GCR Downgrades five State government ratings, places the Nigerian sub-national sector on ‘Negative Outlook’

18 May 2015 In Rating Notifications, Market Alerts

GCR Downgrades five State government ratings, places the Nigerian sub-national sector on ‘Negative Outlook’

Lagos, 18 May 2015—GCR Downgrades five State government ratings, places the Nigerian sub-national sector on ‘Negative Outlook

BACKGROUND

During 2H 2014, GCR had warned in its rating reports that the significant reliance on federal receipts could pose severe funding constraints on several State Governments in light of the precipitous fall in global oil prices. This is because, for many States, receipts from the Federal Government account for over 75% of funding for operations and executing capital projects. At the Federal Government (“FG”) level, these are receipts derived predominantly from oil receipts, resulting in a direct linkage between the oil price and the amount of funding available for States. Thus, in view of projections for sustained low crude oil prices in the near term, and the impact of reduced revenue on the States’ performance going forward, GCR has taken a number of rating actions, as follows.

  • All State Government ratings have been placed on negative outlook.
  • State Governments that are dependent on the Federal Government for more than 75% of their income have been downgraded by at least one notch.
  • The linkage between the Issuer and the Secured Bond rating, based on the protection afforded by the Irrevocable Standing Payment Order (“ISPO”), has been loosened in most cases to three notches, with possible allowance made for more or less notches depending on the circumstances.

In addition, GCR has been in contact with all States it currently rates with a view to bringing the rating reviews forward to 2Q and 3Q 2015. However, cognisance is taken of the fact that the major impact of the lower oil prices will only become evident during the 2015 financial year, as oil prices remained relatively high through most of 2014. Thus, GCR will place increased weighting on the management accounts for 4Q F14 and 1Q F15. The reviews may result in further rating action if deemed appropriate.

Key factors leading to the above rating decisions are elaborated below.

STATES’ DEPENDENCE ON FEDERAL RECEIPTS- A CASE FOR INVESTMENT OR NON-INVESTMENT GRADE RATINGS

With the exception of Lagos State, which has a more diverse economic base and a well-developed tax collection system, most Nigerian States display significant reliance on federally allocated revenue for financial sustenance. This is evidenced by the wide disparity between IGR, which in many cases amounts to just 15-25% of income, compared to the ratio of recurring expenses to income to exceed 65% across much of the sector. The disparity has been driven by the significant development activity undertaken by many States in recent years, facilitated by growing receipts from the Federal Government. While the development activity was intended to ultimately lessen States’ dependence on the FG, the income generated by such projects has been disappointing, entrenching their reliance of FG funding. Thus, States are currently saddled with high recurring cost structures (with employee costs in particular accounting for a substantial portion), but the decline in oil receipts has diminished the capacity of the FG to effectively fund the States’ operations and development activity. As a result, certain States have been unable to pay workers’ salaries and pensions in recent months, while others have resorted to borrowings in order to bridge the funding gap. Although only a limited number of States are currently unable to meet their operational requirements, all are likely to face a much more constrained fiscal environment going forward and struggle to balance their budgets.

Based on the assumption of Federal support, GCR has historically accorded investment grade ratings to all States it has reviewed, irrespective of the level of dependence on statutory receipts. In effect, however, if the Federal support was removed most States would be unable to fund their operations, implying that as standalone entities, they may not be investment grade. Nevertheless, at some point, the FG would be compelled to provide financial support, thus offering strong protection to investors in terms of ultimate payments (as opposed to timely payment), and supporting long term investment grade ratings. However, this support can no longer be assumed with regard to meeting short term operational requirements, and those States that cannot meet their day-to-day operational requirements are no longer considered investment grade.

THE SECURITY OFFERED BY ISPOs

ISPO issuance in Nigeria is backed by section 224(3) of the Investment and Securities Act 2007 (“ISA”) which makes it a prerequisite for States before bonds will be approved for issuance by the Securities and Exchange Commission (“SEC”). Before an ISPO application from a State is granted, the Federal Ministry of Finance (“FMoF”) carries out a proper assessment of the financial capacity of the State, considering its debt level, statutory receipts, IGR growth prospects, recurrent expenditure, as well as its debt and other obligations. On several occasions, the FMoF has reduced the quantum of proposed borrowing in order to grant an ISPO to States. Thus, the approval of an ISPO amount is a reflection of the FG’s belief that a State has the necessary debt repayment capacity to cover a specific issuance.

Protection to Bondholders is afforded by the mechanism of the ISPO, whereby ISPO deductions from statutory allocations are administered by the FGN and deposited into transaction specific bank accounts managed by independent trustees. Contributions to the sinking fund account are ring fenced and the State has no access to these funds. The Accountant General of the Federation is empowered to transfer statutory allocation of a State directly to the trustees on behalf of the bondholders within six months of default by the State, ultimately reducing the risk of non-payment of principal. The enforceability of an ISPO cannot be subverted, as SEC regulations provide that an existing ISPO cannot be revoked even when priorities of the government (or a new administration) changes. The only exception granted is that the State can apply for a change in the utilisation of bond proceeds for the unused portion of the proceeds. Notwithstanding the above, there is little legal precedent to underpin the enforceability of ISPOs in practice.

GCR has also taken cognisance of the fact that the ISPO is not a guarantee from the FG, but rather a commitment to give priority of payments to Bondholders. Thus, were the FG not to provide a State with any funding, the bondholders would have no recourse to the FG. However, the composition of the multi-tier government structure in Nigeria is such that, in practice, the FG will have to continue providing a substantial level of financial support to State governments. Thus, the security afforded to bondholders by enjoying priority of payment is considered high. Accordingly, even though State governments may receive less financial support, the amount of funding will likely remain well above the level necessary to service the debt obligations. The major negative impact will be borne by unsecured creditors (including staff and suppliers), who will see the amount of cash available to meet their claims diminished by the ISPO deductions. Thus, GCR is of the opinion that the security afforded by the ISPO has not been impaired to the extent that State Government finances have, and therefore any downward rating action to secured bond issuers should be more moderate than for the State Issuers themselves.

RATING ACTION

As a consequence of the above discussion, immediate rating action has been taken, leading to the downgrading of the following State Issuer credit ratings. However, due to the increased three-notch uplift, there has been no change to the respective bond Issues. Nevertheless, there remains potential further rating action to be taken when the individual States undergo their rating review process.  All State ratings detailed below have an expiry of 30 September 2015, with the exception of Osun State.

*  The issuance of the N31.95bn Series 1 Fixed Rate Bond is yet to be concluded.

** Osun State was downgraded in April 2015, expiry July 2015.

 

ANALYTICAL CONTACTS

Primary Analyst

Kunle Ogundijo

Analyst

Lagos

+23 41 462 2545

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Committee Chairperson

Dave King

Chairman

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APPLICABLE METHODOLOGIES AND RELATED RESEARCH

Criteria for Rating Public Entities, updated February 2015

Nigerian State Government Rating Reports

Glossary of Terms/Ratios (February

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