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

  • Germany's recent economic strength and a supportive institutional framework have enabled the State of Saxony to produce a sizable surplus and add to its reserves in 2018.
  • Observing an increase in expenditure and mobilization of reserves before the state election in 2019, we forecast minor, temporary deficits after capital accounts for 2019 and 2020, before Saxony returns to positive results and further reduces its very low debt.
  • We are affirming our 'AAA/A-1+' ratings on Saxony and maintaining our stable outlook.
On March 22, 2019, S&P Global Ratings affirmed its 'AAA' long-term and 'A-1+' 
short-term issuer credit ratings on the German State of Saxony. The outlook 
remains stable.

We believe that, despite a temporary increase in expenditures, Saxony will 
continue to display a very strong budgetary performance with, on average, 
small surpluses after capital accounts. In consequence, the state's already 
very low debt should reduce further from 2021. We assume tax revenue growth in 
Germany will remain resilient and that the reorganization of the national 
fiscal equalization scheme from 2020 will support Saxony's fiscal performance.

Downside Scenario
Any negative rating action on Saxony would require a substantial deterioration 
of several factors that determine the state's stand-alone credit profile 
(SACP). With Saxony's SACP at the same level as the long-term rating, 
additional uplift due to potential extraordinary credit support from other 
German states and the federal government is currently inconsequential, but 
acts as a buffer against a downgrade. We therefore consider a downside 
scenario for the rating to be highly unlikely in the near term.

Saxony has used the fiscally very strong years, 2017 and 2018, to transfer 
unused budgetary headroom for expenditures to accounting reserves. Responding 
to political criticism for focusing excessively on generating surpluses and 
thereby having neglected necessary spending, the state's current two-year 
budget now aims to increase operating and capital expenditure, partly by 
mobilizing previously created accounting reserves. Accordingly, we forecast a 
temporary softening of Saxony's nonetheless still very strong budgetary 
performance. We predict minor deficits after capital accounts for 2019 and 
2020, before the state again posts surpluses from 2021. 

Saxony plans to initially fund the increased expenditure volumes by using 
almost all of its €1 billion of cash held at the beginning of this year, and 
will likely tap the capital market only in 2020, for the first time in several 
years. In any case, we believe the state's unquestioned access to 
capital-market and other funding will ensure that its liquidity position 
remains outstanding.

Our ratings rest on Saxony's debt position, clearly one of the lowest among 
the German states; a very supportive institutional framework that tops up 
Saxony's still comparatively lower tax revenues with significant equalization 
payments; and an economic environment that we assume will stay resilient, 
despite weaker growth prospects.

We consider it likely that Saxony would benefit from extraordinary credit 
support from the federal government or other German states in a stress 
situation. We would normally therefore apply a one-notch uplift to Saxony's 
SACP, but since our SACP assessment is already 'aaa', this currently has no 
effect on the rating.

The institutional framework, economy, and financial management remain key 
structural strengths. 
Saxony benefits from the overall strength of the German economy. We estimate 
Saxony's 2018 regional GDP at close to €31,000 (equivalent to about $36,500), 
roughly 75% of the German average, and we forecast this gap will remain for 
the foreseeable future. However, thanks to the state's close integration into 
the national economy and its long-standing history of industrial production, 
we anticipate growth in Saxony will closely follow that of Germany. Saxony has 
attracted a fair share of corporate activity since Germany's reunification, 
and in February 2019 it posted a comparatively low unemployment rate of 6.0%, 
according to the national definition. Its two largest urban centers, Dresden 
and Leipzig, are thriving and their populations are expanding. 

Germany's federal fiscal architecture, with its extensive tax-revenue sharing 
among states and the federal government, continues to provide Saxony with an 
extremely supportive institutional framework. It ensures that the state 
directly participates in the recent strong growth in national tax revenues, 
rather than being confined to the volume of tax revenues generated on its own 
territory. Before the publication of Saxony's final figures, we estimate that 
the state obtained about €4 billion in tax-resource-dependent transfers from 
the equalization system in 2018, in addition to almost €1 billion of fixed 
supplementary federal grants earmarked for infrastructure development. 
Together, these payments amount to more than 25% of Saxony's operating 
revenues, demonstrating the beneficial nature and importance of the 
equalization system for Saxony. Significant structural changes of the system 
will take place in 2020, but will not have any negative impact on the state, 
in our view. 

We do not consider Saxony's revised approach to financial management, with a 
slightly reduced focus on consolidation, to constitute a meaningful relaxation 
of the strong fiscal discipline it has so far applied. The deliberate 
expenditure increase budgeted for 2019 and 2020 has to be evaluated in the 
context of the upcoming state election, scheduled for Sept. 1, 2019. A strong 
showing of the right-wing AfD party in the 2017 federal election and in recent 
polls, combined with audible criticism of having neglected required 
expenditures by focusing excessively on creating budgetary surpluses, has 
caused the ruling coalition of the conservative and social democratic party to 
modify its fiscal policy. 

It assembled numerous individual measures under the common umbrella of a 
multi-year program of operating and capital expenditures, labeled "Our plan 
for Saxony". Components include, for example, improved employment conditions 
for teachers, additional police officers, and larger transfers to 
municipalities. Additionally, the state's administration aims to access the 
various accounting reserves, largely created from the surpluses of 2017 and 
2018, to temporarily channel a significantly increased volume of funds into 
infrastructure investments during 2019 and 2020, while formally still adhering 
to the current zero-deficit legislation. However, since Saxony is, in essence, 
spending only what it provisioned in previous periods, we believe it will 
continue to display a very prudent and conservative approach to financial 

Saxony's frugal use of fiscal resources in the recent past and its established 
practice of transferring unspent budgetary capacity to accounting reserves for 
future expenditures have, in our view, afforded it stronger budgetary 
flexibility than its relatively limited ability to unilaterally modify its 
revenues and expenditures suggest if viewed in isolation. 

Debt reduction will continue, despite temporary deficits due to planned 
spending increases.
Budget execution data for 2018 confirms another very strong year for Saxony, 
with the operating margin at 14.1% and the balance after capital accounts at 
6.7% of operating revenues. This significant outperformance of budgetary 
targets stemmed from tax and tax-related revenues exceeding the fiscal plan by 
€664 million.

For 2019 and 2020, however, we now predict Saxony will post minimal deficits 
after capital accounts of 1.7% and 1.4%, respectively. This is a moderate 
downward revision of the forecasts made in our last review (see "Ratings On 
The German State of Saxony Affirmed At 'AAA/A-1+'; Outlook Stable," published 
March 23, 2018, on RatingsDirect) and takes into account the increase in 
planned expenditures. Our approach to calculating budgetary performance is 
cash flow focused and aims to consolidate the budget's interaction with about 
20 accounting reserve vehicles ("Sondervermögen"), which add a certain 
complexity to the financial data. We believe that Saxony's targeted higher 
operating spending will reduce operating margins to about 12%. However, the 
predicted small deficits after capital accounts are primarily the result of 
the state's plan to mobilize significant accumulated accounting reserves to 
increase capital expenditure, for example on broadband infrastructure. For 
2021, we assume a more moderate volume of capital expenditures, which should 
ensure Saxony's return to small surpluses after capital accounts.

We believe that Saxony will further reduce its already very low outstanding 
debt in 2019-2022. Based on attributable debt, amounting to just above 20% of 
operating revenues in 2018, Saxony continues to rank alongside Bavaria as the 
least indebted German state. It did not need to borrow at all in 2017 and 
2018, and has no plans for meaningful debt issuance before 2020. 

The recent push to admit more teachers to the coveted civil-servant status has 
increased the present value of Saxony's pension obligations to about €16 
billion as of year-end 2018. At the same time, the state has accumulated more 
than €7 billion of assets in a separate, externally managed pension reserve. 
It continues to fund the reserve with about €600 million per year and will 
replace the remaining €2 billion self-issued "Schuldschein" loan certificates, 
still held by the pension account, with third-party assets over the next four 
years. We therefore anticipate that Saxony's unfunded pension obligations will 
decline gradually.

Saxony held about €1 billion of liquidity at the beginning of 2019, which more 
than fully covers €632 million of debt maturing this year. However, we 
understand that, to fund the projected budgetary expenditures and debt 
repayments, the state's treasury intends to reduce its cash holdings to 
practically zero by year-end 2019 rather than borrow in the capital markets. 
While this is likely to reduce Saxony's debt-service coverage ratios, we 
believe the state's reliable access to institutional money and capital 
markets, back-up bank credit lines, and ability to source liquidity from other 
levels of government will still ensure its outstanding liquidity.

Saxony's contingent liabilities predominately stem from its guarantee of 
promotional bank and development agency, Saechsische Aufbaubank. We regard the 
risk from this guarantee as low, given the bank's strong risk profile and very 
sound capitalization. Contingent liabilities implied by other participations 
and yearly losses from other guarantees are minimal. We are not aware of any 
financially significant litigation risk for Saxony.
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