Research: Lombardy (Region of)
Publication Date: 27-Jan-2003
Reprinted from RatingsDirect
Analysts: Alexandra Dimitrijevic, Paris (33) 1-4420-6663; Massimo Visconti, Milan (39) 02-72111-206
ISSUER CREDIT RATING
Lombardy (Region of)
Issuer credit rating AA+/Stable/–
AFFIRMED RATING AA+
Lombardy (Region of)
Sr unsecd debt AA+
ISSUER CREDIT RATING HISTORY
Dec. 17, 2001 AA+
The ratings on the Region of Lombardy reflect the region’s sound financial performance; very low debt burden (representing less than 1% of regional GDP in 2002); and substantial liquidity, which amply covers debt service. The rating also takes into consideration Lombardy’s very wealthy economy–one of the strongest among European regions–and prudent, sophisticated management.
The ratings are constrained by the concentration of Lombardy’s budget on health care (70% -80%)â€”a difficult expenditure to control–and by the Italian state’s hefty debt, which Lombardy, accounting for 20% of Italy’s GDP, indirectly bears.
Standard & Poor’s assignment of a higher rating to Lombardy than to the Republic of Italy (AA/Negative/A-1+) is supported by Lombardy’s credit strengths as well as by recent changes in Italian legislation, including a 2001 constitutional amendment, which have significantly increased Italian regions’ financial autonomy and flexibility, particularly on the revenue side. This tax flexibility has, however, been temporarily and partially frozen in 2003 for a period of one year, during which a joint commission of the Italian state and regions will work to redefine and further increase regional autonomy, pursuant to the constitutional amendment. The outcome is expected to be made public by end-March 2003, and Lombardy is likely to benefit in particular from enhanced fiscal autonomy given its very wealthy tax base.
Lombardy’s structural credit strengths should enable it to deal with potential pressures from the transfer of new responsibilities from the central government. Thus far, the region has proved its capacity to both fully finance its share of past health care deficits and maintain a very low debt level (relative to other ‘AA+’ rated regional governments internationally).
The stable outlook reflects Standard & Poor’s expectation that the commission will announce a higher level of fiscal autonomy for Italian regions at end-March 2003. If this does not occur, it is unlikely that Lombardy’s rating will be able to remain above Italy’s.
Standard & Poor’s also believes that Lombardy will maintain solid financial performance and low debt levels, thanks to its strong economic base, the measures taken to limit health care expenditure growth, and the state’s participation in financing major regional infrastructure projects.
One of the Strongest Economies in Europe
A large, dynamic demographic base.
Lombardy is located in the center of the vast Po River basin in northern Italy, surrounding the city of Milan (AA/Stable/–). With 9.1 million inhabitants, it is Italy’s most populous region by far (representing 15.8% of the national population in 2000). Lombardy has a dynamic demographic profile, with a relatively young population (18% under the age of 20 and 24% over the age of 60) that is increasing at a moderate pace thanks to positive migratory flows (0.3% average annual growth between 1991 and 2000).
A wealthy economy, with a strong industrial base and a diversified services sector.
Lombardy has a very large and wealthy economy, with GDP of about â‚¬238 billion in 2000 (source: Istat), ranking in terms of size between Austria and Belgium. It is among the wealthiest regions in Europe, as illustrated by its GDP per capita 36% above the EU average in 2000 (source: Eurostat; purchasing power standard).
As one of Italy’s leading industrial centers, Lombardy produced 22.7% of the nation’s industrial GVA in 2000 (latest data available). As a result, the industrial sector accounts for an above-average share of regional employment (40% in 2001, including construction, versus the 32% national average).
Lombardy’s strong industrial base, characterized by a particularly large presence of medium-sized companies, has undergone a large transformation process over the past two decades: Heavy industries, such as chemicals, metallurgy, and minerals, were downsized, while high-tech industries developed and small firms took over the non-core processes of large companies in basic sectors such as steel and car production. After a period of decline, industrial employment has stabilized over the past five years. Lombardy’s industrial network is now dynamic and well diversified, the largest sectors being mechanical industries, electrical machinery and appliances, transportation equipment, chemical and pharmaceutical goods, and textiles. The region’s industry is largely export-oriented, accounting for 29% of Italy’s exports in 2001, of which more than half go to EU countries.
The services sector is the largest contributor to the regional economy, however, employing 58.2% of the regional labor force in 2001. The sector has expanded considerably, with a 13% rise in the number of jobs registered between 1997 and 2001. Part of this expansion is a logical outgrowth of industrial consolidation and modernization and derives from the development of a strong bankingÂ and insurance sector, as well as core business services, high tech, and communications.
Milan is Italy’s main financial center, with 224 banks and 5,400 branc h offices; it is also the seat of the Italian Stock Exchange (aggregated capitalization of â‚¬592 billion in 2001). Home to 12 universities, Lombardy also has 230,000 students (15% of Italy’s university population) and has developed important research activities. Finally, the region is a major tourist destination, with 7.5 million visitors in 2000 (mainly on business trips); it benefits from four international airports and a dense network of roads and railways.
Thanks to its dynamic economic profile, Lombardy’s unemployment rate is one of the lowest in Europe, having fallen to 3.7% in 2002 from 5.8% in 1997 (versus 9.5% at the national and 7.3% EU levels in 2002).
An open economy with dynamic growth prospects.
Lombardy’s economy has mirrored the national trend over the past few years, with an average 1.8% real GDP growth between 1996 and 2001. After a slowdown in 2002, in line with the international trend, the region’s growth is expected to pick up as of 2003 and slightly outperform the national trend.
Lombardy has held up relatively well against past economic downturns thanks to the diversification of its economic base, as well as rapidly growing employment in logistics, high technology, and neweconomy activities. The region is striving to anticipate the major business challenges of the future, and is largely concentrating its efforts on the R&D sector, in addition to technological innovation processes.
More than one-third of Italy’s total foreign direct investment is concentrated in Lombardy, and about 32,000 active businesses have been created over the past three years, reflecting the region’s attractiveness. Lombardy benefits from structural strengths that should sustain its medium-term growth, such as its dense transportation infrastructure, strong business profile, and very open economy. Also, it should continue to benefit from its strategic location at Italy’s north-south and eastwest crossroads.
Prudent and Sophisticated Management
Lombardy is characterized by strong political stability. The same right-wing coalition majority has been in office since 1995, accounting for 63% of the council seats. The president of the region, Roberto Formigoni, was re-elected in 2000 for a second mandate. The main priorities of Lombardy’s council for the 2000-2005 mandate are to:
-Â Â Â Foster the central government’s devolution of new responsibilities to regions,
-Â Â Â Improve the efficiency of the health care system, and
-Â Â Â Develop large infrastructure projects, using mainly state and EU funds, coupled with private partnerships
Lombardy’s management is highly competent and sophisticated. The region has implemented refined programming tools to carefully track the objectives set by the regional council and monitor the results.
Financial statements are timely and well documented. Financial performance has always been better than what was budgeted, demonstrating the prudent management.
Good revenue flexibility, despite current temporary freeze
Italian regions have gained good revenue flexibility with the legal changes that have taken place over the past couple of years. In Lombardy, state transfers account for only 3% of operating revenues in the 2003 budget, down from 85% in 1997. This radical change is, however, mitigated by the fact that a large portion of Lombardy’s tax revenues is derived from a global sum accorded by the state for the purpose of financing health care spending. This sum (made up of the regional tax on productive activities (IRAP), a surcharge on the personal-income tax (IRPEF), and the VAT) is expected to increase by 4% per year between 2002 and 2004.
Nevertheless, regions do have real room for maneuver to modulate the rates of the above-mentioned taxes. Lombardy used part of this flexibility in 2002, gaining an additional 2.2% in tax revenues. Additionally, the region could gain up to 16% more in tax revenues if it were to tap its revenue flexibility to the maximum (mainly on the IRAP and IRPEF taxes, as well as a few other regional ones). This flexibility was, however, temporarily frozen in 2003 by the state financial law, for a period of one year during which a joint state-regions commission is working to redefine the taxing power of Italian regional authorities, in order to grant them more financial autonomy as a follow-up of the 2001 constitutional law. The outcome of this commission’s deliberations is expected to be public by the end of March 2003, and Lombardy anticipates that it will benefit particularly from the enhanced fiscal autonomy given its very wealthy economy.
The region also has a margin of maneuver on the voucher system (i.e., co-financing of pharmaceutical and hospital expenditures), which the state eliminated in 2000, resulting in an explosion of pharmaceutical costs. Regions are now responsible for this item, and 10 regions already reintroduced the voucher system. Lombardy announced its intention to do so in 2003, expecting an additional â‚¬130 million in revenues (equivalent to 1% of tax revenues).
Reasonable expenditure flexibility despite concentration on health care
Lombardy’s expenditure flexibility lies primarily on the capital side; capital investments accounted for 9% of total spending in 2001. Until now, the region has had very few direct investments, and capital expenditures have consisted mainly of contributions to public and private entities.
Lombardy is currently seeking to accelerate infrastructure projects. In this context, it has drawn up an “extraordinary” plan for all major capital investments that are likely to be made over the next 10 years. These projects amount to a total of â‚¬30 billion, but most are largely to be financed by the state, the EU, or other public or private entities. They focus mainly on transportation, the environment, and health care. The largest are the renovation of Malpensa airport; the expansion of the Milan trade-fair center; the building of a high-speed train link to Turin and Bologna; and several improvements to the motorway network, all of which will largely be state financed. Given the size of the projects, they will not be carried out if the state’s funds are not forthcoming.
The share of the infrastructure projects to be financed by the region itself is estimated at â‚¬750 million per year for the 2003-2005 period. The regional share consists primarily of smaller projects in the housing, urban renovation, and transportation sectors. Lombardy’s capital investments are quite flexible given the currently good infrastructure level.
The lion’s share of Lombardy’s operating expenditures is related to health care (75% of the 2003 budget), as in most Italian regions. Lombardy has fully covered all past health care deficits. Its main challenge is now to contain expenditure growth within the limit of the 4% increase in funds assigned by the state. Between 1997 and 2001, health care spending climbed by 7% per year on average, in line with the national trend, and the region estimates another 8% rise for 2002. Part of this high growth was attributable to significant re-evaluations of medical staff wages, but it was also largely ascribable to the sharp rise in pharmaceutical costs following the state’s elimination of the voucher system in 2000.
The region has reasonable room for maneuver to improve efficiency and contain future health care expenditure growth. It has already launched several initiatives, such as:
-Â Â Â The reintroduction of the voucher system, which should result in both a lower consumption of drugs and higher patient payments (a total â‚¬250 million gain expected on the revenue and expenditure sides);
-Â Â Â The use of the price of generic medicine as a basis for reimbursement and a lower reimbursement of certain drugs;
-Â Â Â A gradual staff reduction through limited new hiring;
-Â Â Â Tighter controls over public health care units’ budgetary procedures and organization; and
-Â Â Â Further reorganizing the hospital network.
Despite all of these measures, health care is expected to remain the main source of pressure, with an estimated 4% structural annual growth deriving from an aging population and improvements in technologies and research.
Other key operating expenditures are regional administration (3%) and transfers to public transportation companies (3%). The latter have remained stable over the past five years and are not expected to increase, since regional transportation companies have posted balanced accounts. Since 2001, Italian regions have been responsible for regional rail transportation. In the case of Lombardy, this represents 1% in additional operating expenses, entirely covered by new resources.
Consistently good financial performance.
Lombardy’s financial performance is good and stable. The region’s operating margin accounted for about 2% of operating revenues on average in 2000 and 2001, and the same level is estimated for 2002. Italian regions do not typically boast large operating margins, since they have substantial responsibilities on the operating side and few on the capital front.
Until 2001, Lombardy had fully self-financed its capital investments, using own sources, as well as state and EU capital transfers. As a result, the region’s moderate financing requirements (0.5% of total revenues on average in 2000 and 2001) all related to the financing of past health care deficits, which are now fully financed. In 2002, most of the region’s capital expenditures were financed through state capital subsidies and a loan entirely repaid by dedicated state transfers; Lombardy’s financing requirement is expected to represent a modest 1% of total revenues.
In the coming years, the region’s borrowing needs will derive solely from its capital-investment program, and should remain moderate given the high level of state co-financing. Since Italian legislation now prohibits the debt-financing of the health care deficit, Lombardy used its flexibility on tax rates in 2002 to cover this deficit (â‚¬266 million, or 2% of health care expenditures; â‚¬300 million estimated for 2002). The introduction of a voucher system, together with the other cost-containment measures and higher revenues, should help balance the region’s health care accounts in the future.
Like most Italian regions, Lombardy has a negative unreserved fund balance, which accounted for 6.8% of total revenues at year-end 2001. This ratio includes all expenditures committed but not yet financed given the long delays in carrying out investment plans. The region includes these liabilities every year in the budget, as well as in its assessment of future financing requirements.
Very strong cash position.
The region has a robust cash position, with â‚¬1 billion on average in the first 10 month of 2002 at the regional treasury and â‚¬0.9 billion available at the central treasury level and due by the state. This total liquidity level represents almost 10x the annual debt service and 11% of operating expenditures.
As of March 2001, Italian regions have been able keep a larger portion of their revenues at the regional treasury (representing about 20% of Lombardy’s operating revenues). Only state transfers, IRAP taxes, and the VAT continue to be kept in non-interest-bearing accounts at the Bank of Italy until the region requires them.
Very low debt.
At year-end 2002, Lombardy’s total debt accounted for a very low 16% of operating revenues, or 1% of regional GDP. Half of this debt is composed of loans entirely serviced by dedicated state contributions and related to past health care deficits or large infrastructure projects at charge of the state.
Of the $1 billion bond issued by the region in October 2002, â‚¬398 million was used to refinance existing loans serviced by the state, â‚¬525M to finance infrastructure projects with the debt service entirely financed by the state, and the remaining â‚¬102M for regional investments.
Lombardy’s debt service accounted for a very low 2.6% of operating revenues in 2003. Debt management is prudent, with no foreign exchange risk, and 49% of the debt is at fixed rates. The $1 billion bond was swapped to cover both the currency risk and the conversion of a bullet maturity into an amortizing profile. The region launched a â‚¬2 billion Euro Medium-Term Note program in order to diversify its funding sources in 2002, but has not launched any issue under this program thus far.
In the next three years, total debt could rise to 25%-30% of operating revenues in a very prudent scenario, but it is more likely to increase only marginally from the current level, given Lombardy’s high self-financing capacity and the state financing of important infrastructure projects.
Low contingent liabilities.
The region has a very small guaranteed debt level (<1% of operating revenues) and no pension liabilities. It has stakes in a few companies, none of which represents a significant risk. Lombardy has some off-balance-sheet liabilities deriving from one peculiarity in the Italian accounting system for regions, whereby operating expenditures committed but not paid are cancelled after two years, and capital expenditures after seven years, following which they become “perenti.” The region is legally responsible for the payment of these perenti, even though some of the liabilities are very old and are unlikely to come due at all. In practice, only a limited portion of the liabilities comes due in the year (21% for Lombardy in 2001). Lombardy inserts a provision in its annual budget to cover potential financing requirements deriving from them. At year-end 2001, perenti represented about 7% of operating revenues and were 71% covered by a provision in the 2002 budget.
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