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      FRIDAY, 23/02/2024 - Scope Ratings GmbH
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      Scope affirms the Free State of Bavaria's AAA rating with Stable Outlook

      Low debt, ample liquidity, strong budgetary performance, a wealthy economy and an integrated institutional framework support the rating. Limited revenue flexibility, sizeable contingent liabilities, and high pension liabilities are challenges.

      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 associated rating report is available here.

      Summary and Outlook

      The AAA rating is underpinned by the highly integrated institutional framework under which all German federal sates, or Länder, operate, characterised by a very strong revenue equalisation system and the federal solidarity principle, which results in a close alignment of Länder’s creditworthiness with the German federal government’s AAA/Stable ratings.

      Bavaria’s AAA rating is further underpinned by the following individual credit strengths: i) a low debt burden; ii) excellent capital market access; iii) ample liquidity including high cash reserves; iv) strong budgetary performance with an above-average expenditure flexibility; and v) a wealthy and highly competitive economy.

      Challenges are: i) limited revenue flexibility; ii) high pension liabilities that weigh on long-term expenditure flexibility; and iii) sizeable but manageable contingent liabilities.

      The Stable Outlook represents Scope’s view that risks to the ratings over the next 12 to 18 months are 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

      First, Bavaria benefits from very low debt and excellent capital market access. 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, debt levels have since declined to EUR 19bn in 2022 and are expected to remain stable in 2023, before gradually declining from 2024 as pandemic-related debt is repaid.

      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 budget, no new credit authorisations were included and a decrease in debt of EUR 50m has been budgeted.

      Pandemic-related funds have been 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. 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, in line with the authorities’ plans. At end-2022, debt taken up under chapter 13 19 amounted to EUR 10.21bn, significantly below the EUR 37.4bn authorised.

      Credit authorisations under the debt brake emergency clause come with a pre-defined redemption plan. Bavaria planned to 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, and from 2025 for debt incurred under the 2021 credit authorisation. The draft Budget Act 2024/2025 limits planned repayments to EUR 50m in 2024 and the same amount in 2025 given the challenging short-term economic outlook. In addition, EUR 310.4m in 2024 and EUR 460.5m in 2025 will be allocated as a provision in the budget, which can then be used to cover any annual deficit or for further debt repayment. Any pandemic-related debt still outstanding at the end of 2025 will be repaid in equal instalments with the debt fully paid off by 2044. 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 over the coming years.

      As for all German Länder, Scope assesses Bavaria’s access to capital markets as excellent. This was 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 public capital markets as the ECB tightened monetary policy considerably. Similarly, public debt markets were not accessed in 2023, with EUR 1.3bn issued through private placements and EUR 1bn issued through promissory notes. Bavaria employs a conservative debt-management strategy with no foreign currency exposure and limited interest rate risks. Going forward, Bavaria’s debt management strategy remains conservative and envisions: i) borrowing largely based on the liquidity profile; ii) depending on the steepness of the yield curve, a focus on longer maturities; and iii) a focus on achieving a balanced repayment structure, taking into account statutory repayment obligations related to the pandemic credit authorisations.

      Second, Bavaria’s AAA rating is further underpinned by its sizeable cash reserves, which is higher than that of other Länder. While cash holdings have declined over the past year, they remain sizeable compared to national peers, stemming from its sound budgetary and financial management. Bavaria’s cash holdings comfortably cover debt service through to 2026. 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.

      Third, 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, 2022 and 2023, instead of the usual two years being reintroduced for 2024/2025.

      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. In 2022, the state posted strong results, ending the year with a EUR 2.8bn surplus before debt movements, or 3.7% of total revenue, on the back of a strong recovery in tax revenue. In line with its 2023 Budget, Scope expects that Bavaria did not require any new net borrowing in 2023 and that net debt decreased by EUR 50m. Bavaria should therefore effectively absorb the adverse budgetary effects of the pandemic with debt metrics gradually improving over the coming years thanks to its: i) conservative budget management; ii) track record of commitment to fiscal consolidation; iii) ability to adjust budgets in view of the high investment levels; and iv) economic and demographic outperformance of national peers.

      Going forward, Bavaria will return to two-year budget plans. The planned 2024/2025 budget continues to adhere to the debt brake and therefore does not include any new debt. From 2024, the repayment of the debt taken on in the special pandemic fund in the years 2020 to 2022 will begin with repayments of EUR 50m in 2024 and in 2025. The balance before debt movement is expected to remain in surplus throughout our projection horizon until 2026. Scope expects the operating balance to remain slightly above pre-pandemic levels with operating revenues growing at around 3% per year as tax revenue growth returns following a decline of around 1.5% in 2023. Operating expenditure is expected to increase by around 2.6% per year, mainly driven by higher personnel costs. The conservative budget management is expected to allow for increased planned investment spending, with capital expenditure as a share of total expenditure rising to around 15%.

      Fourth, Bavaria’s AAA credit profile further benefits from a wealthy, well-diversified and highly competitive economy, which constituted 19% of German GDP in 2022. 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 52% above the EU average.

      Bavaria’s real GDP declined by 3.7% in 2020 due to the Covid-19 shock, in line with the German average. The economic recovery in 2021 and 2022 was robust and above the national average with 2.8% and 2.1% real GDP growth respectively. This was despite the impact of global supply chain disruptions, as well as high energy prices and other economic effects of the Russian invasion of Ukraine. While economic output in the German economy fell by 0.3% in 2023, Scope expects stronger results for Bavaria’s economy given robust growth during the first half of the year.

      Bavaria enjoys favourable labour market characteristics, even though the Covid-19 shock caused the unemployment rate to increase to a high of 4.2% in February 2021, from 2.8% in December 2019. In January 2024, the unemployment rate stood at 3.9%, 1.1 pp above its 2019 level. Robust labour market outcomes over the course of the pandemic and energy shocks reflect the federal government’s large discretionary support, e.g. in the form of a national furlough scheme, or Kurzarbeit. While the unemployment rate has started to increase in recent months amid a weakening economy, Bavaria has the lowest unemployment rate among all German Länder and enjoys positive demographic developments, further supporting its long-term growth and tax revenue potential.

      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. Over these years, the federal government financed most crisis measures, leading to federal budget deficits of an average 3.5% 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 solid capital base, reflected by a CET1 capital ratio of 18.2% in September 2023, well above the regulatory requirement (9.4% minimum for 2024); and ii) a low NPL ratio of 0.7%. 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. However, the reduction of pandemic restrictions resulted in substantial performance improvements, particularly for the Messe München GmbH due to a large increase in demand for trade fairs and conference events, and airports in Munich and Nuremberg saw a recovery in passenger numbers.

      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 3.5bn at end-2022. 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 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 ambitious 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 Outlooks (Sub-sovereigns Rating Methodology, 11 October 2023) 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 and Outlooks 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, Managing Director
      The Credit Ratings/Outlooks were first released by Scope Ratings on 12 July 2019. The Credit Ratings/Outlooks were last updated on 17 March 2023.

      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
      © 2024 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Ratings UK Limited, Scope Fund Analysis 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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