Friday, April 10, 2020 / 12:59 PM / By Fitch Ratings / Header Image Credit: Oyibos Online
Fitch Ratings has downgraded Lagos's Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) to 'B' from 'B+'. The Outlooks are Negative.
Under EU credit rating agency (CRA) regulation, the publication of International Public Finance reviews is subject to restrictions and must take place according to a published schedule, except where it is necessary for CRAs to deviate from this in order to comply with their legal obligations. Fitch interprets this provision as allowing us to publish a rating review in situations where there is a material change in the creditworthiness of the issuer that we believe makes it inappropriate for us to wait until the next scheduled review date to update the rating or Outlook/Watch status.
Following the recent downgrade of Nigeria's IDRs (see Fitch Downgrades Nigeria to 'B'; Outlook Negative dated 6 April 2020) we have downgraded Lagos's IDRs to reflect the Sovereign cap, while its Outlooks move in tandem with the sovereign's.
Related Link: Fitch Downgrades Nigeria to 'B'; Outlook Negative
The ratings also reflect the state's weak risk profile by international standards against Fitch's expectations of sustainable debt driven by internally generated revenue (IGR), which underpins Lagos's capacity to serve its financial obligations, as evidenced by its Standalone Credit Profile (SCP) of 'bb+'.
While Nigerian local and regional governments' (LRG) most recently available issuer data may not have indicated performance impairment, material changes in revenue and cost profiles are occurring across the sector and likely to worsen in the coming weeks and months as economic activity suffers and government restrictions are maintained or broadened. Fitch's ratings are forward-looking in nature, and we will monitor developments in the sector for their severity and duration, and incorporate revised base- and rating-case qualitative and quantitative inputs based on performance expectations and assessment of key risks.
The next scheduled review date for Lagos is 18 September 2020.
As per Fitch's rating criteria, Lagos's IDRs are capped by the sovereign's and its Outlooks reflect those on the sovereign. Any rating action on the sovereign's ratings will lead to similar action on Lagos's ratings, provided that Lagos's budgetary performance and debt metrics remain in line with Fitch's expectations.
Risk Profile: Weaker
Fitch has assessed Lagos's risk profile, at Weaker, which combines three factors at Midrange (revenue robustness, expenditure sustainability and adjustability) and three factors at Weaker (revenue adjustability, liabilities and liquidity robustness and flexibility).
Revenue Robustness: Midrange
Lagos's estimated NGN580 billion operating revenue at end-2019 rests on a diversified tax base driven by IGR(70%), underpinning the state's relative autonomy from oil-related transfers by the Federal Government of Nigeria (FGN), which represent 10%-15% of operating revenue. In our rating case of a stressed economy, we forecast a nominal average 8% increase in operating revenue in 2020-2024, taking into account the VAT rate increase to 7.5% from 5.0% effective since February 2020 against flat IGR.
Revenue Adjustability: Weaker
Fitch believes that Lagos's fiscal flexibility relies on the wide but not fully exploited tax base of PAYE (about 75% of IGR), on which it has no tax-setting power, as well as other potential revenue sources such as land use charges. Rigid revenue sources represent collectively more than 85% of Lagos's revenue, driving the Weaker assessment of this factor. Lagos is a net contributor to Nigeria's equalisation system enacted through the Federal Account Allocation Committee (FAAC).
In Fitch's view, the maximum peak-to-trough revenue fall of -5.5% (NGN22 billion) in 2015 over the last 10 years could be theoretically offset by at least 50% with modest additional revenue. However, if another recession should strike Nigeria as a consequence of the sharp fall in oil prices and prolonged lockdown measures to face the pandemic, Fitch believes that Lagos will absorb the revenue shock by reducing its operating margin to about 35% from current 50%.
Expenditure Sustainability: Midrange
In its rating scenario, Fitch expects operating costs to increase by 10% or less than the country's double-digit inflation, but above revenue growth, driven by increased costs to cope with the pandemic and support the weakest layer of its 20 million population, while coping with the 60% minimum wage increase decided back in 2019. Lagos has a diversified set of responsibilities, which include education (20%) and healthcare (15%), which could come under pressure should the pandemic spread in the state.
Expenditure Adjustability: Midrange
There are no mandatory balanced budget rules defined by the central government for states, which are required to keep their deficits at 3% of national GDP. Fitch expects Lagos to cover debt service requirements out of its operating balance by about 2x. Capex makes up 50% of Lagos's expenditure before debt service, keeping the share of inflexible costs below 70%.
Under Fitch's revised rating scenario, which incorporates stresses due to the oil-price shock and the lockdown, Lagos is expected to retain its adjustability potential even in a scenario of capex declining to around 35% of expenditure before debt service, as the high level of capex is necessary to maintain the local attractiveness amid demographic pressures calling for more services on infrastructure, health and education.
Liabilities and Liquidity Robustness: Weaker
The national framework for debt is evolving and thus borrowing limits are quite wide. There are no restrictions concerning debt maturities, interest rates or currency exposure. Lagos applies a prudential rule of debt service not exceeding 30% of operating revenues and aims at reducing its currency exposure at 55% of its NGN850 billion outstanding debt at end-2019. Average cost of debt is around 1% for external loans and above 10% on domestic loans. To ensure timely debt service, its internal debt is assisted by a state-level irrevocable standing payment order while external debt is served by FGN through deductions from FAAC.
Liabilities and Liquidity Flexibility: Weaker
Lagos has consolidated access to financial markets with repeated bond issuances, while domestic counterparties can provide liquidity lines and short-term credit. Counterparty risk on credit lines is in the 'B' category, triggering a Weaker assessment for this factor. Lagos cashes in a sinking fund to support its debt service on bonds and Fitch prudently considers its year-end cash as earmarked to offset payables.
Debt Sustainability: 'aa' category
In Fitch's rating scenario of a stressed economy, Lagos's net adjusted debt is expected to increase above NGN1 trillion in the medium term, reaching NGN1.2 trillion by 2024. Coupled with an operating balance around NGN300 billion, this leads to a payback ratio of around four years. Fitch incorporates Lagos's weak fiscal debt burden of around 140%, which is high compared with the peer group, and debt service coverage at around 2x. Collectively, all these factors lead to a debt sustainability assessed in the 'aa' category.
Lagos is classified as a type B LRG by Fitch, as it covers debt service with its operating balance. Lagos is Nigeria's economic powerhouse with per capita GDP above USD4.000, or double the national average, but is weak by international standards. Fuelled by public and private investment and a population over 20 million, Lagos's diverse economy is supportive of the wide tax base that generates IGR.
Lagos's SCP is assessed at 'bb+', reflecting a combination of a weak risk profile, or debt tolerance, and its debt sustainability in the 'aa' category. The notch-specific rating positioning is assessed at the higher end of the rating category to reflect the payback ratio below five. Fitch does not apply any asymmetric risk or extraordinary support from the central government. The IDR is capped at the sovereign level. The 'B' short-term rating is derived from Lagos's Long-Term IDR.
Qualitative Assumptions and assessments and their respective change since the last review held on 27-Mar-2020 and weight in the rating decision:
Risk Profile: Weaker, unchanged with low weight
Revenue Robustness: Midrange, unchanged with low weight
Revenue Adjustability: Weaker, unchanged with low weight
Expenditure Sustainability: Midrange, unchanged with low weight
Expenditure Adjustability: Midrange, unchanged with low weight
Liabilities and Liquidity Robustness: Weaker, unchanged with low weight
Liabilities and Liquidity Flexibility: Weaker, unchanged with low weight
Debt sustainability: 'aa' category, unchanged with low weight
Asymmetric Risk: n/a
Sovereign Cap: Yes, lowered with high weight
Quantitative assumptions - issuer specific
Fitch's rating case scenario is a "through-the-cycle" scenario, which incorporates a combination of revenue, cost and financial risk stresses. It is based on the 2014-2018 figures, 2019 estimated data 2020-2024 projected ratios. The key assumptions for the scenario include:
Quantitative assumptions - sovereign related
Figures as per Fitch's sovereign actual for 2018 and forecast for 2020, respectively:
Factors that could, individually or collectively, lead to negative rating action/downgrade:
A downgrade of the sovereign's ratings would lead to corresponding action on Lagos's IDR.
A sustained deterioration of the payback ratio above five years in Fitch's rating case scenario, or a reassessment of the key risk factors or risk profile due to unfavourable changes in the economy beyond Fitch's expectations, could also trigger a downgrade.
Factors that could, individually or collectively, lead to positive rating action/upgrade:
Any positive rating action on Nigeria will be reflected on Lagos's ratings, provided that Lagos maintains its strong debt sustainability metrics.
Committee Minute Summary
Committee date: 8 April 2020
There was an appropriate quorum at the committee and the members confirmed that they were free from recusal. It was agreed that the data was sufficiently robust relative to its materiality. During the committee no material issues were raised that were not in the original committee package. The main rating factors under the relevant criteria were discussed by the committee members. The rating decision as discussed in this rating action commentary reflects the committee discussion.
Ratings of Public Finance issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of three notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance.
The principal sources of information used in the analysis are described in the Applicable Criteria.
ESG issues are credit neutral or have only a minimal credit impact on the entity(ies), either due to their nature or the way in which they are being managed by the entity(ies).
Related News - Rating Agencies on Lagos State
Related News - Rating Agencies on Nigeria
Related News - Rating Agencies on Banks
Related News - Rating Agencies on Selected Companies and Notes