Credit quality among non-U.S. regional and local governments (LRGs) is demonstrating its resilience to the weakening global economy, in the view of S&P Global Ratings. That would be reason for cheer at any time, yet it is particularly welcome given expectations that LRGs will have to increase spending over the next 12-18 months to counteract higher-for-longer inflation and tighter labor markets.

We expect LRGs' financial strength to persist and is forecasting only a modest weakening of average budgetary performance, leading to a short-lived uptick in debt that should plateau in 2025.

Chart 1

Ongoing Strength With Greater Volatility

The positive trend for LRG creditworthiness is gradually losing momentum. We raised more than 30 ratings annually in each of 2021 and 2022. In the first half of this year, we have raised only 8 ratings. Moreover, the number of downgrades has exceeded the number of upgrades and has already surpassed the number of downgrades in each of the previous two years. Yet it is skewed by actions take in Latin America where a lower transfer and convertibility assessment of the sovereign led us to downgrade nine Argentinian provinces. Meanwhile, upgrades mainly took place in developed Europe (see chart 2).

Chart 2

Ratings volatility is also set to increase over the next two-to-three years. The share of our ratings with stable outlooks on LRGs has fallen to the lowest level since 2015 (excluding pandemic 2020), with the share of negative outlooks slightly outweighing positive outlooks for the first time since 2021 (see chart 3). More than half of the negative outlooks are on issuers in Argentina and France, where financial pressure on central governments is weighing on LRGs credit worthiness.

Chart 3

We acknowledge some headwinds for New Zealand district councils. Ratings on four of them have negative outlooks and another rating has been placed on CreditWatch Negative. That move was prompted by their decision to embark on large development programs that will lead to rapid debt accumulation. We will also be watching to see if the implementation of the so-called 'three waters reform' on municipal finance, will lead to additional pressure on our ratings on New Zealand local governments. We expect the reform will alter the DNA of the country's local council sector by transferring management of key water services from local councils to new water services entities, though important details such as the debt transfer mechanism are yet to be disclosed (see "Pipedream Or Panacea: Report Examines New Zealand's "Three Waters" Reforms," published Feb. 28, 2023).

Elsewhere we expect a series of positive trends affecting LRGs to continue to offer support to credit quality:

• In Mexico, we see a growing positive trend on a number of LRG ratings as liquidity pressure and reliance on short-term debt eases.
• In Brazil, many states entered 2023 with strong budgetary positions thanks to extraordinary federal support and higher than expected tax receipts. That strength could be enhanced by proposals to reform Brazil's dual-VAT system, which we view as potentially positive for growth. The proposal also includes compensation mechanisms for LRGs' lost revenues. In general, implementation is likely to be slow.
• In Switzerland, cantons and municipalities should continue to benefit from very strong economic resilience, which is translating into higher-than-expected fiscal revenues, even though they might not receive profit distributions from the Swiss National Bank (SNB) until 2025 at least.
• The Spanish autonomous communities' credit profile is particularly supported by a solid economic performance and the availability of EU funds. We have recently raised ratings on two Spanish LRGs and revised one outlook to positive from stable.
• Croatia is benefitting from the positive momentum created by EU and eurozone accession. This is reflected in our recent revision of the trend for the institutional framework under which Croatian LRGs operate, which we changed to improving, as well as the positive outlook on our rating on Croatia's capital Zagreb.

Chart 4

Financial Management To The Fore

We expect financial management will reemerge as a key differentiating factor among LRGs, with risk appetite particularly influencing creditworthiness, especially in developed markets. This could be most evident in federal countries with loose fiscal policy at the sub-national level.

As such, the ratings on the Canadian province of British Columbia, the Belgian region of Brussels-Capital, the Australian Capital Territory, and South Australia all have negative outlooks as we consider that their budgetary performance might not recover to a reasonable degree (see "Province of British Columbia Downgraded To 'AA' From 'AA+' On Record Spending; Outlook Negative," published April 18, 2023, "Belgian Region of Brussels-Capital 'AA-/A-1+' Ratings Affirmed; Outlook Remains Negative," published March 24, 2023, "Australian Capital Territory 'AAA/A-1+' Ratings Affirmed; Outlook Remains Negative," published Nov. 10, 2022, and "South Australia 'AA+/A-1+' Ratings Affirmed; Outlook Negative," published Aug. 30).

We also believe that tighter fiscal policy in the Canadian provinces of Ontario and New Brunswick could result in a stronger financial performance and lower debt burden than currently projected (see "Province of Ontario Outlook Revised To Positive From Stable On Strong Budgetary Performance; 'A+' Ratings Affirmed," June 6, 2023, and "Province of New Brunswick Outlook Revised To Positive From Stable, 'A+' Rating Affirmed On Strong Finances," published May 18, 2023).

Table 1

Budgetary Performance Will Weaken Until 2024

Average budgetary performance is likely to dip, albeit modestly, until 2024 due to a combination of persistent inflation on operating spending, higher wages and interest payments, the funding of large unaddressed investment needs, and the economic slowdown (see chart 5).

Chart 5

Higher investment spending needs and substantial inflationary pressures in the construction sector, especially for Canadian provinces, Australian states, and (to a lesser extent) Chinese and Indian LRGs, mean they will continue to maintain relatively large deficits after capital accounts over our forecast horizon.

German states and Canadian provinces are likely to launch programs to secure some consolidation from 2025 onward (see chart 6).

Chart 6

We project debt burdens will increase for most entities before plateauing in 2025 when resumed economic growth will boost revenues (see chart 7).

Chart 7

Australian states' and Chinese provinces' debt burdens will continue to increase, and notably at a faster rate than among German states and Canadian provinces (see chart 8). In China, investment-driven stimulus will continue to support strong economic growth and revenue recovery. It is notable that borrowing by Chinese provinces is largely onlent to lower-tier LRGs. This inflates the provinces' debt metrics and should be taken into account when making comparisons with other LRGs.

In Canada, provincial debt will level off despite sizeable capital deficits. This is supported by significant borrowing in 2020 and, comparatively strong revenue growth.

Elsewhere, low-rated emerging market LRGs may find it especially difficult to maintain access to debt markets. International capital markets are effectively closed to Argentina's provinces, and recently announced restrictions on dollar access. This presents a further challenge to their ability to service debt on bonds that were restructured in 2021. (See "Argentine Provinces Try To Avoid Default After Latest Capital Controls," June 14, 2023).

Chart 8

LRGs Are Generally Vulnerable To Property Market Corrections

The real estate sector typically contributes a large portion of local economic growth and a chunk of LRGs' revenue, especially in large urban centers. Proceeds from land and other asset sales, and from real estate transaction fees tend to be volatile and the resulting revenue is likely to follow market trends. LRGs that are largely dependent on that revenue (see chart 9) can be quickly affected by lower valuations and a reduced number of transactions. Recurring property taxes and other taxes from the real estate sector tend to be less volatile, yet lower property prices can still negatively affect revenue from these sources over time, or lead to higher tax burden on residents and businesses. We also take into account LRGs' indirect exposure, which comes through taxes on the real estate sector (e.g., corporate income tax).

Chart 9

Wage Increases Are Eroding Budgetary Flexibility

Tight labor markets and the rising cost of living are leading to widespread wage increases in the public sector, albeit with some delay, especially in developed markets such as Australia, Canada, and Germany (see "New German Municipal Wage Deal: Expensive But Still Manageable," published May 22, 2023). In some countries, including Belgium and France, public sector wages are automatically adjusted to inflation, which has already contributed to downward pressure on our ratings. In other countries, such as Italy and Spain, the inflation's effects are primarily felt through higher costs of goods and services on the balance sheet of LRGs.

Larger-than-planned wage bills could constrain budgetary flexibility over the next three to five years, and possibly longer, as they have historically proven hard to cut. We anticipate German states will experience a substantial increase in their wage bill following the upcoming renewal of collective agreements with public sector employees due later this year. Similar collective agreements have been updated in Austria, Spain, and among the German municipalities, while Canada's provinces and municipalities are budgeting for rising costs.

On a positive note, many governments are entering these negotiations from a position of financial strength, meaning that increases may have only a marginal impact on their credit quality. Moreover, central governments in many Central and Eastern European (CEE) countries and Italy regulate government wages and transfer payment changes to LRGs.

Elevated Interest Rates May Pressure Operating Performance

We expect interest rates to remain elevated over the medium-term due to monetary policy tightening almost everywhere, except for China and Japan. In the shorter-term, the higher interest costs will impact most LRGs with relatively significant funding needs, via the maintenance of large deficits or due to significant amounts of debt coming due (see chart 10). In China, Provinces' interest payments include onlent interest expense relating to lower-tier LRGs, leading to comparatively inflated metrics.

Chart 10

The longer interest rates remain elevated the more LRGs will feel the pressure of high interest expenses, which will outweigh the benefits of gradual debt amortization, more than we currently project. We expect Australian states, Canadian provinces, and Spanish regions will experience the most significant increases in interest spending in this scenario in the medium term. Australian entities and Canadian provinces would particularly suffer from higher-for-longer interest rates due to their already significant debt burden and high deficits over the coming years. While Spanish regions' interest spending should also increase, it will likely be to a lesser extent due to their steady efforts to lower future funding needs through gradual budget consolidation (see "Subnational Debt 2023: The Best-Placed Local And Regional Governments To Handle Rising Interest Rates," published March 2, 2023).

Volatile Weather Will Test LRGs' Climate Change Resilience

The increasing volatility of the weather will put pressure on many LRGs to renew infrastructure to ensure baseline services. They may also face increasing costs to insure assets against losses from climate-related disasters, or to adapt to chronic pressure from drought or water stress. The costs of investments in adaptation, insurance, and other mitigation efforts could impact entities' budgetary performance or debt assessment, for example through increasing leverage or capital outlay to improve infrastructure. Furthermore, underinvestment in infrastructure, particularly when frequent disasters are a concern, could signal a deterioration in credit quality and affect long term economic growth prospects.

Water stress poses a chronic risk to LRGs' economic productivity, as well as to populations. LRGs in parts of Mexico, Spain, Italy, and Bulgaria all have high exposure to water stress. Furthermore, we consider that the economic structure of some areas may increase their vulnerability to water stress (see "More Mexican States May Face Water Stress by 2050," published April 4, 2023).

Higher levels of government have historically shouldered a large share of the cost of disaster recovery and financing resilience, although that may be changing. For example, recent wildfires in Canada have prompted debate over reforms to the federal mechanism that provides emergency disaster aid to provinces and territories. A proposed reform would increase investment in disaster risk reduction and make provinces and territories more accountable for improving disaster resilience. Depending on the details, the reform could ultimately affect Canadian provinces' and municipalities' credit vulnerability to natural disasters.

Tighter Fiscal Frameworks May Constrain Efforts To Address Demographic And Climate Challenges

Efforts to address demographic and climate challenges could be hampered by a combination of the lengthy planning and investments horizon for infrastructure projects and post-pandemic tightening of the limits on budget deficits. We particularly expect debate over, and actual changes to, institutional frameworks in countries where national governments set very prescriptive fiscal rules for LRGs.

For instance, changes could emerge in the EU, where the ongoing reform of the Stability and Growth Pact, whatever its result, may spur changes to national legislation. Absent of changes in domestic laws, we expect real-term capital spending by rated EMEA LRGs to remain muted over our forecast horizon (see chart 11). That fall in investments will result from lower projected operating balances and tighter limits on deficits--even though LRGs in southern European and CEE could benefit from NextGenerationEU funding grants in the near term.

Chart 11

China has no explicit fiscal rules that determine budgetary deficits, yet the central government looks at certain financial indicators when setting annual borrowing for Tier-1 governments. We understand that some Chinese LRGs are already breaching the soft guidance on acceptable debt thresholds. That is likely to constrain further debt increases in the near future, beyond what we currently project.

Further Decentralization Is Likely

In response to increasing financial pressure, we expect to see a trend toward the decentralization of the provision of public services. That shift might improve service efficiency but it could also weigh on LRGs' budgetary performance, particularly if delegated revenue sources fail to cover new costs.

The pros and cons of decentralization has become a serious and regular subject of public policy debate in large European unitary states. That is notably the case in France, Italy, and the U.K., where political parties have proposed different options, most of which seem united in a willingness to delegate more responsibility to LRGs.

So far, Italy has taken the most decisive steps in that direction, in the form of the government's draft law on regional decentralization (see "Italy's Decentralization Push Unlikely To Affect Budgets But Could Broaden Regional Differences," published April 5, 2023). We believe that Italy's lead will prove to be part of a wider trend. If that is the case, it could be a shift that reshapes LRGs roles (and perhaps budgets) across major unitrary countries, and which has the potential to spread beyond Europe's borders.

Related Research

• Argentine Provinces Try To Avoid Default After Latest Capital Controls, June 14, 2023
• New German Municipal Wage Deal: Expensive But Still Manageable, May 22, 2023
• Italy's Decentralization Push Unlikely To Affect Budgets But Could Broaden Regional Differences, April 5, 2023
• More Mexican States May Face Water Stress by 2050, April 4, 2023
• Institutional Framework Assessments For Local And Regional Governments Outside Of The U.S., March 22 2023
• Subnational Debt 2023: The Best-Placed Local And Regional Governments To Handle Rising Interest Rates, March 2, 2023
• Pipedream Or Panacea: Report Examines New Zealand's "Three Waters" Reforms, Feb. 27, 2023
• Global Ratings List: International Public Finance Entities 2023, Jan. 9 2023