State of Minas Gerais Ratings Affirmed At 'SD'


Overview

  • The Brazilian state of Minas Gerais continues to transfer its debt service payment obligations to the central government through an existing guarantee payment mechanism. As of today's report, Minas Gerais hasn't confirmed if it cured defaults on two foreign currency denominated loans due March or debt service payments on another eight loans due April 15th.
  • Given the absence of a stated debt service grace period on Minas Gerais' loan contracts, and that we expect the sovereign guarantee mechanism to make payments beyond five business days, we affirm our ratings Minas Gerais at 'SD' (selective default) on its foreign and local currency debt obligations during the coming months.

Rating Action

SAO PAULO (S&P Global Ratings) April 16, 2019--S&P Global Ratings affirmed its global scale and national scale ratings on the state of Minas Gerais at 'SD'.

Rationale

The ratings on Minas Gerais reflect our opinion that it will continue to selectively default on its local and foreign currency debt obligations, given the current fiscal and liquidity weaknesses. We would only raise the ratings once the state presents a feasible and credible plan for a full and timely payment of all debt obligations.
During the past few years, Minas Gerais has posted weak fiscal results, in part due to lack of capacity to implement effective policies to control expenditures amid limited revenue growth. In 2018, the state reached a record deficit after debt repayment of R$10 billion or 14% of annual total revenue. Minas Gerais' new administration is planning to join Brazil's fiscal consolidation regime in exchange for broader support from the central government. Among other measures, adherence to the regime requires a pension reform and privatization of state assets. However, we expect Minas Gerais to show only modest progress on this front, and our base-case scenario estimates operating deficits around 8% of operating revenues and deficits after capital expenditures (capex) around 9% of total revenues in 2019-2021.
The fiscal consolidation regime, in our opinion, won't be enough to address Minas Gerais' fiscal malaise because its budgetary constraints are likely to remain for the next couple of years. Given that Minas Gerais' own-source revenues already cover slightly more than 80% of operating revenues, any future tax hikes will likely yield only moderate benefits. Conversely, the state's capex are extremely low, likely to remain at around 2% of total spending during 2019-2021, making further cuts unlikely. Therefore, addressing Minas Gerais' fiscal woes will be on the operating expenditure side, but significant cuts are unlikely in the next 12-24 months.
Given Minas Gerais' frequent debt service defaults, we don't expect the state to access new borrowings in 2019. Therefore, we expect a gradual reduction in its debt stock, trending towards 130% of operating revenues by 2022. Minas Gerais owes about 80% of its debt to the sovereign, while the remainder consists of commercial, development bank, and multilateral debt. If we we're to assume that Minas Gerais is current on all obligations, total interest burden would be around 5.5% of operating revenues, while debt service would represent around 10% in 2019-2021. Also, the state's pension deficit is higher than 100% of its operating revenues, and annual cost already represents 10% and is continuing to rise.
Minas Gerais' liquidity position is very weak, as seen in its frequent failure to meet all debt service obligations and substantial amount of payables. We estimate that the state's free cash is close to zero (gross cash is mostly committed to previous years' unfunded budget), while cash flow deficits estimated for 2019 result in a debt service coverage ratio of -20.5%. Minas Gerais' non-debt payables also rose to R$34.7 billion as of the end of 2018 from R$21 billion in 2017, or 48% of operating revenues, which leads us to believe that there could be also a significant amount of underestimated spending.
Minas Gerais has moderate contingent liabilities, the largest of which stems from several state-owned companies including Companhia Energetica de Minas Gerais - CEMIG (B/Stable/--) and Banco de Desenvolvimento de Minas Gerais S.A. - BDMG (B/Negative/--), which we consider self-supporting entities. In addition, the state has 10 public-private partnerships (PPPs) and we incorporate the contingent liabilities stemming from them in our analysis. If the contingent liabilities from the self-supporting entities and PPPs were to materialize, they would represent around 16% of the state's 2018 operating revenue.
Romeu Zema became Minas Gerais' governor on Jan. 1, 2019 (Partido Novo, 2019-2022) and currently faces a precarious fiscal and liquidity situation, and a very high debt level. The new administration is planning to take steps to strengthen the fiscal situation, such a recent agreement with the municipalities to address arrears on transfers, which would reduce the overall payables amount over time. Moreover, in addition to joining the fiscal consolidation regime, an administrative reform is in the works, aiming for a more efficient government structure. Nevertheless, the governing party has a relatively weak position in the state legislature, coupled with a very short track record of passing and implementing unpopular fiscal measures, which results in ongoing uncertainty about the administration's capacity to pass and implement reforms.
We estimate that the state's GDP per capita was $8,854 for 2018, compared with than Brazil's $7,785. Minas Gerais' economy generates around 8.7% of the national GDP. Most of the state's economy is based on the services sector, which accounts for a 58% share, while the manufacturing sector makes up 33%, and agriculture 9%. Minas Gerais posted a slightly better GDP growth in 2018, compared with 2017, and our base-case scenario assumes the state economy would grow in line with the sovereign's in 2019-2021.

In addition to Minas Gerais' structural imbalances, we believe that the intergovernmental system for Brazilian local and regional governments (LRGs) has prevented the latter from reaching a revenue-and-expenditure balance due to the system's intrinsic rigidities. Overall, our current assessment draws on our evaluation of an intrinsically rigid intergovernmental system that has failed to address LRGs' significant budgetary imbalances, and this isn't likely to change over the short to intermediate term. Therefore, these factors, in our view, have left LRGs unprepared to address key long-term spending trends and financing options. At the same time, we believe the system continues to have an adequate level of fiscal predictability and transparency, with enhanced central government oversight of LRGs' finances.
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