August 1, 2023/Fitch Ratings

Fitch Ratings has affirmed Lagos State’s Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) at ‘B-‘ with Stable Outlook. 

The affirmation reflects Lagos’s vulnerable risk profile by international standards and Fitch’s expectations of rising but sustainable adjusted debt. Internally generated revenue (IGR) underpins Lagos’s capacity to service its financial obligations, as evidenced by its Standalone Credit Profile (SCP) of ‘b+’. The IDRs are capped by the sovereign’s ‘B-‘ ratings. The Stable Outlook on the IDRs mirrors that on the sovereign.

Key Rating Drivers 

Risk Profile: ‘Vulnerable’

Lagos’s ‘Vulnerable’ risk profile reflects a very high risk that the state’s ability to cover debt service with its operating balance may weaken unexpectedly over our forecast horizon (2023-2027). This may be due to lower-than-expected revenue, higher-than-expected expenditure, or an unexpected rise in liabilities or debt-service requirements.

The risk profile combines two ‘Midrange’ key risk factors (revenue robustness, expenditure adjustability) and four ‘Weaker’ factors (revenue adjustability, expenditure sustainability, liabilities and liquidity robustness and flexibility).

Revenue Robustness: ‘Midrange’

Lagos benefits from a broad tax base and a diversified economy that contribute to a stable revenue structure led by IGR. IGR represented over 70% of its NGN893 billion operating revenue at end-2022 and is driven by moderately cyclical taxes such as personal income tax (PAYE). The stability of tax revenue is counterbalanced by some volatility in other operating revenue sources such as sales proceeds, rents, land-use charges, fees and fines.

Fitch does not view Lagos as being reliant on government transfers from the Federal Account Allocation Committee (FAAC), as statutory allocations (excluding VAT) represent less than 10% of Lagos’s operating revenue. Under our rating case of a stressed economy, we forecast a nominal average increase in operating revenue of around 9%-10% in 2023-2027, driven by moderate economic growth prospects.

Revenue Adjustability: ‘Weaker’

Fitch believes that Lagos’s fiscal flexibility relies on the wide but not fully exploited tax base of PAYE (which corresponds to about 45% of operating revenue), on which it has no tax-setting power. Rigid revenue sources collectively represent more than 85% of Lagos’s revenue, driving ‘Weaker’ revenue adjustability.

Lagos saw its maximum peak-to-trough revenue fall of 9% (NGN26 billion) in real terms over the last 10 years. This could have been offset by increasing its PAYE tax base by leveraging on Lagos’s large informal economy or by increasing revenue sources such as land use charges. However, Fitch believes that Lagos will more likely absorb possible revenue shocks by reducing its operating margin towards 35%-40% from last five years’ average of over 45%.

Expenditure Sustainability: ‘Weaker’

Lagos is exposed to a deteriorating operating environment, which weakens the state’s control over total expenditure growth, influenced by high inflation, rising commodity prices, and supply constraint amid naira depreciation. Lagos has a wide set of responsibilities and high need for capital spending to maintain its attractiveness as Nigeria’s main economic hub, with demographic pressures to provide more infrastructure, health and education services, limiting the scope for cutbacks. We expect Nigeria’s double-digit inflation to affect the 17% opex growth on average, a faster pace than operating revenue growth.

Expenditure Adjustability: ‘Midrange’

The central government does not have mandatory balanced-budget rules defined for Nigerian states, which are required to maintain their deficits at 3% of national GDP. Capex makes up 40% of Lagos’s expenditure before debt service, keeping the share of inflexible costs well below 70%, meaning there is some scope for adjustability.

Lagos’s expenditure cuts are moderately affordable, owing to better infrastructure and existing services compared with national peers. However, Fitch expects Lagos will continue to maintain a high level of capex to maintain its attractiveness for companies and residents.

Liabilities & Liquidity Robustness: ‘Weaker’

Nigeria’s framework for local and regional government debt is evolving so borrowing limits are quite wide. Nigerian states have no restrictions on debt maturities, interest rates or currency exposure. Lagos prudently keeps debt service at no more than 30% of operating revenue. To ensure timely debt service, its internal debt is assisted by a state-level irrevocable standing payment order while external debt is serviced by deductions from FAAC.

External debt with development lenders accounted for 44% of Lagos’s total debt at end-2022, exposing the state’s debt service to the fast naira depreciation observed in June 2023. In particular, we expect a steep rise in Lagos’s debt stock by end-2023, driven by the exchange rate expected at end 2023 at over 700 NGN/USD from 448 NGN/USD at end-2022. Our scenarios consider that Lagos could hit NGN2 trillion debt stock by end-2025.

Liabilities & Liquidity Flexibility: ‘Weaker’

Lagos has good access to local financial markets with repeat bond issuance, which represented 21% of its NGN1.3 trillion debt at end-2022. Lagos can access liquidity lines and short-term credit from domestic banks rated in the ‘B’ category, which drives our ‘Weaker’ assessment of this factor. Lagos holds cash in a sinking fund to support its debt service on bonds and Fitch conservatively deems year-end cash as earmarked to offset payables.

Debt Sustainability: ‘aa category’

Under Fitch’s rating case, Lagos’s debt payback ratio (net Fitch-adjusted debt/operating balance) hovers just above 5x in 2027. The ‘aa’ debt sustainability assessment also factors in lower debt service coverage (expected to be 1.1x by 2027) and higher debt-to-revenue ratio (190% by 2027) compared with peers.

Lagos benefits from a resilient fiscal performance with a sound operating margin above 45%, supported by the dynamism of IGR (+18% in 2022, in line with average IGR medium-term growth). Our rating case envisages a progressive reduction of the operating margin towards 35%-40%, incorporating stagnant IGR against inflation-driven operating expenditure.

Lagos’s net Fitch-adjusted debt is expected to reach NGN2.7 trillion by 2027, or 190% of revenue, under a scenario in which the NGN/USD exchange rate remains above 700. Fitch estimates a NGN3 trillion capex plan in the medium term, largely funded by the state’s own resources and new borrowing. Lagos’s ambitious capex plan aims to speed up the completion of several infrastructure projects (mostly schools, transports, health facilities) and to boost the state’s technology capacity and food security.

Derivation Summary

Lagos’s ‘b+’ SCP reflects a combination of a ‘Vulnerable’ risk profile and debt sustainability in the ‘aa’ category. The ‘b+’ SCP also reflects a debt payback ratio around 5x in the medium term. Fitch does not apply any asymmetric risk or extraordinary support from the central government. The IDR is capped at the sovereign level, as the federal government retains a dominant influence over Nigerian inter-governmental relations and resource allocation to states.

National Ratings

The ‘AAA(nga)’ National Rating reflects Lagos’s strength compared with national peers, thanks to its stronger operating performance driven by IGR, which make Lagos an outlier in the national context and underpins its capacity to serve its financial obligations.

Key Assumptions

Risk Profile: ‘Vulnerable’

Revenue Robustness: ‘Midrange’

Revenue Adjustability: ‘Weaker’

Expenditure Sustainability: ‘Weaker’

Expenditure Adjustability: ‘Midrange’

Liabilities and Liquidity Robustness: ‘Weaker’

Liabilities and Liquidity Flexibility: ‘Weaker’

Debt sustainability: ‘aa’

Support (Budget Loans): ‘N/A’

Support (Ad Hoc): ‘N/A’

Asymmetric Risk: ‘N/A’

Rating Cap (LT IDR): ‘B-‘

Rating Cap (LT LC IDR) ‘B-‘

Rating Floor: ‘N/A’

Quantitative assumptions – Issuer Specific

Fitch’s rating case is a “through-the-cycle” scenario, which incorporates a combination of revenue, cost and financial risk stresses. It is based on 2018-2022 figures and 2023-2027 projected ratios. The key assumptions for the scenario include:

– Operating revenue growing at around 10% on average, below nominal GDP growth rate; the revenue dynamic considers that transfers growth is driven by oil-price adjustments and NGN/USD exchange rate;

– Operating expenditure growth at 17% on average, driven by inflation;

– Average cost of debt expected to remain around 8% on average;

– Debt stock at NGN2.7 trillion stresses the conversion of foreign debt with a NGN/USD exchange rate above 700 across the rating horizon;

– Capital expenditure is expected to be financed with operating margins, minor capital grants and new debt.

Liquidity and Debt Structure

Fitch-adjusted debt include Lagos’s bond issuances at end-2022 of NGN275 billion and loans (both foreign and domestic) of NGN1.1 trillion. Fitch-adjusted debt includes NGN34 billion for leasing and pension liabilities. Liquidity includes a NGN30 billion sinking fund and NGN74 billion cash reserves, which Fitch deems as earmarked to offset payables.

Issuer Profile

Lagos is Nigeria’s economic centre with per capita GDP double the national average, but weak by international standards. Lagos’s diverse economy generates around 20% of Nigeria’s GDP, fuelled by public and private investment and a population of over 20 million.

Rating Sensitivities 

Factors that Could, Individually or Collectively, Lead to Negative Rating Action/Downgrade

A downgrade of the sovereign’s ratings could lead to corresponding action on Lagos’s IDRs.

Factors that Could, Individually or Collectively, Lead to Positive Rating Action/Upgrade

Positive rating action on Nigeria could be reflected in Lagos’s ratings.

ESG Considerations

The highest level of ESG credit relevance is a score of ‘3’, unless otherwise disclosed in this section. A score of ‘3’ means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. Fitch’s ESG Relevance Scores are not inputs in the rating process; they are an observation on the relevance and materiality of ESG factors in the rating decision. 

Discussion Note

There was an appropriate quorum at the committee and the members confirmed that they were free from recusal. It was agreed that the data was sufficiently robust relative to its materiality. During the committee no material issues were raised that were not in the original committee package. The main rating factors under the relevant criteria were discussed by the committee members. The rating decision as discussed in this rating action commentary reflects the committee discussion.

Public Ratings With Credit Linkage to Other Ratings

Lagos’s ratings are capped by Nigeria’s sovereign ratings (B-/Stable).

Best/Worst Case Rating Scenario

International scale credit ratings of Sovereigns, Public Finance and Infrastructure issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of three notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from ‘AAA’ to ‘D’. Best- and worst-case scenario credit ratings are based on historical performance. 

References for Substantially Material Source Cited as Key Driver Rating

The principal sources of information used in the analysis are described in the Applicable Criteria.