OREANDA-NEWS. Fitch Ratings has downgraded the Brazilian state of Rio de Janeiro's Long-term Issuer Default Rating (IDR) to 'BB+' from 'BBB-'. Fitch has also downgraded the National long-term rating to 'A+(bra)' from 'AA-(bra)'. The Rating Outlook remains Negative, which reflects the Negative Outlook assigned to Brazil on April 9, 2015.

KEY RATING DRIVERS
The downgrade reflects Fitch's belief that the State of Rio de Janeiro (ERio) is no longer able to present operating margins compatible with historical values since pension payment should consume an increasing portion of the state's revenues in the coming years. Moreover, the state has committed to relevant debt increases until 2017, undermining its capacity to service the outstanding debt. The state has been resorting to non-recurring revenues to cover for operating expenditures.

ERio posted a thin operating margin of 0.4% in 2014, following the worse than expected value-added tax-ICMS tax collection growth. For 2015, operating margins should be distorted by the inclusion of non-recurring revenues. As a response, ERio has launched a refinance agreement with marginal increases in tax collections and some measures to control expenditures that may not be sufficient to provide a sustainable fiscal trajectory.

ERio projects that the pace of personnel expenditure growth should moderate to an annual average of 7% over the next three years, which is lower than the 9.2% posted in 2014. This is challenging considering the political costs involved. ERio's personnel expenditures reached BRL34.6 billion in 2014, which corresponds to a high 51.8% of operating revenues in a growing historical trend.

Given the high demand for investments in urban mobility and infrastructure associated with the World Cup and the Olympic Games to be held in 2016, ERio has entered into significant credit agreements. The state obtained BRL7.6 billion in 2014, and another BRL8.6 billion is expected to be added to the state's debt structure until 2017, according to the latest Fiscal Adjustment Program signed with the Federal Government in 2014. ERio's debt burden increased 5.5% in 2014, reaching BRL83.2 billion, considered higher when compared to other large states in Brazil.

In 2015, Rioprevidencia should receive some BRL6.2 billion from the usage of judicial deposits held by the state. Rioprevidencia can also enter into additional oil securitization since it holds a USD5 billion. In 2014, Rioprevidencia issued the equivalent to USD3.1 billion, which is considered as 'net indirect debt'. Although some corrective initiatives were adopted a few years ago to improve its pension's actuarial deficit, ERio allocates a large amount of resources to its proprietary pension system.

RATING SENSITIVITIES
Downgrade Factors: Any further negative action affecting the Brazilian sovereign ratings could have a direct corresponding effect on the state's ratings. The ratings could be reviewed should ERio suffer from any adverse change in its regulatory environment such as, but not limited to, changes in oil royalty regulation and dynamics.

Upgrade Factors: Despite unlikely in the short run, the ratings could benefit from an overall improvement in budgetary performance coupled with a larger tax-contribution base, despite this being constrained by the increased debt levels. A decline in indebtedness levels could also positively affect the ratings.

Located in the southeastern region of Brazil, Rio de Janeiro is the second largest state in Brazil in terms of economic stature, with about average infrastructure level in relation to other states in Brazil.

KEY ASSUMPTIONS
The ratings and Outlooks are sensitive to the following assumptions:

--Fitch assumes a strong level of sovereign support for Rio de Janeiro given that the state's most relevant creditor is the Federal Government.

--Global assumptions are consistent with Fitch's published 'Global Economic Outlook', including the subdued outlook for commodity prices.

Fitch has taken the following rating actions on ERio:

--Foreign and Local Currency Long-Term IDR downgraded to 'BB+' from 'BBB-'; Outlook Negative
--Foreign and Local Currency Short-Term IDR downgraded to 'B' from 'F3';
--National Long-term downgraded to 'A+(bra)' from 'AA-(bra)'; Outlook Negative;
--National Short-term rating downgraded to 'F1(bra)' from 'F1+(bra)'.