The European Central Bank's asset purchase programme should help underpin inflation expectations, and supports our base case that in the context of an economic recovery, Spain and the eurozone will avoid prolonged deflation. However, Spain's competitiveness adjustment within the currency union will continue to exert downward pressure on prices over the medium term. This will make the balance-sheet adjustment of the public and private sectors more challenging.