Fitch Ratings has affirmed Lagos State’s Long-Term Foreign and Local Currency Issuer Default Ratings (IDRs) at ‘B+’ with Negative Outlook and Short-Term Foreign Currency IDR at ‘B’. The National Long-Term Rating has been affirmed at ‘AA+(nga)’, with a Stable Outlook. The ratings on Lagos’ medium-term note (MTN) programme, as well as senior unsecured bonds, have also been affirmed at ‘B+’/AA+(nga)’.
The affirmation reflects the state’s weak socio-economic indicators by international standards. It also reflects Fitch’s expectations of resilient operating performance in the medium term, adequate transparency compared with national standards and satisfactory debt metrics. The Negative Outlook on the IDRs reflects that of Nigeria (B+/Negative).
KEY RATING DRIVERS
Weak Institutional Framework: A constitutional equalization system enacted through the Federal Account Allocation Committee (FAAC) pools oil and non-oil revenue collected by the central government and transfers them to local and regional governments. FAAC’s funding has proved volatile as Nigeria’s federal budget depends on oil for more than a third of its revenue and the severe oil price slowdown from 2012 has resulted in lower transfers to local government entities. This was particularly true in 2017 when oil statutory allocations were expected by Lagos to have been 10% lower than 2016
Given that the revenue framework is highly equalized and irrespective of the minimum level of service provided, incentives for operating spending efficiencies are limited. Economic development of states is dependent on capital projects, which often face challenging budget implementation and are driven by available funding options.
IGR Supporting Revenue Growth: Lagos benefits from a diversified revenue structure and, especially, from strong internally generated revenue (IGR), which mitigates dependency on state statutory allocations from FAAC. Lagos’ IGR represents on average over 70% of the state revenue budget or about 40% of IGR collected in the country. This should support Fitch’s forecast of an operating margin of around 50% for Lagos through to 2019 but is challenged by a large informal economy. Together with the administration’s commitment to keeping cost growth under double-digit inflation, Lagos should see a growing tax revenue base. In addition, FAAC transfers are likely to benefit from a gradual improvement of oil prices.
Improved Administration Practice: Fitch expects that the administration’s commitment to investment will boost capex over the medium term up to NGN1 trillion over 2017-2019, mostly focused on transportation, water, health, education and social care. Despite Nigeria’s weak governance indicators, as measured by the World Bank, Lagos is improving its governance and accounts disclosure, and new accrual accounting rules effective from 2016 should improve transparency and accountability.
Growing Debt, Adequate Liquidity: Lagos’ debt will grow over the medium term up to over NGN1 trillion or over 170% of tax revenue, driven by a demanding capex programme, the negative effect of the naira devaluation on foreign currency-denominated debt and a new USD200 million loan with the World Bank to finance new investments.
Foreign currency debt repayment is aided by irrevocable standing payment orders (ISPOs), through which the central government deducts from monthly transfers to service the states’ bonds, thereby making the ISPO mechanism a first-lien charge on the central government transfers.
Fitch expects long-term debt sustainability to remain compatible with Lagos’ rating profile, with an average pay-back (debt-to-current balance) ratio of five years. Fitch expects liquidity and, in particular, refinancing risk to remain under control despite the large capex programme given Lagos’ access to IGR, as well as government and bank facilities to fund working capital needs.
Growth and Socio-Economic Improvement: Lagos’ GDP per capita at USD5,000 results in, among others, weak socio-economic indicators by international standards. In the national context, Lagos is Nigeria’s economic powerhouse as its GDP accounts for 20%-25% of national GDP. Domestic production is fuelled by a diversified economy, with services, construction, transport, and industry representing 80% of the local economy. Lagos’ socio-economic indicators should further improve as Fitch forecasts the local economy to outperform national real GDP growth, at 4.5%-5.5% in 2017-2018.
RATING SENSITIVITIES
A downgrade of the sovereign’s ratings would lead to a corresponding action on Lagos’ IDRs. In the absence of a sovereign downgrade, an operating margin declining towards 30%, unfavorable changes in the national tax policy, debt rising beyond Fitch’s expectations over the medium term and economic instability, even at the local level, could lead to a downgrade.
A sovereign upgrade may be reflected in Lagos’ ratings, provided that budgetary improvements reduce debt levels to 1x the budget. Further improvement of the local economy giving an additional boost to IGR would also be positive for the ratings.