Rating action

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+. Scope has also affirmed the sub-sovereign’s senior unsecured debt 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 low debt burden, excellent access to capital markets, ample liquidity, strong budgetary performance, wealthy economy, 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 that Bavaria faces remain balanced. The ratings could be downgraded if: i) Germany’s sovereign rating were downgraded; ii) changes to the institutional framework were to result in a notably weaker individual credit profile; and/or iii) the individual credit profile deteriorated significantly and structurally.

Rating rationale

The AAA rating reflects Bavaria’s very low debt, excellent capital market access and strong budgetary performance resulting in significant liquidity buffers 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. While pandemic-related borrowing has increased debt to 29% of operating revenue (EUR 19.9bn) at end-2021, up from 20% of operating revenue in 2019, Scope expects an increase in revenue to result in a reduction in the debt/ operating revenue ratio in 2022. Based on figures from Destatis, debt had already declined to EUR 19bn as of Q3 2022.

In response to the Covid-19 crisis, Bavaria passed legislation to invoke the safeguard clause of its debt brake and adopted budgetary measures and credit authorisations of up to EUR 20bn of new debt in 2020, up to EUR 11.6bn in 2021 and EUR 5.8bn in 2022. In the 2023 draft budget, no net borrowing is planned and a decrease in debt of EUR 50m has been budgeted.

Bavaria’s debt take-up has been significantly lower than credit authorisations over 2020-2022, and the volume of the 2020 authorisation of EUR 20bn was sufficient to cover funding over these three years. Unused credit authorisations are transferable to subsequent years under certain conditions, supporting the Land’s financing flexibility. Pandemic-related funds are collected under a dedicated account (chapter 13 19 ‘Sonderfonds Corona-Pandemie’) in the Land’s core budget created in 2020 to address the Covid-19 crisis. At end-2022, debt taken up under chapter 13 19 amounted to EUR 10.21bn.

Under the debt brake rule, credit authorisations under the emergency clause come with a pre-defined redemption plan. Bavaria will amortise debt taken on under chapter 13 19 in annual instalments of 5% of the total amount 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. Conservatively, a utilisation of EUR 20bn for the years 2020-22 would lead to additional debt service costs of about EUR 1bn annually from 2026, somewhat reducing expenditure flexibility. However, as actual take-up of debt was substantially lower than budgeted, mandatory redemptions should stay well below EUR 1bn per year. Thanks to favourable financing rates, Scope expects interest payments to stay below 1% of operating revenue.

As for all German Länder, Scope assesses Bavaria’s access to capital markets as excellent. This was again observed during the Covid-19 crisis. Bavaria re-entered the bond markets for the first time since end-2014 in 2020, issuing EUR 7.2bn mostly at near-zero coupons. In 2021, Bavaria issued another EUR 3.4bn of debt. In 2022, Bavaria issued promissory notes amounting to EUR 338.5m, but did not tap public debt markets, indicating limited financing needs and reflecting volatile capital markets as the ECB tightened monetary policy considerably. Bavaria employs a conservative debt-management strategy with no foreign currency exposure and limited interest rate risks. Going forward, Bavaria’s debt management strategy envisions: i) the issuance of fixed-rate debt only; and ii) the exclusion of new derivatives to minimise risks and maintain low administrative costs in debt management.

Bavaria’s AAA rating is further underpinned by its sizeable cash reserves, which is higher than that of other Länder. These reserves stem from its sound budgetary and financial management, and they comfortably cover debt service through 2024. Access to external liquidity, if required, is available at short notice via credit facilities from major financial institutions. German Länder lend excess liquidity to each other via commercial cash transactions, generating another source of liquidity. Combined with Bavaria’s own sizeable reserves, this makes the risk of a liquidity shortfall negligible.

The AAA rating also reflects prudent fiscal management by the Bavarian administration. The state’s budgetary performance has been strong in the years before the pandemic. Between 2015 and 2019, operating surpluses averaged 12.9% of operating revenue, and surpluses before debt movements have been significant, averaging 4.2% of total revenue despite high investment levels relative to national peers. This performance was underpinned by strong tax revenue growth, 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, budgetary results in 2020 and 2021 were driven by the Covid-19 pandemic. Due to greater uncertainty and efforts to increase operational flexibility, Bavaria passed one-year budgets for 2021 and 2022, instead of the usual two years.

Bavaria’s financial results worsened from a surplus of around EUR 1.2bn in 2019, or 2% of total revenue, to deficits of 10.3% in 2020 and 1.7% in 2021. For 2022, Scope expects a surplus of around 4% of total revenue on the back of a strong recovery in tax revenue. Scope expects adverse budgetary effects of the pandemic and the Russia-Ukraine war will be counterbalanced over the medium term by Bavaria’s: i) conservative budget management; ii) record of commitment to fiscal consolidation; iii) ability to adjust budgets in view of high investment levels; and iv) economic and demographic outperformance of national peers.

Bavaria's financial plan for 2022-2026 aims to keep investments at a record-high of around 15% of total expenditure and foresees no net borrowing. This will entail significant consolidation efforts via an economic recovery and some expenditure adjustments. Policy priorities are demographic developments and greenhouse gas reduction, as well as economic stimulus in response to the Covid-19 and energy crises. The following measures are in place: i) the technology initiatives Hightech Agenda Bayern, to which EUR 2bn is allocated until the end of the legislative period in 2023, the ii) Hightech Agenda Plus, a supplement to the former in response to the Covid-19 crisis to provide additional growth stimulus of EUR 900m for 2021 and 2022, iii) a EUR 1.5bn Covid-19 investment programme in 2022 and iv) a EUR 1.7bn Bavarian Hardship Fund in 2023 to finance transfers to financially weak households as well as businesses to buffer the energy shock, on top of measures financed by the federal government.

Bavaria’s AAA credit profile further benefits from a wealthy, well-diversified and highly competitive economy, which constituted 19% of German GDP in 2021. This results in a high regional growth potential and a strong ability to consistently generate its own revenues. The state is one of the wealthiest regions in Europe, with a GDP per capita of 17% above the German average and 40% above the euro area average.

Bavaria’s real GDP declined by 4.3% in 2020 due to the Covid-19 shock, slightly less than the German average of 4.6%. The economic recovery in 2021 was robust with 3% real GDP growth, however new supply chain disruptions slowed growth markedly towards the end of the year. In 2022, high energy prices and other economic effects of the Russian invasion of Ukraine substantially weighed on the growth outlook, though very adverse scenarios centred around gas rationing over the winter have not materialised. The Bavarian export-oriented automotive industry further benefitted from an easing in pandemic supply chain disruptions and recovering external demand. The German economy grew by 1.8% in 2022, and Scope expects a similar figure for the Bavarian economy.

The Covid-19 pandemic caused the unemployment rate to increase to a high of 4.2% in February 2021, from 2.8% in December 2019. In February 2023, the rate stood at 3.6%, 0.4 pp above its 2019 level. Robust labour market outcomes over the course of the pandemic and energy shocks also reflect the federal government’s large discretionary support, e.g. in the form of a national furlough scheme, or Kurzarbeit. Bavaria has the lowest unemployment rate among all German Länder and enjoys positive demographic developments, further supporting its tax revenue growth over the medium term.

Finally, like all German Länder, Bavaria benefits from a mature, highly predictable and integrated institutional framework. The key elements are: i) a strongly interconnected revenue equalisation mechanism enshrined in the constitution; ii) strict fiscal rules and monitoring, iii) wide-ranging participation and veto rights of the federal states in the national legislation; iv) equal entitlement of federal states regarding negotiations on federal reforms; and v) a solidarity principle that ensures extraordinary system support during budgetary emergencies. The federal government confirmed its role as a countercyclical primary shock absorber in the Covid-19 and energy crises in 2020-2023, shouldering a large part of the costs to the economy, leading to federal budget deficits averaging 3.3% of GDP over 2020-2022.

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

First, Bavaria mainly receives shared taxes like all Länder (largely personal income taxes, VAT taxes and corporate taxes) and a substantial share of taxes is subject to federal revenue equalisation. This limits revenue flexibility and weakens the link between tax revenue 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 16.1% at September 2022, in excess of the regulatory requirement; and ii) a low NPL ratio of 0.6%. In addition, Bavaria’s strong management of its shareholdings is reflected in good overall annual financial results in past years.

The Covid-19 crisis hindered the profitability of several holdings in 2020 and 2021, with Bavaria providing support via loans or capital injections. Among the worst-hit entities were the Nuremberg Airport and exhibition centres. However, the reduction of pandemic restrictions should substantially improve performance in these sectors.

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 a maximum of 12.6% of the budget from 2037 till 2043 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 3.8bn at end-2021. Overall, the combined measures, including the anticipated savings, would result in a moderate share of pension expenditure with a peak of 10%-12% of budget, broadly in line with levels in 2018.

Institutional framework assessment

Scope’s institutional framework assessment determines the intergovernmental integration between sub-sovereigns and their rating anchor, which is the sovereign or a higher-tier government. To perform this assessment, Scope applies the Institutional Framework scorecard (QS1), centred on six analytical components: i) extraordinary support and bailout practices; ii) ordinary budgetary support and fiscal equalisation; iii) funding practices; iv) fiscal rules and oversight; v) revenue and spending powers; and vi) political coherence and multilevel governance.

Scope considers the institutional framework under which the German Länder operate to display full integration for: i) extraordinary support and bailout practices; ii) ordinary budgetary support and fiscal equalisation; iii) fiscal rules and oversight; iv) revenue and spending powers; and v) political coherence and multilevel governance. The institutional framework displays medium integration for: i) funding practices. 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.

Individual credit profile

Scope assesses the individual credit profile based on quantitative and qualitative analysis of four risk categories: i) debt and liquidity; ii) budget; iii) economy; and iv) governance. These are further complemented by additional adjustments for environmental and social factors & resilience.

The outcome of these assessments, as reflected in the application of the Individual Credit Profile scorecard (QS2), is an individual credit profile score for Bavaria of 90 out of 100.

The mapping of this score to the range defined by the Institutional Framework assessment results in an indicative rating for the Free State of Bavaria aligned with the sovereign rating, corresponding to an AAA indicative rating.

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

Rating derivation

The review of potential exceptional circumstances that cannot be captured by the Institutional Framework and Individual Credit Profile scorecards did not lead to further adjustments to Bavaria’s indicative rating. As such, the final rating corresponds to the indicative rating of AAA.

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

Factoring of Environment, Social and Governance (ESG)

ESG factors material to Bavaria’s credit quality are captured by Scope’s rating approach through several analytical areas.

Scope’s assessment of Germany’s sovereign credit quality includes an appraisal of ESG risks, as detailed in Scope’s Sovereign Rating Methodology.

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 record of sound liquidity and debt management practices.

The institutional framework assessments capture governance factors under fiscal rules and oversight, assessed as ‘full integration’ for the German Länder. This reflects the comprehensive and credible fiscal framework in the form of the debt brake, as well as the strong oversight role of the Stability Council. Governance factors are also captured under political coherence and multilevel governance, assessed as ‘full integration’, reflecting Germany’s predictable and supportive federal system, where any major reforms are discussed and agreed upon well in advance and in consultation with the Länder.

The individual credit profile captures governance factors under the quality of governance and financial management, where Bavaria is assessed as ‘stronger’ relative to peers, reflecting the region’s i) record of nominal debt reduction; ii) regular fulfilment of policy objectives defined in strategic plans; and iii) ability to weather economic downturns by cutting costs to compensate for adverse budgetary developments.

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 the assessment of rating-relevant credit risks, Scope also considers long-term environmental developments that did not play a direct role in this rating action. 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 increased to a 65% CO2 reduction by 2030, and climate neutrality by 2040.

Additional environmental and social factors can be material for sub-sovereign creditworthiness beyond what is already captured in other sections of the methodology. However, in the case of Bavaria, no additional adjustments to the individual credit profile apply for social and environmental factors & resilience beyond what is already reflected under other risk pillars.

Rating Committee
The main points discussed by the rating committee were: i) institutional framework for German Länder; ii) debt and liquidity profile; iii) budget performance, revenue and expenditure flexibility; iv) economic developments; v) governance, regional socioeconomic and environmental risks; and vii) peer comparison.

Methodology
The methodology used for these Credit Ratings and/or Outlooks (Sub-Sovereigns Rating Methodology, 11 October 2022) is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
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: public domain, the Rated Entity.
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 Outlooks and the principal grounds on which the Credit Ratings and Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.

Regulatory disclosures
These Credit Ratings and Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and Outlooks are UK-endorsed.
Lead analyst: Eiko Sievert, Director
Person responsible for approval of the Credit Ratings: Alvise Lennkh-Yunus, Executive Director
The Credit Ratings/Outlooks were first released by Scope Ratings on 12 July 2019. The Credit Ratings/Outlooks were last updated on 8 April 2022.

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

Conditions of use / exclusion of liability
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