Fitch Affirms Nigeria's Lagos State at ''B ''; Outlook Negative

Tuesday, August 07, 2018 08:53 AM / Fitch Ratings

FitchRatings has affirmed Lagos State's Long-Term Foreign and Local Currency IssuerDefault Ratings (IDRs) at 'B+' with Negative Outlook and the state's Short-TermForeign Currency IDR at 'B'. The National Long-Term Rating has been affirmed at'AA+(nga)', with a Stable Outlook. The ratings on Lagos' medium-term note (MTN)programme as well as senior unsecured bonds have also been affirmed at'B+'/AA+(nga)'.

Theratings reflect the state's weak socio-economic indicators by internationalstandards against Fitch's expectations of satisfactory operating performance inthe medium term, driven by internally generated revenue (IGR). The ratings alsoreflect adequate transparency compared with national standards and rising butsustainable debt. The Negative Outlook on the IDRs reflects that of the FederalGovernment of Nigeria (FGN, B+/Negative).

Key Rating Drivers

InstitutionalFramework (Weakness/Stable)

Aconstitutional equalisation system enacted through the Federal AccountAllocation Committee (FAAC) pools oil and non-oil revenue collected by thecentral government and transfers them to local and regional governments. FAAC'sfunding has proved volatile as Nigeria's federal budget depends on oil for morethan a third of its revenue and the severe oil price slowdown from 2012 hasresulted in lower transfers to local government entities. For Lagos, IGRcontribute far more of Lagos's revenue than transfers from the federalgovernment, mitigating exposure to oil price swings.

Economicdevelopment of states is dependent on capital projects, which often facechallenging budget implementation and are driven by available funding options.Lagos' foreign debt service is supported by ISPO (Irrevocable Standing PaymentOrders) issued by the Federal government to pay bondholders. The amount paidfor debt service is then deducted from the states' FAAC share.

FiscalPerformance (Neutral/Stable)

Lagosbenefits from a diversified revenue structure led by IGR, which represent over75% of its NGN490 billion current revenue, thus mitigating the reliance on FAACallocation from FGN. In its base scenario, Fitch expects the operating margindriven by IGR to remain stable at around 50% in the medium term, comfortablycovering debt service by nearly 1.5x. Fitch projects IGR to grow 10%-15% in themedium term but faces downside risk from the large informal economy thataccounts for nearly 40% of local tax-related revenue.

Inits base case scenario, Fitch expects operating costs to increase less than thecountry's double-digit inflation, factoring in a tighter grip on currentexpenditure and compliance with expenditure targets. Fitch believes that theadministration's commitment to investment will boost capex over the medium termup to NGN1 trillion over 2018-2020, mostly focused on transportation, water,energy and power, including a minimum of 5% dedicated to upgrading health,educational and social facilities.

Debtand Liquidity (Neutral/Stable)

Lagos'debt will grow over the medium term to up to over NGN1 trillion or over 170% oftax revenue, driven by a demanding capex programme, the negative effect of thenaira devaluation on foreign currency-denominated debt and a new borrowings tofinance roughly NGN1 trillion investments in the medium term.

Fitchexpects long-term debt sustainability to remain compatible with Lagos' ratingprofile, with an average pay-back (debt-to-current balance) ratio of fiveyears. Fitch expects liquidity to remain ample and, in particular, refinancingrisk, to remain under control despite the large capex programme. This is basedon Lagos' IGR proceeds, as well as government and bank facilities to fundworking capital needs.

Managementand Administration (Neutral/Stable)

Lagos'administration is committed to improving transparency and disclosure, emphasisingthe availability of financial data while working on the transition from acash-based to accrual-based accounting that, in Fitch's view, will becredit-positive as it restricts the scope for discretionary initiatives. Lagosprovides three-year budget and has sophisticated debt management compared withnational peers. Fitch believes that cash would remain around 25% of operatingrevenue, safeguarding Lagos from liquidity pressures.

Economy(Weakness/Stable)

Lagos'GDP per capita at USD4,500 is weak by international standards. However, Lagosis the main economic hub in Nigeria, accounting for over 20% of GDP, bolsteredby the presence of roughly 90% of companies' headquarters and 60% of industrialinvestments in the country. The economy is well-diversified between services,including information and communication technologies, industry and transports.Fitch estimates that Lagos' young and fast growing population of over 20million inhabitants will drive the increase of social and healthcareexpenditure above one fourth of the state's budget in the forthcoming years.

Rating Sensitivities

Asovereign upgrade may be reflected in Lagos's ratings, provided thatimprovements in budgetary performance result in debt levels at 1x the budgetsize. Further improvement of the local economy giving additional boost to IGRwill also be positive for the ratings.

Theratings of Lagos are aligned with the sovereign's. A downgrade on thesovereign's ratings would lead to a corresponding action on Lagos' IDR. Inabsence of a sovereign downgrade, declining operating margin, unfavourablechanges in the national tax policy, debt rising beyond Fitch's expectationsover the medium term, coupled with economic instability, could lead to adowngrade.