Standard and Poor's Ratings Services has raised its long-term issuer credit rating on the Bulgarian capital city of Sofia to 'BBB' from 'BBB-', with a stable outlook.

"The rating on Sofia reflects our view of the city's very positive liquidity position, consistently high operating budgetary performance, and relatively good budgetary flexibility. Its strategic position as the administrative, financial, and economic center of the Republic of Bulgaria (BBB/Stable/A-2) also supports the rating," the credit rating agency said in a statement.

"The rating is constrained by our "consolidating but uneven" assessment of the institutional framework for Bulgarian municipalities, which, combined with emerging strategic and financial planning in the city, limits the predictability of the city's financial performance. Relatively high exposure of the city's debt to market risks and large contingent liabilities related to its municipal companies also constrain the rating," it added.

"In common with other cities in Bulgaria, Sofia's overall creditworthiness is constrained by what we view as the "consolidating but uneven" institutional framework under which Bulgarian local governments operate.

"The city enjoys relatively high budgetary flexibility, however, due to increasing control over local taxes after the central government raised the upper bracket of the real estate tax. The city could have garnered up to 25% of additional adjusted operating revenues in 2012 if the tax rates had been set at the maximum legal level and collectability had not been affected.

"Sofia's flexibility stems from its position as Bulgaria's administrative, financial, and commercial center. We view its economy as moderately wealthy, above national levels, and well-diversified with a strong focus on services. The city's GDP per capita is estimated at about USD 17,000 in 2011 and is expected to grow by about 3.5% on average in 2012-2014.

As a result of this flexibility SP expects Sofia to maintain its adjusted operating surplus (net of expenditures delegated by the central government and corresponding revenues) as a percentage of adjusted operating revenues at an average of 20% during 2012-2014. While strong, this will have reduced from the 25% average achieved in 2008-2010.

"The city's strong operating performance will help it finance its ambitious capital expenditure (capex) program. However, although the city also receives substantial capital transfers from the central government and EU grants, it has to borrow to cofinance its high capex needs in transport infrastructure and waste treatment facilities. Therefore, in our base-case scenario we project the city's deficit after capital accounts to stabilize at an average 6% of revenues in 2012-2014," said the agency.

"We expect high capex to slightly increase Sofia's tax-supported debt, which will reach 77% of consolidated adjusted operating revenues by year-end 2014 under our base-case scenario, compared with 68% in 2010. But thanks to a favorable long-term maturity profile, grace periods in principal loan repayments, and an amortizing debt structure, Sofia's debt service will remain at an estimated low of 6% of adjusted operating revenues in 2012-2014. Nevertheless, although the city's indebtedness is moderate, it has a significant exposure to market risks. As of June 30, 2012, about 50% of the city's debt was denominated in Japanese yen and remained unhedged," it added.

Sofia's rating is said to be constrained by sizable contingent liabilities, which we calculate at about 30% of its adjusted operating revenues. They include a potential capital requirement of Municipal Bank A.D. (NR), over which Sofia has recently reestablished control; the debt of city-owned heating utility Toplofikatsiya (NR); and payables of Urban Mobility Center, the city's newly created company coordinating public transport services. In addition, emerging long-term financial planning in the city limits the predictability of the city's financial policy, according to SP.

"In line with our methodology, we consider Sofia's liquidity to be very positive. Our assessment is based on its currently very strong coverage of debt service with available cash reserves and high internal cash generating capacity, which offsets what we view as its limited access to external liquidity due to weaknesses in Bulgaria's banking system and its shallow capital markets.

"From Aug. 1, 2011 to July 1, 2012, the city's average cash accounted for about Bulgarian lev (BGN) 87.2 M. Given that a portion of the accumulated cash can be used to cover the projected city's deficit, its cash is expected to exceed debt service falling due in the next 12 months by at least 1.5x in 2012-2013.

"Furthermore, if needed, we understand the city can temporarily use funds in its off-budget accounts, which, according to the city, amounted to BGN 41 M at June 30, 2012. We regard these funds as equivalent to a committed line.

"The city holds free cash on accounts and deposits in unrated Municipal bank A.D., but we do not apply a haircut to cash holdings. We understand that banks in Bulgaria are legally obliged to hold Bulgarian treasuries as collateral for municipalities' cash holdings at a special account at the Bulgarian National Bank. Nevertheless, if the Bulgarian National Bank were to revise its policy, we could revise downward our assessment of the city's liquidity position.

"We view the city's access to external liquidity as limited, on account of Bulgaria's weak domestic banking sector, as reflected in our banking industry country risk assessment (BICRA) score of '7' (1 being the lowest risk, and 10 being the highest; see "Banking Industry Country Risk Assessments," published Oct. 6, 2011).

"The stable outlook reflects our view that Sofia's large internal self-funding capacity and the cofinancing of its projects from the central government budget will help the city improve its infrastructure with just moderate exposure to debt and no negative impact on its currently very positive liquidity position.

"We could raise the ratings on Sofia in the next two years if the rating on the Republic of Bulgaria is raised and if the city's financial management develops a medium-term financial program and proves able to stick to its fiscal targets, broadly in line with our base-case scenario.

"We could lower the ratings in the next two years if, in line with our downside-case scenario, economic stagnation in the city leads to operating margin pressures and widening deficit after capital accounts to more than 10% of total revenues. This would put additional pressure on the city's liquidity position, lowering cash below its debt service falling due within the next 12 months," SP's statement concludes.

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