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      FRIDAY, 08/04/2022 - Scope Ratings GmbH
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      Scope affirms the Free State of Bavaria’s AAA rating with Stable Outlook

      A wealthy economy, strong budgetary performance, low debt, ample liquidity and an integrated institutional framework support the rating. High pension liabilities, limited revenue flexibility and sizeable contingent liabilities are challenges.

      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.

      The latest information on the rating, including rating reports and related methodologies, is available here.

      Summary and Outlook

      Scope’s 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) Germany’s sovereign rating was downgraded; or ii) changes affected 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 19% of German GDP in 2020. This results in high regional growth potential and a strong ability to consistently generate own revenues. Bavaria is one of the wealthiest regions in Europe; its GDP per capita outperformed the euro area average by 41% in 2020.

      Bavaria’s real GDP in 2020 declined by 4.3% due to the Covid-19 shock, slightly less than the German average of 4.6%. Given the regional economy’s high degree of international fragmentation of its production processes, the global shutdown in early 2020 hit Bavaria’s industrial sector hard, with exports declining by 11% YoY for the year as a whole. The economic recovery in 2021 was robust with 3% real GDP growth, however a repeated increase in supply disruptions slowed growth markedly towards the end of the year. In 2022, the repercussions of the war and the imposition of international sanctions on Russia are aggravating price pressures and supply disruptions in Europe, therefore weighing on Bavaria’s growth outlook. We currently estimate real GDP growth in Germany of 2.6% this year, and a similar level for the Bavarian economy, subject to high uncertainty and assuming no embargo of Russian energy.

      The pandemic caused unemployment to increase to 4.2% in February 2021, from 2.8% in December 2019. In March 2022, the rate stood at 3%, back at its March 2019 level. Robust labour market outcomes reflect the federal government’s large discretionary support, e.g. in the form of a national furlough scheme, now extended until mid-2022 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 growth over the medium term.

      The AAA rating also reflects prudent fiscal management by the Bavarian administration. The state’s budgetary performance has been strong in recent 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 relative to national peers. This performance was underpinned by strong growth in tax revenue, continuous cost control and conservative budget management. These factors have also helped substantially reduce direct debt and build up substantial cash reserves.

      After years of budgetary surpluses and net debt reduction, results in 2020 and 2021 were driven by the Covid-19 pandemic. Due to greater uncertainty and efforts to increase operational flexibility, Bavaria passed a budget just for 2021 instead of for the usual two years. The same practice will apply in 2022, with a draft budget for just one year.

      Bavaria’s financial results worsened from a surplus of around EUR 1.2bn in 2019, or 2% of total revenues, to a deficit of 10% for 2020. For 2021, Scope expects a moderate surplus of around 1% of total revenues on the back of a strong recovery of tax revenues. In Scope’s view, adverse budgetary effects of the pandemic and Russia’s war in the Ukraine will be counterbalanced over the medium-term due to Bavaria’s: i) conservative budget management; ii) track record of commitment to fiscal consolidation; iii) ability to adjust budgets in view of high investment levels; and iv) economic and demographic outperformance versus national peers. Bavaria's financial plan for 2021-25 is based on keeping investments at a record-high level (from around 12% of total expenditure in 2020 to 15% in 2025) and a return to a balanced budget in 2023. This will entail significant consolidation efforts via an economic recovery and some expenditure adjustments given rapidly increasing renovation and construction costs.

      The crisis has resulted in lower-than-budgeted tax revenues of around EUR 1.6bn in 2020, but they rebounded strongly in 2021, to EUR 50.1bn from EUR 44.5bn in the previous year. On the expenditure side, Bavaria has taken fiscal measures to mitigate the Covid-19 shock on top of those provided at the federal level. Bavaria’s total additional pandemic-related expenditure is estimated at around EUR 7bn in 2020 and 2021 and another EUR 4.7bn in 2022. This is mainly related to investments to increase healthcare capacity and procure medical equipment and the vaccination campaign, fiscal support to households and municipalities, and funds directed to transfers, loan guarantees and capital injections for small and medium-sized businesses. Bavaria also approved the Hightech Agenda Plus investment programme, which provides EUR 900m for research and development in 2021 and 2022. Finally, a Covid investment programme totalling EUR 1.5bn will be launched in 2022, further increasing the Land’s investment activities.

      The AAA rating also reflects Bavaria’s very low debt by both national and international standards. The state repaid all maturing debt without recourse to credit authorisations in recent years, underpinned by high own cash holdings. By the end of 2019, Bavaria’s direct debt had fallen significantly to EUR 13bn, or 20% of operating revenues, down from 64% in 2012. The Covid-19 crisis has led 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. In the 2022 draft budget, another EUR 5.8bn of credit authorisations are foreseen.

      Actual debt take-up has been lower than authorisations, and the volume of the 2020 authorisation of EUR 20bn should be roughly sufficient to cover funding needs for 2020-22. Bavaria’s direct debt increased by about EUR 4.9bn in 2020 and another EUR 2.1bn in 2021, according to the national statistical office’s figures. Unused credit authorisations can be transferred to subsequent years under certain conditions, supporting Bavaria’s financing flexibility. The funds will be collected under a dedicated account in the state’s core budget created to address the Covid-19 crisis. Bavaria’s direct debt relative to its operating revenues increased by about 9pps in 2020 and Scope expects that the debt-to-operating-revenue ratio has already reached its pandemic-induced peak in 2020. In 2021, Scope projects a slight decline of the ratio, based on a strong rebound of revenues and despite the nominal debt increase.

      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 debt incurred under the 2020 credit authorisation from 2024, from 2025 for debt incurred under the 2021 credit authorisation, and from 2026 for debt incurred under the 2022 credit authorisation. An expected overall utilisation of EUR 20bn for the years 2020-22 would lead to additional debt service costs annually of EUR 1bn from 2026, somewhat reducing expenditure flexibility. Thanks to favourable financing rates, we expect the interest-payment burden to stay below 1% of operating revenue.

      Scope assesses Bavaria’s access to capital markets as excellent, like all German Länder, demonstrating investor confidence in the framework. This was evident during the Covid-19 crisis, when all Länder maintained their excellent market access. To finance measures in response to the Covid-19 shock, Bavaria re-entered the bond markets for the first time since 2014 with EUR 7.2bn issued mostly at near-zero coupons. Bavaria issued another EUR 3.4bn in 2021. 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 envisions the issuance of fixed-rate debt only.

      Bavaria’s AAA rating is further underpinned by its sizeable cash reserves versus other German Länder. These reserves stem from its sound budgetary and financial management, and they comfortably cover debt service through 2023. 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, like all German Länder, Bavaria 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 during budgetary emergencies. In the Covid-19 pandemic, the federal government has assumed the role of primary shock, shouldering 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 federal revenue equalisation, Bavaria mainly receives shared taxes like 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 state’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 state’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 17.3% at end-2021, in excess of the regulatory requirement; and ii) a low NPL ratio of 0.6% at the end of 2021. In addition, Bavaria’s strong management of its shareholdings is reflected in good overall annual financial results in past years.

      The Covid-19 crisis adversely affected the profitability of several of the state’s holdings, especially in 2020, with the state providing support via loans or capital injections. However, the expected normalisation of the economic situation should lead to a reduced risk of related debt contingencies materialising. Among the worst-hit entities are Nuremberg Airport and exhibition centres. The total debt of entities in which Bavaria holds a majority share (excluding financial institutions) increased in 2020 to around EUR 2.35bn, as did the share of debt of participations with a negative annual result. These increased to around 63% of all the state’s participations, from 3% in 2019. Scope expects this to be largely an event-driven one-off.

      Finally, over the long term, Bavaria’s budget is burdened by high pension payments, placing structural pressure on expenditure flexibility. To ease rising pressure from pension obligations (which could reach 12.6% of expenditure in an unlikely worst-case scenario), Bavaria has: i) implemented cost-saving measures; ii) pursued prudent fiscal policy; and iii) created a pension fund, which was endowed with EUR 3.4bn at the end of 2020. 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 current 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 up to one notch between the German sovereign (AAA/Stable) and the rating of an individual state.

      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 of 1 to 100, with a high (low) score being associated with a strong (weak) credit profile.

      Scope assesses 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 defined above (individual credit profile score equal to 87 out 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 rising pressures on housing affordability.

      Alongside Scope’s assessment of rating-relevant credit risks, the agency also considers long-term environmental developments that did not play a direct role in this rating action. Still, Scope notes policy objectives to achieve a reduction of CO2 emissions per inhabitant in Bavaria by 55% relative to 1990 levels by 2030 and achieve climate neutrality by 2050. In a draft law from end-2021, both targets were made more ambitious, to a 65% reduction by 2030, and climate neutrality by 2040 already.

      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 socioeconomic and demographic developments; and vii) peer comparison. 

      Methodology
      The methodology used for these Credit Ratings and/or Outlooks, (Rating Methodology: Sub-Sovereigns, 12 May 2021), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
      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 Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. 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 Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
      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 30 April 2021.

      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
      © 2022 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Ratings UK Limited, Scope Analysis GmbH, Scope Investor Services GmbH, and Scope ESG Analysis GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions 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. Scope’s ratings, rating reports, rating opinions, or related research and credit opinions are provided ‘as is’ without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or other damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party as, opinions on relative credit risk and not a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings GmbH at Lennéstraße 5 D-10785 Berlin.
        

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