German State of Baden-Wuerttemberg Ratings Affirmed At 'AAA/A-1+'; Outlook Stable

  • We expect that over our forecast horizon through 2022, Baden-Wuerttemberg will continue to post surpluses after capital accounts, thereby strengthening its financial position.
  • We think Baden-Wuerttemberg will cover any capital expenditures for its investment backlog with cash reserves, accumulated through ongoing surpluses, and reduce its tax-supported debt over 2018-2021.
  • We are therefore affirming our 'AAA/A-1+' ratings on Baden-Wuerttemberg.
  • The outlook is stable.
RATING ACTION
On Feb. 15, 2019, S&P Global Ratings affirmed its 'AAA/A-1+' long- and 
short-term issuer credit ratings on the German State of Baden-Wuerttemberg. 
The outlook is stable. At the same time, we affirmed our 'AAA' issue rating on 
Baden-Wuerttemberg's senior unsecured debt.

OUTLOOK
The stable outlook reflects our expectation that Baden-Wuerttemberg will 
continue posting robust financial performances and gradually decrease its debt 
levels, despite the reduction of its backlog of capital expenditures (capex) 
over our forecast horizon. Furthermore, we expect Baden-Wuerttemberg will 
successfully manage the impact of any future challenges not covered by policy 
measures, such as global policy changes and risks arising from personnel 
compensation, including rising pension expenditures.

Downside scenario
We might consider a negative rating action if Baden-Wuerttemberg's financial 
position were to materially deteriorate, for example through much higher than 
expected funding needs for its implicit indebtedness (backlog of capex) or 
because it was unable to respond to external challenges or manage unforeseen 
pressures on budgets. Substantial weakening of the state's excellent liquidity 
position related to a material reduction in cash holding, combined with weaker 
access to external liquidity, could also weigh on the rating.


RATIONALE
Baden-Wuerttemberg benefits from its strong economic base and its management's 
adherence to limited spending growth. Even though the continuing slowdown in 
the German manufacturing industry will likely result in slower tax revenue 
growth for Baden-Wuerttemberg, we believe the state will remain committed to 
Germany's debt-brake rule and maintain positive balances after capital 
accounts. Furthermore, its sound budgetary performance has helped the state 
reduce its debt burden. Additionally, the rating is supported by the state's 
partial debt repayment to Landesbeteiligungen Baden-Wuerttemberg GmbH, (LBT) 
further decreasing the state's debt, and moderate contingent liabilities. 
Baden-Wuerttemberg benefits from high liquidity reserves, accumulated to cover 
increasing capex linked to the investment backlog, as well as exceptional 
access to external liquidity. 

Robust economic development and very good management set the basis for 
improvements
Baden-Wuerttemberg benefits from a very strong and diversified economy, but 
has experienced some slowdown in manufacturing due to the global economic 
environment. In 2018, we expect that the state's GDP growth will be 1.6%-1.8% 
in real terms, which should remain marginally above Germany's 1.5%. Its robust 
economic development was supported by slowing but still rising exports (up 1% 
in the first nine months of 2018). These account for roughly 41% of the 
state's gross value added or 16% of Germany's exports, and rank it No. 1 among 
German states. This reliance on exports could leave Baden-Wuerttemberg more 
vulnerable to external risks, which include those stemming from Brexit 
(exports already declined by 11.4% in January to November 2018) and the U.S. 
administration potentially taking a more protectionist stance (exports 
increased by 3.7% in January to November 2018). However, we expect these risks 
will be mitigated by the expansion of exports to new destinations, reflecting 
the resilience and adaptability of Baden-Wuerttemberg's economy. The state has 
a large manufacturing sector with an important automotive industry (Mercedes, 
Porsche, Bosch), but also headquarters one of the leading IT companies, SAP. 
Even though economic growth slowed in 2018, employment increased by roughly 
1.0% in January to September 2018, and the unemployment rate decreased to 3.2% 
from 3.7% the previous year. We expect these rates will slow slightly in the 
coming years, but do not foresee significant changes. The business community 
has raised concerns about the decreased supply of labor, especially skilled 
labor. Therefore, improving the skills of employees and boosting the 
immigration of skilled laborers, combined with productivity gains, should 
assist Baden-Wuerttemberg in meeting labor market challenges.

We view the institutional framework in which German states operate as one of 
the most predictable and supportive in the world. Baden-Wuerttemberg is a 
major net contributor to the interstate tax-equalization system, which 
facilitates almost equal per-capita revenues for all German states. In 2018, 
it contributed €3.3 billion to equalization payments, representing 7.3% of its 
operating expenditures. The new equalization system, based primarily on 
value-added tax distribution, will be implemented as of 2020. Due to higher 
federal government contributions, the net effect of this amendment should lead 
to higher revenues of about €570 million in 2020. We expect any new political 
programs or projects of the federal government will be negotiated carefully, 
in order to avoid any major financial disruptions in Baden-Wuerttemberg's 
accounts, since we believe most of the expenses linked to programs might need 
to be covered by additional federal funds.

All German states, including Baden-Wuerttemberg, are bound by the 
constitutional "Schuldenbremse" (debt-brake law), under which they must 
refrain from net new borrowing by 2020, except in certain legally defined 
cases. We view Baden-Wuerttemberg's financial management as very strong in all 
aspects, implementing new budgeting and controlling techniques, as well as new 
reporting tools. The state's management has publicly committed to 
consolidating its budget according to the debt-brake law, abstaining from net 
new borrowing until 2021. The state even budgeted net debt repayments until 
2021 of several hundreds of millions. Robust tax revenue growth beyond 
forecasts and the continuation of cost-containment measures allow the state to 
easily manage these limitations. Newly approved personnel increases and the 
state's emphasis on reducing the backlog of investment projects, thereby 
cutting what it calls the state's "implicit indebtedness," should not harm 
this goal.

Budgetary surpluses and continuously reducing debt levels pave the way for 
financial stability
We expect Baden-Wuerttemberg's budgetary performance will remain very strong 
with consistent budget surpluses, despite its rising pension spending and 
investment backlog, and supported by management's continued commitment to the 
debt-brake rule. Some preliminary financial data for 2018 indicates continued 
robust tax revenue growth (up 6.8% compared with 2017) based on strong 
economic fundamentals, supported by highest ever employment levels and despite 
some slowdown in economic growth. Cost-containment measures of reassessing 
expenditure needs and political projects have continued. We expect lower 
refugee-related spending and unspent residual amounts in different spending 
areas. The operating surplus should have reached 10.1% of operating revenues 
in 2018, and the surplus after capital accounts, 3.1%. Over 2019-2021, we 
expect continued robust and marginally improving financial results (base-case 
average: operating surpluses at 10.8% of operating revenues, and surpluses 
after capital accounts at 2.3% of total revenues), thanks to increasing tax 
revenues, higher shares in taxes due to the new equalization as of 2020, and 
further reducing refugee-related spending. Although we previously expected 
quicker cutback in the investment backlog, it will take longer due to 
personnel constraints in planning, as well as to limited construction market 
resources. Nevertheless, the state provisioned excess surpluses for addressing 
the backlog, particularly in 2018-2019, and has also already increased capex 
for that purpose.

Baden-Wuerttemberg's average budgetary flexibility relies mainly on possible 
cuts, both to operating and capital spending. Revenues offer less financial 
flexibility because the real estate transfer tax has already been raised, and 
asset sales are not planned.

We view Baden-Wuerttemberg's liquidity as exceptionally strong in relation to 
the annual debt service. This is based on existing liquidity at bank accounts 
and, as a last resort in the case of emergencies, the accumulated funds in the 
state's pension funds (Versorgungsfonds). Together, these make up 135% of the 
next 12 months' debt service (after having applied haircuts for different 
asset classes). Cash surpluses, thanks to substantial provisioning for the 
investment backlog, significantly improved the state's liquidity buffers. 
Furthermore, we include the state's access to committed credit lines at 
different banks amounting to €2.3 billion, which remained nearly fully 
available throughout the year (177% of the next 12 months' debt service). 
Baden-Wuerttemberg has, in our view, strong access to external liquidity. The 
state has access to deep and liquid capital markets at all times, and to 
well-established and reliable liquidity sources from other levels of 
government. We also reflect this view in our placement of Germany's banking 
sector in group '2' under our Banking Industry Country Risk Assessment 
methodology (on a 1-10 scale, group '1' denotes the lowest risk banking 
systems; see "Banking Industry Country Risk Assessment: Germany," published 
Nov. 2, 2018). Baden-Wuerttemberg's reserves and access to credit lines 
compare favorably with those of other German states.

Debt levels reduced considerably to 92% of consolidated operating revenues in 
2018 from 98% the previous year, supported by a net direct debt repayment in 
2018, backed by a €400 million redemption of LBT debt. A denominator effect 
(higher operating revenues) added to debt reduction. Our calculations of 
tax-supported debt include direct debt and two additional items: €5.4 billion 
of guaranteed debt for the acquisition of energy company EnBW via an 
outsourced entity (NECKARPRI) and €1.7 billion for the outsourced financing 
(LBT) of a capital increase in Landesbank Baden-Württemberg (LBBW). 

Over our forecast horizon, we expect Baden-Wuerttemberg's tax-supported debt 
will gradually decrease in absolute and relative terms. Nevertheless, we 
regard as negative the large amount of unfunded pension liabilities and other 
post-employment benefits, for which the state calculated an actuarial value of 
363% of operating revenues in its first annual report published for 2017. 
Baden-Wuerttemberg has curtailed mounting pension payments by annually 
contributing to two pension funds. We do not deduct either fund from the 
pension provisions because of their small size compared with pension 
provisions and the pension funds we use in our liquidity assessment. In our 
view, the high level of unfunded pension liabilities could pressure future 
budgetary flexibility through increased annual pension payments, but 
Baden-Wuerttemberg has partly resolved this issue by accumulating pension 
funds. In our opinion, unfunded pension liabilities do not compete with credit 
market debt in a stress case, due to the timing differences (monthly pension 
payments versus fixed maturity dates).

Baden-Wuerttemberg's contingent liability burden is stagnating in our opinion 
and lies below 15% of operating revenues, which is average in an international 
comparison. The burden predominantly stems from the state's guarantees for 
Landeskreditbank Baden-Wuerttemberg - Foerderbank and its ownership of LBBW, 
excluding liabilities grandfathered for LBBW. The overall amount of contingent 
liabilities, which implies various risks, also includes potential 
recapitalization needs at LBBW in an 'A' type stress scenario (under which GDP 
declines by as much as 6%, unemployment rises as high as 15%, and the stock 
market drops by up to 60%; see "Understanding S&P Global Ratings' Rating 
Definitions," published June 3, 2009, on RatingsDirect). We do not expect any 
other material risks from Baden-Wuerttemberg's participations in institutions 
and companies.
We work across the world

From London to San Francisco, to our home base in (Saint Helier) Jersey, we’re looking for extraordinary and creative scientists to help us drive the field forward.

Disclaimers: AC Investment Inc. currently does not act as an equities executing broker or route orders containing equities securities. All data and information is provided “as is” for personal informational purposes only, and is not intended for trading purposes or advice. Please consult your broker or financial representative to verify pricing before executing any trade.

77 Massachusetts Avenue Cambridge, MA 02139 617-253-1000 pr@ademcetinkaya.com