Fitch Rates South Carolina's $58MM GO Bonds 'AAA'; Outlook Stable
--$49.85 million GO state institution bonds (issued on behalf of Clemson University), series 2016F;
--$8.28 million GO state institution refunding bonds (issued on behalf of Lander University), series 2016G.
The bonds are scheduled to sell via competitive bid on Sept. 22, 2016.
In addition, Fitch has affirmed the following ratings for South Carolina:
--Issuer Default Rating (IDR) at 'AAA';
--$1.3 billion GO bonds at 'AAA';
--$4.4 million in outstanding lease revenue bonds issued by the South Carolina State Budget and Control Board at 'AA+'.
The Rating Outlook is Stable.
The bonds are general obligations of the state, secured by a pledge of South Carolina's full faith, credit, and taxing power. By statute, state institution bonds are also secured by tuition fees received by the university.
KEY RATING DRIVERS
South Carolina's 'AAA' IDR and GO rating rests on the state's proven ability and willingness to maintain a high level of financial flexibility, aided by constitutional reserve requirements and established replenishment provisions. The state's financial operations continue to be sound, bolstered by strong growth in the state's economic base and extensive budget controls. The state's liability levels are low; bond issuance is limited and amortization of GO bonds is rapid.
The rating on the lease revenue bonds, at one notch below the state's IDR, reflects the requirement for annual appropriation by the state legislature in support of debt service on the bonds.
Economic Resource Base
South Carolina's broad economic base with a large manufacturing sector has recorded solid growth coming out of the recession, aided by significant investments in aerospace, high tech, and automobile manufacturing by companies such as Boeing and BMW. Economic diversification is provided by the increased presence of trade, transportation, and warehousing operations. Unemployment rates are above national averages despite strong job growth, as they are boosted by robust labor force growth. While wealth levels remain below both southeastern U. S. and national averages, the state has been recording strong growth in personal income measures.
Revenue Framework: 'aaa' factor assessment
South Carolina has experienced strong revenue growth coming out of the Great Recession, reflecting an economic expansion that continues at a pace ahead of national averages. Fitch believes revenue growth prospects will continue to be strong over the medium term. The state has an unlimited legal ability to control its sources of revenue.
Expenditure Framework: 'aaa' factor assessment
The state has demonstrated ample expenditure flexibility and the broad expense-cutting ability common to most U. S. states. Fitch expects the natural pace of spending growth, largely driven by education and Medicaid funding needs, to be generally in line with revenue growth. South Carolina is expected to continue to ably manage its transportation capital needs, which have been a budget priority in recent fiscal years.
Long-Term Liability Burden: 'aaa' factor assessment
On a combined basis, the burden of the state's net tax-supported debt and unfunded pension obligations is equal to the U. S. state median at 5.8% and remains a low burden on the state's resource base. The state is a conservative issuer of debt and outstanding principal is rapidly amortized. Pension system funding is low.
Operating Performance: 'aaa' factor assessment
South Carolina has a proven ability and willingness to take action to support fiscal balance. The state has historically applied reserves and reduced expenditures in times of fiscal stress, bolstering its financial position as conditions improve. Fiscal oversight was long provided by the state's budget and control board and fiscal control has remained strong with the recent reallocation of its responsibilities to other government agencies.
The IDR is sensitive to shifts in fundamental credit characteristics, including the state's proactive financial management, commitment to reserve funding, and low liability position.
General fund revenues are derived from varied sources, with the personal income tax (PIT) and sales tax representing the largest share of revenues, at 46% and 39%, respectively. The state's Board of Economic Advisors (BEA) and Revenue and Fiscal Affairs Office are important contributors to the state's maintenance of fiscal balance through their frequent economic and revenue forecast updates and ongoing monitoring of financial operations.
Prospects for revenue growth are strong and are expected to coincide with the robust economic growth currently occurring in the state. The BEA's forecast for the fiscal year that began on July 1, 2016 projects 2% growth in state employment and 4.9% growth in personal income which is expected to provide for operating revenue growth absent policy measures approximately equal to growth in national GDP. The BEA's forecast for fiscal 2017 is for slightly weaker economic growth than that experienced in fiscal 2016 and notes that the lack of a large operating surplus in fiscal 2016 will reduce revenues available for appropriation in fiscal 2018 due to the state's surplus rollover policies. The BEA currently forecasts balanced operations in fiscal 2017 while noting additional, although smaller revenue growth for fiscal 2018.
The state has no legal limitations on its ability to raise revenues through base broadenings, tax rate increases, or the assessment of new taxes or fees.
As in most states, education and health and human services are South Carolina's largest operating expenditures. Education, accounting for 46% of general fund expenditures is the larger item of the two, as the state provides significant funding for K-12 education and its public college and university system. Health and human services spending is the second largest area of spending at about 26% of general fund expenditures with Medicaid being the primary driver. State budget discussions in recent years have focused on both the level of per pupil state spending on K-12 education as well as an identified need for additional spending for transportation capital projects. The state appropriated $301 million in additional funds for K-12 education in fiscal 2017, an 11% increase from actual expenditures in fiscal 2016.
Fitch expects that spending growth, absent policy actions, will be somewhat ahead of natural revenue growth, driven by both Medicaid as well as other service needs in this growing state, and require regular budgetary adjustments to ensure ongoing balance. The fiscal challenge of Medicaid is common to all U. S. states and the nature of the program as well as federal government rules limit the states' options in managing the pace of growth. In other areas, such as education and transportation, the state can more easily adjust the pace of spending growth.
Overall, South Carolina retains ample flexibility to adjust expenditures to meet changing fiscal circumstances. While Medicaid is an ongoing cost pressure, spending requirements for debt service, pension obligations, and other post-employment benefits (OPEB), while above the U. S. state median, are low. The state recently approved a 0.5% increase in employer and employee contributions to the state's pension systems; the cost to the general fund is approximately $18.5 million in fiscal 2017; a small expense in the context of the overall state budget that Fitch expects to have limited impact on improving the low funded ratios.
Long-Term Liability Burden
South Carolina's combined long-term debt and unfunded pension liability is low and at the median for U. S. states at 5.8%, per Fitch's October 2015 state pension update. The state has well-established constitutional and statutory debt policies which limit the purposes for debt issuance as well as place caps on maximum annual debt service requirements. The most significant use of GO debt has been for capital projects for higher education, transportation, and economic development. Outstanding debt for the state's transportation infrastructure bank (SCTIB), a state agency governed by a seven-member board that includes the chairman of the South Carolina department of transportation (DOT), approximates $1.7 billion (about 56% of the state's total net tax-supported debt) and is secured by various pledged revenue sources.
The funded ratios for the state's pension systems are low. A rolling, 30-year funding amortization method used by most of the five systems has resulted in annual contributions that while meeting 100% of the actuarially-required contribution (ARC), are less than the interest on the outstanding unfunded liability (UAAL). Additionally, the pension systems have not met their 7.5% rate of return targets over the past decade, contributing to the annual increases in the UAAL. Fitch notes that SCRS's plan fiduciary net position as a percentage of the total pension liability fell from 59.9% as of June 30, 2015 to 57% as of June 30, 2016. It is uncertain if the state will further address the decline in funding in the near future, although the state did modestly increase employer and employee contribution rates in the 2016 legislative session, as noted above. Given the low funded ratios and the state's pension policies, Fitch believes that the annual funding demands of pensions as well as the unfunded liability burden are likely to continue to rise.
South Carolina's ability to respond to cyclical downturns rests with its superior budget flexibility and evidenced ability to reduce expenditures and apply balances in its reserve funds to maintain balance. The state's finances were challenged by economic performance during the most recent recession that was more negative than that of the nation as a whole, with 7% total employment loss from 2008 through 2010 as compared to 5.5% for the nation. The state's operating revenues declined over these three consecutive years and the state addressed the loss through both programmatic reductions and the eventual depletion of the general reserve fund, which occurred in fiscal 2009. The state also fully applied balances in the capital reserve fund, generally applied to capital projects, to gap closing over the three years.
The state's careful approach to financial operations and solid revenue growth in the recovery has resulted in replenishment of the state's reserves to constitutionally required levels. The general reserve fund, available to close operating deficits, totaled $327.6 million at the end of fiscal 2016, equal to the required 5% of general fund revenues from the prior fiscal year. The capital reserve fund, which provides annual pay-go capital and was funded at the required 2% of prior year general fund revenues, $131 million for fiscal 2016, is also available to address operating deficits. The general fund's financial position is boosted by the maintenance of additional reserves and undesignated fund balances.
A 2014 administrative restructuring act established two financial agencies as key successors to the state's longtime Budget and Control Board. Effective July 1, 2015, the state's fiscal accountability authority provides significant oversight for the state's bond issuance, while the revenue and fiscal affairs office, overseen by the BEA, is responsible for the state's budget and frequent revenue and economic forecasting. Other revisions from the act have strengthened the ability to implement mid-year budget adjustments due to unexpected revenue underperformance, maintaining South Carolina's strong fiscal controls.
If the BEA reduces the revenue forecast for the fiscal year by 3% or less from projections, the director of the Executive Budget Office (EBO) must reduce general fund appropriations by the requisite amount to avoid a deficit. If the revenue estimate is revised downward by more than 3%, the legislature could be called into session to take action to avoid a year-end deficit. Should the legislature fail to convene or otherwise take measures to avoid a deficit within 20 days of the BEA's revision of the forecast, the director of the EBO is required to reduce general fund appropriations.
Current Operating Performance
Financial performance consistent with recent results is estimated for fiscal 2016, with revenue growth in the general fund of 4.4% from fiscal 2015, net of statutory deposits of income tax revenue to the tax relief trust fund, and expenditure growth of 5.4%. Programs benefited from the appropriation of surplus funds from prior fiscal years as the state recorded PIT revenue that was slightly below mid-year expectations although above the forecast used to enact the budget. The state's general reserve and capital reserve funds received modest deposits, maintaining balances at required levels. The BEA estimates smaller surplus operations in fiscal 2016, resulting in less revenue available to roll forward to fund operations in fiscal 2018.
For fiscal 2017, the BEA anticipates stable economic performance will provide for 4.8% gross general fund revenue growth that incorporates the positive impact of the biennial collection of many motor vehicle fees that adds a boost to revenues. Revenue growth and carryforward balances from fiscal 2015 support the enacted $7.6 billion general fund budget that includes $142 million in spending tied to the floods that caused severe damage in the state in October 2015. The bulk of funds to mitigate flood damages came from the Federal Emergency Management Agency. The state also appropriated over $200 million in additional recurring funds to its transportation budget to address capital needs. The state's reserve funds are expected to remain funded at required levels.