Economic Recovery Will Dominate LRG Credit Risks

We expect most economies across the world to rebound next year from the sudden slowdown or contraction caused by the COVID-19 pandemic, particularly toward the second half of 2021. Yet, the pace of the recovery could be more gradual than we previously expected, owing to recent new waves off the pandemic in some regions, even though a number of sovereigns have just started or are about to start their vaccination programs.

Credit risks for many local and regional governments (LRGs) worldwide in 2021 will likely be defined by the economic recovery path ahead. The willingness and ability of LRGs to provide a fiscal response to economic challenges, and the availability of additional funding from their respective sovereign and regional governments will also be key risks. For the moment, our ratings on LRGs show a strong negative outlook bias: 68 have a negative outlook while only 15 carry positive outlooks (see chart 1). Still, ratings in the sector remain resilient: 79% of rated issuers are investment grade ('BBB-' or above). In 2020, most LRG rating downgrades were in Argentina, where LRGs are restructuring their debt.

Chart 1

Economies focusing on hospitality, transport, real estate management, and other services requiring interaction, could be hit more heavily by the pandemic and require more time to recover. We believe that LRGs located in large urban areas and popular tourist destinations could be more heavily affected than others in this respect.

In response to the economic challenges they are facing, we expect that many LRGs will maintain or increase their spending, at least temporarily. Although many central and regional governments provide additional grants to subnational governments, the predictability and adequacy of these grants will vary between countries. We expect those LRGs that provide substantial fiscal stimulus to the local economies to stretch their borrowing capacity, and they might exit the pandemic with a considerably higher debt burden than other LRGS. LRGs in many emerging markets might face limited support from the central government, which would result in either materially higher deficits or lower spending.

Public policy changes at sovereign levels, and social and political dynamics at local levels could undermine LRGs' capacity to maintain healthy public finances in the next few years. Pension expenditures and demographic trends will continue to increase fiscal pressures on local governments in some countries.

We believe that the capacity of local governments to deal with growing fiscal pressures amid more complex global political and economic conditions will continue to be tested, not only in 2021 but over the next few years. Public policy decisions and credit risks at the sovereign level, along with lower growth prospects globally--more so in some regions than others--could affect LRGs' performance in light of increasing demands for better services and infrastructure in the next few years following the pandemic.

LRGs In All Regions Face Budgetary Risks

The COVID-19 pandemic is eroding revenues and increasing spending needs of LRGs across the world, in most cases translating into rising debt burdens. However, the effects of the pandemic on creditworthiness vary depending on LRGs' economic resilience and characteristics, the policy response from management, and the availability of additional grants from their respective sovereign and regional governments (see table 1).

Large urban centers are likely to take longer to recover from the pandemic. Services, which thrive on interaction of people, form the backbone of their economies. Consequently, social-distancing measures have translated into a more abrupt drop in consumption, and consequently lower tax collection. Moreover, the governments in such areas tend to have large social welfare programs to fight widespread inequalities and support public transport systems, therefore putting further pressure on their budgetary performance. Cities such as London, Paris, Rome, Madrid, Stockholm, Brussels, Moscow, Melbourne, Sydney, and the surrounding regions might face a prolonged period of large deficits.

The pandemic, has also very severely hit the tourist sector, due to worldwide travel restrictions. We are seeing additional fiscal pressure on some rated regions in Spain, such as the Balearic and Canary Islands, as well as on some Mexican and Italian LRGs that depend largely on tourism. We believe these entities will continue to suffer during 2021 as travel restrictions remain in place. Their recovery to pre-crisis levels will take several years, in our view.

Table 1

Some large subnational governments have decided to increase spending despite shrinking revenues. Most Australian states, Austrian states, Canadian provinces, Chinese provinces, and German states have applied substantial economic stimulus measures. They are sharing this responsibility with their respective sovereigns, thereby widening deficits and accumulating debts materially beyond our pre-COVID expectations. Since the beginning of 2020, we have lowered the ratings on five issuers in this group of entities, including the Australian states of New South Wales and Victoria, the German states of Baden-Wuerttemberg and Saxony-Anhalt, and a Chinese province.

We believe that regions exposed to these additional risks might suffer most during 2021 if the economic recovery turns out be more gradual than we currently expect, despite recent news on availability of vaccines. The outlooks on LRGs we rate have the strongest negative bias since the eurozone debt crisis of 2012. However, unlike back then, the pressure is spread across the whole rating spectrum.

Favorable Borrowing Conditions Likely To Persist Throughout 2021

In general, we expect debt burdens to increase in most LRG regions as a direct consequence of increased deficits caused by the higher spending needs and lower taxes. However, LRGs in developed markets and China have in general strong access to market funding, and will benefit from low interest rates, alleviating their financing risks over 2021. Unlike the previous crisis, we expect market liquidity and access to funding to remain plentiful and at favorable rates in EMEA, while some LRG sectors in Latin America could encounter more interest-rate volatility.

The Pandemic Tests The Predictability And Comprehensiveness Of State Government Support

Central government support is key to cushioning the effects of the pandemic on LRGs. Some sovereigns have decided to absorb the entire cost of the pandemic on their own accounts, largely limiting the financial impact on their LRGs. LRGs in Israel, Italy, France, Japan, Sweden, and Spain should therefore be able to cover own revenue losses and higher spending with additional grants from the central government.

Moreover, strong government support combined with a relatively mild impact of the pandemic on some local economies have created positive ratings momentum for many Israeli and New Zealand municipalities.

Rating Volatility Likely For LRGs In Emerging Markets

Some LRGs in emerging markets, specifically those in Argentina, Mexico, and Brazil, will continue to suffer over 2021 due to insufficient central government support and lower resources to combat the effects of the pandemic. Two-thirds of the 27 LRG rating downgrades we took in 2020 occurred in Latin American countries. Conversely, we have lowered ratings on only seven investment-grade ratings worldwide. We have not upgraded any LRG during 2020, reflecting the numerous uncertainties and direct impact from COVID-19 during the year (see chart 2). This statistic excludes intra-year movements, for instance, recent upgrades of some Argentinian provinces from 'SD' (selective default) when new ratings remain lower than those at the beginning of the year.

Chart 2

LRGs located in Argentina and Brazil are being allowed by their respective central governments to restructure their debt. In the case of Brazil, the restructuring is with state-owned banks, which in our view does not constitute a default The debt restructuring is adding rating volatility. During this process we placed ratings on Argentinian provinces on 'SD'. The ratings might go upward in 2021 once the restructuring is finalized. Ratings on seven issuers are currently on 'SD'.

LRGs Are Exposed To Movements In Sovereign Ratings

Although most of rating actions in 2020 have been driven by a change in intrinsic credit factors, developments at the sovereign level or a sector-wide ability to balance revenue and spending responsibility in the long run will also be key factors for credit quality. Currently, the ratings on 14 LRG remain constrained by, or equal to, their respective sovereigns. This is the case for LRGs in Australia, Colombia, Malaysia, Mexico, and Spain, for which the sovereigns have a negative outlook, and LRGs in New Zealand, where the sovereign rating has a positive outlook. Another factor that might affect a large number of subnational ratings is our view of the strength and predictability of the institutional framework in which they operate. For example, Swedish and U.K. LRGs are under long-term pressure to increase spending to address rising demand for public services.

More Downgrades Likely In 2021

The negative outlook bias on the 294 LRGs we rate outside the U.S. indicates that more downgrades than upgrades are likely in 2021. This is a departure from the past three years, when positive outlooks outweighed negative ones.

Currently, 23% of the sector has a negative outlook (see chart 3). The country with the most negative outlooks is Mexico, where central government support has been insufficient to cushion the effects of the pandemic. This is followed by Sweden, where the sector suffered in 2020 as a consequence of lower tax revenues and increased expenditures. It is nevertheless expected to recover over 2021, as the central government has provided additional funding. Negative outlooks also weigh in Spain, mainly mirroring the sovereign negative outlook, and the large exposure to tourism of some LRGs.

Conversely, 5% of the sector carries a positive outlook, mostly in Israel and New Zealand, where LRGs have proved to have stronger credit characteristics to face the current crisis and have limited health-care responsibilities.

Chart 3

We Continue To Expect Solid Ratings

We currently have 79% of LRG ratings at investment grade. The highest proportion of ratings are the 'AA' category (41%), followed by the 'BBB' category (15%), 'A' (15%), and 'AAA' (8.5%) (see chart 4). However, we are seeing an increase in the proportion of ratings at the lower end of the scale; currently 4.4% are 'CCC' or below (including SD), compared to just 1.3% a year ago.

Chart 4

S&P Global Ratings believes there remains a high degree of uncertainty about the evolution of the coronavirus pandemic. Reports that at least one experimental vaccine is highly effective and might gain initial approval by the end of the year are promising, but this is merely the first step toward a return to social and economic normality; equally critical is the widespread availability of effective immunization, which could come by the middle of next year. We use this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Related Research

• Global Credit Outlook 2021: Back on Track? Dec. 3, 2020
• Credit FAQ: Why We Downgraded The Australian States Of New South Wales And Victoria, Dec. 7, 2020
• Institutional Framework Assessments For International Local And Regional Governments, Dec. 1, 2020
• Prudent Financial Management And A Strong Institutional Framework Are Helping Canadian Municipalities Negotiate The Impact Of COVID-19, Nov. 30, 2020
• Credit FAQ: How Will A €100 Billion Revenue Loss Affect German States?, Nov. 10, 2020
• Global Ratings List: Local And Regional Governments 2020, Aug. 6, 2020
• Comparative Statistics: Risk Indicators For Canadian Local And Regional Governments, July 23, 2020
• Comparative Statistics: European Local And Regional Government Risk Indicators, June 30, 2020
• COVID-19: Fiscal Response Will Lift Local And Regional Government Borrowing To Record High, June 9, 2020
• Comparative Statistics: Asia-Pacific Local And Regional Government Risk Indicators, July 29, 2020