Regions face higher cost of debt and increased inequality while repaying federal loans

• In 2017, the Russian regions will be forced to repay more federal budget loans than they may receive. To balance the budget, the Russian government will continue to cut costs and reduce the amount of loans provided to federation subjects.
• ACRA expects the regions to see their weighted average lending rate grow, as starting 2017 the loans they received from the federal budget will be gradually phased out by some RUB 220 bln of market debt each year. By ACRA’s estimates, despite a 1.0-1.5 pps drop in market rates expected in 2-3 years, debt structure changes will push the weighted average interest rate on the regional loan portfolio up to 10.8% by end 2018 versus 9.2% seen in 2015.
• A switch from state support to state control will force the regions to cut spending heavily. Declining federal loan amounts will result in stiffer control over regional budgets. The Ministry of Finance has proposed to introduce a debt control system and to break federation subjects into groups depending on their debt sustainability. Regions with an excessive debt burden (22 of them were counted in 2015) will have to run a solvency recovery plan, while being deprived of the right to build up debt further.
• Cutting the debt burden of overleveraged regions will result in a greater inequality between the regions across the board. Unable to borrow, indebted regions will have to cut capital expenditures to fund their current needs. Assuming that social expenditures will be climbing 4% each year in 2016-2019, the development reserves of those regions will be depleted in some four years’ time, by ACRA’s estimates.
• The overleveraged regions will have to spend 40% of their revenues on debt repayment within a year, if they are suddenly deprived of the refinancing option.

Despite declining interest rates, the regions will see their cost of debt on the upside

An obligation to align salaries in the public sector with the market has led to an explosive growth in regional budget deficits starting 2012, as the social burden was piling up faster than local authorities could create new sources of tax revenues. As a result, growing current expenditures had to be financed by building up debt.

Federal loans are provided to the regions with a rate of 0.1% per annum and for the term of up to 5 years.

In 2015, some 70% of regional debt growth was attributed to cheap loans from the federal budget. By the end of the year, the latter’s share in the total regional debt stood at 35%. By ACRA’s estimates, while the municipal bond index Cbonds Muni showed a yield growth to 15.1% in December 2014 – March 2015, an increased share of cheap federal loans in regional portfolios allowed the regions to keep the weighted average cost of debt at 9.2% in 2015.

The necessity of a federal budget sequestration this year and an uncertainty about the structure of budget expenditures next year hardly bode for the amount of federal loans to stay unchanged in 2017. In addition, while market rates have stabilized (read more about this in an ACRA report “The Russian economy: absence of usual conditions for growth offset by impetus for structural change” published March 21, 2016), supporting regional budgets with cheap money seems no longer relevant.

ACRA expects the regional debt portfolios to see federal loans phased out by some RUB 220 bln of market debt every year starting 2017, which will raise their weighted average lending rate to 9.5% by end 2017 and to 10.8% by end 2018, despite a general trend of declining interest rates.

Figure 1. Weighted average lending rate growth forecast

New debt load control plans: overleveraged regions will have to restore solvency

The Ministry of Finance plans to amend legislation to provide for more control over regional debt. By 2019, all the regions will be broken down into three groups depending on their debt sustainability.

Table 1. Reference debt ratios

According to the Ministry of Finance, in order to be included into the group A, a region must keep all three ratios within appropriate limits, while the group C would welcome those with two ratios at the worst levels. The rest are slated to end up in the group B.

By ACRA’s estimates based on regional budget execution data, the group C should have accommodated 15 regions in 2014 and as many as 22 by end 2015.

Table 2. The most overleveraged regions at end 2015

ACRA expects that the indicator (2) “Annual debt repayment and servicing / revenues” will not account for turnover related to debt raising and repayment during a year, which might reduce the number of regions in the group C.

However, the regions that do get into this group will lose the right to raise more loans and build up debt. For them, borrowings are proposed to be capped by an amount needed for repayment of liabilities in a particular period. Meanwhile, each region in the group C will have to run a solvency recovery plan, stepping away from which may entail retaliation of up to sacking the head of such region.

To return the debt burden to moderate levels, the regions should save severely for at least four years

ACRA estimates that mandatory expenditures of regional budgets have climbed 8% on average over the last six years. By mandatory expenditures ACRA denotes those on social welfare, health, education and partly on the national economy, as well as public sector wages. Despite restraints put on budget expenses in 2015, their average annual growth in 2016-2019 is expected at 4% to say the least, given the traditional social spending surge during the election period. With tax revenues growth slowing down and new borrowings banned, the regions will be forced to finance their social obligations by cutting other expense items – for instance, capital expenditures. By ACRA’s calculations, in this case the group C will fully exhaust its own funding reserves of mandatory expenditures in four years, which in the long term threatens these regions with a reduction of their investment appeal due to infrastructure underfinancing (read more about regional budgets’ capital expenditures in an ACRA report “Regional Budgets to be Saved Again by Public Budget Loans in 2016” published March 2, 2016).

Slashing capital expenditures by regional governments will be taken as a negative signal by the business community much sooner than the time lapse discussed above, and this will consequently have a detrimental effect on private investments.

ACRA believes that without a systematic support from the federal government or a properly tuned fiscal relations mechanism, the regions will not be able to execute solvency recovery plans efficiently and, having exhausted the resources diverged from infrastructure financing, they will be confronted again by the need to raise debt.

A switch from state support to state control will amplify inequality among the regions

To date, no region has yet allowed the ratio (3) “Debt servicing / expenditures” to exceed the limit, as a significant amount of loans received from the federal budget reduces total loan portfolio costs.

However, the growing weighted average lending rate will boost debt servicing expenses, and the group C may well capture the regions with high debt and a large share of federal loans in their portfolios – in particular, Krasnodar Krai, as well as the Vologda, Ryazan, Penza and Volgograd regions.

The regions with an indirect debt load in the form of guarantees (provided usually in order to draw investments to the region) have found themselves in the same position as federal subjects with a direct debt load. Thus, the Kaluga region with its 13% of debt portfolio represented by guarantees would no longer fit into the group C, if these guarantees are excluded from the total debt count. Being indirect debt, guarantees require a more detailed study pertaining to their inclusion into debt portfolios.

According to ACRA’s calculations, the debt service ratio of the regions trapped in the group C is high – 40.3%. In other words, if these regions are unable to refinance their short-term obligations, they will have to spend 40% of their revenues (RUB 185 bln) on debt repayment. If they prove able to refinance debt and provided that the latter is fixed at a constant level in ruble terms, the ratio (1) will reach the normal value of 85% only in four years, during which time the regional budgets will have to operate in severe austerity.

Figure 2. Debt load forecast for the most overleveraged regions

The measures taken by the Ministry of Finance will allow the regions to systematically manage debt, i.e. to lighten their debt burden (first indicator), lengthen debt (second indicator) and reduce cost of debt (second and third indicators). However, the least successful in terms economic development federation subjects tend to be overburdened with debt in most cases. For regions deserving placement into the group C the average share of federal transfers in 2015 revenues ran into 36%, with 68% of this amount being non-earmarked funding. A consistently high proportion of transfers points to a systemic inability of the regions to finance expenditures on their own. Therefore, it seems obvious that in this situation the regions will hardly find resources to reduce their debt burden without a targeted assistance by federal authorities.

With the new regulatory regime in place and without a prior recovery of the regions with a high debt burden, we are likely to see a further “polarization” of federation subjects, with some still being able to raise commercial debt for development and others forced to constantly refinance the existing portfolio, while spending their entire budget on social needs.