Scope Ratings GmbH (Scope) 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 has also been 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 is downgraded; or ii) changes were to affect the institutional framework, resulting in a notably weaker individual credit profile.

Rating rationale

Bavaria benefits from a wealthy, well-diversified and highly competitive economy, which contributed 18% of German GDP in 2019. This results in a high regional growth potential and a strong ability to consistently generate own revenues. Bavaria is one of the wealthiest regions in Europe: in 2019, its GDP per capita outperformed the euro area average by 40%.

Following real growth of 0.5% in 2019, Bavaria’s real GDP in 2020 declined by 5.5% due to the Covid-19 shock, slightly more than the German average of 4.9%. In early 2020, Bavaria’s export-oriented industry was hard-hit by the global shutdown of activity, with exports declining by 11% in 2020 YoY. However, the exports sector has recovered and continues to perform better than the services sector, as highlighted by a 9-point expansion of the Bavarian ifo business climate index in March 2021. A continuing economic expansion, especially in major trading partners such as the US and China, should facilitate the recovery, which Scope estimates at around 4% in 2021.

The Covid-19 shock has led to an increase in unemployment to 3.9% in March 2021 versus 2.8% in December 2019. This only moderate rise also reflects the federal government’s large discretionary support, e.g. in the form of a national furlough scheme, now extended until the end of 2021 and grants to hard-hit businesses, as well as stimulus measures. Bavaria has the lowest unemployment rate among the German Länder and enjoys positive demographic developments, further supporting its tax revenue potential over the medium term.

The AAA rating also reflects the prudent fiscal management by the Bavarian administration. The Land’s budgetary performance has been strong in past years. Between 2015 and 2019, operating surpluses averaged 12.9% of operating revenues, and surpluses before debt movements have been significant, averaging 4.2% of total revenues despite high investment levels vis-à-vis national peers. Such performance has been underpinned by strongly growing 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.

After years of budgetary surpluses and net debt reduction, results in 2020 and 2021 will be driven by the Covid-19 pandemic. Due to the higher uncertainty and to increase operational flexibility, Bavaria passed a budget for just 2021 instead of the usual two years.

Scope expects Bavaria’s financial results to worsen from a surplus of around EUR 1.2bn in 2019, or 2% of total revenues, to deficits of around 8% for 2020 and 4% in 2021. In our view, the adverse budgetary effects should be counterbalanced, and the budget should return to balance in the medium term due to Bavaria’s: i) conservative budget management; ii) track record of a commitment to fiscal consolidation; iii) possibility to adjust budgets in view of the high investment levels; and iv) economic and demographic outperformance vis-à-vis national peers. Bavaria's financial plan for 2020-24 is based on keeping investments at a record-high level (from around 12% of total expenditure in 2020 to 14% in 2024) and a return to balance in 2022, which will entail significant consolidation efforts via an economic recovery from 2021 and some expenditure adjustments.

The crisis will lead to lower-than-budgeted tax revenues, by around EUR 3.5bn in 2020 and EUR 3.7bn in 2021, and structural annual revenue shortfalls of around 5% of pre-crisis budgeted tax revenue going forward. The pre-crisis level of tax revenue should be reached in 2022. On the expenditure side, Bavaria has taken fiscal measures to mitigate the Covid-19 shock on top of those provided on the federal level. Additional pandemic-related expenditure is estimated at around EUR 9bn in 2020 and 2021 in total, or around 14% of 2019 total revenue, mainly related to investments to increase healthcare capacity and procure medical equipment, fiscal support to households and municipalities, and funds directed towards transfers, loan guarantees and capital injections to small and medium-sized businesses. The Free State has also approved the Hightech Agenda Plus investment programme, with EUR 900m for 2021 and 2022 for research and development.

The AAA rating also reflects Bavaria’s very low debt, by both national and international standards. The state had repaid all maturing debt without recourse to credit authorisations in recent years, underpinned by high own cash holdings. Bavaria’s direct debt amounted to EUR 13bn at the end of 2019. As a share of operating revenues debt declined significantly, to 20% in 2019 from 64% in 2012. In line with previous years, Bavaria’s debt reduction in 2019 was via settling due loans using cash and postponing around EUR 14bn of unused credit authorisations to future budgets, resulting in a further decline in debt service and strengthening fiscal leeway.

The Covid-19 crisis will lead to moderately higher debt levels. To deal with revenue losses and spending pressures caused by the pandemic, Bavaria adopted budgetary measures that allow for up to EUR 20bn of new debt issuances in 2020 and up to EUR 11.6bn in 2021 via credit authorisations. Unused credit authorisations in 2020 and 2021 can be transferred under certain conditions to subsequent years, supporting Bavaria’s financing flexibility. The funds will be collected under a dedicated account in the Land’s core budget created to address the Covid-19 crisis. Scope expects that the overall take-up will be significantly lower, however, and that the volume of the 2020 authorisation of EUR 20bn should be sufficient to cover funding needs for 2020 and 2021. Scope estimates that Bavaria’s direct debt effectively increased by about EUR 4.9bn in 2020, leaving significant headroom to the 2020 authorisation. While this will increase Bavaria’s direct debt by about 10pps of operating revenues in 2020, Scope expects that the debt burden relative to operating revenues will peak in 2021.

Under the debt brake rule, credit authorisations under the emergency clause come with a pre-defined redemption plan. Bavaria will amortise annual instalments of 5% of the total amount used from 2024 to 2044 for debt taken up under the 2020 credit authorisation, and from 2025 to 2045 for debt taken up under the 2021 credit authorisation. If the Free State were to fully utilise the 2020 credit authorisations of EUR 20bn, there would be additional debt service costs of EUR 1bn over the coming years, somewhat reducing expenditure flexibility. Thanks to favourable financing rates, we expect the interest-payment burden at below 1% of operating revenue from 2024.

As for all German Länder, Scope assesses Bavaria’s access to capital markets as excellent, demonstrating investor confidence in the framework. This was evident during the Covid-19 crisis, when all Länder maintained their excellent market access. In response to the Covid-19 crisis, Bavaria re-entered the bond markets for the first time since 2014 with EUR 7.2bn issued at near-zero coupons. 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, which stem from its sound budgetary and financial management and comfortably cover debt service through to 2022. 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 over the coming years.

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 federal government has assumed the role of primary shock absorber, through deficit spending of EUR 390bn to date (or 12% of 2020 GDP) that has absorbed a large part of the costs to the economy caused by ongoing pandemic restrictions as well as direct healthcare spending.

Despite these strengths, Bavaria’s credit profile also faces several medium-term challenges.

First, as most taxes are subject to revenue equalisation, Bavaria mainly receives shared taxes as is the case with all Länder (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.

Second, 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 its state aid in full. The bank’s balance sheet is strong with: i) a comfortable CET1 capital ratio of 15.9% at end-2020, in excess of the regulatory requirement; and ii) a low NPL ratio of 0.6% at the end of 2020, resulting in low risk provisions. In addition, Bavaria’s strong management of its shareholdings is reflected in good overall annual financial results in past years.

The Covid-19 crisis will adversely affect the profitability of several of the Land’s holdings, especially in 2020, with the Land providing support via loans or capital injections. However, the expected normalisation of the economic situation should lead to a reduced risk of materialisation of related debt contingencies. Among the worst-hit entities are Munich Airport, Nuremberg Airport and exhibition centres. The total debt of entities in which Bavaria holds a majority share (excluding financial institutions) remained stable in 2019, at around EUR 1.9bn, as did the share of debt of participations with a negative annual result, which remained at around 3% of all the Land’s participations.

Finally, over the long term, Bavaria’s budget is burdened by high pension payments, placing structural pressure on expenditure flexibility. To ease the rising pressure from pension obligations (which could reach 12.6% of expenditure in an unlikely worst-case scenario), Bavaria plans to co-finance pension payments via: i) savings through implemented 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, endowed with EUR 3.2bn at the end of 2019. Overall, the combined measures, including the anticipated savings, would result in a moderate share of pension expenditure, peaking at below 10-12% and thus broadly 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 zero 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 a 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) budgetary 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’. 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 84 of 100).

The results have been discussed and confirmed by a rating committee.

Factoring of Environment, Social and Governance (ESG)

Governance considerations are material to Bavaria's rating and are included in Scope’s institutional framework assessment and its assessment of Bavaria’s individual credit profile. These highlight the high quality of governance alongside the administration’s track record of sound liquidity and debt management practices.

Social considerations are included in Scope’s assessment of Bavaria’s ‘economy and social profile’, highlighting a healthy labour market and favourable demographics, but also the need to support its citizens in the context of the rising pressures on housing affordability.

Alongside Scope’s assessment of rating-relevant credit risks, the rating agency also considers long-term environmental developments which did not play a direct role in this rating action.

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) contingent liability risks; v) budgetary performance; vi) regional socio-economic and demographic developments; and vii) peers comparison.

Methodology
The methodology used for these Credit Ratings and/or Outlooks (Rating Methodology: Sub-Sovereigns, 18 May 2020) is available on https://www.scoperatings.com/#!methodology/list.
Scope Ratings GmbH and Scope Ratings UK Limited apply the same methodologies/models and key rating assumptions for their credit rating services, while Scope Hamburg GmbH’s methodologies/models and key rating assumptions are different from those of Scope Ratings GmbH and Scope Ratings UK Limited.
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 Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The Rated Entity and/or its Related Third Parties participated in the Credit Rating process.
The following substantially material sources of information were used to prepare the Credit Ratings: the Rated Entity and public domain.
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting these Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data.
Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and/or Outlooks and the principal grounds on which the Credit Ratings and/or Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.

Regulatory disclosures
These Credit Ratings and/or Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and/or Outlooks are UK-endorsed.
Lead Analyst: Jakob Suwalski, Director.
Person responsible for approval of the Credit Ratings: Alvise Lennkh, Executive Director.
The Credit Ratings/Outlooks were first released by Scope Ratings on 12 July 2019. The Credit Ratings/Outlooks were last updated on 13 March 2020.

Potential conflicts
See www.scoperatings.com under Governance & Policies/EU Regulation/Disclosures for a list of potential conflicts of interest related to the issuance of Credit Ratings.

Conditions of use / exclusion of liability
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