Rated non-U.S. local and regional governments (LRGs) appear well-positioned to weather a global economic slowdown, at least for now. For that they can thank a beneficial mix of elevated inflation, which has fueled revenue growth for most LRG's this year, and a firm hand on costs, which has kept spending within budget targets. The resultant budgetary performance will likely exceed expectations and has supported credit quality.

There will be new pressures to come, not least because spending is likely to catch-up to revenue over time. Yet benefits will linger too. S&P Global Ratings expects LRGs' debt burden at the start of 2024 will remain below our previous forecasts due to the faster-than-expected increase in revenue. This has already led to positive rating actions.

Chart 1

More than 85% of our ratings on LRGs have stable outlooks, the highest proportion since 2008. Moreover, the rated portfolio has a solid positive bias, with the percentage of ratings with a negative outlook at its lowest point since at least 2008 (see chart 2). The geographic spread of those negative outlooks is even, while positive outlooks are concentrated in Mexico and Switzerland.

Chart 2

The large number of stable and positive rating outlooks attest to our expectation that LRGs have fiscal headroom to weather two years of tough economic conditions without significant credit quality deterioration. We anticipate that the Russian-Ukraine conflict and the ensuing disturbance to global trade, the energy market, and geopolitics (combined with China's strict COVID-19 policies) will contribute to elevated inflation and a significantly weaker global economic outlook.

If macroeconomic conditions worsen beyond our base case, leading to a protracted period of low economic growth or recession, then governments will have to thread the needle between keeping spending under control while not hobbling longer-term growth prospects. That effort could be further complicated by a handful of factors. For example, some subnational governments will face falling property-related revenues as real estate markets come under pressure due to higher interest rates and slower growth in China. Meanwhile, grants from central governments are set to decrease in real terms as spending priorities shift focus to support social programs, economic growth, and defense. And LRGs will face operating expenditure (opex) inflation, driven by wage growth, rising energy bills, and higher interest payments. The combination of slower revenue growth and rising opex will likely necessitate cuts to real capital expenditure (capex), if LRGs are to meet their budget deficit targets. That could have knock-on effects, notably by delaying economic recovery and hampering the achievement of governments' net-zero carbon targets over the medium- to long-term.

Chart 3

Ratings On LRGs Improve Despite Turbulence

For the second year in a row, there has been a wave of upgrades among LRGs outside the U.S., with the ratings on 35 issuers rising since the start of 2022 (see chart 4). That list is dominated by 21 Canadian municipalities, which we upgraded following a positive revision of the institutional framework under which they operate, owing to their track record of sound fiscal performance through multiple crises, and in recognition of the strong intergovernmental support they receive during periods of severe economic stress (see "Various Rating Actions Taken On Canadian Municipal Governments On Improved Institutional Framework Assessment," June 1, 2022). We also upgraded LRGs of regions that benefit from high commodity prices (the Australian state of Western Australia and the Canadian province of Alberta) and some European governments that have benefited from steady credit quality improvements. In Mexico, we upgraded or revised outlooks in a positive direction for some states and municipalities that demonstrated smooth transitions of power and a marked reduction in their liquidity risk afterwards. The most prominent downgrade occurred on the city of Kyiv, whose credit quality has suffered since Russia invaded Ukraine.

Chart 4

Even though the number of LRG ratings is decreasing, the proportion of issuers from emerging markets has remained above 30% of the total for more than a decade (see chart 5). The decline in that percentage, since 2021, is mostly due to the withdrawal of ratings on Russian subnational governments. Despite the recent economic and geopolitical uncertainties, about 81% of rated LRGs remain of high credit quality ('BBB' or higher), while the 'AA' category still has the largest proportion of ratings (43%), followed by 'A' (17%).

Chart 5

Budgetary Performance Will Remain Solid, Albeit Weakening

Our base-case forecast is that LRGs will maintain their strong budgetary performance through 2024. Beneath that headline, we expect deficits will increase due to rising spending pressure but will stay below a modest 4% of revenues on average in 2023-2024 (see chart 6). A rapid economic recovery and higher commodity prices in Australia and Canada has resulted in stronger than expected budgetary performance over the past two years. More generally, the stronger budgetary performance in 2021 contributed to cash accumulation and/or debt containment that will support credit quality, providing some flexibility as spending pressures mount, in our view.

Chart 6

We anticipate that large issuers in developed markets--Australian states, Canadian provinces, and German states--will gradually reduce deficits in 2023-2024, following a substantial expansion during the pandemic (see chart 7). In Australia, deficits will likely remain historically high, fueled by growing opex (including due to flood relief and spending to fulfill pledges made in upcoming elections) and increasing capital investment. We expect Chinese provinces' deficits will prove moderate but, as in previous years, remain larger than in Europe and Latin America, where we expect deficits to be small. Among European countries, including Germany, Italy, France, and the U.K., there has been a renewed commitment to balanced budgets (in accrual or cash terms) and spending caps. We expect that this will result in stronger budgetary performance, despite a persistent need for spending on public services amid the economic slowdown. Across Central and Eastern European (CEE), we anticipate a widening of subnational deficits due to the finalization of EU-financed capital projects, in particular in 2023.

Chart 7

LRG's elevated deficits are likely to result in an increased debt burden over our forecast horizon. However, the debt accumulation has been slower than we had projected before the outbreak of the war in Ukraine, mainly due to stronger-than-expected revenue in both 2021 and 2022 (see chart 8).

Chart 8

Continued infrastructure investment across the Asia-Pacific region and Canada will result in a debt burden that increases at a faster rate compared to peers' (see chart 9). We expect the average tax-supported debt of rated Chinese provinces (including direct debt and debt of related entities) will exceed a very high 400% of operating revenue by 2024. That debt burden halves when adjusted for onlending, though it is still relatively high. Over the same period to 2024, we forecast Canadian provinces' average debt will normalize at slightly above 200% of operating revenue, the debt ratio of Australian states will climb up to almost 140%, while German states debt burden will likely decrease to about 120% by 2024. Japanese LRGs debt burden is historically high, but remains stable, while the debt burden of LRGs from other areas is generally low.

Chart 9

Some LRGs Are Exposed To A Property Market Correction

Subnational governments that depend on the performance of property market for revenue could find their takings crimped by a combination of oversupply, rising interest (and thus mortgage) rates, and the wide-spread adoption of hybrid working. These trends threaten to weaken demand and, consequently, lower transaction volumes in residential and commercial real estate markets. That could prove particularly onerous for Chinese provinces and cities, whose revenue traditionally depends on proceeds from land sales, which we forecast will decline by about one-third in 2023 due to a slump in the real estate market. French departments, Australian states, and Spanish LRGs also rely on proceeds from real estate transactions, which tend to be quite sensitive to declining transaction volume. Meanwhile, recurrent property taxes represent a large share of revenue for French LRGs, Canadian and New Zealand municipalities (see chart 10). Collection of recurrent property taxes is typically not price-sensitive, and we don't anticipate it will decline in the short term. While it is not our base case, a protracted crisis in the property market could further dampen economic growth, leading to mortgage delinquencies and unemployment. In this case, a larger group of LRGs could face a revenue squeeze.

Chart 10

Central Government Support Will Decrease As Its Focus Shifts

We forecast that financial assistance to LRGs will decline in real terms due to a mixture of depleted state finances and shifting priorities. Central government's ability to bail out troubled sectors was drained during the pandemic and there has been little respite to rebuild that buffer. At the same time, elevated energy prices, underpinned by the continuing Russia-Ukraine war, has required central governments to channel resources towards supporting vulnerable households and utility companies, and provided a geopolitical impetus to increase defense spending. We consider that LRGs in emerging markets have less fiscal flexibility to facilitate these budgetary shifts, for example by diverting expenditures from other areas or by offering tax relief. This could particularly weigh on Chinese subnational governments, whose dependence on central governments and subsidies is relatively high compared with that of international peers (see Chart 11). Mexican and Argentine LRGs shared federal revenues should keep pace with nominal growth, although we forecast meager real growth of 0.8% and 1.0%, respectively, in 2023.

Chart 11

LRGs Budgets May Have To Cover Some Shortfall On Energy Costs

In addition to revenue-side risk, LRGs may face spending pressures that are not incorporated in our base case scenario. They include elevated energy prices, which may weigh on LRGs outgoings and will make cutting energy consumption an imperative, especially in Europe where oil and gas supply disruption remains likely. Beyond the direct burden of providing expensive energy to local facilities and housing, subnational governments might also have to provide additional assistance to their social housing entities, utilities, and transport companies that have been enfeebled by higher energy costs. Additionally, energy price volatility could oblige municipal utilities to pledge liquid assets to ensure production or energy purchases. That may require support from owners, namely the municipalities.

Those pressures will be reflected in LRG budgets. North-Rhine Westphalia, for example, included a €5 billion guarantee framework for loans granted in support of municipal utilities in its recent supplementary budget. Longer-term, missing profits from municipal utilities -- which used to pay for deficits at public transportation, pools, and libraries (in a tax-efficient way) -- may have to be financed out of budget funds.

Owners of energy producers could benefit from the flip side of elevated prices, which will enable them to mitigate rising costs in other areas. For instance, some Swedish LRGs own electricity utilities with production facilities that could generate material windfall revenue due to higher electricity prices. Austrian states are the majority, and sometimes 100%, owners of their regional energy producers (predominantly hydropower) and therefore should benefit from higher energy prices via dividends. In rare cases, LRGs are also benefitting from high energy prices as net energy exporters.

Inflation Could Prompt Wage Rises In Excess Of Current Expectations

Subnational governments jobs could become unattractive if wages don't rise in line with inflation and/or private sector pay. A significant wage adjustment will, however, be onerous for LRGs for which payroll costs are among their largest opex items (see chart 12). And there are other constraints. In Belgium and parts of Switzerland, for example, public-sector wages are indexed to inflation. As a result, the city of Brussels' budgetary performance won't benefit from the upside of rising inflation, rather its financial flexibility is becoming constrained by fast raising wages.

Elsewhere, low unemployment across Europe and North America has strengthened the negotiating power of public sector employees over the last two years. In the U.K., a series of strikes could result in higher wage increases than we currently anticipate. Nevertheless, our base case is that inflation will outpace European wage growth as the economy slows significantly in 2023.

Collective agreements govern wages in Austria, Germany, and Spain, among other countries. Many Austrian states and Spanish regions will revise these in late 2022, while German states will revisit them in late 2023. These countries will therefore experience significant increases in public wages going forward.

Central governments regulate wages in many Eastern European countries and Italy, providing transfers to municipalities, which pay workers. Municipalities that choose to provide payments beyond the national wage may have to fund that additional benefit out of their own pockets.

In Canada, payroll expenditure represents an average of about 45% of provincial operating budgets, and 58% of cities' budgets. Many Canadian entities have recently renegotiated labor contracts, which typically last three to four years, and we expect wage increases will (largely) remain below nominal growth rates through 2024.

Brazilian states' budgetary flexibility is systematically low due to rigid spending requirements, while wage inflation over the next two years could erode extraordinary cash reserves established in 2021 and 2022 (see "Although Brazilian States Are Flush With Cash, Spending Pressures Are Mounting," April 20, 2022). A two-year salary freeze ended this year, while a large, 33%, increase in teachers' salaries is weighing on state budgets directly and indirectly, by providing precedent for negotiations with other groups of state employees. Education payrolls make up 15% of Brazilian states' budgets, while total personnel expenditure averages 60%.

Mexican states and municipalities benefit from flexible personnel expenditure. We expect they will experience some wage pressure but believe salary increases will likely remain below the revenue growth rate, which tracks nominal growth.

Chart 12

Rising Interest Rates May Pressure Operating Performance

If inflation remains higher for longer than we currently expect, central banks could be more aggressive with interest rate hikes that would weigh on LRGs through higher interest payments. This is a particular risk for those with large refinancing or borrowing requirements in 2023, and those whose borrowing is dominated by variable rate debt (see chart 13).

Rated LRGs in CEE seem particularly prone to interest rate risk, as a substantial share of their debt carries variable rates linked to local capital market indexes. Moreover, we expect over 10% of their debt will be refinanced within the next 12 months.

Canadian municipalities and provinces, and Australian states have, on average, less than 10% of debt maturing in 2023. The share of debt requiring refinancing rises to an average of nearly 20% by the end of 2024, meaning higher-for-longer rates could pose a problem.

Entities at the 'B' category or lower could find liquidity strained by higher interest rates, especially if market access is constrained by highly volatile cost of borrowing.

Chart 13

Argentine provinces are notably exposed to significant liquidity and foreign exchange risks due to the country's challenging and unstable macroeconomic situation, which is reflected in their 'CCC+' ratings. We expect those risks will rise in 2023 and 2024, when principal on restructured bonds becomes due (see "Argentine Provinces Will Have To Navigate Rough Waters To Remain Afloat," published Nov. 11, 2021).

Chart 14

Declining Revenue Growth And Rising Opex Could Hurt Capital Spending

The pressures on revenue and operating costs mean LRGs may ultimately face a difficult policy choice between securing near-term savings and supporting long-term economic growth. Financial managers, faced with economic challenges, typically prefer to sacrifice capital investments. This could delay initiatives, including efforts to achieve net-zero carbon emission targets. Our base scenario anticipates that, on average, the largest LRG issuers will gradually reduce capital spending in real terms in 2023 and 2024 (see chart 15). That will be particularly concerning for governments in Latin America that already have infrastructure lags, because less capital spending in real terms will serve to further weaken growth prospects. Elsewhere, we expect German states' capex will remain higher than before the pandemic, while LRGs from other European, Middle Eastern and African countries, Japanese prefectures and cities, Australian states, and Canadian provinces will on average maintain capex at about 2010 levels, in real terms. We also note that subnational governments in Southern and Eastern Europe will temporarily benefit from access to EU capital grants.

Those forecasts are far from certain. LRGs could further cut capital spending if pressures on operating budgets prove stronger than expected. That, in turn, could further delay economic recovery in affected regions.

Chart 15

Related Research:

• Mexican Municipalities' Opportunities To Strengthen Credit Quality After Mayoral Reelection Remain Limited, Nov. 22, 2022
• French LRGs: Tighter Budgets Will Squeeze Capital Spending, Nov. 22, 2022
• Inflation Bolsters German States’ Resilience To Recession, Nov. 10, 2022
• Institutional Framework Assessment: Strong Fiscal Policy Safeguards Will Help U.K. Local Authorities Cope With Lower Grants, Nov. 01, 2022
• China Cities Diverge To Navigate Property Slowdown, Nov. 01, 2022
• Central And Eastern European Local Governments Weather The War But Face Higher Spending, Oct. 27, 2022
• Central And Eastern European Local Governments Weather The War But Face Higher Spending, Oct. 27, 2022
• Lifting The Lid On New Zealand's "Three Waters" Reforms, Oct. 12, 2022
• Institutional Framework Assessments For International Local And Regional Governments, Sept. 13, 2022
• Local And Regional Government Risk Indicators: European LRGs Stay Firm Amid Economic Slowdown And High Inflation, Sept. 22, 2022
• Local And Regional Government Risk Indicators: Institutional Strengths Buoy Canadian LRGs Even In Rough Waters, Sept. 22, 2022
• Local And Regional Government Risk Indicators: Spending Pressure Will Erode Fiscal Margins For LatAm LRGs, Sept. 22, 2022
• Local And Regional Government Risk Indicators: Asia-Pacific LRGs' Post-Pandemic Appetite For Capital Spending Is Strong, Sept. 22, 2022
• Local And Regional Governments Outlook 2022: Life Without Central Government Crutches, July 13, 2022
• Global Ratings List: International Public Finance Entities 2022, June 03, 2022