German State of North Rhine-Westphalia 'AA-/A-1+' Ratings Affirmed; Outlook Positive

  • We believe that North Rhine-Westphalia (NRW) is well positioned to reduce its still very high debt burden and contingent liabilities, backed by solid tax revenue and balanced accounts.
  • That said, Germany's planned exit from brown coal-based energy production might challenge the state's economy.
  • We are affirming our 'AA-/A-1+' issuer credit ratings on NRW.
  • The positive outlook reflects our view that the state might reduce contingent liabilities more quickly than we currently envisage.
On March 15, 2019, S&P Global Ratings affirmed its 'AA-/A-1+' long- and 
short-term issuer credit ratings on the German state of North Rhine-Westphalia 
(NRW). The outlook is positive.

We also affirmed our 'AA-' long-term issue ratings on NRW's senior unsecured 

The positive outlook reflects our expectation that NRW might reduce contingent 
liabilities more quickly than we currently envisage while maintaining its 
consolidation path. 

We would raise the ratings by one notch if a reduction in NRW's contingent 
liabilities leaves the state with a lower share of losses from its bank 
wind-down unit Erste Abwicklungsanstalt (EAA), and at the same time a future 
major recourse to state funds seems less likely. 

Downside scenario
We would consider revising the outlook to stable if the state deviates from 
balanced accounts from 2020, as required by the German debt brake law. In 
addition, if NRW were to lose its currently strong access to the capital 
markets, we would consider a downgrade.

The legacy of a failed state bank continues to weigh on our ratings on NRW. At 
the same time, currently high tax revenue is enabling NRW to improve its 
budgetary performance, although this may become challenging in light of 
reduced GDP growth forecasts in Germany following increasing geopolitical 
risks. NRW benefits from the updated interstate tax-equalization system, which 
will provide the state with additional tax revenue from 2020. The state 
government plans to refrain from net new borrowing, and aims to nominally 
reduce its debt burden from 2019. NRW depends on access to the capital 
markets, because its coverage ratio for maturing debt is low, but increasing.

NRW benefits from the updated tax-equalization system
We view the institutional framework in which German states operate as one of 
the most predictable and supportive in the world. NRW is currently a net 
receiver of the interstate tax-equalization system, but will be a donor from 
2020 under the new system, which includes value-added tax (VAT) into 
equalization calculations. That said, NRW has always been a donor state when 
including the equalization of VAT receipts. The equalization of revenue also 
protects the state from shocks to its revenue base that are above average for 
German states; for example from the impact of Brexit or U.S. tariffs on the 
automotives sector, which might place a greater economic burden on NRW than 
other German states. Higher federal government contributions and the change in 
the equalization system will grant NRW additional revenue of about €1.5 
billion per year (about 2% of operating revenue). 

We consider it likely that NRW would benefit from extraordinary credit support 
from the federal government or other German states in a stressed situation. 
The federal treasury or other state treasuries could quickly invest cash 
holdings in NRW without needing additional legislation. This lending would 
qualify as a cash investment on the lenders' side and not as a state transfer 
(we would define the latter as extraordinary systemic support). We therefore 
factor an additional notch of support into our ratings on NRW.

NRW entered a long-term consolidation path to achieve structurally balanced 
accounts by 2020 at the latest, as required by the German debt brake. Its 
financial management emphasizes "consolidation, modernization, and 
investments" as goals for the current legislation period (until 2022). In late 
2018, NRW passed a financial plan without net new borrowing, and aims to 
nominally reduce the debt burden from 2019. We view this plan as achievable, 
given currently sound tax revenue and the state's commitment to contain 
expenditure growth, but note that the amount of "unspecified savings" is still 
considerable and requires ongoing intraannual savings. NRW's budgetary 
procedures are clear, established, and have regular review cycles, and NRW 
competently manages its debt portfolio. 

NRW's economy is very broad and well diversified, and we expect GDP per capita 
of $47,000 in 2018 (equivalent to about €40,000), which is just slightly below 
the German average ($48,500 equivalent to about €41,000). Because of the 
tax-equalization system, NRW benefits only indirectly from its wealthy 
economy. Given that most of NRW's tax revenue is subject to equalization and 
that NRW's economic growth usually follows national patterns, we base our 
assessment of the economy on national GDP per capita for all German states. We 
expect Germany's real GDP growth will slow by 2021 from an estimated 1.8% in 
2018. Of the 50 largest German companies by revenue, 20 have their 
headquarters in NRW, which highlights the state's economic strength and 
importance. The state contributes about one-fifth of Germany's GDP. 

The region's economy is transitioning into more service-based sectors after 
two centuries of being dominated by hard coal mining and steel production. 
Germany's planned exit from brown coal-based energy production is placing 
additional pressure on NRW to transition away from these industries. The 
federal government has agreed to assist NRW with economic development funding 
through 2038, but we still consider that this shift could present economic 
challenges for the region in coming years. Unemployment is moderate by 
international standards and declining, although it's still well above the 
national average (6.7% in January 2019 against a national average of 4.9%).

The region is well prepared for the ban on net new borrowing, but legacy 
issues remain
In our view, NRW's budgetary performance is sound and improving. Its 
preliminary accounts suggest that it closed 2018 with a surplus after capital 
accounts. We expect operating surpluses will steadily increase to 9.0% of 
operating revenue by 2022. Through 2022, we also expect balanced accounts 
after capital expenditure (capex) on average, building on solid tax revenue 
and contained expenditure growth, and depending on ongoing consolidation 
efforts and budgetary discipline to realize unspecified savings. Contrary to 
the state's financial planning, we include transfers to outsourced entities in 
our base-case scenario over the next three years, and adjust revenue downward 
for our latest economic growth expectations, which reflect increased 
geopolitical risks like Brexit. We have included additional funds in capex to 
cover losses at its bank wind-down unit EAA. We have also incorporated in our 
base-case scenario our assumptions regarding the effects of federally 
discussed measures like the provision of additional funds for the 
digitalization of schools and subsidies for energy transition.

We regard the state's budgetary flexibility as low. German states have only a 
few modifiable revenues, such as fees and tax revenues, and all tax rates, 
except the real estate transfer tax, are set at the federal level. Most tax 
revenue can only be modified--either up or down--if states combine their 
efforts in the Bundesrat, but a majority of the states must vote the same way. 
In addition, the state has a relatively low share of capex. We therefore 
expect that NRW would create room to maneuver in case of need by exercising 
its legislative power to influence spending in addition to cutting 

NRW's liquidity position is strong due to proven access to capital markets. 
NRW redeems a high level of debt every year, and we note that about €14 
billion-€18 billion (including short-term debt) is scheduled to mature by 
2022. Including interest payments, the share of debt service is consequently 
high, at about one-third of adjusted operating revenue. NRW employs a 
zero-cash strategy, and has limited cash holdings throughout the year. 
Debt-service coverage is low, since net free cash and liquid assets cover 
slightly more than 40% of the next 12 months' debt service. As liquid assets, 
we take into account parts of the pension fund assets, which we consider to be 
last-resort liquidity available to the state that NRW is willing to use. We 
expect that the overall coverage ratio will increase in the next few years 
because of the dual effect of an increasing pension fund and a decreasing debt 
burden. Nonetheless, the low coverage ratio leaves the state dependent on its 
access to capital markets. NRW is a regular issuer of private placements and 
benchmark bonds in 18 different currencies. Like all German states, NRW 
benefits from strong access to capital markets, as well as access to 
short-term funding from the German federal treasury and intraday access to 
Bundesbank funds.

NRW is one of the most indebted local or regional governments we rate 
worldwide, with an estimated direct debt stock of €142 billion in 2018 (€140 
billion in capital market debt and debt to public sector plus €1.9 billion in 
short-term debt). NRW's tax-supported debt, including the debt of 
non-self-supporting entities, is decreasing, and we expect it will drop below 
200% of operating revenue by 2020 from its 2010 peak of 306%. The closing of 
net new borrowing needs and, more importantly, a larger budget, have helped 
the state reduce its debt burden in relative terms, and this trend should 
become more pronounced with nominal debt reduction from 2019. In our base-case 
forecast for NRW's tax-supported debt, we include parts of the EAA guarantee 
because we consider it highly likely that NRW will help cover EAA's portfolio 
losses. We also add the credit market debt of the Bau- und 
Liegenschaftsbetrieb, a non-self-supporting entity, and an NRW.Bank 
prefinanced school investment program to tax-supported debt.

In our view, NRW's high pension obligations and other postemployment benefits 
weigh on its indebtedness further. Pensions are paid on a pay-as-you-go basis 
and are almost completely unfunded. We estimate that pension liabilities 
amount to slightly less than 300% of operating revenue, limiting NRW's 
long-term budgetary flexibility. NRW holds a pension fund, which amounted to 
about €12 billion (16% of operating revenue) as of 2018. In our view, this 
fund does not counterbalance high pension liabilities, but should ease the 
peak in pension payouts over the next few years.

The state's contingent liabilities stem from the former state bank's wind-down 
unit EAA as well as what we see as riskier guarantees and the sheer size of 
guaranteed debt, albeit mostly at self-supporting entities such as NRW.Bank. 
EAA has only limited equity and equity drawing rights of about €1 billion and 
relies on guarantees from NRW and others. The overall wind-down portfolio 
continues to decline substantially each year, and stood at €42.9 billion as of 
third-quarter 2018. Its inherited derivatives portfolio has also reduced 
substantially. It remains to be seen if the remaining parts of EAA will wind 
down without major recourse to funds from the state.
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