S&P Global Ratings expects most rated non-U.S. local and regional governments (LRGs) to withstand the projected economic downturn without a material impact on their creditworthiness. We forecast global growth to slow in 2024 driven by elevated interest rates. Moreover, cost pressures will likely persist next year, leading to weaker average budgetary performance and a moderate average increase in the debt burdens of LRGs.

We expect some easing of those constraints in 2025, though it is conditional on the evolution of macro conditions and especially geopolitical tensions. Weaker global inflationary and interest rate pressures should provide LRGs greater financial leeway to make strategic and previously deferred capital investments. We also expect structural changes to public finance systems in response to rising demand for public services and already high indebtedness.

Emerging risks, such as climate and cyber risks, are gaining in importance and their related costs are likely to increase from current levels.

Chart 1

Continued Rating Volatility And Increasing Negative Bias

The positive rating trend among LRGs has decelerated, with the number of upgrades and downgrades almost balanced in the second half of the year (see chart 2). Year-to-date we have raised the ratings on 18 LRGs--well below the number of annual rating upgrades in 2021 and 2022. Those upgrades occurred mostly in developed Europe (predominantly in Switzerland) and in Mexico. The number of downgrades closely matched upgrades, mostly because we lowered ratings on nine Argentine provinces following a lower transfer and convertibility assessment of the sovereign.

Chart 2

We anticipate moderate volatility in LRG ratings, which is reflected in our non-stable outlook on about 21% of the entities we rate. Moreover, the balance of outlooks is gradually turning negative, driven largely by structural challenges for public finances in Argentina and France--which together account for half of the negative outlooks (see chart 3). That situation is reflected in negative outlooks on the respective sovereign ratings.

Chart 3

Chart 4

We expect above average volatility in LRG ratings in Latin America, with heightened risk of default among Argentine provinces due to the country's many economic imbalances and a significant political transition (see "Argentina's Incoming Administration Faces Difficult Economic Policy Implementation" published Nov. 21, 2023).

Liquidity pressure have eased in some regions, and are notably supporting positive outlooks on some Mexican states and municipalities. Meanwhile, in Brazil, greater certainty about stable fiscal and monetary policy led us, in June 2023, to revise our outlook on Brazil to positive from stable. Our view of the institutional framework for Brazilian states and municipalities remains unchanged due to continued fiscal rigidity (see "Brazilian States And Municipalities' Fiscal Flexibility Will Remain Limited Despite Reforms," Nov. 7 2023).

Positive rating actions are likely in Canada, where financial policy is a key differentiating factor. We project Canadian LRGs will generally continue to decrease debt as a share of revenue despite ambitious investment plans and unfolding climate challenges. British Columbia is an exception, where an expansionary budgetary policy is resulting in rapid debt accumulation and higher credit risk (see "Canadian Provinces: Credit Update And Fiscal Outlook," October 2023).

In Europe, the city of Zagreb is benefitting from positive momentum created by Croatia's EU and eurozone accession. This is reflected in our recent revision of the trend for the institutional framework under which Croatian LRGs operate, which was changed to improving from stable. Swiss cantons and municipalities benefit from the very strong economic resilience of the Swiss economy, which has translated into stronger-than-budgeted tax collection. This positive movement is reflected in recent rating actions--ratings on three cantons have a positive outlook, while we have also upgraded three cantons and the city of Zurich since the start of 2023.

In Asia-Pacific there is a strong negative bias on New Zealand councils largely due to their ambitious investment programs. As of now, ratings on six (or almost a quarter) of the rated councils have negative outlooks.

Table 1

Political Risks, Demographic Challenges, And Budget Pressures

Global political tensions pose a risk to our macroeconomic assumptions, complicate long-term demographic challenges, and will divert investment from conflict zones. The Russia-Ukraine conflict, the Israel-Hamas war, and the intensification of political tensions in the Balkans, Caucasus, and Asia-Pacific are testing the economic and financial resilience of rated LRGs, in our view. An escalation of military conflicts or tensions could further complicate economic recovery.

Ukraine's economic prospects and trade have been disrupted by conflict, which has also fueled migration flows to neighboring countries (Bulgaria, Latvia, Poland and Czech Republic) and more broadly to Europe, the U.S. and Canada.

The latest conflict between Israel and Hamas has intensified geopolitical risks in the Middle East. We expect the conflict to remain centered in the Gaza Strip and consequently expect credit pressure on Israeli LRGs to remain contained (at least for now).

Continuing political tensions in Bosnia and Herzegovina have encouraged significant movements of younger people to developed Europe. This poses long-term demographic and budgetary challenges for Republika Srpska.

Migrant flows have also affected LRGs in Canada, which in the last two years has seen the highest population-growth rate since the 1950s. While federal immigration policy drives population growth, it also places the burden of service provision largely on provincial and local governments, in our view.

Globally, while immigration could improve labor market flexibility, it also raises demand for public service and can fuel the popularity of radical political movements--leading to government fragmentation and less effective policy making. Central government support to cover social care and infrastructure development costs could gradually wane, leaving LRGs with uncompensated spending. In our view, this could ultimately hurt long-term economic growth and affect the institutional framework for some LRGs.

Public Finance Reforms Could Create Ratings Volatility

An economic slowdown alongside globally elevated government-debt is likely to lead to more substantial changes in the institutional frameworks for LRGs than in previous years. Such reforms might have both positive and negative impacts on creditworthiness.

In some countries we anticipate an easing of financial pressure on LRGs. We expect the next Polish government to address the recent weakening of LRGs' budgetary performance. This resulted from the devolution of spending responsibilities without a corresponding transfer of revenues, and delayed distribution of EU funds due to political tensions between the EU and Poland.

In contrast, the incoming government in New Zealand is set to repeal the predecessor's planned water reform laws which sort to shift responsibility (and associated liabilities and assets) for water infrastructure from local councils to new water utilities. The new government has signaled that it prefers to see councils remain in control of water assets. This could saddle LRGs with significant spending needs to renew ageing assets and comply with new water quality standards (see "New Zealand Local Government Outlook 2024: Bridge Over Troubled Waters," Nov. 20, 2023).

High and uneven indebtedness of Chinese LRGs and an economic slowdown has prompted China's central government to become more selective in granting new borrowing quotas for provinces. We understand that some Chinese LRGs are already breaching the soft guidance on acceptable debt thresholds. Further measures to balance financial risks and fiscal stimulus will follow in 2024, in our view.

In the meantime, a new wave of Chinese LRG special-refinancing issuances signals China's policy objective to contain spillover risks at state-owned enterprises (SOEs). This has notably involved the exposure of "hidden" debts currently on the balance sheets of local SOEs. The scale of these new swaps is relatively small compared to the LRGs' direct debt.

In Spain, we could see a highly unusual write-off of regional government debt in 2024, as part of the political negotiations to form a new central government. Details of the possible arrangement are still unknown, but the government has acknowledged that structural problems in the regional financing system impose undue financial pressure on some regions. We expect the measure to have a neutral to positive impact on regional ratings, depending on the specific amounts and relative initial positions. However, the likely support may generate moral hazard by reducing regional incentives to moderate deficits and keep a lid on debt growth in future years (see "Spanish Regions May Receive Debt Relief From State," Nov. 7, 2023).

German states and the federal government are exploring opportunities to spur capital investments at regional and local levels despite tighter budgets and balanced budget requirements. A few states have resorted to off-budget special spending envelopes that are front-loaded with debt and justified by referring to climate change as an emergency that permits such constructs. The federal government has installed a similar vehicle and earmarked part of it for grants to states and municipalities. The idea to fund this activity using leftover borrowing authorizations from a federal vehicle related to COVID-19 was recently struck down by a federal constitutional court. That threatens a material part of the planned spending program, unless political efforts to set up constitutionally compliant alternative funding mechanism are successful.

Elsewhere in Europe, reforms may lead to decentralization of public services. Italy has taken the most decisive steps in that direction, in the form of a draft law on regional decentralization. This reform could allow regions to expand the scope of their responsibilities. However, we see significant political and technical hurdles, which are delaying its implementation (see "Credit FAQ: Italy's Decentralization Push Unlikely To Affect Budgets But Could Broaden Regional Differences," April 5, 2023). In the U.K., leading political parties have proposed devolution of services to local authorities ahead of a general election in late 2024-early 2025.

In addition to various planned reforms, we expect LRG funding will be affected by a decline in central governments' operating transfers, which will fall from pandemic highs (see chart 5).

Chart 5

In Brazil, reforms are moving toward tax simplification. A proposed dual-VAT tax reform would likely be revenue neutral for LRGs but could improve long-term economic growth prospects. Argentina, meanwhile, is entering a period of political transition amid significant economic imbalances. There are new risks for LRGs, including inflation running at over 100% and a dual exchange rate that creates the potential for a significant devaluation of the peso. We see risks of additional fiscal pressure for provinces as the new Argentine administration outlines its fiscal consolidation plan.

LRGs Revenues Are Vulnerable To Property Market Corrections

The cooling global real estate markets will impact LRGs, especially in large urban areas. This is because real estate taxes typically account for a significant portion of revenues and property markets are a driver of local economic growth.

We believe LRGs will be able to manage short-term real estate market volatility and that its impact on performance will be quite limited. Chinese LRGs and French departments are generally more sensitive to the global real estate market downturn than other LRGs (see chart 6) due to their reliance on transaction-based revenues and asset sales. The cities of Melbourne, Sydney, and London are most vulnerable to developments in the commercial real estate market, in our view (see "Chinese And French LRGs, And Cities Globally, Could Lose Revenue From Real Estate Slowdowns," July. 27, 2023).

Chart 6

Persistently Higher Wages And Interest Rates Will Pressure Operating Performance

Elevated inflation and strong demand for public services will continue to fuel operating spending and constrain operating performance over the medium-term.

Wage increases will contribute to a weakening of budgetary performance globally throughout 2024. In some countries, for example in Belgium, public sector wages are automatically adjusted to inflation, meaning LRG spending increased in 2022. In other countries, including Australia, Canada, and Sweden, adjustments have been made with some delays. Many Australian states have multi-year wage agreements which can ease pressure to match salaries with temporary spikes in inflation, while some offer only one-off bonuses that help limit growth in spending.

In Germany, wages for state level employees are currently being renegotiated. We will see the full impact of the, presumably substantial, adjustments from 2024. Germany's municipal employees already secured a material pay rise earlier this year (see "New German Municipal Wage Deal: Expensive But Still Manageable," May 22, 2023).

Larger-than-planned wage bills could constrain budgetary flexibility over the medium-term. Still, many LRGs entered wage negotiations from a position of strength, meaning that increases may have only a marginal impact on their credit quality. In addition, central governments in many Central and Eastern European (CEE) countries, Spain, and Italy regulate government wages and transfer corresponding funds to LRGs.

In the U.K., an equal pay debate, which began at few local councils, could affect LRGs across the country and abroad. We note that a growing number of claims could burden budgets, while lengthy strikes could hinder the provision of public services.

Higher Interest Rates Should Limit New Debt Accumulation

We project tighter monetary policies will continue into early 2024, meaning higher marginal interest payments for LRGs, before slowly easing from 2025. In our view, higher-for-longer interest rates will limit the appetite for material debt accumulation and investment spending. This could be especially the case for LRGs that have a relatively high reliance on short-term borrowing (LRGs in Sweden), a high share of variable rate debt (LRGs in Poland), demonstrate a high share of foreign currency borrowing (LRGs in Argentina), and those that have large refinancing needs.

Chart 7

Canadian provinces, which recently benefitted from strong revenue performance and lower borrowing, and Australian LRGs could suffer most under higher-for-longer interest rates. This is due to their already significant debt burdens and likely-high deficits over the coming years, in our view.

Interest costs are also rising rapidly for New Zealand's councils as they refinance existing low-cost debt at higher interest rates. That is a result of their central bank, which started tightening policy earlier than most advanced economy peers, coupled with already high council debt burdens, elevated capital investment plans, and relatively short tenors of borrowing.

In China, spending on interest is still moderate compared with overall spending. This is due to large central government subsidies for big operating expenses and a benign inflationary environment, which has kept interest rates stably low. Nonetheless, the Chinese LRG sector's growing debt is leading to sharply increasing interest payments (see chart 8).

Chart 8

Budgetary Performance Will Remain Solid, Albeit Weaker

We anticipate that operating performance in 2024 will remain generally solid, though weaker due to the pressures detailed earlier. Average operating surpluses are likely to remain marginally below 10% of operating revenues in 2024-2025 (see chart 9).

Chart 9

At the same time, large, unaddressed, and more expensive funding of investment spending will drive relatively high deficits after capital accounts over our forecast horizon for different LRGs. We note that, on average, Canadian provinces, Australian states, and German states are likely to reduce spending and thus should reduce their balance after capital account deficits from 2025 onward (see chart 10).

Chart 10

Spending Under Pressure, For Now

We expect investment spending (in real terms) will moderate in most countries as financial pressures trigger re-prioritization. The exceptions will likely be German states, Canadian provinces, and Brazilian states, which plan to maintain investment spending significantly above historical levels (see Chart 11). That said, Germany's strategy to continue its strong investment spending have been put into doubt by the recent cancellation of the borrowing authorization of a large federal financing vehicle. The judgement also casts some doubts over some German states' similarly structured off-budget funding vehicles.

Following the pandemic, Canadian provinces are allocating a large proportion of capital spending to health care facilities and to road and transit infrastructure. Once built, we expect that investment spending will decline from historically high levels.

In Brazil, revenue windfalls in 2021-22 coupled with temporary wage freezes during the pandemic left the states with considerable fiscal space to increase capital spending, making up for several years of real-term declines.

From 2025, investment spending could pick up again amid lower interest rates and as EU-related projects gain in momentum from the new multi-annual financial framework. This could lead to higher investment spending than we currently expect.

Chart 11

Stronger Than Expected Revenues Should Slow Debt Growth

The debt burden for most LRGs will rise until 2025, albeit at a slightly slower pace than our previous forecast, in June 2023, because of higher-than-expected revenues (see chart 12).

Chart 12

Australian states' and Chinese LRGs' debt burdens will continue to rise comparably faster than German states or Canadian provinces (see chart 13).

In Australia, debt will finance states' record capital investment budgets, which will pay for projects including public transport, health, education, and climate transition. We also forecast that the sector-wide debt-to-operating revenue ratio will return to an upward trajectory after broadly flattening in 2022-2023.

In Canada, provincial debt will stabilize despite sizeable capital deficits. This is supported by significant borrowing in 2020, comparatively solid revenue growth, and low growth in investment spending in 2025.

In China, investment-driven stimulus will continue to support economic growth and revenue recovery, though we expect the scale of this stimulus to shrink compared with 2021 and 2022. We also forecast local public sector debt-growth will trend toward nominal economic growth over time. It is notable that borrowing by Chinese provinces is largely onlent to lower-tier LRGs.

Chart 13

In Latin America, average debt levels have been declining from a comparatively low starting point, owing primarily to reduced market access and limited fiscal flexibility (see chart 14).

International capital markets are effectively closed to Argentina's provinces, and recently announced restrictions on dollar access present a further challenge to their ability to service debt on foreign currency bonds that were restructured in 2021(see "Argentine Provinces Try To Avoid Default After Latest Capital Controls," June 14, 2023)

Chart 14

Climate Issues And Cyber Risks Are Gaining In Importance

More frequent and damaging extreme weather and physical risks will impose economic and financial costs on LRGs. This will increase the need to invest in resilient infrastructure and risk reduction while maintaining public services.

Entities may be forced to defer or reprioritize spending on climate resilience as the economy slows and the cost of inputs and financing for infrastructure remain elevated.

Underinvestment in needed infrastructure could signal a deterioration in credit quality (see "The Evolving Impact Of Environmental And Social Factors On Credit Ratings," Oct. 25, 2023) and affect long term economic growth prospects. For example, the damage caused by Hurricane Otis to the Mexican state of Guerrero (mxBBB/Stable/--) in October could have a lasting impact on growth, even if the major city of Acapulco recovers quickly (see "Hurricane Otis Unlikely To Affect Mexican Ratings," Oct. 26, 2023.)

Water stress poses a chronic risk to economic productivity, as well as to populations. LRGs in Mexico(see "More Mexican States May Face Water Stress by 2050," April 4, 2023), Spain, and Italy have high exposure to water stress. They also have varying ability to step up investment in infrastructure repair, water storage and transport, and other adaptative measures.

The increasing frequency and severity of climate-related events will likely also result in stronger reform momentum. For example, record wildfires in Canada this year fueled policy discussions on disaster assistance programs and incentives for risk reduction.

Cyber attacks against LRGs are likely to lead to more disruption and greater spending on cybersecurity, in our view.

So far, we have seen mostly distributed denial of service attacks (DDoS) and ransomware attacks against the entity, affiliated companies, and third-party service providers. Both regulators and LRGs have made efforts to improve cyber defenses and will have to continue to do so given the constantly changing environment.

Generally, we expect LRGs with weak cyber security infrastructure, governance, and small cyber budgets face a greater risk of an attack that would have a significant impact on credit quality. Year-to-date, cyber attacks have not had a material impact on the creditworthiness of LRGs (see "Cyber Risk In A New Era: International Public Finance Is A Target," July 19 2022).

Related Research

• Argentina's Incoming Administration Faces Difficult Economic Policy Implementation, Nov 21. 2023
• Canadian Provinces Credit Update and Fiscal Outlook October 2023, Oct. 18, 2023
• New Zealand Local Government Outlook 2024: Bridge Over Troubled Waters, Nov. 20, 2023
• Spanish Regions May Receive Debt Relief From State, Nov. 7, 2023
• Brazilian States And Municipalities' Fiscal Flexibility Will Remain Limited Despite Reforms, Nov 07, 2023
• Hurricane Otis Unlikely To Affect Mexican Ratings, Oct. 26, 2023
• The Evolving Impact Of Environmental And Social Factors On Credit Ratings, Oct. 25, 2023
• Sweden's Local And Regional Governments Have Less Room To Maneuver Over The Next Year As Pension Costs Rise, Sep. 14, 2023
• Credit FAQ: What Are China's Options To Resolve Local-Government SOE Debt Risk, Aug. 3, 2023
• Chinese And French LRGs, And Cities Globally, Could Lose Revenue From Real Estate Slowdowns, July 27 2023
• 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
• Cyber Risk In A New Era: International Public Finance Is A Target, Jul 19, 2022