Scope affirms and publishes Baden-Wurttemberg’s AAA credit rating with Stable Outlook
Scope Ratings GmbH today affirmed Baden-Wurttemberg’s long-term issuer rating of AAA in both local and foreign currency. The agency also affirmed a short-term issuer rating of S-1+ in both local and foreign currency. The sub-sovereign’s senior unsecured debt in both local and foreign currency was also rated at AAA. All Outlooks are Stable.
The AAA rating reflects the Land of Baden-Wurttemberg’s wealthy and resilient economy, solid budgetary performance with strong commitment to maintain balanced budgets, excellent access to capital markets, and an integrated institutional framework. These supportive factors are balanced by challenges related to limited revenue flexibility, a high pension burden weighing on long-term expenditure flexibility, and high, yet stabilizing, debt levels. The Stable Outlook reflects Scope’s assessment that the risks Baden-Wurttemberg faces remain well balanced.
Baden-Wurttemberg benefits from a wealthy, resilient and highly competitive economy, which contributed 15.1% of German GDP in 2018 with the highest export volume among the Länder in 2018 accounting for 15.4% of German exports. This results in a high regional growth potential and a strong ability to consistently generate own revenues. The Land is one of the wealthiest regions in Europe: in 2018, its GDP per capita outperformed both the German and euro area average, by around 13% and 36.7% respectively. Baden-Wurttemberg enjoys resilient economic fundamentals with a strong manufacturing base, including machinery and automotive, with companies such as Daimler, Bosch, SAP and Porsche, resulting in favourable labour market conditions and positive demographics, further supporting the Land’s tax revenue potential. Due to constant job creation, unemployment remains low at 3.2% in October 2019, even in the current slowing economic environment in view of challenges for the German automotive sector alongside uncertainties of the global economic environment. Baden-Wurttemberg also benefits from a high ratio of working age population (15-64), at 66% in 2017. Moreover, according to the Federal Statistical Office, the total population is projected to increase by 2.5% through to 2040, thus offsetting adverse dynamics stemming from an ageing population.
The AAA rating also reflects the sound fiscal management by the regional administration. The Land’s budgetary performance has been strong with operating surpluses averaging 11.5% of operating revenues between 2016-18, and comfortable surpluses before debt movement averaging around 2% of total revenues despite high investment levels vis-à-vis national peers. Such performance has been underpinned by strong growth in tax revenue averaging annually 6% in 2016-18, as well as continuous cost control and conservative budget management. These factors have also helped to reduce the debt burden on the Land’s budget and build up reserves. Based on recent tax projections and in view of Baden-Wurttemberg’s conservative budgetary management and plans to increase investment, Scope expects the Land will maintain its solid budgetary performance in 2019, driven by favourable tax revenue growth above budgetary assumptions and lower contributions to the German equalisation system than expected. Scope expects the Land to maintain its operating surplus at around 12% of operating revenues in 2019 and a surplus before debt movement of around 3% of total revenues, from around 6% in 2018.
According to Baden-Wurttemberg’s financial plan for 2018-22, the Land intends to increase its level of investment, from 9% of adjusted expenditure in 2018 to 10% in 2022, to be financed predominantly by the current balance while keeping budgets before debt repayment balanced at the same time. In Scope’s opinion, the slower expected growth for tax revenue in 2021-22, which mirrors the anticipated national economic slowdown, should be mitigated by Baden-Wurttemberg’s i) economic and demographic outperformance vis-à-vis national peers; ii) conservative estimates of tax revenue growth; and iii) declining debt service costs, which are creating some additional fiscal space. Over the medium term, Scope expects Baden-Wurttemberg to adhere to its fiscal consolidation strategy to build up reserves and remain compliant with the debt brake rule.
As for all German Länder, Scope assesses Baden-Wurttemberg’s access to capital markets and liquidity as excellent. This was particularly evident during the last financial crisis, when all Länder maintained their excellent access, demonstrating investor confidence in the German framework. In common with other Länder, liquidity management plans are based on predictable cash flows. While outflows are not subject to large deviations, Scope believes that inflows are calculated conservatively. Baden-Wurttemberg holds sizeable cash reserves vis-à-vis other German Länder, stemming from its sound budgetary and financial management. Access to external liquidity, if required, is available at short notice through credit facilities from various major financial institutions or commercial cash transactions between the German Länder, resulting in a negligible risk of potential liquidity shortage.
Finally, the Land of Baden-Wurttemberg, like all German Länder, benefits from a mature and strongly integrated institutional framework. The key elements of the framework are: i) a strong revenue equalisation mechanism; ii) wide-ranging participation- and veto-rights by the Länder in national legislation; iii) equal entitlement of the Länder regarding negotiations on federal reforms; and iv) a solidarity principle that ensures extraordinary support in situations of budgetary emergency. The strong integration in the cooperative federal system aligns the credit ratings of the federal government (AAA/Stable) with the German Länder.
Despite these strengths, the rating is balanced by several challenges. As most taxes are subject to revenue equalisation, Baden-Wurttemberg mainly receives shared taxes (largely personal income taxes, value-added taxes and corporate taxes). This limits revenue flexibility and weakens the link between tax revenues and the Land’s economic performance, given that Baden-Wurttemberg is a significant net contributor to the German equalisation system.
Challenges also relate to Baden-Wurttemberg’s debt levels which are high by international standards, despite the stabilizing trend as the Land has taken on no new debt since 2015. Direct debt amounts to around EUR 46bn or 85% of operating revenues as of end-2018, down from 115% two years earlier. The robust growth of tax revenues and conservative budgetary policy have resulted in sustained budgetary surpluses that have enabled a downward trend of the debt burden. Scope expects this downward trend to continue, in keeping with the Land’s medium-term financial planning. In the years 2018 and 2019, for the first time, credit market debt will be redeemed to a significant extent (totaling EUR 1.25bn), in addition to settling of postponed credit authorisations of EUR 1.5bn via own cash holdings. Moreover, while the administration has publicly committed to refrain from net new borrowing until 2022, the Land’s interest expenses have strongly benefitted from the Land’s refinancing strategy, the status of the Länder as safe-havens and the low interest rate environment.
Finally, Baden-Wurttemberg’s budget, in common with the budgets of the western Länder, is burdened by high pension payments. Annual expenditure on pension and benefits amounted to around 13% of total expenditure in 2017, above the national average of 11.3%. The projected increase of pensioners to around 167,300 in the year 2060 (from 135,332 in 2018) will further limit long-term expenditure flexibility, in addition to the Land’s requirements to increase investment expenditure and constraining minimum legislative requirements of some expenditure items, making most items difficult to trim. We view risks related to the growing pension liabilities as moderate, given the Land’s regular contributions to two pension funds, with a planned accumulated volume of retirement provisioning of EUR 8bn in 2020 (from EUR 6.8bn in 2018), which will curb the spending increase and cushion negative revenue developments.
Institutional framework assessment
Scope’s institutional framework assessment determines the intergovernmental integration between sovereign and sub-sovereign levels. Scope uses three key analytical factors to assess systemic support: i) institutionalised support; ii) fiscal interlinkage; and iii) political alignment between government tiers. The outcome of this assessment results in a downward rating range between the sovereign rating and the rating of the sub-sovereign entity between 0 notches (high integration) and 10 notches (low integration).
Scope considers the institutional and financing framework under which the German Länder operate to display high integration for i) institutionalised support, ii) fiscal interlinkage and iii) political alignment. Consequently, Scope’s assessment results in an indicative downward rating distance of at maximum one notch between the German sovereign (AAA/Stable) and the rating of an individual Land.
The results have been discussed and confirmed by a rating committee.
Core Variable Scorecard (CVS) and Qualitative Scorecard (QS)
Scope assesses the individual credit profile based on a qualitative and quantitative analysis of four key risk categories: i) debt burden and liquidity profile; ii) budget performance and flexibility; iii) economy and social profile; and iv) quality of governance. This risk assessment is conducted on a scale from 1 to 100, whereby a high (low) score is associated with a strong (weak) credit profile.
Scope assesses Baden-Wurttemberg’s individual credit profile as strong, reflecting the outcome of the quantitative Core Variable Scorecard and the qualitative assessment in the four respective categories as defined above (individual credit profile score equal to 75 of 100).
The results have been discussed and confirmed by a rating committee.
Long-term environmental and social risks
Alongside our assessment of rating-relevant credit risks, we consider long-term environmental and social developments, which did not play a direct role in this rating action. We assess developments regarding the German Länder by using selected sustainability indicators as defined by the German Sustainability Strategy (DNS), which itself is based on the Sustainable Development Goals (SDGs) set by the United Nations for 2030.
With regards to social indicators, Baden-Wurttemberg excels in educational achievements, reflected by a low share of early school-leavers (8.7% against a DNS target of below 10%). The Land outperforms the German Länder average and meets the DNS target in the proportion of students with at least an upper-secondary education (50.2% against a national average of 44.4% and a DNS target of above 42%). In common with other Länder, Baden-Wurttemberg fails to meet benchmarks on compatibility of family and career, reflected by low shares in the provision of full-day child care (10.7% for children between 0 and 2 years against a national average of 23% and a DNS target of 35% until 2030).
On environmental indicators, Baden-Wurttemberg remains below the average of German Länder in terms of renewable energy use and accessibility with public transport. In common with other Länder, Baden-Wurttemberg has also failed to meet DNS targets, particularly related to the reduction of greenhouse gas emissions (12% against a 40% benchmark).
Outlook and rating-change drivers
The Stable Outlook reflects Scope’s assessment that the risks Baden-Wurttemberg faces remain balanced.
The ratings could be downgraded if: i) the German sovereign rating were to be downgraded or ii) changes were to affect the institutional framework, resulting in notably weaker individual credit profile.
The main points discussed by the rating committee were: i) institutional framework for German Länder; ii) debt burden; iii) budgetary performance and flexibility; iv) debt management strategy; v) regional socio-economic and demographic developments; vi) peers consideration.
The methodology applicable for this rating and/or rating outlook, Sub-Sovereign Credit Rating, is available on www.scoperatings.com.
Historical default rates of the entities rated by Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. Please also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerepweb/statistics/defaults.xhtml. A comprehensive clarification of Scope’s definition of default as well as definitions of rating notations can be found in Scope’s public credit rating methodologies on www.scoperatings.com.
The rating outlook indicates the most likely direction of the rating if the rating were to change within the next 12 to 18 months.
Solicitation, key sources and quality of information
The rating was not requested by the rated entity or its agents. The rated entity did not participate in the rating process. Scope had no access to accounts, management and/or other relevant internal documents for the rated entity or related third party.
The following substantially material sources of information were used to prepare the credit rating: public domain. Key sources of information for the rating include: Ministry of Finance Baden-Wurttemberg, Statistical Office Baden-Wurttemberg, Federal Ministry of Finance, Federal Statistical Office, the Stability Council, European Commission, and Haver Analytics. Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data.
Prior to the issuance of the rating or outlook action, the rated entity was given the opportunity to review the rating and/or outlook and the principal grounds on which the credit rating and/or outlook is based. Following that review, the rating was not amended before being issued.
This credit rating and/or rating outlook is issued by Scope Ratings GmbH.
Rating prepared by Jakob Suwalski, Lead Analyst
Person responsible for approval of the rating: Dr Giacomo Barisone, Managing Director
The ratings/outlook was first published by Scope on 13 December 2019.
As a "sovereign rating" (as defined in EU CRA Regulation 1060/2009 "EU CRA Regulation"), the ratings on Baden-Wurttemberg are subject to certain publication restrictions set out in Art 8a of the EU CRA Regulation, including publication in accordance with a pre-established calendar (see "Sovereign Ratings Calendar of 2019" published on 22.07.2019 on www.scoperatings.com. Under the EU CRA Regulation, deviations from the announced calendar are allowed only in limited circumstances and must be accompanied by a detailed explanation of the reasons for the deviation. In this case the deviation from Scope’s published calendar was due to the first-time publication of the ratings.
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.
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