OREANDA-NEWS. Fitch Ratings has affirmed the Estonian City of Tallinn's Long-term foreign and local currency Issuer Default Ratings (IDRs) at 'A' with Stable Outlooks. Fitch has also affirmed Tallinn's Short-term foreign currency IDR at 'F1'.

The affirmation reflects our unchanged view that the city will maintain its strong performance over the medium term, providing adequate debt service.

KEY RATING DRIVERS
The 'A' ratings reflect Tallinn's sound fiscal performance, stable and moderate direct debt, high self-funding capacity of investments, a well-diversified but modest-sized local economy and a stable regulatory regime. The ratings also factor in the growing debt of the city's companies.

In our unchanged view, we expect that the city will be able to maintain a stable operating margin of around 9% over the medium term, despite structural limitations on operating revenue and ongoing pressure on operating expenditure. Effective financial and cost management helped limit growth in current spending to below that of operating revenue in 2013-2015 and we expect this approach to continue in the medium term. As a result, the city's operating balance to operating revenue improved to 9.1% in 2015 from 7.3% in 2013.

We expect Tallinn's capital outlays to average EUR75m per year for 2016-2018 or 13% of total spending. Infrastructure investments are likely to dominate (roads, tram line, renovation of city's property). The city's capacity to self-fund investments is high, with capital revenue (mainly EU grants) and the current balance covering most of its capital expenditure. This should reduce Tallinn's new financing needs. In 2015, capital expenditure was EUR43m and fully financed from current balance and capital revenue.

We expect the city's direct debt to stabilise at a moderate 40% of current revenue in 2016-2018 (2015: 38.6%) as a result of the high current balance and EU grants almost fully financing investments. Direct debt is expected to hover around EUR200m in 2016-2018, slightly above the EUR196m reported at end-2015. About half of the debt stock at end-2015 was loans granted by the European Investment Bank, which lowers the interest burden for the city. The loans mature in 2027-2034 and provide Tallinn with a smoothly amortising repayment schedule.

According to our projections, Tallinn's operating balance should comfortably cover debt service in 2016-2018. The debt payback ratio (debt/current balance) is forecast to stabilise at five years, the same level as in 2015 and should be well below the city's average debt maturity of 13 years, which is credit positive. The annual debt service is expected to average EUR20m and account for 44% of operating balance on average in 2016-2018, lower than the annual average in 2011-2014 (EUR23m or 74% of operating balance).

Indirect risk is low and therefore does not exert pressure on the city's budget. Tallinn expects the debt of its companies to increase and peak to about EUR90m at end-2017 from EUR77m at end-2015, mainly due to debt-financed investments of the transportation company renewing its fleet. The companies' debt counts towards the city's debt limits and is strictly monitored by Tallinn's administration.

As Estonia's economic centre, Tallinn contributes about 50% of national GDP. Its service-oriented and diversified economy results in high tax revenue for the city. We expect that management's efforts and our projected expansion of the national economy of around 3% annually in the medium term will further support the local tax base expansion and the city's tax revenue. Together with prudent budgeting and a conservative debt policy, this helps underpin Tallinn's ratings.

RATING SENSITIVITIES
The ratings could be upgraded if the city's operating balance structurally strengthens to about 10% of operating revenue, accompanied by stable direct and indirect risk over the medium term.

Negative rating action could result from a sustained deterioration of the operating margin to well below 7% or a significant rise in Tallinn's direct debt, leading to the city's debt payback ratio (debt/current balance) exceeding 10 years.

KEY ASSUMPTIONS
Fitch expects the city to continue exercising operating expenditure restraint and to manage the budget prudently over the medium term.

Fitch also assumes that the city will continue to comply with all the EU regulations and procedures when implementing investments projects co-financed by the EU. Otherwise, Tallinn could face the penalty of having to return previously received EU grants.