State of Santa Catarina #BB# Rating Placed On CreditWatch Negative On Conflict Over The Debt Payment Calculation

Stocks and Financial Services Press Releases Tuesday March 15, 2016 09:01
Standard & Poor's--15 Mar--Standard & Poor's
On March 14, 2016, Standard & Poor's Ratings Services placed its global scale 'BB' and national scale 'brAA-' ratings on the state of Santa Catarina on CreditWatch with negative implications.
RATIONALE

The CreditWatch placement reflects our view that the current conflict over the calculation of the outstanding debt the state owes to the federal government could result in a prolonged delay in the payment of regularly scheduled debt installments. We do not consider such scenario as a default because it is an inter-government payment. In addition, the state has capacity to pay. However, the non-payment informs our opinion of the state's willingness to pay and could lead to a change in our financial management assessment of Santa Catarina.

In 1998, the State of Santa Catarina signed a debt refinancing agreement with the federal government under the Law 9.496/97. In November 2014, Congress approved the Complementary Law 148 which includes the following measures:

The use of new index for the local and regional governments' (LRGs') and municipalities' new refinancing debt agreements depending on which index, either the broad consumer price index (IPCA) plus an annual spread of 4% (or the central bank reference interest rate [Selic]) or of the general price index (GPI) plus 6%, is lower.In addition, article 3 stipulates that the federal government will grant discounts on the LRGs' outstanding debt consisting of the difference between the outstanding amount as of Jan. 1, 2013, and the one determined by the accumulated variation of the Selic rate since the signature of the respective contracts.

In order for the LRGs to take advantage of the Complementary Law 148, they had to sign contractual amendments with the federal government before Jan. 31, 2016.

The state of Santa Catarina disagreed with the calculation of the outstanding debt as specified in the December 2015 decree (Decreto federal 8.616). The state claims that the debt calculation in this decree refers to the compound Selic rate, instead of the accumulated variation of the Selic rate under the Law 148, increasing Santa Catarina's debt that it owes to the federal government*. The state initiated legal proceedings in the Supreme Court of Justice (SCJ) against the federal government, but the motion was denied by one of the justices. The state is currently waiting for the resolution of an appeal it submitted to the SCJ.

In addition, Santa Catarina, along with other Brazilian states, is trying to reach a deal with the Ministry of Finance on an alternative agreement that would include a lengthening of the debt payments coupled with a discount on the installments for 12 or 24 months. Until the SCJ makes the decision on the appeal or an agreement with the Ministry of Finance materializes, the state announced that it will deposit the debt payment installments into a special account at Banco do Brasil beginning with the February 2016 installment of R$89 million. In response, the federal government froze the equivalent of R$89 million of transfers to Santa Catarina.

In our opinion, the state's decision to suspend the debt installment payments, regardless of the legitimacy of its claim, throws in doubt its willingness to comply with its financial obligations. If the suspension of the debt payments persists, we could revise downward our assessment of the state's financial management.

We believe that Santa Catarina's has capacity to pay, as seen in its decision of keeping the debt payment installment in a special account, which may also affect our view of its willingness to comply with financial obligations and its overall financial management assessment.

The ratings on the state continue to reflect its average budgetary performance and budgetary flexibility. The mitigating factors are the state's moderate debt levels, weak yet diversified economy, and weak liquidity. Furthermore, we consider the institutional framework for all Brazilian states to be evolving and unbalanced.

Our assessment of Santa Catarina's budgetary performance reflects operating surpluses of about 7.6% for the past five years and deficits after capital expenditures below 5% of total revenues, despite a deterioration in finances since 2014 as a result of weak domestic economy.

We expect an operating surplus of 5.9% of operating revenues in 2016, slightly down from 6.3% in 2015, given the projected deceleration of state's own revenues and growth in federal transfers. We expect an operating surplus of around 7% starting in 2017. Deficit after capital expenditures will be around 1.8% of total revenues in 2016 as Santa Catarina continues to reduce its capital spending.

We expect no or very slight deficits in 2017 and 2018. Nevertheless, the state's ability to implement capex continues to rely on borrowings and uncertain federal transfers. Santa Catarina's budgetary flexibility remains average as a result of its high own-source revenue base, which accounted for 73% of the state's operating revenues in 2015, slightly down from 75% in 2014. Own-source revenues have averaged 73% in 2011-2015.

We expect these revenues to remain around 74% for the next three years as the state will receive lower federal transfers amid weak economy. Still, Santa Catarina faces high wage cost pressures, like most Brazilian LRGs. Public-sector employee wages (including pensions) and interest payments represent around 64% of Santa Catarina's total expenditures. However, the state recently approved a pension reform package in order to reduce pension costs. We expect capex to remain around 8% of total expenses in the next three years, down from its 11.3% peak in 2014, given the reduction in external financing. Brazil's stagnant economy has taken a toll on Santa Catarina's finances, although to a lesser extent than in other states thanks to its well balanced and diversified economy.

The state's GDP per capita averaged $13,364 in 2012-2014, consistent with a weak economy by international standards, but it was above the national average of $10,995.
We believe that Santa Catarina's debt will remain moderate because the state will continue to have limited access to new loans in the short term.

The debt reached R$21 billion at end of 2015 or 104% of operating revenues. We estimate that debt will reach R$26.7 billion in 2018, equivalent to 103% of operating revenues. Although Santa Catarina's debt-to-revenues ratio is below those of many of its domestic peers, it remains high by international standards. We expect the state's debt service to remain below 5% of operating revenues in the next two to three years.

We consider that the state's contingent liabilities remain moderate. Most of Santa Catarina's government-related entities (GREs) are included in its budget and total debt. Together with its domestic peers, Santa Catarina operates in what we view as an evolving and unbalanced institutional framework.

The system that divides the fiscal powers between the central government and the LRGs in Brazil is based on three key parameters that have remained in place for a long time and have gained strong political and economic support. Liquidity Santa Catarina has a weak liquidity position.

At the end of 2015, free cash and equivalents was around R$930 million and debt to suppliers was R$190 million. Considering our projections for a balance after capex, debt payments, and interest projections in 2016, available liquidity should cover 62% of the state's financial obligations.

We consider that Santa Catarina's access to external borrowing is limited given our Banking Industry Risk Assessment of group '6' on Brazil. CREDITWATCH We aim to resolve the CreditWatch placement within the next three months. We could decide to keep the ratings on CreditWatch or we could remove and affirm or lower them. We could affirm our ratings on the state if it reaches an agreement with the federal government or if a SCJ ruling facilitates renewed, timely repayment of the debt installments, thereby limiting the negative impact on Santa Catarina's financial management.

Conversely, we could lower our global ratings on Santa Catarina by up to four notches if we believe there will be a prolonged delay in the debt payments, underscoring doubts over the state's willingness to pay its debt amid high liquidity pressures.

The measure of the Selic rate is done in two ways: through the simple factor of capitalization (Selic accumulated) or through the compound factor of capitalization (Selic compound). In the latter, interests apply on the sum of the principal and past interests. Under the former, interests only apply on the principal.


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