Scope affirms the Land of Berlin at AAA with Stable Outlook
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Scope Ratings GmbH has today affirmed the Land of Berlin’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 AAA rating reflects the highly integrated institutional framework under which the Land of Berlin operates and its good budgetary performance, strict commitment to fiscal consolidation, prudent liquidity management, excellent capital market access, favourable debt profile, and solid economic base. These supportive factors are balanced by challenges related to high direct debt, limited revenue flexibility, unfunded pension liabilities weighing on long-term expenditure flexibility, as well as sizeable, yet manageable, contingent liabilities.
The Stable Outlook reflects Scope’s assessment that the risks Berlin faces remain balanced. The ratings could be downgraded if: i) the German sovereign rating was downgraded; or ii) changes were made that affect the institutional framework, resulting in notably weaker support.
The Land of Berlin, like all German Länder, benefits from a mature and highly 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 co-operative federal system aligns the credit ratings of the German Länder with that of the federal government (AAA/Stable).
In an international context, Scope views the established German institutional framework, with a proven record of institutional support from the national government, to be able to tackle the economic challenges and withstand the pressure on sub-sovereign finances caused by the Covid-19 crisis. Co-operation on the policy response between the German Länder and the sovereign has been strong during the crisis. Also, the federal government has assumed the primary role as stabiliser by implementing substantial deficit spending policies to absorb the costs of higher unemployment and support economic output.
The AAA is also supported by Berlin’s good budgetary performance, which has been underpinned by controlled expenditure growth since 2012, with high operating surpluses averaging 14.5% of operating revenues. The administration has shown a strict commitment to fiscal consolidation through effective measures to control spending, with growth in operating expenditure slower than for operating revenues since 2012. In 2019, Berlin reported a financing surplus for the eighth successive year and surpassed its own spending control targets despite rising demand for social services due to population growth.
Conservative budget planning and accommodative financing conditions have resulted in Berlin’s interest-payment burden halving since 2012, strengthening its budgetary flexibility. Berlin also benefits from a high share of investment relative to total expenditure (11% in 2019), enabling some capital expenditure to be postponed. Berlin’s investment strategy is based on three pillars: i) the core budget including funds from the federal government's investment promotion programmes; ii) the SIWA fund; and iii) infrastructure investments by the Land’s shareholdings, which improve budgetary flexibility. While the core budget and SIWA contribute EUR 3bn annually for investments, Berlin’s major holdings have regularly undertaken EUR 2.5bn in infrastructure investments in recent years.
The administration reacted promptly to the Covid-19 shock, making the necessary adjustments to the budget for 2020/21 and ensuring access to liquidity for the regional economy via direct fiscal support or liquidity assistance for the hardest-hit businesses. Other measures included a pre-emptive establishment of a coronavirus treatment centre to increase healthcare capacity. At the same time, spending controls were reinforced. For 2020/21, Scope expects a material shortfall in Berlin’s tax revenues due to: i) substantial cyclical losses caused by the macroeconomic impact of the pandemic lockdown measures in view of the Land’s high share of businesses in the services sector; ii) temporary losses due to federal fiscal measures to support the national economic recovery including reductions in VAT; and iii) potential structural losses due to behavioral changes among people and businesses in response to the pandemic along with global travel restrictions, given Berlin’s status as a metropolitan city. Based on current tax estimates and recent budgetary measures to respond to the Covid-19 crisis, Scope expects Berlin’s financial results to deteriorate from a surplus of around EUR 800m (2.6% of total revenues) in 2019 to deficits of around EUR 4.1bn, or 14% of total revenues, in 2020 and EUR 2.4bn in 2021 (9% of total revenues).
Over the medium term, Scope expects Berlin to report small budget surpluses and adhere to its long-term consolidation strategy, supported by conservative budget management, low financing costs, possibility to adjust spending in view of high investment levels, and its economic and demographic outperformance vis-à-vis national peers.
As for all German Länder, Scope assesses Berlin’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. In addition, Berlin employs a conservative debt-management strategy with no foreign currency risks and limited interest rate risks. Going forward, in view of the low interest rate environment, Berlin’s debt management strategy foresees i) no new foreign currency exposure; ii) the majority of issuance at fixed interest rates; and iii) limited and declining use of interest rate derivatives.
Scope views Berlin’s liquidity management as sound due to comprehensive inter-year cash planning and the availability of numerous sources of liquidity. Berlin also benefits from conservative financial planning and maintains a sizeable cash buffer throughout the year. The administration’s liquidity strategy is to limit cash holdings by lending excess liquidity upon the receipt of large tax revenues. Access to liquidity to bridge intraday needs, if required, is available through credit facilities from major financial institutions. An additional source of liquidity is provided by commercial cash transactions between the German Länder, which lend excess liquidity to each other. In combination with excellent market access, the risk of potential liquidity shortages is negligible.
The AAA rating is also supported by Berlin’s favourable economic and demographic long-term trends. In 2019, Berlin's GDP expanded by 3%, outperforming the German average of 0.6%. The GDP-per-capita gap between the Land of Berlin and the German average was closed in 2019, and the figure now stands at 101.5% of the national average. In addition, strong economic growth led to a reduction in Berlin’s unemployment rate, down to 7.8% in 2019 from 12.3% in 2012.
For 2020, Scope expects the Land’s economy to be hit harder by the Covid-19 crisis than other German Länder and projects real GDP to contract by around 6-7%, worse than the projection of -5.2% for Germany. This is due to structural factors that expose Berlin’s economy more to the economic repercussions of the containment measures, such as the economy’s above-average share of hard-hit sectors like travel, trade, and arts and recreation. However, due to Berlin’s recent economic and demographic outperformance vis-à-vis national peers and substantial support measures at the federal level, Scope expects a strong post-crisis recovery for the Land.
Despite these strengths, the rating is balanced by several challenges. Berlin’s direct debt levels are high by national and international standards, despite the firm long-term downward trend. Direct debt amounts to EUR 57.6bn or 199% of operating revenues as of end-2019, down from 283% at end-2013. Similarly, debt service is on a declining trend but remains high at EUR 5.7bn in 2019 or 20% of operating revenues in 2019, significantly down from EUR 9.7bn or 44.6% in 2013 and mitigated by excellent access to capital markets.
In response to the Covid-19 crisis and in line with the German sovereign and most other Länder, Berlin has invoked the constitutionally allowed safeguard rule and has temporarily suspended its debt brake law and adopted a supplementary budget that allows for EUR 6bn of new net debt issuances this year. While the Land intends to issue the full EUR 6bn this year, EUR 5.5bn thereof will be placed in a reserve earmarked for expected tax revenue shortfalls and additional support measures, mainly for fiscal years 2020 and 2021. As a result of the new net debt issuances, Scope expects debt as a percentage of operating revenues to increase to 246% from 199% in 2020. Given the long-term decline in interest rates, Scope expects Berlin’s interest payment burden to remain manageable at below 4.5%.
Due to the extensive shareholdings of the Land of Berlin, the high level of contingent liabilities is a notable credit challenge, though mitigated by the largely low-risk profiles of the companies owned partially or wholly by the Land of Berlin. While the Covid-19 crisis will adversely affect the profitability of some of Berlin’s holdings and require financial support by the Land in 2020, the budgetary impact is limited. Scope views positively the entities’ low consolidated leverage ratio of 0.55 (total liabilities to assets).
Over the long term, Berlin faces high pension contributions to its civil servants. Pension payments amounted to 9% of total expenditure in 2019, which was below the national average of 10%, because after reunification, civil servants in the new Länder were not included in the pension scheme but in a pay-as-you-go system under the Pension Transition Act. To ease the pressure from pension obligations, Berlin provides mandatory payments to the pension contribution plan, which stood at around EUR 1.2bn in 2019, resulting in largely unfunded pension liabilities.
Finally, as for all German Länder, Berlin has low flexibility to adjust revenues. Berlin receives shared taxes in line with constitutional arrangements between the Länder and the Bund. These revenues initially flow into Berlin’s budget but are later redistributed at a national level in accordance with revenue-sharing agreements and additional transfer mechanisms, essentially weakening their link to the Land’s economic performance.
Factoring of ESG
Governance considerations are material to Berlin's rating and are included in Scope’s institutional framework assessment, as well as in its assessment of Berlin’s individual credit profile, highlighting the high quality of governance alongside the administration’s strict commitment to fiscal consolidation, conservative budget management and prudent liquidity planning.
Social considerations are included in Scope’s assessment of Berlin’s ‘economy and social profile’, highlighting favourable demographics.
Alongside an assessment of rating-relevant credit risks, Scope considers long-term social and environmental developments that are not material to Berlin’s rating. Developments regarding the German Länder are assessed using selected sustainability indicators as defined by the German Sustainability Strategy, which itself is based on the Sustainable Development Goals set by the United Nations for 2030.
With regards to environmental indicators, Berlin presents a positive profile relative to national peers. The Land performed below average in 2015 as regards its share of renewable energy sources, at 2.5% against the national average of 32%. However, it was above average in terms of reductions in both energy use and greenhouse gas emissions.
With regards to social indicators, Berlin is above average in educational attainment, gender pay equality and childcare options. It is only below average for early school-leavers, which Berlin is actively tackling via its ‘Schulbauoffensive’, the biggest investment programme of the current legislative period with up to EUR 5.5bn allocated to renovate existing schools and build new capacity to improve the quality of schooling. Moreover, the Land has provided tablets to tackle the challenge of digital schooling during the pandemic, especially for pupils without access to digital learning solutions or mobile devices.
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; ii) 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 Berlin’s individual credit profile as strong, reflecting the outcome of the quantitative Core Variable Scorecard and the qualitative assessment (QS) in the four respective categories as defined above (individual credit profile score equal to 70 of 100).
The review of potentially exceptional circumstances that cannot be captured by the quantitative and qualitative scorecards did not lead to further adjustments of Berlin’s indicative rating of AAA.
The results have been discussed and confirmed by a rating committee.
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) budgetary performance and contingent liability risks; v) regional socio-economic and demographic developments; and vi) peer comparison.
The methodology used for this rating and/or rating outlook, Rating Methodology: Sub-Sovereigns, published on 18 May 2020; is available on https://www.scoperatings.com/#!methodology/list.
Information on the meaning of each rating category, including definitions of default and recoveries can be viewed in the “Rating Definitions - Credit Ratings and Ancillary Services” published on https://www.scoperatings.com/#!governance-and-policies/rating-scale. 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/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope’s definitions of default and rating notations can be found at https://www.scoperatings.com/#governance-and-policies/rating-scale. Guidance and information on how Environmental, Social or Governance factors (ESG factor) are incorporated into the rating can be found in the respective sections of the methodologies or guidance documents provided on https://www.scoperatings.com/#!methodology/list.
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: public domain and the rated entity.
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, 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, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0.
Lead analyst: 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 14 July 2017. The ratings/outlooks were last updated on 24 May 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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