Scope affirms the Free State of Bavaria at AAA with Stable Outlook
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Scope Ratings GmbH has today affirmed the Free State of Bavaria’s long-term issuer rating at AAA and short-term issuer rating at S-1+. The sub-sovereign’s senior unsecured debt is also affirmed at AAA. All ratings are expressed in both local and foreign currency. All Outlooks are Stable.
Summary and Outlook
The affirmation of the Free State of Bavaria’s AAA rating is supported by Bavaria’s wealthy economy, strong budgetary performance, low debt burden, ample liquidity, excellent access to capital markets, and integrated institutional framework. These supportive factors are balanced by challenges related to limited revenue flexibility, high pension liabilities weighing on long-term expenditure flexibility, and sizeable, yet manageable, contingent liabilities.
The Stable Outlook reflects Scope’s assessment that the risks Bavaria 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 a notably weaker individual credit profile.
Bavaria benefits from a wealthy, well-diversified and highly competitive economy, which contributed 18% of German GDP in 2018. This results in a high regional growth potential and a strong ability to consistently generate its own revenues. Bavaria is one of the wealthiest regions in Europe: in 2018, its GDP per capita outperformed the euro area average by 40%. The slowing economic momentum in Germany is also reflected in the slower growth rate in Bavaria, driven by a declining industrial production in the region and reduced exports. At the same time, the economic situation in domestically oriented sectors remains good, reflected in Bavaria’s growth rate of 0.9% in the first half of 2019 (national average: 0.4%). Bavaria enjoys favourable labour market characteristics and positive demographics, further supporting the state’s tax revenue potential. Due to constant job creation, unemployment continues to fall, down to 2.8% in September 2019, and remains the lowest of the 16 German Länder.
The AAA rating also reflects the prudent fiscal management by the Bavarian administration. The Land’s budgetary performance has been strong. Between 2014 and 2018, operating surpluses averaged 12.9% of operating revenues, and significant surpluses before debt movements averaged 4.7% of total revenues despite high investment levels vis-à-vis national peers. Such performance has been underpinned by the strong growth in tax revenue, continuous cost control and conservative budget management. These factors have also helped to substantially reduce direct debt and build up substantial cash reserves.
Mirroring favourable national economic growth in 2018, Bavaria’s tax revenue rose by around EUR 4bn (+ 8.6%). Taking further changes into account, the Free State of Bavaria recorded a surplus before debt movements of 6.6% of total revenues in 2018, an improvement compared to the budgetary target of around EUR 4.2bn. The surplus was allocated to the budgetary reserve. Based on recent tax estimates, deteriorating economic trends and in view of Bavaria’s conservative budgetary management, Scope forecasts that the Free State will exceed its 2019 budget but on a lower level than in 2018. Therefore, Scope expects an operating surplus of around 10% of operating revenues (from 15.5% in 2018) and a surplus before debt movements of around 2% of total revenues, from 6.6% in 2018.
According to Bavaria’s financial plan for 2019-23, the Free State intends to increase its already high level of investment – from 13% of expenditure in 2019 to 14.6% in 2023, to be financed predominantly by the current balance – and continue with debt reduction at the same time. In Scope’s opinion, the slower expected growth for tax revenue in 2020-21, which mirrors the anticipated national economic slow-down, should be mitigated by Bavaria’s i) conservative tax revenue growth assumptions and the possibility for budgetary adjustments, given the high investment expenditure; iii) low and declining debt service costs combined with solid liquidity; and iii) rising current expenditure for research and climate protection (including 1,000 new professorships), from which Bavaria’s economy should benefit in the long term.
Bavaria’s debt burden is very low by national and international standards. In addition, Bavaria has repaid all maturing debt without recourse to credit authorisations in recent years, underpinned by Bavaria’s high own cash holdings. Bavaria’s direct debt as a share of operating revenues reduced significantly between 2012 and 2018, from 64% to around 26%. In 2018, Bavaria reduced its legacy debt (including postponed borrowing authorisations) by 5.3% to around EUR 27bn, via settling due loans using cash holdings and postponing unused credit authorisations of around EUR 11bn to future budgets. This will also result in a further decline in debt service, strengthening the state’s fiscal leeway.
Municipal finances compare favourably in a national context. The interest burden of Bavarian municipalities fell from 0.8% of operating revenues in 2016 to 0.6% in 2018, which is moderate relative to the national average (0.9%). In addition, Bavarian municipalities’ cash advances to the non-public sector (‘Kassenkredite’) as a share of total debt remained low at 1.4% in 2018 (national average: 21.5%).
As for all German Länder, Scope assesses Bavaria’s access to capital markets 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. Bavaria’s debt-management strategy is also conservative, with no foreign currency exposure and limited interest rate risks. Going forward, in view of the low interest rate environment, Bavaria’s debt management strategy foresees the issuance of fixed-rate debt only.
Bavaria’s AAA rating is further underpinned by the Land’s sizeable cash reserves, vis-à-vis other German Länder, stemming from its sound budgetary and financial management, comfortably covering debt service through to 2021. Access to external liquidity, if required, is available at short notice through credit facilities from various major financial institutions. Combined with Bavaria’s own sizeable reserves, this makes the risk of a liquidity shortfall negligible. While Bavaria is likely to use some of its liquidity reserves for net debt repayment and to finance strategically important expenditure programmes, Scope expects liquidity reserves to remain very robust.
Finally, the Free State of Bavaria, 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.
Bavaria has a unique role in the national political landscape. It is the only Land with a separate party: the Christian Social Union in Bavaria, or the CSU. The CSU has been in power since 1957 under different coalitions, but usually as a one-party government, and has always appointed the Land’s prime minister. The party also has a long-standing agreement with the Christian Democrats (CDU) to co-operate in federal and regional elections. While the CDU does not compete with the CSU in Bavaria, the two parties form a common parliamentary party at the national level, increasing Bavaria’s influence on national policy-making relative to the other Länder.
Despite these strengths, the rating is balanced by several challenges. As most taxes are subject to revenue equalisation, Bavaria 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 Bavaria is the largest contributor to the German equalisation system.
Challenges also relate to Bavaria’s sizeable though low-risk contingent liabilities, mainly due to its 75% shareholding in the BayernLB bank. Financial risk stemming from the Land’s exposure declined in 2017, after BayernLB repaid in full its state aid. The bank’s balance sheet is strong with: i) a comfortable CET1 capital ratio of 14.5% in the first nine months in 2019, well in excess of the regulatory requirement; and ii) a low NPL ratio of 0.7% in the first three months in 2019, resulting in low risk provisions. In addition, Bavaria’s strong management of its shareholdings is reflected in overall good annual financial results, indicating a low risk of materialisation of related debt contingencies. The total debt of entities in which Bavaria holds a majority share (excluding financial institutions) remained stable in 2018, at around EUR 1.8 bn, as did the share of debt of participations with a negative annual result, which remained at around 3%.
Finally, over the long term, Bavaria’s budget is burdened by high pension payments, weighing on expenditure flexibility. To ease the rising pressure from unfunded pension obligations (expected to increase up to 13.5% of expenditure in an unlikely worst case scenario), Bavaria plans to co-finance pension payments via: i) savings through structural changes to the pension age and compensation levels; ii) continuous debt reduction, thereby generating some fiscal room; and iii) withdrawals from its pension fund. Overall, the combined measures, including the anticipated savings, would result in a moderate share of pension expenditure, peaking at below 10% and thus similar to today’s levels.
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 of 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; fiscal interlinkage and iii) political alignment. Consequently, Scope’s assessment results in an indicative downward rating distance of 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 the Free State of Bavaria’s individual credit profile as ‘exceptionally strong’ in view of the state’s ability to maintain balanced budgets and cover debt repayments, even under adverse conditions. The assessment is reflected by 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 86 of 100).
The results have been discussed and confirmed by a rating committee.
Long-term environmental and social risks
Alongside Scope’s assessment of rating-relevant credit risks, long-term environmental and social developments are considered. Scope assesses 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 environmental indicators, Bavaria remains below the average of German Länder in terms of greenhouse gas emissions, primary energy consumption and renewable energy use. The Land has also failed to meet DNS targets, particularly related to the reduction of greenhouse gas emissions (11% against a 40% benchmark). As part of the new Bavarian climate protection offensive, the Free State will provide an additional EUR 240m over 2020-23 to strengthen climate protection measures. The 2019/20 budget has also allocated around EUR 231m for the Free State's Climate Protection Program 2050. The climate protection offensive includes a 10-point plan with 96 concrete measures and is based on the three pillars of Bavarian climate policy: i) reduce the region’s greenhouse gas emissions; ii) adapt to the consequences of climate change; and iii) intensify research on environmental and climate protection.
With regards to social indicators, Bavaria excels in educational attainment and exceeds the goals of the DNS.
The main points discussed by the rating committee were: i) institutional framework for German Länder; ii) liquidity profile and debt burden; iii) debt management strategy; iv) contingent liability risks; v) budgetary performance; vi) regional socio-economic and demographic developments; vii) peers comparison.
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 rated entity and/or its agents participated in the ratings process.
The following substantially material sources of information were used to prepare the credit rating: the rated entity, public domain. 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 publication, the rated entity was given the opportunity to review the rating and/or outlook and the principal grounds upon 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.
Lead Analyst: Rating prepared by Jakob Suwalski, Associate Director.
Person responsible for approval of the rating Dr Giacomo Barisone, Managing Director.
The ratings/outlook was first released by Scope on 12 July 2019.
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.
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