OREANDA-NEWS. Fitch Ratings has downgraded the Brazilian state of Sao Paulo's national long-term rating to 'AA(bra)' from 'AA+(bra)' with a Stable Outlook as a result of ratings recalibration following successive downgrades of the sovereign over the last six months.

Fitch has also affirmed the Long-Term Issuer Default Rating (IDR) at 'BB'. The Rating Outlook remains Negative. The Outlook reflects the Negative Outlook assigned to Brazil. The full list of rating actions follows at the end of this release.

KEY RATING DRIVERS

The state of Sao Paulo's rating affirmation reflects its strong economy, which is about one-third of the Brazilian GDP. The ratings are based on an adequate fiscal performance when compared to peers in the same rating category with a better fiscal autonomy in relation to Brazilian states. The ratings are also supported by the fact that Sao Paulo's most important creditor is the federal government.

Fitch no longer expects Sao Paulo to post operating margins higher than 5%. In 2015, operating margins reached 5.4%. Operating margins should stabilize close to 3% by 2018, according to Fitch's calculations. Fitch believes the state has been resorting to using nonrecurring revenues, but in much lower proportion when compared to other large Brazilian states.

The prolonged economic recession has translated into a poor performance in tax collections, especially for Sao Paulo, whose economy is more influenced by the industrial sector. Sao Paulo's fiscal performance is dependent on the Imposto Sobre Circulacao de Mercadorias e Servicos (ICMS) tax, which is highly correlated with the performance of the national economy. Fitch expects Brazil to contract by 3.5% in 2016, with some recovery expected in 2017.

Sao Paulo's financial debt has been increasing. In 2015, direct debt over current balance jumped to 7.6 years from 1.9 years registered in 2014. According to the state's debt projections, this ratio should materially diverge from historical values reaching levels close to 20 years, but still lower than 'BB' rated entities (33 years). Sao Paulo's exposure to foreign debt is relatively low and should consume less than 25% of the state's operating balance until 2019.

Pension payments have been compromising a relevant portion of personnel expenditures. In 2015, Sao Paulo allocated some 34.5% of total annual personnel expenditures, or BRL2.3 billion per month, to its proprietary pension system. Operating as a cash-based fund, financial shortages should increase on average by 15% over the last five years, reaching BRL19.3 billion in 2016, or 9.5% the state's operating revenues.

Fitch considers Sao Paulo's liquidity as adequate, with no short-term concerns, even considering an amount of unpaid commercial short-term liabilities that corresponded to 8% of operating revenues in 2015. The short-term obligations are mainly composed of debt service (33%) and credit and tax provisions (23%). The outstanding cash positions of BRL22.2 billion covered 42.4% of the state's obligations due in 2016 and corresponded to 10.9% of the state's operating revenues (9.3% in 2014).

RATING SENSITIVITIES

State of Sao Paulo's ratings are capped by the Brazilian sovereign. Any rating action affecting the Federative Republic of Brazil, currently rated 'BB'/Outlook Negative, will exert a direct impact over Sao Paulo's ratings.

An operating margin lower than 2% coupled with a higher level of financial debt and expressed by a direct debt/current balance higher than the equivalent to 20 years, could exert negative pressure on Sao Paulo's ratings.

KEY ASSUMPTIONS

The ratings and Outlooks are sensitive to these assumptions:

--Fitch assumes a high level of sovereign support for Sao Paulo given the national relevance of the state and the fact the state's most relevant creditor is the Federal Government.

--Fitch assumes that any political transition to a new government during the impeachment process will be smooth and peaceful but with some delays in progress on the government's legislative agenda especially the ones affecting subnationals such as pension reform and federal debt renegotiation.

Fitch has taken the following rating actions:

State of Sao Paulo:

--Foreign Currency Long-Term IDR affirmed at 'BB'; Negative Outlook;

--Foreign Currency Short-Term IDR affirmed at 'B';

--Local Currency Long-Term IDR affirmed at 'BB'; Negative Outlook;

--Local Currency Short-Term IDR affirmed at 'B';

--National Long-term downgraded to 'AA(bra)' from 'AA+(bra)'; Stable Outlook;

--National Short-term rating at 'F1+(bra)'.