Oyo State Depends on ‘Transfer’ Despite IGR Growth –Fitch
Fitch Ratings, assigned Oyo State a ‘B-‘ Long-Term IDR with a stable outlook, citing overdependence revenue dependency on transfers from the central government despite increasing internally generated revenue (IGR).
According to the global rating agency, Oyo’s standalone credit profile of b reflects the state’s manageable debt level, with limited foreign currency exposure. It said Oyo’s ‘Vulnerable’ risk profile reflects a very high risk that the state’s ability to cover debt service with its operating balance may weaken unexpectedly over Fitch’s forecast horizon (2023-2027).
The rating note said this may be due to lower-than-expected revenue, higher-than-expected expenditure, or an unexpected rise in liabilities or debt-service requirements. It added that Oyo’s revenue robustness is influenced by the state’s overall weak socio-economic profile and reliance on volatile transfers from the federal government.
Oil-related federal transfers represented 30% of Oyo’s total revenue in 2022 and Fitch analysts expect them to increase by 18% in the next five years, thanks to a higher naira exchange rate against the dollar, which compensates oil price volatility.
The state has significantly improved its IGR, which has grown by 15% in the last five years, thanks to a tighter grip on the informal economy that expanded the tax base, according to the rating note.
Analysts said the reform of the land-use charge could sustain the increase of non-tax IGR with an additional N5 billion-N6 billion a year (currently around N1.5 billion).
Even in times of economic stress, Fitch expects Oyo to sustain its positive trend of IGR and envisages tax revenue growth (including VAT) on average around 12% in 2023-2027.
Meanwhile, the rating note explained that Oyo’s revenue potential depends on the state’s ability to broaden its tax base and enforce tax compliance.
The main fiscal revenue is pay-as-you-earn taxes, on which Oyo cannot set the tax rate, and land charges, where Oyo targets measures to expand the tax base, Fitch added.
It views the ability to expand the tax base as limited by the large informal economy and the population’s low level of income. However, the modest poverty rate compared with other Nigerian states suggests upside potential.
On expenditure sustainability, Fitch rated Oyo state as weak. It said Oyo has a broad set of responsibilities and high spending needs to support the local economy. The state spending responsibilities range from a social sector (39%, including education and healthcare) and economic development (40%).
“Oyo is exposed to a deteriorating operating environment, which weakens the state’s control over total expenditure growth, influenced by high inflation, rising commodity prices, and supply constraint amid naira depreciation”.
Fitch expects spending growth to outpace revenue growth in the medium term in its rating case of a prolonged economic downturn, driven by an increasing workforce and high inflation on purchases.
Analysts also expect higher capital expenditure (capex) of the state to support the state’s 2023-2027 sustainable development plan, especially on infrastructure. The Nigerian federal government has no mandatory balanced budget rules for states, which are required to keep their deficits at 3% of national GDP.
On that, Fitch considers Oyo’s cost structure as moderately rigid, with staff-related payments (including pension) making up two-thirds of Oyo’s operating expenses. Although capex represents around 30% of the state’s total expenditure, Fitch Ratings envisages limited scope for its adjustability, in light of planned infrastructure investments.
Fitch said the national framework for debt is evolving and thus borrowing limits are quite wide. Nigerian states have no restrictions on debt maturities, interest rates or currency exposure. Oyo’s debt is mostly made up of domestic debt with local counterparties, including several facilities sponsored by the federal government that collectively represented more than half of Oyo’s outstanding debt at end-2022.
“We include pension, contractor arrears and bank overdrafts in Oyo’s adjusted debt. The debt structure is fairly conservative, with amortising repayments and fixed interest rates”. Oyo’s debt is largely serviced through deductions from the statutory allocation.
Fitch deems Oyo’s liquidity as weak as the state has no committed liquidity lines and domestic banks rated in the ‘B’ category tend to extend credit lines either with short maturities or with backup from the federal government through direct deductions from the statutory allocation for longer maturities..
It noted that emergency liquidity may also come directly from the federal government, helping states to meet liquidity shortfalls and fund payments of salaries and pensions. Oyo had N10 billion bank overdrafts at the end-2022 but analysts expect them to have been fully covered in 2023 thanks to higher federal transfers.
Under Fitch’s rating case, Oyo’s debt payback ratio hovers at around 8x in 2026-2027. “We override the debt sustainability assessment to ‘a’ as we factor in some volatility in the operating balance and weak secondary metrics, in particular, debt service coverage just at 1x by 2027 and our expectation of fiscal debt burden growing above 200% by 2027”, Fitch said.
The rating note stated that Oyo’s operating balances have been quite volatile in the last five years and the state resorted to bank overdrafts to meet its cash needs. However, analysts expect this weak cash position to have recovered in 2023 thanks to federal transfer revenue that more than doubled compared with 2022.
The positive dynamics of IGR (+15% average increase in the last five years) further supports Fitch rating case assumptions and mean the operating balance is less volatile (at average 25% of operating revenue) amid inflation-driven operating expenditure.
“We expect Oyo’s net Fitch-adjusted debt to significantly increase to above N500 billion in the base case, or above N600 billion in a rating case of lower oil-related transfers”. This includes depreciation of Oyo’s foreign-currency debt – about 20% of direct debt at end-2022 – under a scenario in which the exchange rate remains above 900.
Oyo’s capex plan of about N500 billion in five years focuses on the state’s pillars of economic development, education, health, and security with attention to infrastructure development, in particular roads, also leveraging on public-private partnerships.
