(The following statement was released by the rating agency)
Sept 17 -
Summary analysis -- Ostrava (City of) ----------------------------- 17-Sep-2012
CREDIT RATING: A+/Stable/A-1 Country: Czech Republic
Primary SIC: Legislative
Credit Rating History:
Local currency Foreign currency
02-Aug-2012 A+/A-1 A+/A-1
20-Sep-2010 A/A-1 A/A-1
The ratings on the Czech City of Ostrava reflect Standard & Poor’s Ratings Services view of the city’s “very positive” liquidity position, as our criteria define the term, moderate debt burden, solid budgetary performance, and limited risks associated with contingent liabilities. However, the ratings are constrained by the city’s limited budgetary flexibility and an economy that still lags national and European peers.
We view the institutional framework for Czech cities as “evolving but sound,” given their prudent fiscal policy framework, adequate predictability of reforms, and fair revenue and expenditure match. This is despite the absence of systemic extraordinary support for cities in case of financial distress.
Under our base-case scenario, Ostrava’s operating balance will deteriorate slightly to 10.5% by the end of 2014 despite continued expenditure controls, compared with 8% under our base-case scenario from last year. The central government’s reform of the redistribution of shared taxes in 2013 will have a limited impact on Ostrava’s budgetary performance. We estimate that the reform will reduce tax revenue in 2013 by Czech koruna (CZK)150 million (about EUR5.9 million), but we understand the city could offset this with new revenue, notably from gambling fees. We project that Ostrava will post deficits after capital accounts of an average 2.4% in 2012-2014 as it increases investments to CZK2.5 billion per year in 2012-2014. This investment expenditure is in line with 2010, but much higher than 2011, when it was very low at CZK1.9 billion.
Ostrava maintained strong operating margins in 2009-2011, averaging 12%, owing to its tight grip over operating expenditure. In 2011, the operating balance reached 12.1% of operating revenue, in line with 2010’s 12.6%. Operating revenue grew by 1.2%, fueled by increasing shared taxes but affected by some reduction in subsidies. The city contained operating expenditure growth at 1.8%. Ostrava cut its capital investment sharply in 2011, and posted a 3.3% surplus after capital expenditure (capex) following a 1.3% deficit in 2010.
Ostrava’s budgetary flexibility is restricted, which is typical for Czech cities. Most revenues comprise nationally redistributed shared taxes, accounting for 56% of Ostrava’s 2011 operating revenue, which offer no leeway on rates and mostly depend upon the national economic situation. Operating expenditure is also fairly rigid, consisting of social transfers and charges for community services, such as wages, subsidies, and contract payments. However, we note that Ostrava’s executives were able to control expenditure significantly in 2009-2011. We do not view capital investments, which accounted for 18% of expenditure in 2011, as very flexible, given the city’s significant infrastructure needs.
We currently view Ostrava’s debt burden as moderate. Its tax-supported debt represented 40% of operating revenue in 2011. Under our base-case scenario, this will gradually increase to about 57% by the end of 2013 because the city is partly debt funding its capital investment plan, mostly from its European Investment Bank (EIB; AAA/Negative/A-1+) loan, CZK1.2 billion of which remained unused as of the end of July 2012. However, we expect tax-supported debt to decline significantly to about 37% for 2014 once the city redeems its bullet Eurobond from its strictly earmarked sinking fund. Ostrava has set aside this sinking fund to repay its EUR100 million bond maturing in July 2014, reflecting prudent debt management. We understand that this fund is mostly invested in time deposits with three highly rated European banks, sovereign Czech Republic bonds, and to a lesser extent in corporate and bank bonds.
We understand that the city has not been hedged against currency risks over the redemption of the bond since it cancelled a currency swap agreement in July 2010, but that it is considering hedging its position once again.
We consider risks related to contingent liabilities to be currently limited for Ostrava, and we believe that the city’s management will tightly control its municipal companies.
While Ostrava’s local economic base has increasingly diversified, we consider its wealth indicators still rank comparatively low in an international perspective.
We view Ostrava’s liquidity position as “very positive.” We estimate that free cash available on its current accounts will represent more than 150% of its estimated debt service over the coming 12 months. On June 30, 2012, the city’s basic current accounts stood at CZK0.4 billion, excluding CZK1.3 billion earmarked funds drawn from EIB loans for investment projects and CZK2 billion invested in its sinking fund, earmarked for redemption of the city’s bullet Eurobond. The cash held on the city’s districts’ accounts is also not included in our calculation of Ostrava’s liquidity position because the city cannot consolidate the districts’ cash on its own account.
Under our base-case scenario, the city’s consolidated debt service, including that of the districts, is set to increase from a low 2% in 2010-2012 to about 4% from 2013, as Ostrava starts to repay the first tranches of its amortizing EIB loans. It will peak in 2014, when the city redeems its bullet bond, but then decrease to about 4% of operating revenues in 2012-2014.
Ostrava generates very robust internal cash flows. Its operating margin before interest exceeded 7x debt service in 2011. While the city experiences cash flow seasonality throughout the year, this is predictable and overall quite even, and is controlled by the city management.
We view Ostrava’s access to external liquidity as satisfactory in the context of the Czech Republic’s resilient banking sector. Standard & Poor’s assigns a Banking Industry Country Risk Assessment (BICRA) score of ‘4’ to the Czech domestic banking sector (‘1’ being the lowest risk and ‘10’ the highest; see “Banking Industry Country Risk Assessments,” published Oct. 6, 2011, on RatingsDirect on the Global Credit Portal).
The stable outlook reflects our base-case scenario expectations that Ostrava will contain the deterioration of its operating margins and limit its deficit after capital accounts to below 5% of total revenue in 2012-2014, resulting in limited debt growth over the period.
Under our downside scenario, we might consider a negative rating action if the city recorded structurally growing deficits after capital accounts in excess of 5% on average in 2012-2014 as a result of looser control over operating spending, more sluggish tax revenue growth, or increasing capex. This would lead to a downward assessment of our view of its financial management.
Under our upside scenario, we might consider an upgrade if the city enhanced its operating balance and posted structural surpluses after capital accounts because of stronger revenues, better spending controls, or lower capex.
However, we view both our upside and downside scenarios as very unlikely at this stage.
Related Criteria And Research
-- Institutional Framework Assessments For International Local And Regional Governments, March 2, 2011
-- Methodology For Rating International Local And Regional Governments, Sept. 20, 2010
-- Methodology And Assumptions For Analyzing The Liquidity Of Non-U.S. Local And Regional Governments And Related Entities And For Rating Their Commercial Paper Programs, Oct. 15, 2009