Outlook On Spain's Autonomous Community of Valencia Revised To Stable From Positive; 'BB/B' Ratings Affirmed

  • The Autonomous Community of Valencia posted weaker budgetary results in 2018 than we anticipated, deviating from the previous trend of budgetary consolidation.
  • We now expect the region to maintain high, albeit declining, deficits over our forecast period through 2021, absent any structural reform to the regional financing system.
  • In our opinion, Spain's central government will continue to give Valencia sufficient and timely liquidity support to meet its debt refinancing needs and finance its deficits.
  • We are revising our outlook on Valencia to stable from positive and affirming our 'BB/B' ratings.

Rating Action

On May 24, 2019, S&P Global Ratings revised its outlook on the Autonomous Community of Valencia to stable from positive, and affirmed its 'BB/B' long- and short-term issuer credit ratings on the region.

Outlook

The stable outlook on Valencia reflects our expectation of continued central government support for the region, which in our view mitigates the risks arising from Valencia's high deficits and very high levels of indebtedness.
Downside scenario
We could downgrade Valencia if we expected the region to increase expenditure in a way that would lead to materially widening budgetary deficits, which could bring into question the regional government's commitment to budgetary consolidation.
Upside scenario
We could upgrade Valencia if the central government wrote off a substantial portion of the loans it lent to the region. We would not consider debt relief from the central government a default, given our view of Valencia's debt with the central government as intergovernmental debt.
We could also upgrade Valencia if the region's budgetary performance materially improved, signaling a renewed commitment to budgetary consolidation, so that we forecast deficits after capital accounts structurally below 10% of total revenue.

Rationale

The outlook revision reflects our view that there is now a lower likelihood of Valencia outperforming our base-case scenario and structurally improving its budgetary performance. We currently expect the region will continue posting sizable negative operating balances and only slightly declining deficits after capital accounts during our forecast period through 2021.
Valencia increased its operating deficit to 8.4% of operating revenue in 2018, from 4.4% in 2017. This followed lower revenue growth than the region expected, coupled with higher expenditure growth than we anticipated, as the region tries to catch up with the Spanish average in terms of per capita spending on essential social services. Valencia's budgetary performance suffers from the region's continued below-average funding compared with other Spanish normal-status regions.
Despite the challenges that the regional financing system poses for Valencia, we expect the region's revenue will continue to expand, driven by Spain's (and Valencia's) ongoing economic recovery. Despite relatively high deficits, this should allow Valencia to stabilize its very high debt burden. In our previous base case, we envisaged a slight deleveraging in relative terms.
At the same time, the rating affirmation reflects our view of the strength and reliability of central government liquidity support, which we expect will continue to be available to Valencia as required through our forecast horizon to 2021.
Valencia benefits from a supportive framework, but the regional financing system is not favorable to the region
We believe that the Spanish institutional framework under which Valencia operates is generally supportive. Spain's central government provides financial support to the regional tier via liquidity facilities that were first created in 2012. These facilities have gradually evolved to meet practically all of the funding needs of those regions that adhere to them, including Valencia, on very favorable terms. From 2012 to March 2019, the region received about €43 billion from these liquidity facilities, and an additional €8.8 billion to finance supplier payables between 2012 and 2014. About 83% of Valencia's debt at year-end 2018 is due to the central government's liquidity facilities.
However, we think that the regional financing system still suffers from weaknesses. In our view, the main drawback is the difficulty in matching revenues and expenditures, especially at low points of the economic cycle. Reform of the system is overdue, in our view. While technical analysis has advanced, with several proposals on the table from experts and regions, we understand the current electoral cycle (with national and regional elections in 2019), as well as a generally fragmented political spectrum, has once again delayed the political negotiations that would be required to change the system. We therefore can't predict the timing or extent of a potential reform.
Overall, we continue to deem this reform as crucial to ensuring the long-term sustainability of Spanish regional finances. Given the comparatively very low levels of funding that Valencia receives from the current system, such a reform is even more urgent for the region.
With Spain's economic growth continuing (albeit at a gradually slower pace, according to our forecasts), and despite the absence of a new financing system, regions' revenues continue to expand, although in 2018 Valencia's growth was slower than other Spanish regions'.
Given the strong equalization component of Spain's public finance system for normal-status regions, we take national GDP per capita figures into consideration when evaluating the economy of such regions. We expect economic growth will translate into higher revenue for Valencia. However, we also factor in that Valencia's socioeconomic profile is less favorable than that of other Spanish regions. Valencia's GDP per capita is 87.5% of the national average, based on 2018 data from the national statistics office. The region's unemployment rate, at 14.3% of the active population, is now largely in line with the national average, but continues to be high in an international comparison. We believe that Valencia's relatively weak socioeconomic profile is not adequately compensated by Spain's equalization system.
Valencia has so far failed to comply with the official deficit targets set by the central government even though its deficit has materially shrunk since the crisis years. In 2014, Valencia posted a deficit of 2.6% of regional GDP, which has gradually fallen, reaching 0.82% of regional GDP by 2017. However, in 2018 the deficit climbed back up to 1.29%, against a target of 0.4%.
High deficits and very high debt burden remain long-term constraints
We expect Valencia to continue recording very weak budgetary performance, with a sizable operating deficit for the next three years, despite growing revenues. Nevertheless, we estimate operating deficits and deficits after capital accounts should gradually improve over the period.
We expect Valencia's revenue will continue expanding on the back of Spain's economic recovery. We assume an annual increase in operating revenue of 3.5%, on average, over 2019-2021, broadly in line with our projections of Spain's nominal GDP growth.
Valencia has included in its 2019 budget, as it did in previous years, about €1.3 billion of additional transfers from the central government as a way to request the reform of the regional financing system and offset the region's structural underfunding. However, the central government has yet to grant these amounts or overhaul the system, and we therefore do not include them in our assessments.
In our base case, we anticipate that Valencia's operating expenditure will increase by close to 3% annually over 2019-2021--below the growth rate of operating revenue. Consequently, we expect Valencia will reduce its operating deficit to close to 6.6% of operating revenue by 2021, from 8.4% in 2018. At the same time, we expect the region to only gradually reduce its deficit after capital accounts, to 10.6% of total revenue in 2021 from 13.3% in 2018.
In our view, Valencia's budgetary flexibility is weak, given the region's limited ability to cut expenditure. The region's operating expenditure per capita is already among the lowest in Spain, reflecting the region's relative underfunding. This largely explains the obstacles the region faces in reducing its deficits.
We expect Valencia will continue accumulating debt in nominal terms and therefore its debt will remain very high. Nevertheless, thanks to expanding revenue and gradually amortizing company debt, we estimate that tax-supported debt will stabilize at about 330% of consolidated operating revenue during our forecast horizon of 2019-2021.
We take into account that the central government is refinancing the region's long-term debt. Importantly, debt maturities of companies under the scope of European System of National and Regional Accounts (ESA)-2010 are eligible for central government funding as well. This mitigates the risk arising from Valencia's large stock of tax-supported debt, in our opinion.
In our view, the regional government's measures to streamline its public-sector companies and directly manage its debt limit the impact of these companies on Valencia's credit profile. We include all of the debt of Valencia's satellite companies in our calculation of tax-supported debt. Given the broad perimeter of consolidation, we believe Valencia has low contingent liabilities.

In our view, Valencia has very low capacity to generate cash internally because it still presents deficits after capital accounts. We understand that the region has slightly more than €2 billion of short-term facilities. We calculate that the average cash holdings and the unused portion of short-term facilities cover less than 40% of Valencia's debt service for the next 12 months, which we estimate at €5.7 billion. In our view, this low debt service coverage ratio is mitigated by Valencia's strong access to central government liquidity mechanisms. Our expectation that central government liquidity support will be sufficient and timely underpins our ratings on Spanish normal-status regions, including Valencia.
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