Market borrowing by state is a major source of deficit financing. Investment in debt securities floated by state governments constitutes a significant proportion of the asset portfolios for institutional investors. The state government finances vastly differ and hence there is a need for pricing the risk across different securities issued by different states and a common understanding for the market participants. The knowledge of credit rating of state governments would help the state run corporations to benchmark their own issues. Brickwork ratings of State Governments include both state guaranteed and stand alone borrowings of state run corporations, such as electricity boards, road development corporations, PSUs, etc…
Brickwork rates domestic currency obligations and the States of the Union somewhat indirectly. Implicit sovereign ratings of the States can be derived from their State level undertakings or special purpose vehicles set up with State government guarantees. Brickwork Ratings considers the economic structure of States, finances of the governments, political management as well as the Human Development Index.
While viewing a rating, it is necessary to appreciate the basis. For example, in the case of rating of a State, at Brickwork, we state that this rating view is relative to that of other States and with the Union Government of India viewed as "Best Safety" for local currency obligations. Yet another important consideration in rating of a State is its contingent liabilities, where unlike actual liabilities the obligations of a State depend upon occurrence of a discrete event.
The guarantees, whether of the Union or the States, can and do involve a range of terminology with corresponding legal impact on financial liability. It is in this context that use of terminologies such as letters of comfort, and conditional or unconditional default guarantees become critical. Governments are well advised to note that once the legal liability on the guarantee gets established, it is akin to Governments' own liabilities. However, in the case of letters of comfort, though such an automatic equation with a government's liability in respect of guarantees may or may not be technically appropriate, the wording of the letter could have some form of holding out expectation, and in any case, a government may not ignore the reputational risk involved in repudiation of moral obligations implicit in the issue of such a letter. In fact, international practice appears to treat the letter of comfort of a sovereign on a par with a guarantee.
Brickwork has adopted a separate criteria framework for assigning ratings for State Governments as different from other ratings criteria. The broad parameters considered for State Government Ratings are Economic Risk, Inter-Governmental System Support, Management Structure and Financial position. Each of the broad parameter consists of several parameters and a high level chart is placed for ready reference.
| Rating Criteria - State Governments & Local Bodies |
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Demographics
The absolute size, density, growth rate, literacy rates, employment rates and age distribution of the population is assessed in light of their ability to influence future revenue growth and the demand for public services. A declining or rapidly growing population will likely constrain government finances by shrinking revenue or dramatically accelerating service demands. However, high population growth due to significant in-migration of a working-age population and, in particular, of skilled workers could be a positive. Similarly growth rate due to a high birth rate could pose a problem. An important aspect of demographics is the size of the dependent population.
Economic structure
This part of the analysis focuses on the depth, diversity, and prosperity of the local or regional economic base to gauge the likely stability of government revenue growth. Factors considered include labor force characteristics, employment mix, and income levels. Medium term variations in employment growth, per capita income and output, and the unemployment level are the best historical indicators of an economic base’s stability. Local or regional trends are compared to national trends for the same indicators.
Growth prospects
Brickwork evaluates the outlook for an economy based upon recent trends in employment, output, and investment, adjusted for any recent structural or policy changes. Independent economic forecasts are useful, but their accuracy is not taken for granted. Brickwork emphasizes long-term structural trends and their implications for future growth, not developments related simply to business cycles.
Intergovernmental system stability and predictability
- The State Government ratings take into account the intergovernmental system’s stability and supportiveness, factors that often carry significant influence in a rating decision.
- Intergovernmental transfers can be a revenue source and/or a service responsibility and, as such, can either enhance or constrain budgetary flexibility.
- Transfers are examined in terms of their size, predictability, and the ease with which they can be adjusted to meet changing circumstances. Brickwork looks at the composition of revenue transfers between general revenue-sharing allocations, specific-purpose grants, and equalization payments. Fiscal equalization is perhaps the most important transfer program from a ratings perspective.
- Barring predictable financial assistance being available well in advance of an acute financial crisis, no sovereign guarantee is acknowledged in the rating. However, a track record that demonstrates general intergovernmental supportiveness may be cited as an extraordinary item incorporated into the entity’s stand-alone rating.
Management Structure, Systems & Controls
This factor addresses the impact of a State Government’s legal, political and administrative structure on budgetary and financial flexibility. The presence of legal limits on the government’s capacity to raise taxes, cut services or issue debt could be an important rating factor, depending on how restrictive the limits and how cumbersome the process of raising the limits.
The stability of political leadership and the relationship between elected officials and professional staff is another analytical focus of this rating factor. A concern would be political settings where changes in government are frequent and lead to major fiscal and financial policy shifts or where political fragmentation (e.g., minority or weak coalition governments, different parties in control of the executive and legislative branches, etc.) creates policy stalemate.
Management capacity and institutional legitimacy
The focus here is upon the consistency and rigor of budgetary and financial policies as demonstrated over several administrations and political alignments. Management structure, systems, and controls are useful indicators of future financial stability and reliance upon a few key administrators. Institutionalized rules governing debt issuance and mandating a balanced budget are strengths. Control over spending is measured by a medium-term comparison of expenditure growth to economic expansion. Similarly, the ability to limit budget variances is an important factor. Another consideration is the timeliness and comprehensiveness of financial reporting practices, planning documents, mid-year fiscal reports, and cash flow.
Fiscal Flexibility and Performance
Analyzing fiscal performance involves reviewing the base and relative growth trends of revenue and expenditure, the flexibility to adjust revenue and expenses, and the level of budgetary imbalances experienced over a five-year period.
Revenue sources and flexibility
Evaluating the revenue structure focuses upon the major sources, their changing importance over time, and their suitability with respect to the economic base.
Budgetary performance and financing requirements
When evaluating budgetary performance, an important factor is the magnitude of the variance between initial budget projections and the revised estimates. Significant recurring differences raise questions about the adequacy of forecasting techniques, budget controls, and management’s ability and willingness to make intra-year adjustments. The operating balance measures the government’s capacity to manage its recurrent activities and helps to identify any structural mismatch between ongoing income and expenses.
Financial Position
a) Liquidity and debt management.
The evaluation of an issuer’s liquidity position emphasizes the appropriateness of internal liquidity, investment policies, and committed support from RBI or the Union government. This analysis factors in any outstanding short term or variable-rate debt or bonds with bullet maturities. The average and minimum reserves and cash balances relative to total expenditure and debt service are important to the analysis.
b) Debt burden
The burden posed by debt is measured by comparing annual charges and year-end stocks with available resources. Several measurements of debt are used, including the government’s direct and guaranteed debt and the total tax-supported debt burden, including the obligations of the State Government non self-supporting enterprises and trusts.
c) Revenue Stability
The revenue stream of the state government is studied and the key factors that are considered in this are revenue generation ability and the sustainability of such revenue. The other perspective looked at Brickwork include the state’s share in the overall revenue as compared to the transfers from the central government.
d) Expenditure Management
Brickwork classification of expenses includes Development expenses and non-Development expenses. If the composition of expenses for non-development expenses are higher, a detailed evaluation is carried out to see whether such a feature is predominantly driven by political scenario or by the economic scenario.
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