Welcome Fernando to our discussion and thank you for taking the time to share your knowledge with our global Community of Practice members.
I’d like to get started with a more general discussion on the experience of your firms in working on sub-sovereign finance and credit ratings before moving on to some specifics of the ratings process itself. Please go ahead and tackle one or more of the following initial questions:
In which countries outside the EU and United States has your firm worked on sub-sovereign credit ratings?
Fitch has over 500 subnational ratings outside of the EU and US. Our coverage is split between Local and Regional Governments (LRGs) and Public Sector Entities (PSEs) – both are referred to as “subnationals”. PSEs are generally companies which are owned either by a local and regional government or the sovereign and/or they undertake essential public services on behalf of their public sector owners. The main sectors of PSEs rated by Fitch are in the area of education, health care, public transportation, social housing and specialised financial vehicles.
Subnationals can obtain either an international scale rating or a national scale rating or both. International ratings are normally obtained for bond issuance in the international capital markets and can be either for local currency borrowing (in other words off-shore issuance in the domestic currency) or in foreign currency (off-shore issuance in a foreign currency, normally USD, EUR etc.). Some subnationals also seek international ratings even though they may not wish to tap the capital markets as they would use this for benchmark purposes against other key international cities or entities. International ratings are comparable globallyand they use the familiar ‘AAA’ to ‘C’ ratings scale with ‘AAA’ indicating the highest credit quality.
In addition subnationals may seek a national rating. This could be for various reasons such as regulatory requirements or because the subnational may be prohibited from borrowing externally or in foreign currency. National scale ratings are not internationally comparable but “relative” ratings, with the strongest credit in the country being ‘AAA’ (this would in general be the sovereign but not necessarily so) and all other entities rated relative to that entity. National sale ratings are identified with a three letter country code after the rating, in the case of Mexico for example (mex).
By sector breakdown, around 65% are LRGs and the remainder PSEs. Fitch’s largest coverage has traditionally been in LRGs but PSEs are increasing in importance as LRGs are looking at ways of decentralizing risk or offloading debt to municipal entities. By region, 53% of all our ratings are in Latin America, 42% in EMEA and 5% in APAC.
Our largest country coverage is in Mexico where we rate most of the Mexican states (29) and around 110 municipalities. In Colombia we also have significant coverage (with around 80 Departments and Cities rated). The majority of our ratings in Mexico and Colombia are in the national scale. We also rate a large number of PSEs in Mexico on the whole in the area of water and sewage. Outside of Mexico and Colombia we have a number of states and cities rated in Brazil, Argentina and Peru (all at the international ratings scale and therefore comparable globall.
Fitch also rates a large number of subnationals in Russia, with over 45 LRGs rated both in the internationally and national ratings scale; a small number in Ukraine (although the ratings level are very low given the situation in the country); Kazakhstan; Azerbaijan; a number of metropolitan cities in Turkey as well as the City of Johannesburg in South Africa and Lagos State in Nigeria (although we use to rate five states in Nigeria). In the past we rated three cities in Morocco but these ratings were withdrawn.
In recent years there has been significant growth in our coverage in Asia, primarily in China although all the public international ratings in this country are PSEs (or Local Government Financing Vehicles). Nevertheless, as we adopt a “top down” ratings approach (in other words the rating of the PSE is determined by the rating of its sponsor – the LRG) and we notch down, we have also undertaken a large number of international assessments of Chinese provinces and cities. Outside China we have a number of PSEs rated in Indonesia (primarily infrastructure finance for PPPs), India and South Korea. However, we envisage significant potential in this region as the government decentralised services and LRGs take on more responsibility for infrastructure spending.
Also of note is an increased interest for ratings by New Zealand local governments while we maintain a small number of ratings in Australia.
Answers to the other questions will follow.
Does your firm have a particular regional/subject area of expertise?
The International Public Finance (IPF) department in Fitch rates Local and Regional Governments globally so we have expertise both in developed and emerging markets. The IPF group has over 50 analysts located in 11 offices globally (in addition to a large number of analysts based in the New York/San Francisco covering the US market). This local presence gives Fitch the opportunity to be more closely linked to the subnational market, regulators, and central government and also gives us a wide understanding of the Institutional Framework in each market. Our coverage is roughly split 50/50 between developed and emerging markets with increasing exposure to entities in the APAC region.
Fitch has two main criteria – one that covers Local and Regional Governments and explains the main factors in assessing the rating of LRGs and a criteria for the rating of Public Sector Entities (PSEs). For PSEs, Fitch follows either a “top-down” ratings approach (in other words we assess the rating of the support provider and notch the PSE from this and the rating is credit linked) or a “bottom up” ratings approach (where we assess the standalone and enhance the rating by up to three notches depending on the likelihood of extraordinary support from the public sector).
Other criteria that we have published include the assessment of enhanced financial instruments for emerging markets where the rating of a bond or a financial instrument can be rated higher than the entity itself because of certain credit enhancements provided. We have also published a criteria for assessing obligations under PPP contracts by the subnational. This latter case is particularly important as a larger number of subnationals are using this form of procurement for capital expenditure.
The main sectors that we rate under PSEs include public transportation (for example Transport for London, Beijing metro, Paris metro, MTR in Hong Kong etc.); health care including a number of hospitals in France, UK and Colombia; higher education including universities in France, UK, Mexico and Colombia; and social housing providers (primarily in the UK and France).
In addition to our research reports on subnationals and ratings, Fitch has been providing regular commentaries on developments in the market either by way of short comments/press releases to highlight key points or more extensive special reports describing the institutional framework of subnational in key markets where we have a large presence. We have also published topical research such as our report comparing a number of key emerging market cities in terms of budgetary performance or debt burden, or our report on oil dependency in some subnationals (particularly with the decline in oil prices and its impact on revenues and transfers).
What are some of the trends you see in sub-sovereign finance in the countries in which you work?
I will summarise some of the key points of our Outlook report published in December 2015:
Improving economic trends in the eurozone countries and sovereign fiscal adjustments are paving the way for LRGs budgetary discipline and debt stabilisation. However, LRGs continue to face budgetary pressure from dynamic public spending, some territorial reforms – notably in France and Italy – and the budgetary paradox whereby LRGs are required to both participate in the national deficit and debt reduction plans and continue to implement capital spending plans.
On the other hand, Russian LRGs’ ratings will remain under pressure in 2016 following negative debt metrics dynamics and decelerated fiscal performance. Fitch Ratings projects aggregated direct risk to reach 29% of total revenue at end-2015 and revenue growth will slow in 2016. Fitch’s view on the outlooks for Polish LRGs is positive, driven mainly by expected sound operating performance and diminishing debt. Also, we maintain a stable outlook for the Turkish LRGs, as their budgetary performance remains sound.
The ratings of Brazilian LRGs are mainly correlated with those of the sovereign, but a restructuring process is expected to result in LRGs having to adjust expenditures to fallen revenues in 2016. The outlook for Mexican LRGs for 2016 is stable amid economic challenges at the national and international levels, following an expected negative impact for 2016 on federal revenues sharing.
Chinese LRGs are expected to face more fiscal pressure in 2016 against the backdrop of slower economic growth and contracting land sales. Nevertheless, the LRG debt swap programme and other major LRG reform policies are expected to ease LRGs’ refinancing risks, alleviate interest burden and build a better fundamental framework for Chinese subnationals.
Economic drivers differ between the six Australian states and two territories. However, all regions benefit from sustained national economic growth, notably housing, strong governance and effective public and social institutions. Fitch’s outlook for New Zealand LRGs is stable, reflecting a strong institutional framework, manageable expenditure pressures, a sound economy and modest debt levels.