Fitch Ratings has revised the Outlook on Kaduna State’s Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) to Negative from Stable and affirmed the IDRs at ‘B’.
Under EU credit rating agency (CRA) regulation, the publication of International Public Finance reviews is subject to restrictions and must take place according to a published schedule, except where it is necessary for CRAs to deviate from this in order to comply with their legal obligations. Fitch interprets this provision as allowing us to publish a rating review in situations where there is a material change in the creditworthiness of the issuer that we believe makes it inappropriate for us to wait until the next scheduled review date to update the rating or Outlook/Watch status. The next scheduled review date for Kaduna is 18 September 2020.
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Following the recent downgrade of Nigeria’s IDRs (see Fitch Downgrades Nigeria to ‘B’; Outlook Negative dated 6 April 2020) we have revised Kaduna’s Outlooks to Negative as its Outlooks move in tandem with the sovereign’s.
Related Link: Fitch Downgrades Nigeria to ‘B’; Outlook Negative
The ratings also reflect the state’s dependence on oil-related transfers from the Federal Government of Nigeria (FGN), which makes the state’s revenue base quite sensitive to oil prices swings. The ratings further consider Kaduna’s growing debt to fund necessary capex for the development of basic infrastructures and social services.
While Nigerian local and regional governments’ (LRG) most recently available issuer data may not have indicated performance impairment, material changes in revenue and cost profiles are occurring across the sector and likely to worsen in the coming weeks and months as economic activity suffers and government restrictions are maintained or broadened. Fitch’s ratings are forward-looking in nature, and we will monitor developments in the sector for their severity and duration, and incorporate revised base- and rating-case qualitative and quantitative inputs based on performance expectations and assessment of key risks.
Key Rating Drivers
Kaduna’s IDRs are currently aligned with the sovereign’s and its Outlooks reflect those on the sovereign. A further downgrade of the sovereign’s ratings will be mirrored on Kaduna’s ratings.
Risk Profile: ‘Vulnerable’
Fitch has assessed Kaduna’s risk profile, or debt tolerance, at Vulnerable, which combines five factors at Weaker and one factor at Midrange (expenditure adjustability).
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Revenue Robustness: ‘Weaker’
About 50% of Kaduna’s NGN100 billion operating revenue at end-2019 depends on allocations of oil revenue transferred monthly from the Federal Accounts Allocation Committee (FAAC), which are expected to decline by more than 40% in 2020 following the sharp decrease in oil prices. The decline in transfers will not be offset with the VAT expected increase to 7.5% from 5.0%, which could bring an additional NGN6 billion additional revenue, by Fitch’s estimates. Improvements in internally generated revenue (IGR), which grew by over 50% according to preliminary 2019 financials versus 2018, could halt if Nigeria enters into a new recession and/or if lockdown measures are prolonged.
Revenue Adjustability: ‘Weaker’
Kaduna’s revenue potential depends on the state’s ability to expand its tax bases, both in terms of broadening the pool of taxpayers and enforcing tax compliance. The main fiscal revenues are pay-as-you-earn taxes, on which Kaduna cannot set the tax rate, and land charges, for which Kaduna is implementing measures to expand the tax base. The ability to enlarge the pay-as-you-earn tax base is limited by the low level of income of the population, with over 50% living below the poverty line.
Expenditure Sustainability: ‘Weaker’
Kaduna’s varied set of responsibilities ranges from education (25%), healthcare (15%), economic development (over 15%), energy and environment (around 8%). Past expenditure dynamics show a good track record of cost control, with operating revenue and expenditure growing on average at the same pace in 2010-2018, around 7.5%-8.0%.
Under its revised scenarios of a stressed economy, Fitch expects expenditure to grow above revenue in 2020 and then adjust in 2021-2024, as the state copes with the minimum wage increase for public employees amid declining revenue. The operating margin will remain in positive territory, but is expected to decline below 15% in case of prolonged lockdown measures calling for more support from the state for the economy and healthcare.
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. Kaduna’s cost structure is moderately flexible, as an average 40% of expenditure is capex, which is largely financed with the operating balance and can be delayed in case of need, as occurred during the last recession in 2015-2016. In Fitch’s view, expenditure reduction is moderately affordable given the high potential to increase the existing level of healthcare and infrastructure services, while improvements in the procurement process could improve expenditure allocation.
Liabilities and Liquidity Robustness: ‘Weaker’
The national framework for debt is evolving and thus borrowing limits are quite wide. There are no restrictions on debt maturities, interest rates or currency exposure. Over 90% of Kaduna’s debt is served through deductions from the statutory allocation, including loans with local banks for salary bailouts, while the remaining part is made up of intergovernmental loans.
At end-2019, 70% of Kaduna’s NGN241.2 billion adjusted debt, when included pension and contractors arrears, was in foreign currency and the figure is expected to increase towards 80% for a debt burden of over NGN350 billion by 2024, after the disbursement under the USD350 million loan from the World Bank. The historical average cost of debt is below 1% for multilateral foreign debt, while domestic debt carries interest rates around 10%. Kaduna’s debt amortisation profile is smooth with long maturities and sustainable debt service well below 1x the operating balance.
Liabilities and Liquidity Flexibility: ‘Weaker’
Fitch deems Kaduna’s liquidity as weak as the state has no committed liquidity lines and domestic banks rated in the ‘B’ category tend to extend credit lines either with short maturities or with FGN backup through direct deductions from FAAC for longer maturities. Fitch prudentially considers cash as restricted for payables. Emergency liquidity may also come directly from the federal government, as was the case in 2015-2016, with the Budget Support Facility helping states to tackle pressures due to liquidity shortfalls, supporting payments of salaries and pensions.
Debt sustainability: ‘bb’ category
According to Fitch’s rating case of a prolonged stressed economy, Kaduna’s debt payback ratio (net debt-to-operating balance) – the primary metric of debt sustainability assessment – could deteriorate to 23 years in the medium term, incorporating the effects of an economic downturn, corresponding to a ‘bb’ assessment. Secondary metrics – fiscal debt burden measured by net adjusted debt-to-operating revenue – could move above 350% and is assessed at ‘b’, while its actual debt-servicing coverage ratio above 1.5x is assessed at ‘a’.
Kaduna is classified as type B LRG by Fitch, as it covers debt service with its operating balance. Kaduna’s fast-growing 8.2 million young residents, growing unemployment rate of around 30%, and a traditionally strong primary sector contribute to weak socio-economic standards. The public sector is a key employer in the state, directly and through its planned investment programmes. A large informal economy hinders private sector development, which ultimately affects the IGR tax base. Although dominant agricultural and service sectors drive the economy, Kaduna’s development plan is focused on the state’s rich minerals resources by attracting foreign investors to key industrial projects.
Fitch assesses Kaduna’s Standalone Credit Profile (SCP) at ‘b’, reflecting a combination of a vulnerable risk profile assessment and a ‘bb’ assessment of debt sustainability. The SCP also factors in Kaduna’s high debt burden compared with international peers, in particular South-American states and provinces. Fitch does not apply any asymmetric risk or ad-hoc support from the central government and assesses intergovernmental financing as neutral to Kaduna’s ratings. The ‘B’ IDR reflects Kaduna’s own payment capacity, while debt-service support from the central government through deductions from the statutory allocation is factored into the debt framework.
Qualitative Assumptions and assessments and their respective change since the last review 27 March 2020 and weight in the rating decision:
Risk Profile: Vulnerable, unchanged with low weight
Revenue Robustness: Weaker, unchanged with low weight
Revenue Adjustability: Weaker, unchanged with low weight
Expenditure Sustainability: Weaker, unchanged with low weight
Expenditure Adjustability: Midrange, unchanged with low weight
Liabilities and Liquidity Robustness: Weaker, unchanged with low weight
Liabilities and Liquidity Flexibility: Weaker, unchanged with low weight
Debt sustainability: ‘bb’ category, unchanged with low weight
Asymmetric Risk: n/a
Sovereign Cap: Yes, lowered with high weight
Quantitative assumptions – issuer specific
Fitch’s rating case scenario is a “through-the-cycle” scenario, which incorporates a combination of revenue, cost and financial risk stresses. It is based on the 2015-2018 figures, 2019 preliminary figures and 2020-2024 projected ratios. The key assumptions for the scenario include:
5% increase in operating revenue on average in 2020-2024 versus 8% in baseline scenario; 6% increase in operating spending on average in 2020-2024 versus 8% in baseline scenario; 1.5% cost of debt in 2020-2024.
Quantitative assumptions – sovereign related (note that no weights are included as none of these assumptions was material to the rating action)
Quantitative assumptions – sovereign related
Figures as per Fitch’s sovereign actual for 2018 and forecast for 2020, respectively:
GDP per capita (US dollar, market exchange rate): 1,820.7; 2,004 Real GDP growth (%): 1.9; -1.0 Consumer prices (annual average % change): 12.1; 13.2 General government balance (% of GDP): -4.0; -5.8 General government debt (% of GDP): 24.9; 31.5 Current account balance plus net FDI (% of GDP): 1.1; -4.7 Net external debt (% of GDP): -15.0; -0.2 IMF Development Classification: EM CDS Market Implied Rating: n/a
Factors that could, individually or collectively, lead to negative rating action/downgrade:
A downgrade of the sovereign would lead to corresponding rating action on Kaduna's ratings. A weakening debt amortisation profile or financial debt growth leading to consistently higher debt-to-current revenue ratios and an operating balance insufficient to cover debt service with respect to Fitch's expectations could result in a downgrade.
Factors that could, individually or collectively, lead to positive rating action/upgrade:
Fitch deems an upgrade of Kaduna's ratings as unlikely given the Nigerian sovereign rating (B/Negative). However, a higher overall assessment of its risk profile and a payback below five on a sustained basis years would be positive for Kaduna's ratings.
Committee Minute Summary
Committee date: 8 April 2020
There was an appropriate quorum at the committee and the members confirmed that they were free from recusal. It was agreed that the data was sufficiently robust relative to its materiality. During the committee no material issues were raised that were not in the original committee package. The main rating factors under the relevant criteria were discussed by the committee members. The rating decision as discussed in this rating action commentary reflects the committee discussion.
Best/Worst Case Rating Scenario
Ratings of Public Finance issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of three notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from ‘AAA’ to ‘D’. Best- and worst-case scenario credit ratings are based on historical performance.
Summary Of Financial Adjustments
Contractors’ and pension arrears reported under Other Fitch Classified debt
Capex figures adjusted to mirror Fitch’s estimated cash-like data
References For Substantially Material Source Cited As Key Driver Of Rating
The principal sources of information used in the analysis are described in the Applicable Criteria.
Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of 3 – ESG issues are credit neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity.
Kaduna has an ESG Relevance Score of 4 for Energy Management due to problems with electricity and dependency on oil-related transfers, which has a negative impact on the credit profile, and is relevant to the ratings in conjunction with other factors.
Kaduna has an ESG Relevance Score of 4 for Human Rights and Political Freedoms due to the presence of conflicts in the region, which has a negative impact on the credit profile, and is relevant to the ratings in conjunction with other factors.
Kaduna has an ESG Relevance Score of 4 for Human Development, Health and Education as the majority of the population lives below the poverty line, which has a negative impact on the credit profile, and is relevant to the ratings in conjunction with other factors.
Kaduna has an ESG Relevance Score of 4 for Political Stability and Rights as political divisions leading to unpredictable policy shifts with low budget predictability, which has a negative impact on the credit profile, and is relevant to the ratings in conjunction with other factors.