S&P Viewpoint

At the top end of the rating scale, in the, 'AAA', 'AA', and 'A' categories, ratings have been generally stable within their categories. Even over seven years, an average of 72% of entities in these top investment-grade categories have maintained their level.

In the lower-investment-grade 'BBB' category, however, ratings have proved much less stable, particularly over a longer period. Only 36% of entities in the 'BBB' category are in the same category after seven years. This lack of stability has mostly been due to improving creditworthiness, with entities in the 'BBB' category predominantly upgraded rather than downgraded. After just one year, for instance, 5% of entities in the 'BBB' category were upgraded to the 'A' category, while less than 1% were downgraded two levels to the 'B' category.

There has been significantly less stability in the speculative-grade (below 'BBB') rating categories. After seven years, a small 18% of 'BB' category entities have remained in the same category. Only 9% were upgraded, while a significant majority of 64% defaulted.

Over three years (see Table 2), the transitions from 'BB' are less drastic. A majority of 62% stayed within the same category, while only 13% defaulted. After one year, however, the transition is even smaller, with less than 2% defaulting. This minimal level after one year shows Standard & Poor's ability to anticipate the likelihood of default occurring within one year, and to change the rating accordingly.

By far the highest level of default (17%) after one year occurred with entities rated in the lowest category: 'CCC/CC'. Ratings in the 'CCC/CC' category also proved the least stable of all ratings. Even after one year, only 50% of entities had remained within that category, while after five years, none remained. Of those entities, nearly all of them (91%) were upgraded in equal proportions to the 'BB' and 'B' category, while the rest defaulted. (Standard & Poor's only began to assign ratings in the 'CCC/CC' category in the mid-1990s, and the transition data is based on a relatively small number of entities.)

Chart 2 compares the stability of LRG ratings with those of the global corporate ratings over one year. Although LRG ratings show somewhat greater stability and narrower bands of rating movement than the corporate ratings, the rating trends are similar: the lower the rating, the less stable and the higher the probability of default. The sample size of LRG ratings is considerably smaller than that used in the corporate study (more than 10,000 ratings), but as the number of LRG ratings grows, particularly in the speculative grade category, Standard & Poor's expects the transition rates to converge over time.

In 2004, Standard & Poor's upgraded three LRG entities in Western Europe, while there were 16 downgrades, 11 of which were prompted by Italy's sovereign downgrade. Based on rating outlooks, there is an indication of a more promising trend for 2005: at year-end 2004, six LRGs had positive outlooks, versus five with negative outlooks.

In 2005, the second phase of a vast decentralization process is set to transfer an estimated €10 billion ($12 billion) of responsibilities to French LRGs from central government. This will reduce financial flexibility, which may put pressure going forward on the creditworthiness of French LRGs. (For further information, see "Decentralization Should Lead French LRGs to Find New Sources of Flexibility," published on Sept. 3, 2004, on RatingsDirect.) This means that the number of negative outlooks may increase and upgrades are less likely, but Standard & Poor's does not foresee a significant deterioration of the credit quality of French LRGs.

For regions, the outlook revisions have been both positive and negative. The Autonomous Communities of Madrid (AA/Positive/A-1+), which maintains a robust financial performance, and Aragon (AA-/Positive/--), which has a shrinking debt burden, have been assigned positive outlooks; conversely, the Autonomous Community of the Balearic Islands (AA+/Negative/--), where increasing health care costs led to a deterioration of margins, has been assigned a negative outlook. The outlook on the City of Madrid (AA+/Negative/--) was also revised to negative, given the deterioration of its budgetary performance and the increase in the debt burden. Overall, Spanish LRGs are likely to keep a robust credit profile.

In 2005, the interstate revenue-equalization system will be amended, slightly reducing the degree of equalization. The moderate reforms will primarily confirm the strong stability and predictability of the system. This positive credit feature will, however, be largely offset by the challenges posed to LRG budgets in 2005, due to the final step of the income tax reform taken on Jan. 1, 2005. The national tax estimate predicts that the states' tax revenues will stagnate in 2005, compared with 2004. To reduce budget deficits, the states would therefore need to reduce their expenditure, which Standard & Poor's considers will be hard to achieve. It will be particularly difficult as, in previous years, control on spending was partly achieved through a reduction in investment expenditure, a reduction that cannot be maintained in the medium-term, despite Germany's currently still high level of infrastructure investment. Although nine rated German states had stable outlooks at the end of 2004, failure to reduce budget deficits may prompt further pressures on the ratings in 2005.

Looking forward to 2005, Standard & Poor's expects the credit trend to be stable, as no rating action on the sovereign is expected: all but two of the 34 rated Italian LRGs had stable outlooks at year-end 2004. In addition, Italian LRGs will continue to seek ratings, for both promotional and capital market purposes, building on the five new ratings in 2004. Italy has become the largest European market for LRG ratings, as a result of increased awareness of the benefits that ratings can bring.

Overall, the tax revenues of Swiss LRGs (cantons and cities) developed better in 2004 than in 2003. For more information, see "Industry Report Card: Swiss Local and Regional Governments," published on Nov. 22, 2004, on RatingsDirect. Cost-cutting programs, focusing on personnel and social welfare expenses, as well as on efficiency gains in the public administration, are expected to generate some improvement in their budgetary performance in 2004 and 2005. Hence Standard & Poor's expects that budget goals should broadly be achieved on average. Although two of the 11 rated LRGs had negative outlooks at year-end 2004, if budgetary performances improve, the credit trend overall should remain stable.

In Central and Eastern Europe, creditworthiness continued to improve in 2004, with positive rating actions dominating the scene. CEE's five upgrades (all but one in Russia) compare favorably with the three upgrades in Western Europe. As can be seen in Table 5, the positive rating actions in CEE occurred in the speculative-grade category ('BB' and below), whereas the Western European upgrades were all in the mid-to-high investment-grade range. In addition, there were no downgrades in CEE, compared with Western Europe's 16.

Just as creditworthiness is improving in CEE, so is the demand for ratings driven by Russian LRGs: CEE gained nine new LRG ratings in 2004, compared with Western Europe's seven. Six of the nine new LRG ratings were requested by Russian LRGs (three were assigned with local currency ratings, two were assigned only with foreign currency ratings, and one only with the national scale rating; all the local and foreign currency ratings were assigned in the 'B' category). In addition, the Romanian capital Bucharest and two Bulgarian cities were assigned ratings in the 'BB' category. Ratings have been used both to raise LRGs' profiles and to tap the bond markets.

At year-end 2004, all except one of the CEE LRGs with local currency ratings had stable outlooks. Looking forward, CEE LRGs will continue to benefit from growing economies and wealth levels, but this may be coupled with increased debt and potentially volatile financial performance, due to large infrastructure needs, increasing service demands, and growing operating-expenditure pressures, particularly from rising salaries. Strong new rating activity is expected to continue in 2005.

Standard & Poor's expects that Russian LRGs will continue to grow stronger in 2005 from a credit perspective. Already, on Feb. 1, 2005, the City of Moscow (foreign currency BBB-/Stable/--) was upgraded to investment grade, following the sovereign upgrade of The Russian Federation (foreign currency BBB-/Stable/B; local currency BBB-/Stable/A-3) on Jan. 31, 2005.

The pace of improving creditworthiness may, however, slow in the next two-to-three years. LRGs will be subject to increasing pressure from public sector salary growth, strong revenue and decision-making centralization trends, slowing economic growth, and further intergovernmental reform. Meanwhile, improvements in LRGs' management sophistication, transparency of finances and operations, maintenance of conservative debt levels, and development of services will be important for the LRGs' creditworthiness and potential rating upgrades. The gap between stronger and weaker LRGs, in terms of creditworthiness and ratings, will continue to grow.

Standard & Poor's expects that Russian LRG debt issuance in the Russian domestic market will continue to rise rapidly in 2005, due to large infrastructure needs and the current low debt levels. For further information, see "Sector Review: Russian Local and Regional Governments," published on Dec. 9, 2004 on RatingsDirect.

In 2004, there were only positive rating actions among the Australian and New Zealand LRGs: two upgrades in Australia and one in New Zealand, all due to strong fiscal performance: the State of South Australia (AAA/Stable/A-1+) and the State of Tasmania (AA+/Stable/A-1+) in Australia, and New Plymouth District Council (AAA/Stable/A-1+) in New Zealand. The ratings on the other nine Australian and seven New Zealand LRGs were unchanged. In addition, there was a new rating assigned to an Australian municipality.

Standard & Poor's expects ratings to remain stable in 2005, reflected by 18 of the 19 LRG ratings carrying a stable outlook at year-end 2004. Most Australian and New Zealand LRGs are expected to maintain their strong commitment to fiscal discipline and budget surpluses. In particular, they are expected to refrain from rushing into projects or other initiatives that would seriously jeopardize their financial profiles.

Most of the 'AAA' Australian states have shown a general aversion to debt increases. Nevertheless, there is some headroom for a modest increase in their debt without threatening their ratings. This is because the states have very low debt levels by historical standards and by comparison with similar developed countries.

The LRGs in New Zealand, and the local governments in Australia have stable and predictable revenue bases, and well-developed institutional systems. Furthermore, relatively narrow service mandates, which are subject to little change, limit the variability in their operating expenditures. Nevertheless, ratings on some New Zealand local governments could come under pressure because their debt burdens might increase significantly as they embark on large capital-expenditure programs.

The credit story among the 48 rated Canadian LRGs continued positively in 2004, despite some of the larger provinces seeing their budgetary deficits persist. Five LRGs were upgraded (three remaining in the 'AA' category, one moving into the 'AA' category,and one remaining in the 'A' category) and four placed on positive outlook, reflecting a steady improvement in their budgetary performances. Due to a growing debt burden in British Columbia's municipal sector, the outlooks on both the City of Vancouver (AAA/Negative/--) and the Municipal Finance Authority of British Columbia (AAA/Negative/A-1+) were revised to negative. There were no ratings lowered in 2004.

In addition, three Canadian LRGs--two cities and one county--were assigned ratings in the high investment-grade category.

Standard & Poor's expects that the larger overall provincial deficits in fiscal 2004 and the expected, albeit smaller, deficits in fiscal 2005 will contribute to an increase in net provincial debt as a share of GDP in the near term. In the medium term, further reductions in the debt burden are possible, if provinces stay the course with remedial actions already implemented to deal with the recent budgetary deficits. The emphasis, however, on debt reduction that was previously made by some governments could be lessened as the focus is shifted to re-investments in the health care and infrastructure networks in response to political pressure. In cases where material increases in debt burdens occur, downward ratings actions for provinces could ensue.

Prospects for improved creditworthiness for the rated LRGs in Argentina are dependent on successful sovereign debt restructuring. Once Argentina has cured its default, the heightened liquidity in the banking system should enable the subnational governments with stronger fiscal positions to access domestic capital markets.

Table 5 International Local and Regional Government Upgrades, 2004*
Country	Government	To	From
Argentina	Mendoza (Province of)	CCC+	SD
Australia	South Australia (State of)	AAA	AA+
Australia	Tasmania (State of)	AA+	AA
Canada	British Columbia (Province of)	AA	AA-
Canada	Calgary (City of)	AA+	AA
Canada	Edmonton (City of)	AA+	AA
Canada	Nova Scotia (Province of)	A	A-
Canada	Saskatchewan (Province of)	AA-	A+
France	Hauts-de-Seine (Department of)	AAA	AA+
France	Sytral	AA-	A+
New Zealand	New Plymouth District Council	AAA	AA+
Russia	Bashkortostan (Republic of)	BB-	B+
Russia	St. Petersburg (City of)	BB+	BB
Russia	Sverdlovsk Oblast	B	B-
Russia	Sverdlovsk (Region of)	B+	B
Spain	Consorcio de Transportes de Bizkaia	AA-	A+
Turkey	Istanbul (City of)	B+	B
*Rating actions refer to public long-term local currency ratings only. As a result, the numbers of upgrades are different to those referred to in other publications, which include foreign currency and national scale ratings. This discrepancy is of particular relevance to upgrades on Russian LRGs. Data is correct as of Dec. 31, 2004.

Table 6 International Local and Regional Government Downgrades, 2004*
Country	Government	To	From
Germany	Baden-Wuerttemberg (State of)	AA+	AAA
Germany	Brandenburg (State of)	AA-	AA
Germany	North Rhine-Westphalia (State of)	AA-	AA
Italy	Bologna (City of)	AA-	AA
Italy	Brescia (City of)	AA-	AA
Italy	Emilia-Romagna (Region of)	AA-	AA
Italy	Florence (City of)	AA-	AA
Italy	Friuli-Venezia Giulia (Region of)	AA-	AA
Italy	Lazio (Region of)	A	A+
Italy	Lombardy (Region of)	AA-	AA
Italy	Milan (City of)	AA-	AA
Italy	Sesto Fiorentino (City of)	AA-	AA
Italy	Tuscany (Region of)	AA-	AA
Italy	Valle d'Aosta (Region of)	AA-	AA
Italy	Venice (City of)	AA-	AA
Switzerland	Geneva (Republic and Canton of)	A	A+
*Rating actions refer to public long-term local currency ratings only. Data covers Jan. 1, 2004 to Dec. 31, 2004.