The outlook on the rating is stable, S&P said in a statement.
The ratings agency also said in the statement:
"[..] The rating on Zagreb reflects its position as the administrative, financial, and commercial center of Croatia, as well as our view of the city's continuing robust budgetary performance and low direct debt.
These factors are constrained by the city's weak liquidity and limited budgetary flexibility and debt-raising capacity in the context of a consolidating but uneven institutional framework, ongoing tensions between the city's administration and council, as well as high contingent liabilities.
Given Zagreb's relatively wealthy, service-oriented economy, as well as the gradual increase in tariffs on public transport and the water supply, our base-case scenario assumes Zagreb's budgetary performance will remain relatively robust. Its operating surplus as a percentage of operating revenues will account for about a sound 12% in 2012-2015 depending on GDP growth, although it will remain significantly weaker than before the global financial crisis, when it averaged a very high 26% during 2005-2008.
As the central government imposes strict limits on municipal net borrowings, the city cannot afford to have a consistent deficit after capital accounts. In our base-case scenario, we expect Zagreb's budget to remain broadly balanced in 2012-2015.
Consequently, Zagreb outsources its investment program--and concomitant debt accumulation--to Zagrebacki Holding, but provides transfers linked to debt service.
While Zagreb's direct debt, including guarantees it services currently, has remained low at about 20% of operating revenues and below 300% of its operating surplus, its tax-supported debt increased to 75% at end-2011. We expect the debt accumulation of both to slow, while we forecast the city's operating revenues will grow in line with our base-case scenario. This means the city's tax-supported debt will likely reduce, albeit to a still-sizable 62% of consolidated operating revenues, by end-2014.
The city's financial management is a ratings weakness, in our view. In the years before the global financial crisis, the city rapidly increased its social spending as well as investments funded via its holding company, including in risky real estate projects. Moreover, since the previous municipal election in 2009 the political tensions between the city administration and the city council have intensified. The city administration and council have been slower to adjust its budget spending to reflect shrinking revenues, so payables have accumulated and pressure on Zagrebacki Holding's liquidity position has intensified.
Additional pressure on the city's creditworthiness comes from contingent liabilities associated with Zagrebacki Holding and liabilities to the central government. The holding's financing needs are growing, while the city's ability to cover the entity's additional funding needs immediately and in full has diminished since 2008, in our view. Since 2010, the company has been accumulating losses and covering them with short-term borrowings, and is now exposed to refinancing and market risks.
Croatian kuna (HRK) 337 million or 6% of the city's annual revenues are due to the central government as a result of a contradictory legal framework governing the allocation of shared taxes to local budgets. In 2012, the central government tried to force the city to repay these payables in full, but this was blocked by Croatia's Administrative Court. In our base-case scenario we assume that the city will not be forced to repay these payables all at once.
We view Zagreb's liquidity position as negative, based on its very low cash holdings. Further, in light of our revised for stagnant growth in Croatia in, the generally robust internal cash-generating capacity may be somewhat diminished.
Access to external liquidity remains satisfactory, in our view. From November 2011 to October 2012, the city's average cash position was HRK66.2 million (€8.9 million), which accounted for about 17% of its direct debt service falling due within the next 12 months. We estimate the city's direct debt service at about HRK395 million, including annual transfers to Zagrebacki Holding earmarked for debt repayment of about HRK180 million. The city transfers another HRK180 million in line with the rent contracts between the city and the holding, receivables on which are used by the holding as a pledge on its debts. In line with our base-case scenario, we expect Zagreb's cash position to remain low over the next year, although we do view its robust internal cash generation ability positively. We expect operating surpluses to cover the city's debt service in 2013 twice over.
During the worst economic contraction, the city also accumulated payables: about 23.7% of the city's annual expenditures at year-end 2011. Nevertheless, in our base-case scenario, we expect payables to return to a sustainable level of about 14% of total spending over the next five years.
Although we view Croatia's banking system as exposed to ongoing economic contraction, which is reflected by our Banking Industry Country Risk Assessment score of '6' (a score of '1' indicates the lowest risk and '10' the highest), we believe that Zagreb continues to have satisfactory access to external liquidity especially in the context of its very limited borrowing needs.
The stable outlook reflects our view that budgetary consolidation measures applied Zagreb's government may prevent further weakening of the city's budgetary performance and liquidity, despite ongoing economic contraction.
We would lower the rating on Zagreb if we were to lower the sovereign rating on Croatia.
We could lower the rating on Zagreb within 12 months even if the sovereign rating were to remain unchanged if, under our down-side scenario, the city's budgetary performance and liquidity position deteriorated significantly. This could happen because of declining revenues, as well as the government needing to provide additional support to Zagrebacki Holding and return payables owed to the central government.
Alternatively, a downward revision of our assessment of the supportiveness and predictability of the institutional framework under which Croatian local governments operate could also lead us to lower the rating on Zagreb.
We could raise the rating within 12 months if the rating on Croatia is raised and the city strengthens its liquidity position with cash consistently covering about 50%-60% of annual debt service. This might also allow the city to reduce payables and increase transfers to Zagrebacki Holding, thereby stabilizing the latter's liquidity position."
