S&P Global Ratings expects the global economic recovery to continue next year, stabilizing credit quality of our rated non-U.S. local and regional governments (LRGs). This recovery, which started in first-half 2021, is reducing volatility and uncertainty caused by the pandemic. Sufficient government support, especially in unitary countries, has also helped LRGs to stabilize their finances. For the moment, our ratings on LRGs show a moderate, but decreasing, negative bias: the share of LRG ratings on negative outlooks decreased to 12% from almost 23% at year-end 2020 (see chart 1). Most of the negative outlooks on LRG ratings reflect the rising debt burdens of regional governments in federal countries that pursue expansionary fiscal policy, or mirror the outlooks on the related sovereigns.

Chart 1

Overall, since the beginning of the year we have revised 35 outlooks on our LRG ratings to stable from negative. Moreover, we have raised 33 ratings and lowered only seven.

In our view, LRGs' agendas will shift focus next year to adapt to the post-pandemic reality and longer-term issues, such as demographic shifts and decarbonization. We assume that subnational governments will need to adjust their financial policies to a new reality in 2022, with both revenue and expenditure challenges. We also anticipate that additional grants from central or regional governments will mostly be phased out next year (see "Non-U.S. Local Governments: To What Extent Did Sovereign Support Offset The Pandemic Downdraft?," published July 19, 2021, on RatingsDirect), while tax revenue growth could be gradual amid weaker economic growth than we currently expect. At the same time, inflation could make it more difficult to reduce social support measures and invest in infrastructure needs, which have been mounting due to subdued capital spending for years before the pandemic. Our assumption remains that LRGs in certain emerging markets, as well as regional governments in federal countries with advanced economies, will be more prone to downward pressure due to higher deficits and debt burdens than we currently forecast.

We also assume that lower-rated subnational governments in Argentina and Central and Eastern Europe (CEE) will remain exposed to volatile lending conditions. Unstable macroeconomic conditions will exacerbate Argentine LRGs' very limited access to financing, and failure to reach an IMF deal could put even multilateral funding out of reach.

Fewer Downgrades Are Likely In 2022, But Negative Bias Remains

Even though our ratings on LRGs outside the U.S. have been stabilizing since the beginning of the year, we note a modest negative bias above pre-pandemic levels. This indicates that downgrades could still outpace upgrades in 2022, albeit at a decreasing level compared with 2020 (see chart 1). About 6% of our ratings carry positive outlooks, suggesting a modest probability of upward rating movements next year, but this is close to pre-pandemic levels. In 2022, potential upside triggers for our current assumptions could be improved revenue performance due to a faster expected economic rebound, higher intergovernmental and multilateral financial support, as well as strengthening related central government financial positions.

Following the debt restructuring by Argentinian provinces, and tighter control over debt accumulation by Chinese provinces, we have raised 33 LRG ratings so far in 2021 (see chart 2). We anticipate limited rating movements in 2022, since only about 17% of our LRG ratings have a positive or negative outlook compared with 28% at year-end 2020. Still, changes in our assessment of the institutional frameworks for LRGs in a given country can be a source of significant rating movement, as was the case in China this year. Currently, we see improving trends for institutional frameworks covering Russian regions and Canadian First Nations. We view the trends as weakening for Swedish municipalities and counties, Finnish municipalities, U.K. local authorities, and Mexican states. (see "Institutional Framework Assessments For International Local And Regional Governments," published Nov. 4, 2021). If these trends result in material changes to our institutional framework assessments, it could affect multiple entities.

Chart 2

LRG Rating Movements Will Depend On Sovereign Trends

Generally, we believe that our ratings on LRGs cannot exceed those on the related sovereigns. We currently have three exceptions, all in Spain, but even in those cases we limit the gap between the LRG and sovereign ratings to two notches. Consequently, actions on the sovereign rating may impose, lift, or lower the caps on LRG ratings and outlooks. Currently, almost one-third of our 35 negative outlooks on LRG ratings, including six in Spain, four in Mexico, and one in Malaysia, reflect those on the related sovereigns. Likewise, our upgrades of six councils in New Zealand followed the raising of the sovereign rating in February 2021, and the rating action on the District of Bogota followed the downgrade of Colombia in May 2021. Similarly, in October 2021 we revised the outlooks on two Italian regions to positive from stable following the sovereign rating action.

LRGs Face The Twin Threats Of Continued Spending Needs And A Slower Than Expected Economic Recovery

With COVID-19 vaccinations picking up globally, we expect economies to continue their recovery in 2022, albeit with slower growth. Even though the spread of new variants, vaccine hesitancy, and rising inflation may delay the recovery--especially in emerging markets--we believe LRGs will generally benefit from better tax collection.

In 2022, we expect LRGs will largely adapt to the reality of living with COVID-19, even where vaccination progress is slow. We expect lockdowns, where they persist or are reintroduced, won't hit economic activity as heavily as previous waves due to governments imposing less stringent restrictions, and people cautiously returning to work and public life. However, we continue to acknowledge a degree of uncertainty about the evolution of the pandemic.

A delayed economic recovery could mean volatile performance for LRGs, especially those in emerging markets that face challenging tradeoffs between balancing fiscal results and continued spending to support a fragile economic recovery. Moreover, gradual reductions of pandemic-related grants from central and regional governments (in countries where they were provided at all) could pose a risk to further revenue recovery next year (see table 1).

Table 1

Disruption to global trade and supply chains has put upward pressure on prices worldwide. S&P Global Ratings continues to expect that inflation will be transitory. However, we believe downside risks are increasing. Although inflation often accrues to LRGs' benefit in balancing budgets, it can be a risk if rising wage pressure is not balanced by increasing tax revenue. Localized inflation is also a liquidity risk when debt is denominated in dollars, particularly in Argentina where macroeconomic conditions are highly unstable and the peso could depreciate rapidly.

Medium-term infrastructure needs will likely put additional cost pressure on subnational budgets in most countries in the medium-term, and failure to address them will limit long-term growth potential. Moreover, LRG capital spending has been largely subdued over the past decade and is expected to increase, with the notable exceptions of China and India. Although infrastructure investments increased during the pandemic in Europe (including Germany), Canada, and Japan, we expect many regional governments to scale back spending in real terms post-pandemic (see chart 4). The large infrastructure backlog will also likely constrain subnational budget flexibility in Latin America.

Chart 3

Our Recovery Assumptions Differ For Developed Market LRGs In Federal And Unitary Countries, As Well As Those In Emerging Markets

Regions in federal countries with advanced economies, especially in Australia, Austria, Belgium, Canada, and Germany, will likely face relatively slow fiscal consolidation since they remain committed to expansionary financial policies. We expect these LRGs will maintain significant measures to support the economic recovery in 2022. However, they are not expected to receive higher transfers from their federal governments to match the costs. Therefore, it will take several years for the fiscal impact of the pandemic to unwind. For Canadian provinces, a key challenge, will be managing through the recovery with limited support from the central government, particularly where growth is slower. In contrast, Canadian municipalities have enjoyed support from higher levels of government to offset the fiscal hit from the pandemic.

We also note that the fiscal policy frameworks in some countries have softened during the pandemic. For instance, Germany has lifted its constitutional debt-brake rule since the pandemic began, which requires states to balance their annual budgets. We currently expect that the rule will be reinstated in an adapted manner in 2023. Moreover, the formation of the new German government and its policy direction will have a significant influence at the European level. This might come in the form of a faster energy transition and other net-carbon-zero related spending.

Overall, we view this group of LRGs as the most vulnerable in developed markets in the short term. We maintain negative outlooks on nine regions in federal countries. After downgrading two German and two Australian states in 2020, we have lowered our ratings on the Canadian provinces of Alberta and British Columbia and the Belgian capital, the City of Brussels, so far in 2021.

Compared to peers in federal countries, LRGs in unitary developed countries have shown resilience to economic volatility. During the pandemic they managed to generally balance their budgets. In some countries, like France and Japan, local taxes performed well, while in others, like Sweden and the U.K., additional transfers more than covered revenue losses, in our view. However, most of the latter will be sensitive to the phasing out of additional grants from the upper tiers of government, especially if rising taxes and charges don't make up for the shortfall.

Rising debt burdens affect our view on the credit quality of China's LRG sector. China's central government recently shifted its focus to control risk at highly indebted entities, such as domestic developers, which could lead to contagion risks for LRGs. Expected land sale declines will pressure LRGs' revenue growth accordingly, extending fiscal consolidation plans. However, we believe that the central government is taking tangible steps to ensure the sector's financial sustainability; LRGs are responsible for about 70% of general government debt. China's central government tightly controls new borrowings and total debt at LRGs and recently halved the net borrowing quota for one of the most indebted governments--the Municipality of Tianjin--which should slow its debt accumulation pace. This will push LRGs to deepen their spending discipline.

Sub-national governments in Latin America and other emerging market economies face difficult tradeoffs between balancing their budgets and continued spending to support a fragile economic recovery. In the case of Mexico, for example, federal transfers to LRGs have not kept up with baseline spending needs. Although budgeted federal 2022 participation revenue is almost flat compared to this year, states and cities still face increasing operational expenses, large capital spending needs, and significant pension liabilities. A slow economic recovery will constrain revenue and defer productive investment, further limiting long-term growth. Large economic disparities and uneven recoveries for Mexican states and municipalities (see "Mexican Local Governments' Economic Recovery Prospects After Largest-Ever Election," published June 9, 2021) highlight the potential volatility of their credit quality. One-quarter of our Mexican LRG ratings carry positive or negative outlooks and might change over the next 12 months.

For our ratings on Brazilian states, we believe that central government financial support will become more unlikely, and debt levels will remain high. Although additional grants adequately covered LRGs' spending during the pandemic, we expect that mounting pressures will require LRGs to use liquidity buffers, constraining credit quality in the future.

Lower-Rated LRGs Remain Exposed To Changes In Lending Conditions

Although most entities benefit from currently favorable capital market conditions, a rise in interest rates could constrain the liquidity positions of some emerging market LRGs. Limited domestic capital markets and large funding needs increase the exposure of most Argentinian issuers, as well as subnational governments in eastern Europe, to investor sentiment.

Argentinian provinces' debt restructurings were finalized during 2021, but the overall credit picture remains tenuous. Nine of the 10 rated LRGs restructured their debt with international bondholders following the sovereign default, as the pandemic exacerbated already weak macroeconomic conditions, reflected in low liquidity and limited market access since 2018. As a result, we lowered our ratings to 'SD' (selective default). After the restructurings were completed, we raised the ratings to 'CCC+', reflecting continuing macroeconomic instability, burdensome debt service profiles in the medium term that will weigh on liquidity, and the credit risk from the transfer and convertibility assessment on Argentina ('CCC+').

Nevertheless, currently about 80% of LRGs are of high credit quality, rated investment grade ('BBB' category or higher), despite the turbulence caused by the pandemic. Compared to last year, the share of LRGs rated 'A' or higher increased to 68% from 64%. Like in the past, the 'AA' category has the largest proportion of ratings (42%), followed by 'A' (17%), which has surpassed 'BBB' (12%) since the beginning of the year.

Moreover, even though the number of LRG ratings is decreasing, the share of emerging-market ratings has remained relatively stable. They constitute about 39% of our total ratings on average (see chart 3), with most in Latin America and Asia-Pacific.

Chart 4

Long-Term Challenges Will Shape LRGs' Credit Quality And Spending Priorities

In our view, environmental, social, and governance (ESG)-related trends will strengthen, meaning LRGs will face new, but manageable, challenges over the medium- to long-term. The general need to increase investments in infrastructure, including those related to ambitious decarbonization targets and demographic shifts, will likely boost subnational governments' debt burdens in 2022 and beyond. Therefore, LRGs' ability to mitigate rising debt will remain key to our view of financial management, and ultimately their creditworthiness.

In places where debt capacity or budgetary flexibility are limited, critical infrastructure spending needs could weigh directly on budgetary performance. In Latin America, slow economic growth and tighter budgets will constrain subnational governments' ability to maintain capital investment, which was squeezed by increasing operating expenditure even before the pandemic. Executing local capital projects is increasingly difficult due to poor access to financing, high procedural hurdles, and incentives that are not well aligned with undertaking long-term planning and investment. Over time, declining investment in physical infrastructure by sub-national governments will constrain economic activity.

The pandemic has also reshaped the landscape in ways that will have a lasting impact on LRGs' credit quality. One means is through accelerating digitalization of business, markets, and government operations. Digitalization has also accelerated remote work, facilitated by increasing online capabilities. Many local governments took advantage of the pandemic to strengthen digital collection capabilities, improving revenue collection even at a time when the tax base was flat or contracting. At the same time, these digital capabilities expose more governments to the risk of cyber attacks.

In our view, large urban areas, particularly core cities, are likely to experience lower fiscal consolidation due to accelerated suburbanization and lower demand for transport services and commercial and residential real estate. This would double burden cities through a lower property tax base and higher subsidies to municipal companies. Simultaneously, more remote areas of commuter belts could benefit from larger populations and greater demand for public services.

Related Research

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• Non-U.S. Local Governments: To What Extent Did Sovereign Support Offset The Pandemic Downdraft?, July 19 2021
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• Global Credit Outlook 2021: Back on Track?, Dec. 3, 2020