Lagos State Fiscal Debt Burden to Hover Towards 150% – Report
Lagos State fiscal debt burden, a measure of debt to revenue ratio has been projected to hover around 150%, Fitch Ratings said in a new report, adding that its fiscal flexibility relies on the wide but not fully exploited tax base on which it has no tax-setting power.
Nigeria’s Debt Management Office (DMO) domestic borrowings record shows that Lagos has more than N507 billion exposure. As of December 2020, the state owed a total sum of $1.406 billion – $1.262 billion exposure to multilateral lenders and $143.830 to bilateral lenders.
In the report, Fitch assesses Lagos’s standalone credit profile at ‘bb+’, reflecting a combination of a weaker risk profile and debt sustainability in the ‘aa’ category but sound financial coverage and revenue position.
According to the report, the most performing state in Nigeria in terms of economic growth and development has a weaker risk profile, but it projects that the state debt service coverage will decline amidst ballooning borrowings.
Fitch Ratings 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’. It also said the state 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, as evidenced by its standalone credit profile of ‘bb+”
Meanwhile, the report stated that the Lagos state’s issuer default ratings incorporate the Nigeria’s rating cap, Fitch said while the stable outlook on the IDRs mirrors that on the sovereign.
It indicates that 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 the capacity to serve its financial obligations.
Lagos state assessed risk profile combines three factors at ‘Midrange’ -revenue robustness, expenditure sustainability and adjustability and three factors at ‘weaker’.
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.
In the report, Fitch analysts said Lagos benefits from a solid revenue structure driven by its strong internally generated revenue, which represented 70% of its N620 billion operating revenue at end of 2020.
However, the ratings agency noted that the state’s IGR is driven by moderately cyclical taxes such as pay as you earn, a form of personal income tax, which remained fairly stable during the pandemic shock.
But added that stability of tax revenue is counterbalanced by dynamic oil-related transfers from the central government which represents 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”, the ratings agency said.
Revenue Adjustability: ‘Weaker’
Fitch believes that Lagos’s fiscal flexibility relies on the wide but not fully exploited tax base of pay as you earn which corresponds to about 45% of operating revenue, on which it has no tax-setting power.
It said rigid revenue sources represent more than 85% of Lagos’s income, driving the ‘Weaker’ assessment of this factor. Lagos is a net contributor to Nigeria’s equalisation system through the Federal Account Allocation Committee (FAAC).
The state’s peak-to-trough revenue in real terms over the last 10 years was 9% or N26 billion in 2019, Fitch said, noting that 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 the current 50%.
On expenditure sustainability, Fitch said Lagos has expenditure responsibilities in many sectors, and around 40% of total expenditure before debt service is devoted to capital expenditure, particularly in key areas such as transportation, infrastructure, water and sanitation, healthcare, and education.
The state’s expenditure growth has been broadly in line with revenue growth, as evidenced by a margin above 45% on average in 2010-2020. In its rating scenario, Fitch expects 13% operating expenses growth -close to inflation- amid demographic pressures for more services on infrastructure, health and education.
There are no mandatory balanced budget rules defined by the central government for states, according to Fitch’s report, which is required to maintain their deficits at 3% of national gross domestic products (GDP).
However, capital expenditure 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, says Fitch while attributing this to better infrastructure and existing services compared with national peers. The ratings agency expects that Lagos State will continue to maintain a high level of capital spending to maintain its attractiveness for companies and residents.
Liabilities and Liquidity Robustness
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.
According to the report, 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 N1 trillion outstanding debt at the end of 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
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 triggers a ‘Weaker’ assessment for this factor.
The state 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.
In Fitch’s rating scenario of a stressed economy, Lagos’s payback ratio would be close to 4x-5x in the medium term from 3.3x in 2020. “We expect its debt service coverage to decline towards 1.0x and the debt-to-revenue ratio or fiscal debt burden to hover towards 150%, which is high compared with the peer group”.
Lagos’s net adjusted debt would reach N1.3 trillion by 2025 to cope with a demanding capital project plan, and the operating balance would be around N300 million.
Lagos State Fiscal Debt Burden to Hover Towards 150% – Report