Local Government Ratings

CI’s Approach to Rating Local and Regional Governments

Introduction and Overview

Capital Intelligence’s (CI) public finance issuer ratings are an opinion on the general creditworthiness of a local or regional government and the likelihood that it will meet its financial obligations in full and on time. Credit ratings are assigned following a detailed analysis of a range of financial and non-financial factors which we believe have a significant bearing on the ability and willingness of a sub-national government to adopt and implement sustainable fiscal policies and to take other measures that reduce the risk of default.

Our analysis is disaggregated into six categories:

1. Institutional and Legal Framework
2. Operating Environment
3. Governance and Management
4. Budgetary Performance and Financial Flexibility
5. Debt, Liquidity and Contingent Liabilities
6. Extraordinary Support

The first five categories essentially determine the standalone creditworthiness of the sub-national government. The final category evaluates the likelihood that in the event of financial distress the local or regional government would receive sufficient and timely extraordinary support from a higher tier of government (usually the central government) to prevent it defaulting on its obligations.

1. Institutional and Legal Framework

Institutional arrangements are an important determinant of the financial profile of sub-national governments. Revenue-raising powers and service responsibilities are typically defined by a higher tier of government and in many countries there are restrictions on sub-national government borrowing.

Our analysis focuses on (a) the predictability and stability of intergovernmental fiscal and political relations; (b) the adequacy of expenditure and revenue assignments; (c) the pros and cons of constitutional or statutory restrictions on fiscal policy; and (d) the degree of local government accountability, transparency and oversight.

2. Operating Environment

The financial strength and repayment capacity of a local or regional government are partly determined by the economic and social conditions in which it operates and are also affected by political and economic developments at the regional and national levels, particularly in countries where sub-national governments depend on fiscal transfers from higher levels of government.

Except for in highly centralised systems, the local economy generates a significant proportion of the resources that are potentially available to a sub-national government to fulfil its service responsibilities and repay its debt. The socio-economic profile of a locality, its growth prospects and demography also have an important bearing on the size and composition of government expenditure, as well as on the future demand for public services and public infrastructure.

Accordingly, CI analyses the local economy and draws on separate analysis of the national government’s creditworthiness (summarised by the sovereign rating) to assess the extent to which the operating environment poses a risk to the debt-servicing capacity of sub-national government.

3. Governance and Management

The strength of governance and the sophistication of financial management practices are important determinants of a sub-national government’s ability to use its resources efficiently and effectively, spot potential risks and devise appropriate mitigation strategies, cope with unforeseen adverse developments, and adapt to changes in responsibilities and regulations.

As part of our analysis we consider the following: (a) politics and policies; (b) fiscal transparency; (c) budgetary planning and control; (d) liquidity management; and (e) debt management.

4. Budgetary Performance and Financial Flexibility

To provide adequate services and avoid financial distress in the future a sub-national government must mobilise or be allocated sufficient revenues to meet its expenditure needs. From an analytical perspective we consider: whether ongoing or recurring government operations are sustainable; whether the likely path of capital expenditure is consistent with the government’s resource base and debt-servicing capacity over the medium to long term; and whether, in the event of adverse developments or economic shocks, the government would be able to manoeuvre in an appropriate and timely way in order to continue servicing its debts and keep borrowing at manageable levels.

Persistent operating deficits are viewed negatively from a ratings perspective while small overall budget deficits (relative to revenue or, in jurisdictions where the sub-national government has substantial revenue autonomy, local GDP) need not be a cause for concern provided the quality of capital expenditure is high and the sub-national government’s overall debt burden is low or moderate.

The budget structure is also analysed because it has a bearing on the amount of debt a government can sustain and on its ability to adjust revenue and expenditure in order to meet its financial obligations, especially during times of economic stress.

5. Debt, Liquidity and Contingent Liabilities

Fiscal solvency is evaluated by considering the evolution of (i) gross debt and (ii) net debt against repayment capacity, as measured by operating revenue and, where relevant and the information is available, local GDP or the market value of taxable property.

Gross debt is measured in two ways: (i) narrowly as the direct debt of the sub-national government, including bonds, loans and capitalised lease obligations; and (ii) broadly as direct debt plus indirect debt, which includes guaranteed debt and the non-guaranteed debt of government-related entities.

Net direct and indirect debt is calculated by subtracting from gross debt the following: (i) government financial assets that may be used to repay debt (including cash, marketable securities, loans and sinking fund assets); and (ii) the debt of government-related entities that are run commercially and deemed capable of meeting their debt service obligations from their own operations. Minority equity holdings may also be deducted provided they are readily available for sale in a deep and liquid secondary market. Majority-equity stakes and real estate and infrastructure assets are not netted from gross debt; but where a government has concrete proposals to privatise or dispose of such assets the potential impact on its financial position is taken into account in determining its credit rating.

We consider why the sub-national government incurred, or has plans to incur debt, with borrowing to finance investment in physical and social infrastructure generally deemed less risky than borrowing to finance operating expenditure.

We examine the debt structure for weaknesses and assess the associated financing risks. We calculate the sub-national government’s gross financing requirement and assess its ability to meet its financing needs, as well as the form and cost that any new borrowing is likely to take.

We consider the sub-national government’s access to debt markets – including the stability of that access and the depth and liquidity of the markets. Account is also taken of any formal or self-imposed restrictions on the government’s recourse to debt financing and the extent to which these are binding in practice.

We place significant emphasis on the sub-national government’s ability to mitigate near-term financing risks – and those related to debt service in particular – by drawing on liquid financial assets (assets that are not pledged, earmarked or encumbered in any other way and are readily available to service debt, should the necessity arise) and, to a lesser extent, contingent credit lines (typically committed bank facilities).

We also take into account the financial performance of any commercial or non-commercial entities owned or controlled by the sub-national government and which may therefore be considered as contingent liabilities, either implicitly or, in cases where the obligations of the entity are guaranteed by the government, explicitly. The fiscal risks associated with other off-balance sheet activities and transactions, including the use of public-private partnerships for infrastructure projects, are also analysed.

6. Extraordinary Support

Extraordinary support is defined as intervention by a higher level of government to prevent a sub-national government defaulting on its obligations. Extraordinary support may include emergency cash transfers and the extension of loan guarantees and will typically be provided on a one-off or short-term basis.

CI considers not only whether the higher level of government would be willing to support the sub-national government but also whether it has the financial capacity to do so.

The ability of the higher tier of government to extend financial assistance is gauged by the actual or, in the case of unrated entities, shadow credit ratings of the higher tier, paying particular attention to the strength of the potential supporter’s fiscal position and the debt burden of the sub-national government. The likelihood of timely intervention is generally deemed to be greater in systems where the quality and frequency of financial reporting is high and the financial performance of the sub-national government is closely monitored by the higher level of government.

In cases where CI is convinced that the central government would intervene to enable the sub-national government to continue meeting its financial obligations in a timely manner, the credit rating of the sub-national government would be close to, or the same as, that of the sovereign.