by Rom Badilla, CFA – Bondsquawk.com

Credit Rating Agency Fitch downgraded the sovereign credit of Spain by from AAA to AA+ today which reflects concerns that an economic recovery will be sluggish due their debt burden. Despite the downgrade, Fitch views that the country’s credit remains strong and the outlook is currently stable. According to the report, Fitch states:

The Spanish government has announced an ambitious fiscal consolidation plan to ensure a return to sustainable public finances after the global financial crisis. Fitch believes the Spanish government could find it hard to implement some of the expenditure cuts. In particular, the agency has some doubts over the feasibility of the cuts that need to be made by Spain’s autonomous communities, who may also see a reduction in the transfers they will receive from the state budget.

Fitch believes that the Spanish government will fall short of economic growth projections of a sharp recovery once austerity measures are in place. Fitch is expecting economic growth for 2011 to be 0.5 percent while the Spanish government is expecting a rate of 1.8 percent. In addition, Fitch has doubts of the government’s project of debt relative to GDP totals.

Fitch believes that Spain’s unemployment rate, the legacy of its construction boom, and its high level of indebtedness will weigh on private consumption and investment in the medium term. Consequently, Fitch is forecasting weaker growth for the Spanish economy in the medium term than the government is, although the agency’s projections on the contribution of net trade to growth in the medium term are slightly more optimistic than those of the government.

Fitch’s analysis suggests that, on its weaker growth forecasts, general government debt would rise to 70% of GDP by end-2011, the same as the ‘AAA’ median. However, in Fitch’s scenario, debt would continue to rise, reaching almost 78% of GDP at end-2013, whereas the government projects debt will peak at 74% at end-2012 and start declining. Fitch’s analysis assumes that the government implements all the consolidation measures it has pledged. It also assumes the same stock-flow adjustment over 2010-2013 implicit in the government’s Stability Programme Update (EUR30bn). This reflects, among other operations, debt issuance to finance the restructuring of the banking sector.

Yields across the Spanish curve declined across the maturity spectrum. The yield on the 2-Year finished at 2.33 percent, a decline of 5 basis points. The 5 and 10-Year are down 2-3 basis points to 3.23 and 4.17 percent respectively.