S&P affirms BCC rating at AA+

Standard & Poor’s today issued a statement affirming the ‘AA+’ long-term issuer credit rating of Birmingham City Council (BCC). The ratings rationale, including an outline of the conditions that could prompt an upgrade or downgrade make for interest reading:

“LONDON (Standard & Poor’s) Nov. 7, 2012–Standard & Poor’s Ratings Services today affirmed the ‘AA+’ long-term issuer credit rating on Birmingham City Council (BCC). The outlook is stable.

The rating affirmation reflects our view of the high levels of systemic support offered to BCC by the U.K.’s institutional framework, and BCC’s very positive liquidity position, which is supported by access to the Public Works Loan Board (PWLB) and through the council’s committed liquidity facilities. In our opinion, BCC’s financial management is prudent and “very positive”, as defined under our criteria. We believe that BCC’s management will successfully support the council in a period of funding reductions and significant sector changes.

We believe that reforms and public sector funding reductions will somewhat pressure BCC’s operating surplus levels and we are expecting further narrowing in BCC’s operating surplus levels as a result of the central government’s expected cut in transfers in 2014. We view this as a rating weakness. The rating is also constrained by Birmingham’s high tax-supported debt, expected to be about 106% of consolidated operating revenues by 2015.

As a result of the May 2012 elections, the Labour Party has gained political control of the council, taking over from the previous conservative/liberal democratic-party-led coalition government. We do not expect these election results to lead to significant changes to Birmingham’s strategic approach and fiscal discipline.

In 2012, notwithstanding the overall reduction in public sector resources, we estimate that BCC has posted an operating surplus of about 5% in cash terms. This is stronger than our expectations last year and is partly related to higher levels of revenue support grants than our forecasts, as well as material operating expenditure reduction. From now on the council will have to deal with the implementation of the business rates reform, additional funding reductions from the central government from 2014 on, and cost increases related to inflation.

We expect BCC will adjust its expenditure profile further, by making use of its additional operating expenditure flexibility while posting narrower operating surplus levels. Our base-case scenario assumes average operating surpluses narrowing to 0.2% in 2013-2015 from 3.4% in 2010-2012. We also expect BCC to reduce investment levels compared to previous years, partly in response to current austerity. However, the council is exposed to an equal-pay lawsuit that we estimate might lead to significant payments over the next four years. We note that the timing of these payments is uncertain at the moment and that the final exposure may increase over the next two years. However, in our base case we have assumed that BCC will fund these payments with additional borrowing, leading to average deficits after capital accounts of about 6% within the rating horizon.

In 2012, tax-supported debt levels have increased significantly to 98.0% of consolidated operating revenues, from 84.5% in 2011, largely as a consequence of the Housing Revenue Account Reform (HRA). The reform has allowed BCC to keep the surplus generated on the HRA account (about £10 million in 2013), but in exchange has required the council to take on £336 million of associated debt. BCC has funded this debt through a number of loans from the PWLB. Over the rating horizon, we expect tax-supported debt to increase to about 106% of consolidated operating revenues, partly as a result of the additional borrowing related to the equal-pay lawsuit. Adjusted for these non-recurrent payments, related to the HRA reform and the equal-pay lawsuit, we expect the city to post only limited debt increases.

We view BCC’s liquidity position as very positive for the rating. It is supported by the PWLB, which provides the council with a prompt source of liquidity. In September 2012, BCC’s estimated unrestricted funds after Standard & Poor’s haircuts (which assume a partial loss from selling investments in a stress scenario) totaled about 53.8% of estimated debt service in the financial year ending March 31, 2014. Including access to committed liquidity facilities of £360 million, we estimate liquidity to cover more than 240% of estimated debt service for financial year 2014.

Moreover, BCC benefits from exceptional access to external liquidity and it can readily borrow from PWLB, provided that it acts in accordance with the Prudential Borrowing Code. According to this code, the council assesses its own borrowing limits based on what it judges to be financially sustainable.

The stable outlook reflects our view that BCC will adjust to reforms and funding reductions by making use of its operating expenditure flexibility, as well as maintain a positive–albeit narrowing–operating performance and deficits after capital expenditure averaging between about 5% and 10% of total adjusted revenues from 2013 to 2015.

We could lower the rating if BCC’s management were to fail to use its expenditure flexibility to adjust to funding cuts, or to sustain its currently prudent financial strategy, leading to a structural deterioration of its financial performance and a debt increase beyond our base-case scenario.

Although unlikely, we may consider an upgrade in the case of a combination of factors, such as an improvement in Birmingham’s economy, as well as any reform leading to an increase in revenue flexibility. We would also view favorably an improvement in BCC’s financial performance leading to a reduction of leverage.”