As the pandemic recedes, subnational governments face new fiscal tests. These include higher interest rates and energy prices, a decelerating global economy, and geopolitical anxieties. S&P Global Ratings anticipates budgetary performance will get a little worse before it gets better.

Governments canvassed in this report enter 2023 from a solid starting point. Among the 15 largest regions in developed markets (ex-U.S.), the total cash deficit shrunk to US$37 billion in their respective fiscal 2022 years, or 3.3% of total revenues. This was barely one-third of the US$90 billion combined deficit in the prior year.

Subnational governments have benefited from an economic rebound that was much stronger than expected, and that boosted tax collections and obviated the need for more fiscal stimulus.

However, this year will be tougher than last (see chart 1). We project that the total cash deficit--a proxy for net new borrowing needs--will widen to about US$61 billion in fiscal 2023 (5.2% of total revenues). It will then narrow again in the outer years. Developed markets are experiencing elevated inflation, which tends to boost nominal tax revenues before it hits the expense base with a lag effect.

Chart 1

The Top-15 Subnationals Have US$1.4 Trillion In Combined Debt

We expect nine of the top-15 regions to remain in an after-capital deficit position across the next three years. For Canadian and Australian subnational governments, after-capital deficits will be prolonged by rising capital investment. One implication is that the largest Canadian provinces and Australian states will continue to be major issuers of commercial debt. We project net new borrowing needs for the top-15 in the order of US$36 billion-US$52 billion in fiscal years 2024 and 2025.

This report covers five Canadian provinces, four German states (Länder), four Australian states, and two Japanese prefectures. The coverage is identical to those in our last report (see "Local Government Debt 2022: Credit Quality Recuperating For Largest Regions In Developed Markets," published April 11, 2022, on RatingsDirect). We generally use terms like "subnational" and "regional" interchangeably.

Japan (US$990 billion), Canada (US$830 billion), Germany (US$730 billion), and Australia (US$340 billion) have among the largest subnational government debt stocks, in dollar terms, in the world. These four countries account for 69% of all subnational debt in developed markets ex-U.S. The top-15 regions alone have combined direct debt of about US$1.4 trillion, or 34% of the total.

Economic Obstacles Are Rising ...

While we expect net new debt issuance to decline over the next three years, economic hurdles could change things. A synchronized global tightening of monetary conditions will dampen growth in all four economies covered in this report.

Australia, in our view, is among the developed economies most exposed to monetary policy tightening. This is because of a high share of home mortgages with variable interest rates. Falling transaction-related property taxes will weigh on the budgets of New South Wales and Victoria.

In Japan, we project a modest tightening of the central bank's stance in 2023. By global comparison, though, Japan's ultra-low interest rates will help keep debt serviceability affordable. Central government measures to counter inflation, such as utility subsidies and travel allowances, are easing pressure on subnational government expenditures.

Our base case assumes the Canadian economy will decelerate to zero growth in 2023. The impact of higher prices and interest rates, combined with a recession for the U.S. in 2023, mean we expect a contraction in the first half of 2023. These crosscurrents should recede beyond the current year.

We see the eurozone economy stagnating in 2023. There are also downside risks relating to the Russia-Ukraine conflict. However, the worst-case scenarios around a winter gas shortage appear to have been averted for now. Such shortagas might have necessitated sizable support packages for the economy. For more details, see the following related research:

• Economic Outlook Canada Q1 2023: Economic Chills This Winter, Nov. 29, 2022
• Economic Outlook Eurozone Q1 2023: Reality Check, Nov. 28, 2022
• Economic Outlook Asia-Pacific Q1 2023: Global Slowdown Will Hit, Not Halt, Growth, Nov. 28, 2022

…But The Inflation Hit Is Lagging

Some cost pressures are building and will start feeding through to budget dynamics. But they will arrive with a lag. Indeed, most top-15 regions outperformed their own expectations, and ours, in fiscal 2022. As economies reopened and unemployment rates dropped below even pre-pandemic levels, own-source revenues rebounded strongly.

Major revenue lines such as value-added taxes (VAT), sales taxes, and payroll taxes tend to climb with inflation. Canadian provinces, which collect personal income tax, also benefit over the medium term when rising salaries push taxpayers into higher brackets. Meanwhile, operating expenditure moderated as temporary economic support programs are phased out.

Canadian provinces saw the largest turnarounds, relative to our expectations. Alberta's budget swung from an after-capital deficit of 45% of revenues to a 4% surplus in the space of one year (see chart 2), propelled by soaring oil prices. We project Alberta will remain in surplus through fiscal 2024.

Chart 2

Meanwhile, Ontario booked its first operating surplus since the 2008-2009 financial crisis. But a rising capital budget will weigh on its after-capital metrics in the next two years.

German states beat our expectations for fiscal performance in their fiscal 2022. Inflation is generally credit positive because states receive a fixed share of national tax revenue, which makes up roughly three-quarters of their total revenue. Meanwhile, various economic stimulus packages will have only a modest net cost, equivalent to about 1.3% of 2021 operating revenue (see "Inflation Bolsters German States' Resilience To Recession," Nov. 11, 2022).

However, we slightly revise down our budget-performance expectations for fiscal years 2023-2024. Wage agreements in North Rhine-Westphalia and Hesse are due to expire at the end of 2023. In fact, a common feature of most subnational labor markets covered in this report is their use of collective bargaining agreements. The multi-year nature of these agreements means it takes time for general inflation to materialize in higher public-sector wages; in the meantime, real wages may go backwards. Payroll typically accounts for between one-quarter and 40% of operating spending.

Commodity Windfalls Boost Mineral-Exporting Regions

Alberta's improving budgetary performance is spurred by very strong natural resource revenues, which increased more than fourfold in fiscal 2022 from the previous year (see chart 3). Similarly, Queensland, a major exporter of coal and liquefied natural gas, saw its royalty revenues rise 240% year on year.

Chart 3

Over the next two years, we expect energy prices to recede from their current elevated levels (see "S&P Global Ratings Revises Its Oil And Gas Price Assumptions On Supply/Demand Fundamentals," Nov. 19, 2022). Price volatility will continue, presenting both downside and upside risks for commodity exporters. Alberta's oil export capacity should be boosted by the completion of the Trans Mountain pipeline expansion around 2024.

Fiscal Rules Are An Important Point Of Differentiation

We believe the reimposition of zero-deficit ("debt brake") rules in 2023 should push Hesse and North Rhine-Westphalia to balance after-capital budgets, or come very close. This comes after all German states suspended their debt brakes over 2020-2022. (Note: the debt brake applies in government accounting rather than cash terms.)

We expect rated German states to retain a zero net new borrowing strategy. The central government will bear most of the cost of shielding residents from high energy prices. In a stress scenario that places upward pressure on operating expenditure for the German states, we think they could lower capital expenditure to comply with debt-brake legislation.

As a unitary country, the Japanese central government sets limits on prefectures' deficits and debt service. In contrast, Canada and Australia do not impose restrictions on provincial/state deficits or borrowing. Their subnational governments have substantial autonomy. One novel mechanism for promoting fiscal discipline is the linking of ministerial salaries to the size of the deficit, which occurs under Manitoba's balanced budget legislation.

Sector-wide fiscal rules are important, but idiosyncrasies in financial management also matter. Western Australia is diverging from its east-coast peers and paying down debt, underpinning its upgrade to 'AAA' in 2022. Victoria, on the other hand, removed its self-imposed quantitative debt limit in favor of a vague commitment to stabilize net debt (as a percentage of gross state product) in the "medium term."

Tokyo Metropolitan Government's fiscal discipline underpins its strong 'aa+' stand-alone credit profile, though the issuer credit ratings are constrained by the sovereign ratings on Japan.

Beyond fiscal rules, disparities persist in the levels of decentralization across countries. Canada's more decentralized federal model contributes to wider deficits (on average) among the large Canadian provinces. This is because the provinces are responsible for health and education services which are expensive and difficult to reform.

Rising Capital Investment Will Prolong Deficits

We forecast total capital spending will now plateau over the next two years, supporting the budgetary recovery for the top-15 regions. This comes after most reported an uptick in capital spending over fiscal years 2021 and 2022, as they accelerated projects to stimulate hard-hit economies.

We note substantial intra-country divergence in Canada and Australia. Some regions have made big medium-term commitments to public transport, health care, social infrastructure, and to support lower-tier municipalities. For British Columbia, for example, nominal capital spending in fiscal years 2023 and 2024 will be 75% above the pre-pandemic level.

In Japan, meanwhile, we anticipate a drop in capital spending for Tokyo Metropolitan Government following the Summer Olympics in 2021. The Prefecture of Osaka (unrated) may have higher capital investment needs in the run-up to World Expo 2025, but we think this can be funded through operating surpluses.

Rising Interest Rates Will Not Immediately Hamper Serviceability

We anticipate ratios of interest expenses to revenue will remain well below 5% for top German states, and below 1% for Tokyo Metropolitan Government. This is despite the sharp rise in market interest rates over 2022 as most central banks worldwide attempt to tame elevated global inflation (see chart 4). The Bank of Japan is a notable exception for now, despite widening its 10-year yield target band in December 2022.

Chart 4

Most subnational governments canvassed in this report issue long-dated debt at fixed coupons. This means higher market rates do not affect the existing stock of debt. North Rhine-Westphalia, for example, recently issued about €30 billion of bonds with tenors of between 30 years and 100 years. This pushed the weighted-average tenor of its debt portfolio toward 17 years.

While Canadian provinces with high debt ratios also have the greatest interest costs (see chart 5), they benefit from an average term to maturity of about 12 years. We expect the debt ratio of Manitoba, the most leveraged province, to plateau at around 300%. While nominal debt is high, its debt burden includes significant on-lending to the provincial utility, which is regulated and which we view as self-supporting.

Chart 5

However, regions running larger deficits (see chart 2) are exposed to greater interest rate risk on upcoming new borrowing needs.

Capital Markets Are The Dominant Source Of Debt Finance

We expect the top-15 regions to finance themselves predominantly in capital markets. Canadian provinces borrow only through bond issuance (see table 1). In addition to their Canadian-dollar programs, the provinces have sizable foreign-currency programs, regularly issuing in U.S. dollars, euros, pounds sterling, Australian dollars, and even Norwegian krone. We see this diversification as important given the large size of nominal borrowing.

Table 1

Ontario is by far the largest issuer, singlehandedly accounting for US$300 billion or more (see chart 6). The eastern Australian states, meanwhile, have climbed the charts as overseas peers scaled back issuance.

Chart 6

Bonds represent about 70% of all German states' debt; "Schuldschein" loan certificates and money-market borrowings account for the rest. North Rhine-Westphalia, as the largest German state by economic size, issues bonds in 10 different currencies. Some states--predominantly the smaller ones not covered in this report--issue joint benchmark bonds.

Australian states concentrate on domestic issuance, with only a tiny quantum of foreign-currency term borrowing. Japanese prefectures borrow through a mix of bond issuance in the huge domestic municipal market, bank loans, offshore bond issuance, loans from the central government, and via the Japan Finance Organization for Municipalities (JFM, a public-sector funding agency).

The top-15 subnational governments have a record of successful issuance in times of market disruption, as demonstrated during 2020-2021. They were also aided by the intervention of central banks to soak up bond supply. In the three federal countries, quantitative easing programs helped to backstop demand for subnational government bonds and to keep a lid on domestic bond yields. These programs included:

• For Canadian provinces, the Bank of Canada's Provincial Bond Purchase Program (ended May 2021) and Provincial Money Market Purchase Program (ended November 2020), plus purchases of provincial securities from private financial institutions under term repurchase agreements.
• For German states, the European Central Bank's (ECB) Pandemic Emergency Purchase Program (PEPP, ended March 2022) and Public Sector Purchase Program (PSPP).
• For Australian states, the Reserve Bank of Australia's Bond Purchase Program (ended February 2022), plus a separate series of discretionary purchases early in 2020 to address market dislocations.

The gradual exit of central banks will increase the "free float" of bonds available to other investors. Central banks are in a process of passive quantitative tightening, letting bonds roll off their balance sheets at maturity. For the ECB, maturing principal payments from securities purchased under PEPP will be reinvested until at least end-2024, but there will be only partial reinvestments of redemptions under PSPP from March 2023 onward.

Environmental, Social, And Governance Risks Are In Focus

Physical risks remain manageable. Several of the top-15 borrowers have been buffeted by environmental disasters during the past two years. These include floods in North Rhine-Westphalia (2021), Manitoba (2022), and the eastern states of Australia (2022). Costs are usually shared between central and subnational governments and can be easily met by the balance sheets of highly rated borrowers (see for example "Bigger Flood And Fire Tests Lie Ahead For Australia," Jan. 17, 2023).

Regional governments are often first movers in issuance of green, social, and sustainable (GSS) bonds. Many are years ahead of their respective central governments in tapping the GSS market. Ontario has C$13 billion of green bonds outstanding at the time of writing (about 3% of its bonds on issue). Tokyo Metropolitan Government has been active in green bonds, too, and issued Japan's first-ever municipal social bond in 2021.

Hesse issued the first green bond of benchmark size among German states in 2021. Hesse embedded sustainability as a state objective in an amendment to its constitution in 2018. North Rhine-Westphalia has issued nine sustainability bonds, and its wholly-owned NRW.BANK has borrowed in green and social format.

We anticipate more issuance in GSS format in the coming years. The Canadian sovereign issued an inaugural green bond in 2022, which may help to advance the development of the green market in that country. Mining-oriented Alberta and Western Australia are among notable absences from the GSS market, though the latter is exploring issuing in sustainability format in fiscal 2023.

These use-of-proceeds bonds fit comfortably with policy responsibilities for subnational governments in areas as diverse as public transport, electricity networks, hospitals, forestry management, and climate-change adaptation. Regional governments are frontline providers of infrastructure and key social services, often more so than sovereigns. In some cases, GSS bonds have attracted larger or more diverse order books at primary issuance and priced at a marginal "greenium."

Credit Quality Is Strengthening After Two Dour Years

Our last four rating actions on top-15 regions were positive, signaling a gentle upturn in credit quality. This includes upgrades of two major mineral-exporting regions, Alberta and Western Australia, in 2022 (see table 2). Further upgrades or downgrades appear relatively unlikely over our two-year outlook horizon. This is because all the top-15 regions publicly rated by S&P Global Ratings now carry a stable outlook.

Prior to that, we had taken 11 negative rating actions on top-15 regions. This included downgrades of two Canadian provinces in 2021 and two Australian states in 2020.

Table 2

Methodological Notes

In this report series, we refer to developed markets or advanced economies outside of the U.S. These include Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Italy, Japan, New Zealand, Norway, Spain, Sweden, Switzerland, and the U.K.

Deficits referred to in this report are our measure of after-capital-account balances, in cash terms. We do not rate the City-State of Berlin, State of Lower Saxony, or Prefecture of Osaka, but have incorporated our estimates of their deficits and borrowing in this report.

Related Research

• Subnational Debt 2023: Australian States Navigate Crosscurrents Of COVID, Coal, And Capex, Feb. 27, 2023
• Canadian Local And Regional Government Debt: Economic Headwinds Will Slow Debt Sustainability Efforts In Fiscal 2024, Feb. 15, 2023
• Bigger Flood And Fire Tests Lie Ahead For Australia, Jan. 17, 2023
• Economic Outlook Canada Q1 2023: Economic Chills This Winter, Nov. 29, 2022
• Economic Outlook Eurozone Q1 2023: Reality Check, Nov. 28, 2022
• Economic Outlook Asia-Pacific Q1 2023: Global Slowdown Will Hit, Not Halt, Growth, Nov. 28, 2022
• S&P Global Ratings Revises Its Oil And Gas Price Assumptions On Supply/Demand Fundamentals, Nov. 19, 2022
• Inflation Bolsters German States' Resilience To Recession, Nov. 11, 2022
• Local Government Debt 2022: Credit Quality Recuperating For Largest Regions In Developed Markets, April 11, 2022