MON, 05 SEPT, 2022-theGBJournal| Fitch Ratings has affirmed Lagos State’s Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) at ‘B’ with Stable Outlook, saying the ratings reflect Lagos’s weak risk profile by international standards and Fitch’s expectations of rising but sustainable adjusted debt.
‘’Internally generated revenue (IGR) underpins Lagos’s capacity to service its financial obligations, as evident by a Standalone Credit Profile (SCP) of ‘bb+’. The IDRs are capped by the sovereign’s ‘B’ ratings. The Stable Outlook on the IDRs mirrors that on the sovereign,’’ Fitch said.
The key rating driver for Fitch is Lagos’s ‘Weaker’ risk profile. The ‘Weaker’ risk profile reflects a high risk that Lagos’s ability to cover debt service with its operating balance may weaken unexpectedly over forecast horizon (2022-2026).
Fitch said this may be due to lower-than-expected revenue, higher-than-expected expenditure, or an unexpected rise in liabilities or debt-service requirements.
‘Weaker’ risk profile combines three ‘Midrange’ key risk factors (revenue robustness, expenditure sustainability and adjustability) and three other ‘Weaker’ factors (revenue adjustability, liabilities and liquidity robustness and flexibility).
Revenue Robustness: ‘Midrange’
Lagos benefits from a broad tax base and a diversified economy that contribute to a stable revenue structure led by IGR. IGR represented 70% of its NGN747 billion operating revenue at end-2021 and is driven by moderately cyclical taxes such as PAYE (personal income tax), which remained fairly stable in 2020-2021.
The stability of tax revenue is counterbalanced by some volatility in other operating revenue sources such as sales proceeds, rents, land-use charges, fees and fines. Fitch does not view Lagos as being reliant on government transfers from the Federal Account Allocation Committee (FAAC), as statutory allocations (excluding VAT) represent only a modest 10% of Lagos’s operating revenue. Under our rating case of a stressed economy, we forecast a nominal average increase in operating revenue of around 9% in 2022-2026, driven by moderate economic growth prospects.
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 collectively represent more than 85% of Lagos’s revenue, driving the ‘Weaker’ revenue adjustability.
Lagos saw its maximum peak-to-trough revenue fall of 9% (NGN26 billion) in real terms over the last 10 years in 2019. While this could have been offset by increasing its PAYE tax base by leveraging on Lagos’s large informal economy or by increasing revenue sources such as land use charges, Fitch believes that Lagos will more likely absorb possible revenue shocks by reducing its operating margin towards 35%-40% from the current average 45%.
Expenditure Sustainability: ‘Midrange’
Lagos’s operating expenditure growth has been broadly in line with operating revenue growth, as evident by an average operating margin above 45% in 2011-2021. Lagos has a wide set of responsibilities, including in key areas such as transportation, infrastructure, water and sanitation, healthcare, and education, and benefits from more developed infrastructures and services relative to other Nigerian states.
Lagos is exposed to inflationary pressures on operating cost, with overheads representing close to 17% of total expenditure. Under its rating case Fitch expects a 13% operating expenditure growth (close to inflation) while demographic pressures on more services on infrastructure, health and education will limit the scope for cutbacks.
Expenditure Adjustability: ‘Midrange’
The central government does not have mandatory balanced-budget rules defined for Nigerian 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%, thus yielding some scope for 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 alike.
Liabilities & Liquidity Robustness: ‘Weaker’
Nigeria’s framework for local and regional government (LRG) debt is evolving and thus borrowing limits are quite wide. It has no restrictions on debt maturities, interest rates or currency exposure. Lagos prudently keeps debt service at no more than 30% of operating revenue.
External debt with development lenders accounted for 48% of Lagos’s total debt at end-2021, exposing the state’s debt service to a depreciation in Naira. Lagos’s direct debt is expected to increase towards NGN1.7 trillion by end-2026 to support the state’s ambitious capex plan. To ensure timely debt service, its internal debt is assisted by a state-level irrevocable standing payment order while external debt is serviced by deductions from FAAC.
Liabilities & Liquidity Flexibility: ‘Weaker’
Lagos has consolidated its access to financial markets with repeat bond issuance, which represented 24% of its NGN1.2 trillion debt at end-2021. Domestic counterparties can provide liquidity lines and short-term credit. Counterparty risk in the ‘B’ category results in our ‘Weaker’ assessment for this factor. Lagos holds cash in a sinking fund to support its debt service on bonds and Fitch conservatively deems year-end cash as partly earmarked to offset payables.
Debt Sustainability: ‘aa category’
Under Fitch’s rating case Lagos’s debt payback ratio (net Fitch-adjusted debt/operating balance) of around 4x in 2022-2026, which is consistent with debt sustainability assessment in the ‘aaa’ category, is offset by weak debt service coverage (1.8x) and a fiscal debt burden rising towards 150%, which is high versus the peer group’s. This results in an overall debt sustainability assessment in the ‘aa’ category.
Lagos’s fiscal performance remained resilient in 2021 as operating revenue grew 21% on sustained growth of taxes (up 16%) and fees (up 58%). The operating margin remained sound at 46%, despite inflationary pressures and pandemic-related expenditure driving operating costs 17% higher in 2021. Our rating case envisages a progressive reduction of the operating margin towards 35%-40%, incorporating stagnant IGR against inflation-driven operating expenditure (13%).
Lagos’s net Fitch-adjusted debt is expected to reach NGN1.7 trillion by 2026, or 155% of Lagos’s revenue. Fitch estimates a NGN3 trillion capex plan in the medium term, largely funded by the state’s own resources and new borrowing. Lagos’s ambitious capex plan aims to speed up the completion of several infrastructure projects (mostly schools, transports, health facilities) and to boost the state’s technology capacity and food security.
Fitch Ratings also has affirmed Nigerian Kaduna State’s Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) at ‘B’ with a Stable Outlook.
Fitch assesses Kaduna’s Standalone Credit Profile (SCP) at ‘b’, reflecting the combination of a ‘Vulnerable’ risk profile and debt sustainability metrics in the ‘bb’ category under its rating case.
The ratings reflect Kaduna’s still significant, but declining, revenue dependency on transfers from the central government despite increasing internally generated revenue (IGR).
The ratings also factor in the state’s growing debt to fund necessary capex for the development of basic infrastructures and social services. Kaduna’s IDRs are aligned with the Nigerian sovereign’s and no other rating factors apply to the ratings.
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