Rating Methodology Profile for Sub–National Entities

RATING CRITERIA FOR SUB-NATIONAL GOVERNMENTS OR MUNICIPALITIES

In assessing the creditworthiness of regional and local governments, the focus is on how well the borrower balances the task of providing public services against its ability to levy taxes, charge fees and receive timely any transfer payments it is due from other levels of government. The following areas should be considered: intergovernmental relations, the administrative system, economic structure and growth, fiscal performance and flexibility, and financial position and policies.

The first municipal rating criterion is the system of intergovernmental relations, including specifically the distribution of responsibility for public services, access to the aggregate tax base, authority to borrow (whether with or without centrally imposed restrictions), transfer payments systems, and the system of checks and balances or controls among the different levels of government. The goal is to understand the structure and performance of the regional or local government in light of the powers, constraints and flexibility attributable to other levels of government. For example, intergovernmental transfers can provide revenues and/or require certain expenditures. Fiscal equalization can be critical because it is designed to ensure that political subdivisions can provide reasonably comparable levels of public services with similar tax efforts. The analyst should review the size, stability and responsiveness to changing needs of such transfers. Depending on the structure, together with the relative importance and conditions precedent to the transfers, the creditworthiness of a regional government can be boosted or impaired.

The second criterion is the effectiveness and fiscal prudence of the administrative system of the regional or local authority, which includes the division of responsibility between elected officials and civil servants, labor relations, management systems, controls and audits. An effective and prudent administrative system can protect the financial health of a regional or local authority undergoing significant political transformation or uncertainty. It may also be important to assess the corporate governance practices of the management. When limited legal or political constraints enhance a government's autonomy, credit analysts gain comfort from prudent statutory or policy guidelines on indebtedness, taxation, and budgeting.

The first financial risk-rating criterion is the region's economic structure and growth performance. The focus is on demographics, adequacy of social and economic infrastructure, the level of economic development including trends in savings and investment, the diversity of the economy, the availability of natural resources, the rate and composition of economic growth and employment, price stability, etc. The goal is to understand the dynamics of the economy and its impact on the demand for public services and the revenues available to pay for them.

The second financial risk-rating criterion is the regional or local authority's fiscal performance and flexibility. One should analyze the structure and size of the budget in relation to growth in population and tax base, the flexibility to adjust revenues and expenditures, and the degree of budget deficits over a period of time. Diversity of revenue base, particularly own-source as distinct from transfer receipts, is a positive factor. Also important is the sensitivity of revenues to policy changes and the potential to increase revenues. High and persistent budgetary variances -- the difference between initial budget projections and final outcomes -- raise concerns about the adequacy of budget forecasts, controls and the government's ability and willingness to make "mid-course" adjustments to achieve prudent fiscal objectives. One should assess the extent to which increases in current account expenditures are discretionary or a function of the level of economic activity. Persistently large deficits on the operating accounts - - as distinct from the capital account -- place a serious limit on the government's capacity to sustain a reasonable balance between the demand for public services and the resources needed to pay for them. Such deficits usually result in additional debt, higher debt service burden, reduced financial flexibility, and ultimately lower ratings.

Capital outlays -- as distinct from current expenditures -- are considered more appropriate for debt financing, although pay-as-you-go financing is viewed as a sign of financial strength. Capital expenditures are generally discretionary as they can more readily be delayed or canceled if necessary. But in some less prosperous communities, capital outlays are less discretionary as they represent an ongoing form of economic stimulus.

Finally, the analyst should consider the regional or local government's financial position and policies, including the soundness and conservatism of accounting policies, liquidity planning and management in light of seasonality in revenues and expenditures, net financing requirements (incorporating net on lending, if any, other than to self-supporting entities), and the use of debt.

The debt burden is analyzed to assess the influence of the range and level of services, user charges, capital expenditure programs, intergovernmental financial arrangements, and activities of government-owned enterprises. Both narrow and broad measures of debt burden are used to incorporate as appropriate the impact of direct and government guaranteed debt, the tax-supported and total public sector debt. Tax-supported debt excludes the self-supporting debt of government enterprises but includes the debt of government enterprises dependent on government revenues to service debt or cover operating losses. Net debt ratios may be used to give credit for government assets that could reasonably be used to reduce debt. Account is also taken of non-budgetary items such as unfunded or under funded civil servant pension liabilities.

RATING STATE OR MUNICIPALLY SUPPORTED UTILITIES AND OTHER ENTITIES

In rating state or municipally supported entities, one should seek to balance the willingness and the ability of the government to provide such support with the need for such support. When such support wanes or the government’s ability to provide it diminishes, the borrower’s stand-alone performance becomes more important. Ability to provide support is captured essentially by the rating of the government but there may also be concerns about administrative and regulatory procedures that may be considered important to the permitting or preventing such support on a timely basis.

Willingness of the state or municipal government to provide support depends on three factors: explicit expressions of support, including the government’s legal obligations towards the borrower; the borrower’s political importance to the government; and the borrower’s economic significance. Meaningful evidence of such support includes direct and indirect ownership, grants and subsidies, tax and other regulatory incentives, priority access to credit, and favorable government policies towards capital contributions and dividend requirements.

In assessing political importance of the issuer, consideration is given to the government’s philosophy towards public versus private sector. This is observed from the government’s demonstrated support and public statements about the role of government in business, although new governments may have new approaches and there may be exceptions to the dictates of general philosophy. The political importance of the issuer can be enhanced by the significance of the political objectives it serves and by the political clout of its constituencies.

Economic significance of the issuer is determined by its contribution to the economy in such areas as employment, investment, export earnings, etc. and by the strategic importance of the sector in which it operates. Typically, this kind of information may not be regularly tracked by the borrower and may need to be developed.

The ability of the government to provide support is measured first by its own credit rating.

Key Quantitative Risk Factors

The following should be considered on a 3 to 5 year retrospective basis and 1 to 3 year projected basis in rating sub-national governments:

The following should be considered on a 3 to 5 year retrospective basis and 1 to 3 year projected basis in rating sub-national governments:

• Economic growth rate of geographical area (%)

• Share of GDP represented by manufacturing, services, and agriculture

• GDP per capita

• Inflation (“CPI”)

• Unemployment (%)

Key Financial Risk Indicators

• Own source (tax and other) revenues/total revenues

• Financial transfers from central government/total revenues

• Current expenses/total expenses

• Capital Expenses (excluding debt repayment) /total expenses

• Net operating balance (after debt repayment)/total revenues