Fitch Affirms Lagos State at 'B'; Upgrades National Rating; Outlooks Stable

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Tuesday, September 14, 2021 12:58 PM / by Fitch Ratings/ Header Image Credit: Guardian Nigeria

 

Fitch Ratings has affirmed Lagos State's Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) at 'B' with Stable Outlook and Short-Term Foreign-Currency IDR at 'B'. The National Long-Term Rating has been upgraded to 'AAA(nga)' from 'AA+(nga)' with a Stable Outlook.

 

The IDRs reflect the state's weaker risk profile by international standards against Fitch's expectations of rising but sustainable adjusted debt, coupled with sound debt sustainability driven by internally generated revenue (IGR), as evidenced by its Standalone Credit Profile (SCP) of 'bb+'. The IDRs incorporate the sovereign rating cap. The Stable Outlook on the IDRs mirrors that on the sovereign.

The upgrade of the National Long-Term rating reflects Lagos's strength compared with national peers and the state's resilient operating performance during the pandemic, which underpins Lagos's capacity to serve its financial obligations

Key Rating Drivers

 

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). The assessment reflects Fitch's view of a high risk relative to international peers that the issuer's ability to cover debt service with the operating balance may weaken unexpectedly over the forecast horizon (2021-2025) due to lower revenue, higher expenditure, or an unexpected rise in liabilities or debt or debt-service requirement.

 

Revenue Robustness: 'Midrange'

Lagos benefits from a solid revenue structure driven by IGR, which represented 70% of its NGN620 billion operating revenue at end-2020. IGR is driven by moderately cyclical taxes such as PAYE (personal income tax), which remained fairly stable during the pandemic shock. The stability of tax revenue is counterbalanced by dynamic oil-related transfers from the central government (representing less than 10% of operating revenue) and the volatility of other operating revenue sources such as sales proceeds, rents, land use charges, fees and fines. In our rating case of a stressed economy, we forecast a nominal average 10% increase in operating revenue in 2021-2025, which encompasses post-pandemic recovery, the VAT rate increase to 7.5% from 5.0% effective since February 2020, and stable tax IGR.

 

Revenue Adjustability: 'Weaker'

Fitch believes that Lagos's fiscal flexibility relies on the wide but not fully exploited tax base of PAYE (which corresponds to about 45% of operating revenue), on which it has no tax-setting power. Rigid revenue sources represent more than 85% of Lagos's revenue, driving the 'Weaker' assessment of this factor. Lagos is a net contributor to Nigeria's equalisation system through the Federal Account Allocation Committee (FAAC).

 

Lagos's peak-to-trough revenue in real terms over the last 10 years was 9% (NGN26 billion) in 2019. This could be theoretically offset by at least 50% with modest additional revenue. However, Fitch believes that Lagos will more likely absorb possible revenue shocks by reducing its operating margin to about 35% from current 50%.

 

Expenditure Sustainability: 'Midrange'

Lagos has expenditure responsibilities in many sectors, and around 40% of total expenditure before debt service is devoted to capex, particularly in key areas such as transportation, infrastructure, water and sanitation, healthcare, and education. Lagos's operating expenditure growth has been broadly in line with operating revenue growth, as evidenced by an operating margin above 45% on average in 2010-2020. In its rating scenario, Fitch expects 13% opex growth (close to inflation) amid demographic pressures for more services on infrastructure, health and education.

 

Expenditure Adjustability: 'Midrange'

There are no mandatory balanced budget rules defined by the central government for states, which are required to maintain their deficits at 3% of national GDP. Capex makes up 40% of Lagos's expenditure before debt service, keeping the share of inflexible costs well below 70%, entailing some potential adjustability. Lagos's expenditure cuts are moderately affordable, owing to better infrastructure and existing services compared with national peers. However, Fitch expects Lagos will continue to maintain a high level of capex to maintain its attractiveness for companies and residents.

 

Liabilities and Liquidity Robustness: 'Weaker'

Nigeria's framework for LRGs debt is evolving and borrowing limits are quite wide. There are no restrictions on 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 NGN1 trillion outstanding debt at end-2020. To ensure timely debt service, its internal debt is assisted by a state-level irrevocable standing payment order while external debt is served with deductions from the 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 in the 'B' category trigger a 'Weaker' assessment for this factor. Lagos cashes in a sinking fund to support its debt service on bonds and Fitch prudentially considers its year-end cash as partly earmarked to offset payables.

 

Debt Sustainability: 'aa' category

In Fitch's rating scenario of a stressed economy, Lagos's payback ratio would be close to 4x-5x in the medium term (2020: 3.3x). We expect its debt service coverage to decline towards 1.0x and the debt-to-revenue ratio (fiscal debt burden) to hover towards 150%, which is high compared with the peer group.

 

Lagos's net adjusted debt would reach NGN1.3 trillion by 2025 to cope with a demanding capex plan, and the operating balance would be around NGN300 million.

 

Derivation Summary

Lagos's SCP is assessed at 'bb+', reflecting a combination of a weaker risk profile and debt sustainability in the 'aa' category. The notch-specific rating positioning is assessed at the higher end of the rating category to reflect a payback ratio below 5x. Fitch does not apply any asymmetric risk or extraordinary support from the central government. The IDR is capped at the sovereign level.

 

The upgrade of the National rating to 'AAA(nga)' reflects Lagos's strength compared with national peers, thanks to its stronger operating performance driven by IGR, which make Lagos an outlier in the national context.

 

Key Assumptions

Qualitative assumptions:

Risk Profile

Weaker

Revenue Robustness

Midrange

Revenue Adjustability

Weaker

Expenditure Sustainability

Midrange

Expenditure Adjustability

Midrange

Liabilities and Liquidity Robustness

Weaker

Liabilities and Liquidity Flexibility

Weaker

Debt Sustainability

aa

Budget Loans (Notches)

N/A

Ad-Hoc Support (Notches)

N/A

Asymmetric Risks (Notches)

N/A

Rating Cap

B

Rating Floor

N/A

 

Quantitative assumptions - Issuer Specific

 

Fitch's rating case is a "through-the-cycle" scenario, which incorporates a combination of revenue, cost and financial risk stresses. It is based on 2016-2020 figures and 2021-2025 projected ratios. The key assumptions for the scenario include:

  • Operating revenue growing below nominal GDP growth rate at around 10% on average;
  • Operating expenditure growth at 13% on average;
  • Average cost of debt expected to remain around 9% on average;
  • Capital expenditure is expected to be financed with operating margins, minor capital grants and new debt.

 

Rating Sensitivities

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Positive rating action on Nigeria would be reflected on Lagos's ratings, provided that Lagos maintains its debt payback ratio below 5x according to Fitch's rating scenario.

 

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 multiple-notch downward revision of Lagos's SCP below 'b', which could be driven by a material deterioration of its debt metrics, particularly a sharp increase in the payback ratio sustainably above 20x according to Fitch's rating case, 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.

 

Best/Worst Case Rating Scenario

International scale credit ratings of Sovereigns, Public Finance and Infrastructure 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.

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