Fitch Ratings has affirmed Lagos State’s Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) at ‘B+’ with Stable Outlook and Short-Term Foreign-Currency IDR at ‘B’. The National Long-Term Rating has been affirmed at ‘AA+(nga)’, with a Stable Outlook. The ratings on Lagos’s medium-term note (MTN) programme and senior unsecured bonds have also been affirmed at ‘B+’/’AA+(nga)’.
Under Fitch’s new criteria for LRGs, Lagos’s IDR is capped by the sovereign (B+/Stable). The ratings reflect the state’s weak risk profile by international standards against Fitch’s expectations of sound debt sustainability driven by internally generated revenue (IGR), which underpins Lagos’s capacity to serve its financial obligations. The ratings also reflect rising but sustainable adjusted debt. These assessments incorporate counterparty risks and the sovereign rating. The Stable Outlook on the IDRs mirrors that on the sovereign.
Lagos is Nigeria’s economic powerhouse with per capita GDP above USD4.000, or double the national average, but is weak by international standards. Fuelled by public and private investment and a population over 20 million, Lagos’s diverse economy is supportive of the wide tax base that generates IGRs.
Key Rating Drivers
Revenue Robustness: Midrange
Lagos benefits from a diversified revenue structure led by IGR, which represented over 70% of its NGN560 billion operating revenue at end-2018. IGR is driven by moderately cyclical taxes such as PAYE (personal income tax). The stable tax revenue is counterbalanced by the dynamic oil-related transfers from the central government (representing less than 10% of operating revenue) and some volatility of other operating revenue sources such as sales proceeds, rents, land use charges, fees and fines.
Revenue Adjustability: Weaker
Given that Lagos has no tax-setting power on its main IGR item, PAYE, Fitch believes that Lagos’s fiscal flexibility relies on the wide but not fully exploited tax base of PAYE, as well as other potential revenue sources such as land use charges. In Fitch’s view, additional revenue streams should cover the peak-to-trough revenue fall of -5.52% (NGN22 billion) experienced in 2015 by at least 50%. Lagos is a net contributor to Nigeria’s equalisation system enacted through the Federal Account Allocation Committee (FAAC).
Expenditure Sustainability: Midrange
Lagos’s opex growth averaged 9.6% in 2010-2018, in line with operating revenue growth of 9.9%, allowing for a stable operating margin of around 50% on average. In its rating scenario, Fitch expects operating costs to increase by 9% or less than the country’s double-digit inflation, factoring in a tighter grip on current expenditure and compliance with expenditure targets, while coping with the expected 33% rise in staff costs by 2020 due to the minimum wage increase set by the national government.
Expenditure Adjustability: Midrange
There are no mandatory balanced budget rules defined by the central government for states, which are required to keep their deficits at 3% of national GDP. In its rating scenario of slow economic growth, Fitch expects Lagos to continue to post large operating margins at 40%. Capex makes up 55% of Lagos’s expenditure before debt service, keeping the share of inflexible expenditure well below 70%. Fitch believes that the high level of capex is necessary to maintain the local attractiveness amid demographic pressures calling for more services on infrastructure, health and education.
Liabilities and Liquidity Robustness: Weaker
The national framework for debt is evolving and thus borrowing limits are quite wide. There are no restrictions concerning debt maturities, interest rates or currency exposure. Lagos applies a prudential rule of debt service not exceeding 30% of operating revenues and aims at reducing its currency exposure at 55% of its NGN850 billion outstanding debt at end-2018. To ensure timely debt service, its internal debt is assisted by a state-level irrevocable standing payment order while external debt is served with deductions from FAAC.
Liabilities and Liquidity Flexibility: Weaker
Lagos has consolidated access to financial markets with repeated bond issuances, while domestic counterparties can provide liquidity lines and short-term credit. Counterparty risk on credit lines is in the ‘B’ category, triggering a ‘Weaker’ assessment for this factor. Lagos cashes in a sinking fund to support its debt service on bonds and Fitch prudentially considers its year-end cash as earmarked to offset payables.
Debt Sustainability Assessment: ‘aa’
In Fitch’s rating scenario, Lagos’s debt sustainability is assessed in the ‘aa’ category as reflected by a sound payback ratio (net adjusted debt to operating balance) at around three years in our 2019-2023 rating case scenario. Fitch incorporates Lagos’s weak fiscal debt burden of around 140%, which is high compared with the peer group, and debt service coverage at around 2x.
Lagos’s standalone credit profile (SCP) is assessed at ‘bb+’, reflecting a combination of a weak risk profile and debt sustainability in the ‘aa’ category. The notch-specific rating positioning is assessed at the higher end of the rating category to reflect the strong payback ratio below five. Fitch does not apply any asymmetric risk or extraordinary support from the central government. The SCP is capped at the sovereign level. The ‘B’ short-term rating is derived from Lagos’s Long-Term IDR.
Fitch’s key assumptions within our base and rating case for the issuer include:
Operating revenue growing below nominal GDP growth rate around 15%;
Operating expenditure growth at 11% in base case and 9% in rating case (below inflation rate), with the exception of 2019 and 2020 due to salary increases;
Average cost of debt expected to remain around 10% on average;
Capital expenditure is expected to be financed with operating margins, minor capital grants and new debt.
Any positive rating action on Nigeria will be reflected on Lagos’s ratings, provided that Lagos maintains its strong debt sustainability metrics.
A downgrade of the sovereign’s ratings would lead to corresponding action on Lagos’s IDR. A sustained deterioration of the payback ratio above five years in Fitch’s rating case scenario, or a reassessment of the key risk factors due to unfavourable changes in the economy beyond Fitch’s expectations, could also trigger a downgrade.