OREANDA-NEWS. Fitch Ratings has affirmed the Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) of the State of South Australia (SA) at 'AA'. The Outlooks are Stable. At the same time, Fitch has affirmed the Short-Term Foreign- and Local-Currency IDRs at 'F1+'.

Fitch has affirmed the ratings of SA based upon the expectation that a positive current balance was achieved in the financial year to 30 June 2015 (FY15). From SA's estimated results we calculate a positive current balance of AUD385m. Moreover, SA is budgeting operating revenue growth to exceed expenditure growth over FY16 to FY19, and this would further strengthen operating and current margins.

In assessing how realistic SA's budgeted revenue growth will be, a key consideration for us was that revenue growth will mainly arise from a higher relative share of the national GST pool. This follows the 2015 review by the independent statutory body - the Commonwealth Grants Commission.

KEY RATING DRIVERS

The ratings reflect Australia's strong institutional framework, SA's improving budgetary performance, relatively weak economic performance and sector concentrations, lower capex spend and moderating direct debt levels. The ratings also take into consideration the state's broader financial liabilities including exposures through its guarantee of liabilities of the South Australian Government Financing Authority (SAFA), and unfunded defined pension liabilities.

The Stable Outlooks reflect Fitch's expectations that SA will continue to strengthen its budgetary performance and debt metrics despite our expectation that local economic conditions could be softer than the state's forecast.

Australia's institutional framework supports SA's ratings. Grant income accounts for a large portion (around 52%) of SA's operating revenue, and helps offset high operating expenditure in service areas, such as education and health. Moreover, adjustments in the distribution of goods and services tax based upon the performance of a state or territory, help mitigate any potential relative financial underperformance. In addition, the Australian sovereign (AAA/Stable) has mechanisms to limit the financial impact on a state from natural catastrophes.

SA produced a positive operating margin - albeit small - of 0.56% in FY14 (Fitch estimates 1.76% in FY15), and we believe this will continue to strengthen through FY19, as a result of good expense control and revenue growth. There are downside risks to the local economic climate, although we are still forecasting the operating margin to increase to a solid 9.56% by FYE17.

SA is expecting growth in its gross state product (GSP) of 1.75% in FY15 (FY14: 1.3%), followed by 2% in both FY16 and FY17. Considering falling market estimates for national GDP growth, and that the impact from the closure of the motor industry may be towards the severe end of estimates, as well as the state's low population growth and high unemployment rate (7.9% at end-August 2015), these forecasts may prove optimistic. Weaker than projected economic activity, would likely result in lower than expected revenue growth.

Despite passenger motor vehicles only contributing 3.9% to total exports in FY15, the industry is a significant employer, with market estimates on job losses from the industry closure ranging from 5,000 to 24,000. A key determinant of where the ultimate figures fall will depend on whether companies within the automotive supply chain are able to pick up alternative business.

The commonwealth government's recent announcement that AUD40bn worth of frigates and patrol vessels for the Australian Navy will be built in South Australia will support employment over the long term. However, variable sequencing of project work results in a volatile demand for workers, and as the contracts are not scheduled to begin until 2018, work volume and employment in this sector will fall in the interim.

Fitch estimates South Australia's large capex will reduce to an average AUD1.9bn over FY15 to FY19. This is down from the average annual capex spend of AUD2.1bn over FY08 to FY14, and includes the recognition of the finance lease liability for the new Royal Adelaide Hospital (RAH) of AUD2.8bn. Therefore, the average capex over FY15 to FY19 is around AUD1.3bn per annum excluding the RAH and is more financially sustainable over the long term when combined with improved forecast operating margins.

SA's ratio of direct debt to current revenue was 52% at FYE14 (FYE15 estimate: 30%) and below peers. Using our broadest measure of financial liabilities, net overall risk to current revenue was 165% at FYE14, and is not expected to have reduced by FYE15. This measure incorporates the state's unfunded defined pension liabilities (FYE14: AUD10.9bn) and the guaranteed financial liabilities (FYE14: AUD7.1bn) of SAFA. This broader ratio is at a similar level to peers although SA's operating and coverage ratios are weaker.

RATING SENSITIVITIES

Negative rating action could occur if the state unexpectedly departs from its budgeted constraint and fiscal strategy, and SA's forecast positive current balances turn out to be negative. The negative impact would be compounded should the local economic performance be much weaker than expected.