Fitch Ratings has downgraded Lagos State's Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) to 'B-' from 'B' with Stable Outlook following the downgrade of the sovereign rating (see Fitch Downgrades Nigeria to 'B-'; Outlook Stable).

Under applicable credit rating agency (CRA) regulations, the publication of local and regional government reviews is subject to restrictions and must take place according to a published schedule, except where it is necessary for CRAs to deviate from this schedule in order to comply with the CRAs' obligation to issue credit ratings based on all available and relevant information and disclose credit ratings in a timely manner. Fitch interprets these provisions as allowing us to publish a rating review in situations where there is a material change in the creditworthiness of the issuer that we believe makes it inappropriate for us to wait until the next scheduled review date to update the rating or Outlook/Watch status. The next scheduled review date for Fitch's rating on Lagos State is in 2023, but Fitch believes that developments for the issuer warrant such a deviation from the calendar and our rationale for this is set out in the first part (High weight factors) of the Key Rating Drivers section below.

Following the downgrade of Nigeria's IDRs, we have taken similar rating action on Lagos to reflect the sovereign cap. Its Outlooks move in tandem with the sovereign's.

Fitch has revised Lagos's Standalone Credit Profile (SCP) to 'b+' from 'bb+' due to the reassessment of the risk profile to 'Vulnerable'.

Key Rating Drivers

High

Sovereign Cap

As per Fitch's rating criteria, Lagos's IDRs are capped by the sovereign's and its Outlooks reflect those on the sovereign. Fitch considers that the national government's role remains predominant in Nigerian intergovernmental relations, as it controls the equalisation mechanism enacted through a system of transfers to states. Therefore, rating action on the sovereign will be mirrored on Lagos, as its SCP is currently above that of the sovereign.

Medium

Risk Profile: revised to Vulnerable from Weaker

Fitch has reassessed the 'Expenditure Sustainability' Key Risk Factor to 'Weaker' from 'Midrange' due to the deteriorating operating environment, characterised by high inflation, which will weaken control of total expenditure growth. According to Fitch's International Local and Regional Government (LRG) Rating Criteria, Lagos's Risk Profile has been reassessed at 'Vulnerable' due to the majority of 'Weaker' key rating factors in countries rated in the 'B' category or below.

Lagos's 'Vulnerable' risk profile reflects a very high risk that the state's ability to cover debt service with its operating balance may weaken unexpectedly over our forecast horizon (2022-2026). This may be due to lower-than-expected revenue, higher-than-expected expenditure, or an unexpected rise in liabilities or debt-service requirements.

Expenditure Sustainability: revised to Weaker from Midrange

Lagos is exposed to a deteriorating operating environment, which that weakens the state's control over total expenditure growth, influenced by high inflation, rising commodity prices, and supply constraint amid naira depreciation. Lagos has a wide set of responsibilities and high need for capital spending to maintain its attractiveness as Nigeria's main economic hub, with demographic pressures on more services on infrastructure, health and education that limit the scope for cutbacks.

Low

Debt Sustainability - 'aa' Category

Under Fitch's rating case, Lagos's debt payback ratio (net Fitch-adjusted debt/operating balance) is around 4x in 2022-2026, which is consistent with a debt sustainability assessment in the 'aaa' category. This is offset by weak debt service coverage (1.8x) and a fiscal debt burden rising towards 150%, which is high versus the peer group. This results in an overall debt sustainability assessment in the 'aa' category.

Derivation Summary

The combination of Lagos's 'Vulnerable' risk profile and debt sustainability in the 'aa' category lead to a SCP of 'b+'. Fitch does not apply any asymmetric risk or extraordinary support from the central government. Lagos's IDRs are capped at the sovereign level, as the federal government retains predominant influence over Nigerian inter-governmental relations and resource allocation to states.

Key Assumptions

Qualitative assumptions:

Risk Profile: Vulnerable, Lowered with Medium weight '

Revenue Robustness: 'Midrange, Unchanged with Low weight '

Revenue Adjustability: 'Weaker, Unchanged with Low weight '

Expenditure Sustainability: 'Weaker, Lowered with Medium weight '

Expenditure Adjustability: 'Midrange, Unchanged with Low weight '

Liabilities and Liquidity Robustness: 'Weaker, Unchanged with Low weight '

Liabilities and Liquidity Flexibility: 'Weaker, Unchanged with Low weight '

Debt sustainability: 'aa, Unchanged with Low weight '

Support (Budget Loans): 'N/A, Unchanged with Low weight '

Support (Ad Hoc): 'N/A, Unchanged with Low weight '

Asymmetric Risk: 'N/A, Unchanged with Low weight '

Sovereign Cap: 'B-, Lowered with High weight '

Sovereign Floor: 'N/A, Unchanged with Low weight '

Quantitative assumptions - Issuer Specific

Fitch's rating case is a "through-the-cycle" scenario, which incorporates a combination of revenue, cost and financial risk stresses. It is based on 2017-2021 figures and 2022-2026 projected ratios. The key assumptions for the scenario include:

- Operating revenue to grow at around 9%, below nominal GDP growth; low weight

- Operating expenditure to grow at around 13%, in line with inflation; low weight

- Average cost of debt to remain around 7% on average; low weight

- Capex to be financed by the operating balance, minor capital grants and new debt; low weight

Quantitative assumptions - Sovereign Related

Figures as per Fitch's sovereign actual for 2021 and forecast for 2023, respectively:

-GDP per capita (US dollar, market exchange rate): 2,033.49; 2,373.44

-Real GDP growth (%): 3.65; 3.12

-Consumer prices (annual average % change): 16.98; 17.75

-General government balance (% of GDP): -5.93; -5.21

-General government debt (% of GDP): 32.60; 35.41

-Current account balance plus net FDI (% of GDP): -0.08; 0.15

- Net external debt (% of GDP): 5.17; 6.14

-IMF Development Classification: Emerging Markets

-CDS Market-Implied Rating: N/A

Rating Sensitivities

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Positive rating action on Nigeria would be reflected in Lagos's ratings, provided that Lagos maintains its debt payback ratio below 5x under Fitch's rating case.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

A downgrade of the sovereign's ratings could lead to a downgrade of Lagos's IDRs.

Best/Worst Case Rating Scenario

International scale credit ratings of Sovereigns, Public Finance and Infrastructure issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of three notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. 

Issuer Profile

Lagos is Nigeria's economic centre, with per capita GDP double the national average, but weak by international standards. Lagos's diverse economy generates around 20% of Nigeria's GDP, fuelled by public and private investment and a population over 20 million.

References for Substantially Material Source Cited as Key Driver of Rating

The principal sources of information used in the analysis are described in the Applicable Criteria.

Public Ratings With Credit Linkage to Other Ratings

Lagos's ratings are capped by Nigeria's (B-/Stable).

COMMITTEE MINUTE SUMMARY

Committee date: 25 November 2022

There was an appropriate quorum at the committee and the members confirmed that they were free from recusal. It was agreed that the data was sufficiently robust relative to its materiality. During the committee no material issues were raised that were not in the original committee package. The main rating factors under the relevant criteria were discussed by the committee members. The rating decision as discussed in this rating action commentary reflects the committee discussion.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity.