March 22, 2011

Spain (Kingdom of)

Primary Credit Analyst:
Marko Mrsnik, Madrid +34 913 896 953; marko_mrsnik@standardandpoors.com
Secondary Contact:
Frank Gill, London (44) 20-7176-7129; frank_gill@standardandpoors.com

Table Of Contents
Major Rating Factors
Rationale
Outlook
Comparative Analysis
Political Environment: The Government Is Stepping Up Reform
Economic Prospects: Economic Recovery Slow, With Significant
Downside Risks
Fiscal Flexibility: Budgetary Consolidation On Track, But Important
Challenges Remain
Scenario Analysis

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Spain (Kingdom of)
Major Rating Factors
Strengths: Sovereign Credit Rating
• Wealthy, relatively diversified economy with stable political system AA/Negative/A-1+
• Accelerated pace of structural reform and restoration of public finance
discipline
• Fiscal flexibility underpinned by moderate, albeit rising, general government
debt

Weaknesses:
• Weak economic growth prospects due to ongoing private-sector deleveraging and relative deterioration in export
competitiveness
• High unemployment and labor market rigidities, which we expect will be addressed via ongoing reforms
• Significant net external debt level, implying private sector vulnerability to a deterioration in external financing
conditions

Rationale
The ratings on Spain reflect the benefits of what we view as a modern and relatively diversified economy, as well as
our opinion of the government's continuing political resolve to deal with the outstanding challenges, as reflected in a
significant acceleration in both budgetary consolidation and the structural reform effort since 2010. Moreover,
Spain benefits, in our opinion, from its moderate (albeit increasing) general government debt. Nevertheless, we
believe that the ratings will remain under pressure from what we deem to be high private-sector indebtedness,
challenges to the economy's competitiveness, persistently difficult labor market conditions, and the economy's weak
net external financial position.

Following the 0.1% contraction in GDP we estimate for 2010, we anticipate that the economy will return to positive
growth rates of approximately 0.7% in 2011 and 1.5% in 2012. This recovery, in our opinion, is subject to
significant downside risk due to a combination of: the private sector's continuous deleveraging; what we consider to
be restrictive fiscal policies; limited growth prospects, in our opinion, on the back of the global economic recovery;
persistently high unemployment; financial-sector stress; and large net external debt (we forecast a level equivalent to
78% of GDP in 2011). We believe that these factors make the economy vulnerable to sudden shifts in external
financing conditions, possibly complicating the country's economic recovery.

In an unfavorable economic climate in 2010, the government put in place what we view as a substantial reform
effort, including a front-loaded budgetary consolidation strategy and a comprehensive set of structural reforms. We
estimate that the 2010 general government deficit target of 9.3% of GDP was met, on the back of the government's
fiscal package involving tax hikes and spending cuts. This is mainly due to the significantly better-than-expected
central government deficit (5.1% of GDP versus a planned 5.9%), more than compensating for the slippage at the
local and regional government level. We anticipate that the general government deficit will decline to 6.3% of GDP
in 2011, broadly in line with the government's target of 6.0%, and to 5.1% of GDP in 2012. The difference
between our 2011 forecast and that of the government is attributable to our lower forecast of underlying economic

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growth, and its impact on the budget.

As a result, we forecast an increase in net government debt to 61.6% of GDP in 2011 and 65.0% in 2012, from an
estimated 56.2% in 2010. Further growth in borrowing costs could result in higher interest outlays than the
government currently plans, although the increase in the average interest rate on Spain's outstanding government
debt in 2010 was negligible (3.69%, versus 3.53% in 2009 and 4.32% in 2008)--despite negative market
sentiment--thus limiting the potential additional burden on the budget. Our current government debt projection does
not include the anticipated income from the announced partial privatization of the airport operator AENA and the
National Lottery. Similarly, it does not include potential additional capital injections by the state to further
strengthen the financial sector. In our opinion, such costs could surpass €20 billion--a level recently mentioned by
the government--with the excess driven either by higher-than-expected losses in financial institutions'
property-related loan portfolios; failure of financial-sector entities involved in integration processes to reduce their
operating expenses; or higher funding costs, since, in our opinion, the financial sector's approximate €760 billion of
gross external debt at year-end 2010 leaves it vulnerable to exogenous shocks.

We believe that in the medium to long term, the recently adopted pension reform program, if fully implemented, will
likely lead to important savings in social security outlays. The reform program includes increases in the retirement
age--to 67 for standard retirement and 63 for early retirement--an extension of the pension calculation period to 25
years from 15, and the introduction of a "sustainability factor" linking the financial sustainability of the pension
system to the future evolution of life expectancy. While it is too early, in our view, to assess the impact of labor
reform on Spain's economic growth prospects, we believe that the reform measures implemented to date are a step
in the right direction, though stopping short of a fundamental overhaul of the labor market. Additional labor reform
measures planned by the government for the first quarter of 2011 in the areas of active market policies and
collective bargaining procedures could, however, further reduce some of the structural rigidities that we believe
constrain labor demand in the economy.

Outlook
The negative outlook reflects the possibility of a downgrade if Spain's fiscal position deviates materially, in our
opinion, from the government's budgetary targets for 2011 and 2012. A downgrade could also occur if the
impending correction in private-sector leverage results in what we would consider to be a disorderly adjustment in
the financial sector, leading to a sharper deterioration of the Spanish government's balance sheet or lower economic
growth than we currently anticipate, possibly coupled with resurging deflationary pressures. Moreover, we could
lower the rating if vulnerabilities persist related to external financing conditions or delays in the implementation of
structural reforms.

Conversely, we could revise the outlook to stable if the government meets or exceeds its budgetary objectives in
2011 and 2012, risks to external financing conditions subside, and Spain's economic growth prospects prove to be
more buoyant than we currently envisage as a result of a smooth economic adjustment and restructuring process.

Table 1
Kingdom of Spain - Selected Indicators
Median
2004 2005 2006 2007 2008 2009 2010 2011e 2012f 2013f 2014f AA
GDP per capita ($) 24,660 26,260 28,219 32,423 35,197 31,949 30,548 32,150 31,366 31,964 32,572 45,742

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Table 1
Kingdom of Spain - Selected Indicators (cont.)
Real GDP (% change) 3.3 3.6 4.0 3.6 0.9 (3.7) (0.1) 0.7 1.5 1.4 1.4 2.9
Real GDP per capita 1.6 1.9 2.3 1.9 (0.9) (4.9) (0.6) 0.2 1.0 0.9 0.9 1.6
(% change)
General government (0.3) 1.0 2.0 1.9 (4.2) (11.1) (9.2) (6.3) (5.1) (4.1) (3.3) (3.0)
balance (% of GDP)
General government 46.2 43.0 39.6 36.1 39.8 53.2 63.8 70.4 73.8 76.1 77.6 36.7
debt (% of GDP)
Net general 42.0 37.2 32.8 29.7 32.4 45.1 56.2 61.6 65.2 67.7 69.4 25.5
government debt (%
of GDP)
General government 5.3 4.5 4.1 3.9 4.3 5.1 5.7 7.0 8.0 8.8 9.4 5.1
interest exp. (% of
revenues)
Domestic credit to 112.4 132.2 153.2 167.0 172.0 174.8 172.5 164.7 160.7 160.0 159.4 108.4
private sector &
NFPEs* (% of GDP)
Consumer price index 3.1 3.4 3.6 2.8 4.1 (0.2) 1.8 2.0 1.6 1.3 1.3 2.5
(average; % change)
Gross ext. financing 108.0 117.2 122.0 124.2 314.9 373.4 356.0 349.2 332.5 311.5 294.8 117.4
needs¶ (% of CARs
and usable reserves)
Current account (5.3) (7.4) (9.0) (10.0) (9.8) (5.5) (4.6) (3.8) (3.4) (3.2) (3.1) 7.4
balance (% of GDP)
Narrow net external (6.1) (4.9) (4.7) 311.8 297.1 397.4 350.2 331.9 323.3 303.3 284.4 27.2
debt§ (% of CARs)
*Standard & Poor's estimates that, in a reasonable worst-case economic downturn, gross problematic assets could reach 20% of domestic credit to the private sector
and NFPEs; see "Banking Industry Country Risk Assessments", published monthly on RatingsDirect. ¶Gross external financing needs are defined as current account
outflows plus short-term debt by remaining maturity. §Narrow net external debt is defined as the stock of foreign and local currency public and private sector
borrowings from nonresidents (including nonresident deposits in resident banks) minus liquid nonequity external assets, which include official foreign exchange
reserves, other liquid public sector foreign assets, and financial institutions' deposits with and lending to nonresidents. A negative number indicates net external
lending. f--Forecast. e--Estimate. NFPEs--Nonfinancial public sector enterprises. CARs--Current account receipts.

Comparative Analysis
• Given ongoing economic adjustment and restructuring, prospects for economic growth in Spain are weaker than
for peers, although the ongoing reforms would be beneficial for strengthened growth potential.
• Unemployment will remain higher than for peers, while a relatively weaker net external financial position will
continue to render Spain more vulnerable to external financing conditions deteriorating.
• Despite significant widening in budget deficits, the net government debt will remain relatively lower than that of
several other peers.

Spain's relatively wealthy and diversified economy is politically stable, like most of its peers, but its medium-term
growth prospects are weak due to ongoing economic rebalancing and restructuring. Compared with peers, Spain's
growth potential has declined due to heavy private-sector indebtedness, high unemployment, a distressed financial
sector, and eroded competitiveness due to relatively high wages growth in the run-up to the crisis. In the past,
economic growth was largely fuelled by domestic demand, supported by credit activity and wages growth, which
resulted in a property bubble that is still correcting. As a consequence, we expect a prolonged period of subdued
growth as the economy rebalances and restores its balance sheet. The economy's medium-term growth prospects
compare poorly with peers such as Germany, France, Belgium, and Slovenia, where private sector imbalances are

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not as significant.

Chart 1

In our view, Spain's economy is only modestly open compared with peers, so the pace of recovery in private
consumption and investment will be important to its growth prospects. The private sector's heavy indebtedness and
reliance on variable interest rate mortgages could further pressure domestic consumption once the European Central
Bank (ECB: AAA/Stable/A-1+; unsolicited) hikes the policy rate. Moreover, currently high unemployment--forecast
to hover above 20% until 2013--is another cause for concern that, coupled with the need for the economy to
deleverage, will hold back private-sector savings from being released into the economy. Spain's unemployment rate
is by far the highest in the eurozone and compares poorly with peers in the 'AA' rating category. In France, we
expect unemployment to decline to 8.5% in 2012, from 9.4% in 2010, while in the U.K. we expect it to hover
below 8.0%. In Belgium and Slovenia we expect unemployment of about 8.5% and 7.5%, respectively, while in
Ireland--due to underlying economic developments similar to Spain's--it is expected to surge to 15% this year before
decreasing to 14% in 2012.

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Chart 2

The Spanish authorities are implementing labor market reforms. In our view, however, additional measures are
needed to make the market more flexible, such as: further reducing the severance payments for dismissals; reducing
the transition periods for phasing in the measures; making it easier for companies or individuals to detach
themselves from collective bargaining; and improving the market's capacity to reabsorb the unemployed when the
economic recovery strengthens. In our opinion, these impediments to labor-market flexibility will continue to weigh
on job creation and result in only a slow adjustment of a dual labor market in which employers are increasingly
favoring temporary contracts. Spain is not alone in its labor-market inefficiencies. France, too, has implemented
several structural measures to improve labor market performance, aimed particularly at reducing unemployment.
This bodes well for the French economy and could boost its ongoing economic recovery; together with recent
pension reforms, structural measures should in our view help raise employment levels, increase growth, and thus
alleviate budgetary imbalances. Belgium, on the other hand, has been very slow to fix structural problems. It has
generous unemployment benefits, reduced mobility created by language obstacles, and high marginal personal
income tax (acting as a disincentive to gaining employment).

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Chart 3

On the back of a weak growth outlook, ongoing housing market corrections, and the need to strengthen banks'
balance sheets--coupled with more-difficult funding conditions--we expect anemic credit activity over the medium
term due to reduced demand and supply. This means that the recovery in investment activity and consumption will
continue to be fragile. Moreover, we anticipate that the competitiveness of eurozone periphery economies will suffer
more than other eurozone members mainly because of the growing gap in capital intensity between the periphery
and core. This will delay normal credit activity resuming in Spain, in our view. We believe that banking sector losses
will likely lead to additional state capital injections via FROB (the Fund for Orderly Bank Restructuring), which
currently benefits from a state guarantee of up to €27 billion extendable to up to €90 billion, the latter still well
below the amount the Irish sovereign injected into the banking system (which ultimately led the sovereign to agree to
external financial support from the IMF and EU).

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Chart 4

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Chart 5

During the imminent and prolonged deleveraging period--which will affect Spain's capital intensity--the economy
will be unlikely to harness export growth to the extent that would compensate for anemic domestic demand.
Exports comprise a relatively small share of GDP and wages are adjusting only slowly to more-competitive levels;
both factors are preventing exports from contributing significantly to economic recovery and are limiting Spain's
capacity to benefit from global recovery in the way we expect the likes of Germany, Belgium, and Slovenia will be
able to do. While the openness of these economies--and commensurate susceptibility to external changes--led in
2009 to deeper recessions than in Spain, these economies also recovered more rapidly.

As well as a sharp reduction in credit in the domestic economy, the funding of Spain's external deficit has also been
curtailed and as a result the current account deficit is estimated to have more than halved between 2008 and 2010.
Before falling to around 5% in 2010, it averaged a sizeable 10% of GDP in 2007–2008, indicating a substantial
imbalance in the economy similar to that in New Zealand (9% of GDP). The current account deficit adjustment in
Slovenia was even sharper, falling from 7% of GDP in 2008 to an estimated balanced position in 2010, while
Belgium has maintained a slight current account surplus. Despite a gradual decline in external imbalances and
reduced external financing, Spain's net external position remains significantly negative, making the economy
particularly vulnerable to any deterioration in external financing conditions. The unwinding of the housing boom
has been relatively moderate so far and should lead to a gradual reduction of the net external debt position.
However, continuous pressure on external financing may undermine the pace of economic recovery as episodes of
financial market distress, leading to higher risk premia, restrict access to capital or increase interest payments--in
turn reducing corporate sector profitability and resulting in lower-than-currently-forecast economic growth.

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Chart 6

Spain entered the current downturn in a strong fiscal position; it had regularly posted budgetary surpluses.
However, as in Ireland and the U.K., the structural balance has deteriorated sharply as the economic cycle has
turned and one-off revenue-boosting factors related to the housing and financial market booms have ended. This has
led to budget deficits of above 11% of GDP in 2009 in all three countries. In 2010, the Spanish government--like
many others--instigated substantial budgetary consolidation aimed at bringing the deficit down to 3% of GDP by
2013. In 2010, the government managed to reduce the deficit to slightly below its initial target of 9.3% of GDP and,
like France, which entered the recession under weak budgetary conditions, is aiming for a deficit of 6% of GDP in
2011. Nevertheless, based on our current economic growth projections, additional deficit reduction measures will be
required to further reduce the gap in the budget beyond 2011.

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Chart 7

Along with deteriorating budget balances, government borrowing has risen rapidly across the board and as we do
not expect deficits to fall at the same pace at which they have accrued, increased debt levels are likely to continue for
several years. In our view, consolidation efforts should not rely on economic recovery but on structural measures on
the revenue or expenditure sides (see "European Government Finances: Fixing The Roof After The Storm,"
published Oct. 4, 2010). We expect Spain's gross debt to reach about 70.4% of GDP in 2011 and 73.8% in 2012.
In line with this, we anticipate the general government interest burden will increase to about 2.6% of GDP in 2011.
In early December 2010, the government announced a privatization plan that aims to sell a 49% stake in the airport
operator AENA as well as up to a 30% stake in the national lottery; combined, this is expected to yield about
€13-€15 billion, thus reducing the net government debt. Further rises in borrowing costs--as indicated by the
spreads against German bonds over the past 12 months--could result in higher-than-currently-planned interest
outlays, although it is important to note that the average interest rate on the outstanding debt is falling despite
negative market sentiment, thus limiting any potential increase in interest payments.

In France, we forecast gross debt to rise from about 84% of GDP in 2010 to around 90% in 2012, reflecting budget
deficits. France's 'AAA' rated peers have also seen debt-to-GDP ratios rise. The 2010 ratio in Germany and Austria

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is expected to be 74% and 70% of GDP, respectively. In the U.K., due to large deficits and the significant gross
fiscal cost of government support to the banking system, debt has shot up from 44% of GDP in 2007 to around
75% of GDP in 2010, and may rise to about 79% by the end of 2011. In Belgium, however, successful debt
reduction since 1993 was interrupted in 2008 at 84% of GDP and is expected to hover around 100% before
resuming its decline. Slovenia maintains comparatively low debt levels but its dynamics have been very steep; debt is
expected to double from 22.5% of GDP in 2008 to 45.0% in 2011.

Finally, in order to contain the long-term budgetary challenges of an aging population, several countries, including
Spain, are undergoing pension reforms. Spain is increasing the retirement age to 67 years from 65, while the early
retirement limit is to be raised to 63 years from 61 currently. Widening the calculation period for the pension from
15 to 25 years is also envisaged. France also adopted pension reform in November 2010, although this was
accompanied by substantial social tensions. The reform includes raising the retirement age from 60 to 62, and from
65 to 67 to benefit from a full pension (to discourage early retirement), as well as increases in marginal income tax
rates and corporate taxation. Among other peers, Slovenia is also reforming pensions although the much-needed
process has been hindered by significant trade union opposition leading to a national referendum in 2011, which
could delay the adoption of the planned pension reform.

Chart 8

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Political Environment: The Government Is Stepping Up Reform

• Following a delayed policy reaction to the economic crisis, the government has strengthened its resolve to
accelerate budgetary consolidation and structural reforms.
• Despite declining public support, we believe the current government will fully serve its mandate and maintain the
pace of further budgetary consolidation and structural reforms.
• Beyond 2012, we do not expect shifts in the direction of economic policy, regardless of the outcome in the general
elections.

After an initial delay, the Spanish government (run by the Spanish Socialist Worker's Party [PSOE] and led by José
Luis Rodriguez Zapatero), has significantly accelerated budgetary consolidation and structural reform measures
since Spring 2010. Being a minority government, it has secured support to pass legislation on a case-by-case basis
with regional parties subject to potential concessions regarding regional competencies and finances. Despite the
decline in public support that PSOE has experienced since 2008, we expect the government will be able to fulfill its
mandate of ongoing budgetary consolidation and economic reform. We expect it will uphold its currently strong
resolve to reform the economy, despite relatively adverse financial market sentiment--as evidenced by an increase in
the economy's borrowing costs--and in an attempt to restore eroded electoral support ahead of the 2012 elections.

The government's economic strategy centers on budgetary consolidation (see fiscal flexibility section below) and
reforming the labor market, pension system, and financial sector. The government has displayed stronger
commitment to reform than before 2010, for example by legislating and implementing reforms on deadline even in
the absence of full agreement with other stakeholders. This has led to increased tensions with trade unions on labor
reform and resulted in a general strike in September--but this has not diminished the government's ability to pursue
its reform program. On the whole, despite high unemployment and a likely protracted period of relatively low
economic growth, we expect social tensions to remain contained, more so as the government reached an agreement
in February 2010 with the trade unions and employers' association on further reform efforts. Recent pension
reforms, in our view, further mitigate the risk of social tensions as final reform provisions were agreed with all the
relevant stakeholders, including the trade unions. That said, further austerity measures--required to bring the budget
deficit down--and additional strengthening of labor reforms may heighten popular discontent as well as tensions
among the participating parties in this agreement.

Current public opinion polls indicate that the main opposition Popular Party (PP) has an important advantage ahead
of the 2012 general elections, mainly due to the economic crisis and public perception of a delayed response by the
current government. This is despite several corruption cases in recent years, an internal leadership struggle, and the
apparent absence of firm economic proposals of its own, which in our view may erode the current PP's position. If
the party were to form government in 2012 we would not expect a dramatic shift in economic policy direction from
the current one, although the blend of policy measures could differ. The regional elections in spring 2011 will serve
as a useful indicator of shifts in the Spanish political environment.

Economic Prospects: Economic Recovery Slow, With Significant Downside Risks

• The economy came out of recession in first-half 2010, but numerous downside risks to growth persist.
• High unemployment and the deleveraging process will weigh on economic growth.
• Significant net external debt implies private-sector vulnerability to a deterioration in external financing

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conditions.

Table 2
Kingdom of Spain - Economic & Financial Indicators
2004 2005 2006 2007 2008 2009 2010 2011e 2012f 2013f 2014f
Nominal GDP (bil. €) 841.0 908.8 984.3 1,053.5 1,088.1 1,053.9 1,061.3 1,078.3 1,105.4 1,132.1 1,159.5
Nominal GDP (bil. $) 1,044.3 1,130.2 1,234.8 1,442.0 1,593.9 1,464.2 1,407.0 1,488.2 1,459.1 1,494.4 1,530.4
GDP per capita ($) 24,660.0 26,260.0 28,219.0 32,423.0 35,197.0 31,949.0 30,548.0 32,150.0 31,366.0 31,964.0 32,572.0
Real GDP (% change) 3.3 3.6 4.0 3.6 0.9 (3.7) (0.1) 0.7 1.5 1.4 1.4
Real GDP per capita (% 1.6 1.9 2.3 1.9 (0.9) (4.9) (0.6) 0.2 1.0 0.9 0.9
change)
Real domestic demand 4.9 4.9 5.1 3.9 0.0 (7.0) (0.6) (0.4) 1.3 1.2 1.3
(% change)
Unemployment rate 10.6 9.2 8.5 8.3 11.3 18.0 20.1 21.0 20.5 19.5 18.5
(average claimant count;
%)
Real GDP per employee (0.6) (1.9) (0.1) 0.5 1.3 3.3 2.1 1.2 1.1 0.9 0.9
growth (%)
Consumer price index (% 3.1 3.4 3.6 2.8 4.1 (0.2) 1.8 2.0 1.6 1.3 1.3
change)
Domestic credit to private 17.9 27.2 25.5 16.7 6.4 (1.6) (0.6) (3.0) 0.0 2.0 2.0
sector & NFPEs (%
change)
Domestic credit to private 112.4 132.2 153.2 167.0 172.0 174.8 172.5 164.7 160.7 160.0 159.4
sector & NFPEs (% of
GDP)
f--Forecast. e--Estimate. NFPEs--Nonfinancial public sector enterprises.

Table 3
Kingdom of Spain - External Indicators
2004 2005 2006 2007 2008 2009 2010 2011e 2012f 2013f 2014f
(% of GDP)
Current account balance (5.3) (7.4) (9.0) (10.0) (9.8) (5.5) (4.6) (3.8) (3.4) (3.2) (3.1)
Trade balance (6.4) (7.5) (8.5) (8.7) (8.0) (4.3) (4.3) (3.6) (3.6) (3.5) (3.6)
Net foreign direct investment (3.5) (1.5) (5.9) (5.1) 0.0 (0.1) (0.5) (0.5) (0.5) (0.5) (0.5)

(% of CARs)
Current account balance (16.9) (23.8) (27.1) (29.1) (29.4) (18.7) (14.5) (11.5) (10.1) (9.2) (8.6)
Net external liabilities (6.1) (4.9) (4.7) 235.3 219.7 312.1 289.7 278.6 273.8 259.3 245.4
Gross external debt 0.0 0.0 0.0 415.3 390.8 516.1 477.2 450.4 436.7 408.1 380.9
Narrow net external debt* (6.1) (4.9) (4.7) 311.8 297.1 397.4 350.2 331.9 323.3 303.3 284.4
Net public sector external debt (6.1) (4.9) (4.7) 26.2 35.6 64.3 85.0 91.1 96.9 97.4 96.6
Net nonfinancial private sector 0.0 0.0 0.0 49.6 45.2 50.1 36.6 30.9 24.3 19.2 14.5
external debt
Net financial sector external 0.0 0.0 0.0 114.6 110.5 149.9 116.1 102.4 96.4 86.7 78.5
debt
Net investment payments 4.6 6.1 6.4 8.3 9.9 9.8 7.9 8.3 7.7 7.5 7.4
Gross ext. financing needs¶ 108.0 117.2 122.0 124.2 314.9 373.4 356.0 349.2 332.5 311.5 294.8
(% of CARs and usable
reserves)

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Table 3
Kingdom of Spain - External Indicators (cont.)
*Narrow net external debt is defined as the stock of foreign and local currency public and private sector borrowings from nonresidents (including nonresident deposits in
resident banks) minus liquid nonequity external assets, which include official foreign exchange reserves, other liquid public sector foreign assets, and financial
institutions' deposits with and lending to nonresidents. A negative number indicates net external lending. ¶Gross external financing needs are defined as current account
outflows plus short-term debt by remaining maturity. f--Forecast. e--Estimate. CARs--Current account receipts. CAPs--Current account payments.

Following another year of GDP contraction in 2010, the Spanish economy is slowly recovering although numerous
downside risks persist. Growth potential is reduced due to large private sector indebtedness, high unemployment, a
distressed financial sector, and eroded competitiveness due to relatively high wages growth in the run-up to the
crisis. As a consequence, we expect the economy to undergo a prolonged period of subdued growth as it rebalances.
In terms of growth structure, the contribution of private consumption, in particular the pace of decline in the
economy's relatively high savings rate, is of particular importance. Against a backdrop of persistently high
unemployment, private consumption will be held back by low prospects for wages growth, the deleveraging of
private sector over-indebted balance sheets, and a generally uncertain growth outlook.

We expect investment will contribute to economic growth, but only as of 2012. Deleveraging and low credit activity
coupled with weak domestic consumption and a low capacity utilization rate will lead to only a slow pick-up in
investment. In line with the austerity drive, we expect public consumption to trend downward while the net exports'
contribution to growth is unlikely to be significant. That said, the current account deficit fell from around 10% of
GDP in 2008 to an estimated 4.7% in 2010 and we expect it to correct further to around 3%. Nevertheless, the
economy's external vulnerabilities persist given its large external debt and significantly negative net international
investor position, compounded by adverse external borrowing conditions. Finally, Spain still benefits from the
ECB's loose monetary policy, which cushioned the fall in domestic demand in 2009 and in 2010 and supported
recovery.

Following a period of expansionary fiscal policy that cushioned the impact of economic dislocation, the government
in 2010 started its budgetary consolidation and implemented structural reforms in the labor market and financial
sector, among others. Labor reform included: the reduction to 33 days per year of tenure for unfair dismissal (from
45 days); financing eight days of all severance payments through a fund paid by firms; easing the criteria for fair
dismissal; and broadening the conditions under which firms can opt-out of collective wage agreements. Given the
pace of wages growth before the crisis, a more-flexible labor market would be able to help restore competitiveness
more rapidly in our view. In this context, loosening wage indexation and in particular the possibility of detachment
of companies or individuals from relevant wage agreements--which are negotiated at an industry level--would be
enable the market to better respond to current conditions. These measures are a step in the right direction, in our
opinion, but additional flexibility in the labor market is warranted sooner rather than later if unemployment is to be
reduced more rapidly. In our view, for example, the transition period for equalizing the cost of permanent and
temporary workers could be shortened.

Financial sector reform, the first part of which was implemented in July 2010, was aimed at reducing the sector's
vulnerability in terms of solvency and liquidity. It included changes in corporate governance structures, changes in
the legal form and status of savings banks, and made it possible for savings banks to raise external capital. As a
result, a series of mergers among savings banks saw the number of entities decrease from 45 to 17; this is expected
to eventually lead to an important reduction in excess capacity. Nevertheless, the reforms failed to dissipate concerns
about the financial sector's exposure to real estate and construction and, in the light of erosion in net interest
margins, the savings banks' capacity to deal with possibly higher-than-expected losses was brought into question.

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On top of the Bank of Spain's demand for greater transparency from the savings banks' exposures real estate and
construction, the government announced a second round of reforms that requires all banks to raise core capital to at
least 8%. Should an entity not be able to raise the funds necessary, the state would inject the capital through FROB
(see "The Restructuring Of Spanish Savings Banks: A Profound Transformation Of The Spanish Banking Industry,"
published on Feb. 22, 2011).

We continue to believe that Spain's medium-to-long-term growth potential has been affected by the economic crisis
through increased structural unemployment and unfavorable investment trends. We therefore view the government's
medium-term GDP growth assumptions as somewhat optimistic. At the same time, we believe that structural
reforms aimed at enhancing the economy's competitiveness and labor market flexibility could help strengthen the
recovery. This, in turn, could be enhanced by resolving financial sector uncertainties and continually respecting
budgetary consolidation targets, which would restore market confidence and reduce external vulnerabilities. In the
absence of such efforts, we continue to believe that in the long term Spain will likely post subdued growth compared
with the rest of the eurozone.

Fiscal Flexibility: Budgetary Consolidation On Track, But Important Challenges

Remain
• In 2010, the government started frontloaded and broad-based budgetary consolidation, aiming at a deficit of 3%
of GDP in 2013.
• Net government debt is expected to rise to 69.4% of GDP in 2014. Although subject to eventual further capital
injections through FROB, net debt would increase accordingly while, on the other hand, planned privatization in
2011 would reduce it.
• Despite the negative market sentiment over the past 12 months, the average interest rate on outstanding
government debt continued to fall, thus limiting a potential increase in interest payments.

Table 4
Kingdom of Spain - Fiscal Indicators
2004 2005 2006 2007 2008 2009 2010 2011e 2012f 2013f 2014f
(% of GDP)
General government revenues 38.5 39.4 40.4 41.1 37.1 34.7 36.3 36.8 36.9 37.2 37.3
Of which central government 14.4 14.9 15.5 16.2 13.0 10.6 11.9 12.0 12.0 12.1 12.2
General government expenditures 38.9 38.4 38.4 39.2 41.3 45.8 45.5 43.1 42.0 41.3 40.6
Of which central government 15.7 14.7 14.8 15.1 15.8 19.9 16.9 14.2 15.5 15.1 14.7
General government balance (0.3) 1.0 2.0 1.9 (4.2) (11.1) (9.2) (6.3) (5.1) (4.1) (3.3)
Of which central government (1.3) 0.2 0.7 1.1 (2.8) (9.3) (5.0) (2.1) (3.5) (3.0) (2.5)
Of which local authorities (0.1) (0.3) 0.0 (0.5) (2.1) (2.6) (4.0) (4.1) (1.9) (1.4) (1.0)
General government primary balance 1.7 2.8 3.7 3.5 (2.6) (9.4) (7.1) (3.7) (2.1) (0.8) 0.2
Central government primary balance 0.5 1.8 2.1 2.5 (1.5) (7.8) (3.3) (0.1) (1.2) (0.5) 0.2
General government balance (% of revenues) (0.9) 2.4 5.0 4.6 (11.2) (32.1) (25.3) (17.1) (13.8) (11.0) (8.9)
General gov't interest payments (% of revenues) 5.3 4.5 4.1 3.9 4.3 5.1 5.7 7.0 8.0 8.8 9.4
Central gov't interest payments (% of revenues) 12.6 10.8 9.3 8.4 10.2 14.7 15.4 17.5 19.1 20.8 22.0
General government debt 46.2 43.0 39.6 36.1 39.8 53.2 63.8 70.4 73.8 76.1 77.6
Of which central government debt 39.3 36.4 33.0 30.1 33.7 46.0 51.8 54.5 56.7 58.3 59.5

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 Spain (Kingdom of)

Table 4
Kingdom of Spain - Fiscal Indicators (cont.)
General government net debt 42.0 37.2 32.8 29.7 32.4 45.1 56.2 61.6 65.2 67.7 69.4
Of which central government net debt 36.0 32.0 28.7 26.5 29.6 40.3 46.5 47.9 50.3 52.1 53.3
f--Forecast. e--Estimate.

In 2010, the government reduced its large budget deficit to below the initial target of 9.3% of GDP, from 11.1% in
2009. In its stability program, the government committed to significant deficit reduction aimed at reaching 3% of
GDP in 2013. It is also planning to reduce the deficit to 6% of GDP in 2011 on the back of a series of
deficit-reducing measures including hikes in VAT, personal income tax, excise taxes (some announced in early
December 2010), as well as public wage cuts and a pension freeze. We forecast a 2011 general government deficit of
around 6.3% of GDP as a consequence of our lower forecast for underlying economic growth (1.7%, against 2.3%
assumed by the government) and its impact on the budget, while we believe that the measures proposed are likely to
be effective in bringing the deficit down in 2011.

While the adjustment plans are appropriately frontloaded, we believe that in order to reach the government target of
4.6% deficit in 2012, additional measures would be needed; the abovementioned changes and the forecast economic
growth environment are of themselves insufficient, in our view, to close the budget gap over the medium term
without further revenue-increasing measures or spending cuts. In this context, however, the distribution of effort
between different levels of government is particularly relevant. In 2010, the central government's over-performance
of its budgetary target managed to more than offset the slippage in deficit targets at the local and regional level. In
2011, local and regional compliance with budgetary targets will in most cases require additional measures,
particularly on the spending side. In order to enhance the monitoring and transparency of the regional budgetary
situation, the regions are required to report their budgetary outcomes more frequently.

We do not expect social security's slight deficit position to improve significantly in 2011; although it should
gradually benefit from the adopted pension reforms. Reforms include increasing the retirement age from 65 to 67
years, extending the period used for the calculation of pension rights from 15 to 25 years, and placing restrictions
on early retirement, which is now set at 63 years (61 previously). Reform would also benefit from additional
provisions linking benefits with life expectancy. It is important to note that the government has managed to push
through pension negotiations so far without social tensions, however it remains to be seen whether the final reform
agreement is watered down during negotiations with the trade unions.

Government debt and interest burden

As a result of increased budget deficits, we expect gross debt to reach around 70.4% of GDP in 2011 and about
73.8% in 2012. In line with the above, the general government interest burden will increase--we expect to about
2.6% of GDP in 2011. Ratios calculated also include the current funding provided to FROB. Further rises in
borrowing costs could result in higher-than-currently-planned interest outlays, although it is important to note that
the average interest rate on outstanding debt was falling, until December 2010, despite the negative market
sentiment, thus limiting the potential increase in interest payments. Future rises in borrowing costs, due to the
possible spill-over effects of adverse external financial market conditions, could also occur, although given the
current average costs on the outstanding debt and its relatively long average maturity, the impact of such
developments is limited. For example, were a non-Spanish eurozone commercial bank to default on outstanding
senior debt, such a credit event would almost certainly negatively affect Spanish commercial banks' access to
wholesale funding, which could contribute to higher borrowing costs for the sovereign.

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In early December 2010, the government announced a privatization plan that aims to sell a 49% stake in the airport
operator AENA as well as up to a 30% stake in the National Lotteries, which combined is expected to yield about
€13-€15 billion, thus reducing net debt.

Off-budget and contingent liabilities

We estimate contingent liability from outstanding state guarantees at around 5% of GDP at year-end 2011, but we
believe it is likely to decline as the guarantees related to the banking sector gradually expire, although the growing
stock of outstanding guarantees related to the deficit of the electricity sector will to some extent offset this decline
(see "Fondo de Amortizacion del Deficit Electrico Proposed Bond Issue Assigned 'AA' Rating," published Sept. 30,
2010).

At the same time, some uncertainty exists regarding the funds the state needs to strengthen the reformed savings
banks' capital. The Bank of Spain estimates that around €15.5 billion of capital--private or public--is needed if all
the banks are required to comply with the recently adopted decree, passed in early 2011. The final amount provided
by public funds via FROB will depend on the availability of the banks' own resources or external private funding,
although we cannot discount the fact that it could be higher than €20 billion, which is currently our central
scenario.

Scenario Analysis
We have projected general government debt levels under three scenarios, in addition to our baseline scenario, to
measure the possible impact of lower-than-anticipated growth, a weaker deflator, deviation from the primary
balance, and the potential effect of government capital injections into the banking system, while offsetting these
factors with the expected proceeds from the announced partial privatization of the National Lotteries and AENA.
Assumed off-balance-sheet items in scenarios 2 and 3 are therefore highly hypothetical and devised purely for the
purpose of observing their impact on the government's medium-term debt position.

Baseline general government debt trajectory:

This trajectory incorporates our baseline projections of nominal GDP and primary fiscal balances (PB), without the
required additional government capital injections into the banking system. Also, this scenario does not include the
proceeds from partial privatization of the National Lotteries and AENA.

Scenario 1:
This trajectory incorporates our baseline general government debt trajectory and assumes that the current maximum
estimated amount of required additional banking-sector recapitalization (as expected by Standard & Poor's Rating
Services) of €20 billion is fully borne by the government (see "The Restructuring Of Spanish Savings Banks: A
Profound Transformation Of The Spanish Banking Industry," published Feb. 22, 2011). The scenario also assumes
that the government successfully concludes a partial privatization of the National Lotteries and AENA, with
proceeds assumed to total €14 billion.

Scenario 2:
For 2011-2013, we assume a 70 basis point (bps) decline in real GDP growth versus our baseline projections, and
average deflator growth of 50 bps below baseline projections. In addition, we assume a 0.3% of GDP deterioration
in the primary balance, on an annual basis, during this period. For the purpose of analyzing the government debt
trajectory, this scenario assumes a higher amount of off-balance-sheet items: 5% of GDP, which is not our base-case

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 Spain (Kingdom of)

assumption.

Scenario 3:
For 2011-2013, we assume a 150 bps decrease in real GDP growth versus our baseline projections, and lower
average deflator growth of 100 bps. In addition, we assume that there is 0.6% of GDP deterioration in the primary
balance, on an annual basis, during this period. For the purpose of analyzing the government debt trajectory, this
scenario assumes a higher amount of off-balance sheet items: 10% of GDP, which is not our base-case assumption.

Table 5
Kingdom of Spain - Scenario Analysis
Baseline
2010 2011 2012 2013 2014 2015 2016 2017
Real GDP growth (%) (0.2) 0.7 1.5 1.4 1.4 1.5 1.5 1.5
GDP Deflator (%) 0.9 0.9 1.0 1.0 1.0 1.5 1.5 1.5
Primary balance (% of GDP) (7.1) (3.7) (2.1) (0.8) 0.2 1.2 2.2 3.2
GG balance (% of GDP) (9.2) (6.3) (5.1) (4.1) (3.3) (2.3) (1.3) (0.2)
Off-balance sheet items (% of GDP) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Gross debt (% of GDP) 63.8 69.1 72.5 74.9 76.4 76.5 75.5 73.5
Net GG debt (% of GDP) 56.2 61.6 65.2 67.7 69.4 69.7 68.9 67.1

Scenario 1
2010 2011 2012 2013 2014 2015 2016 2017
Real GDP growth (%) (0.2) 0.7 1.5 1.4 1.4 1.5 1.5 1.5
GDP Deflator (%) 0.9 0.9 1.0 1.0 1.0 1.5 1.5 1.5
Primary balance (% of GDP) (7.1) (3.7) (2.1) (0.8) 0.2 1.2 2.2 3.2
GG balance (% of GDP) (9.2) (6.3) (5.1) (4.1) (3.3) (2.4) (1.3) (0.3)
Off-balance sheet items (% of GDP) 0.0 1.9 0.0 0.0 0.0 0.0 0.0 0.0
Gross debt (% of GDP) 63.8 70.9 74.3 76.7 78.2 78.3 77.3 75.4
Net GG debt (% of GDP) 56.2 63.4 67.0 69.5 71.2 71.5 70.7 69.0

Scenario 2
2010 2011 2012 2013 2014 2015 2016 2017
Real GDP growth (%) (0.2) 0.0 0.8 0.7 1.4 1.5 1.5 1.5
GDP Deflator (%) 0.9 0.4 0.5 0.5 1.0 1.5 1.5 1.5
Primary balance (% of GDP) (7.1) (4.0) (2.4) (1.1) 0.2 1.2 2.2 3.2
GG balance (% of GDP) (9.2) (6.6) (5.6) (4.7) (3.6) (2.7) (1.7) (0.6)
Off-balance sheet items (% of GDP) 0.0 5.0 0.0 0.0 0.0 0.0 0.0 0.0
Gross debt (% of GDP) 63.8 75.2 79.8 83.6 85.2 85.4 84.6 82.8
Net GG debt (% of GDP) 56.2 67.6 72.3 76.1 78.0 78.4 77.8 76.2

Scenario 3
2010 2011 2012 2013 2014 2015 2016 2017
Real GDP growth (%) (0.2) (0.8) 0.0 (0.1) 1.4 1.5 1.5 1.5
GDP Deflator (%) 0.9 (0.1) 0.0 0.0 1.0 1.5 1.5 1.5
Primary balance (% of GDP) (7.1) (4.3) (2.7) (1.4) 0.2 1.2 2.2 3.2
GG balance (% of GDP) (9.2) (7.0) (6.2) (5.4) (4.1) (3.1) (2.1) (1.1)
Off-balance sheet items (% of GDP) 0.0 10.0 0.0 0.0 0.0 0.0 0.0 0.0

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Table 5
Kingdom of Spain - Scenario Analysis (cont.)
Gross debt (% of GDP) 63.8 81.3 87.5 93.1 95.0 95.4 94.7 93.1
Net GG debt (% of GDP) 56.2 73.6 79.8 85.4 87.5 88.1 87.7 86.2

Chart 9

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 Spain (Kingdom of)

Chart 10

Ratings Detail (As Of March 22, 2011)*

Spain (Kingdom of)
Sovereign Credit Rating AA/Negative/A-1+
Transfer & Convertibility Assessment AAA
Commercial Paper
Local Currency A-1+
Senior Unsecured (256 Issues) AA
Senior Unsecured (1 Issue) AAA
Sovereign Credit Ratings History
28-Apr-2010 AA/Negative/A-1+
09-Dec-2009 AA+/Negative/A-1+
19-Jan-2009 AA+/Stable/A-1+
12-Jan-2009 AAA/Watch Neg/A-1+
*Unless otherwise noted, all ratings in this report are global scale ratings. Standard & Poor's credit ratings on the global scale are comparable across countries. Standard
& Poor's credit ratings on a national scale are relative to obligors or obligations within that specific country.

Additional Contact:
Sovereign Ratings; SovereignLondon@standardandpoors.com

Additional Contact:

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 Spain (Kingdom of)

Sovereign Ratings; SovereignLondon@standardandpoors.com

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