OREANDA-NEWS. Fitch Ratings has affirmed the Canton of Zurich's Long-term foreign and local currency Issuer Default Ratings (IDR) at 'AAA' and its Short-term foreign currency IDR at 'F1+'. The Outlooks on the Long-term IDRs are Stable.

KEY RATING DRIVERS
The ratings reflect Zurich's strong autonomy, its wealthy and dynamic economy, which translates into a strong tax base and sound debt coverage ratios, its prudent budgetary management and financial flexibility. The ratings also consider a slightly weaker than envisaged budgetary performance in 2014 and an increasing debt burden in 2015-2018.

The Stable Outlook reflects Fitch's expectations that Zurich will maintain a strong financial profile with a slightly improving budgetary performance in 2015-2018. It also reflects Fitch's view that the canton's debt coverage ratios will remain in line with its rating.

Zurich's preliminary operating performance in 2014 is negative and below previous years' levels. However, high financial revenues and fairly low and declining interest expense, resulted in a preliminary current margin of 2.2%, covering about 40% of the canton's investments. Nevertheless, a higher than envisaged realisation rate of the canton's investments and lower capital revenues led to a small deficit before debt variation of 2.3%.

The weaker than expected budgetary performance in 2014 is driven by lower than expected tax revenues, an outfall of the budgeted profit distribution of the Swiss National Bank and higher provisions for the canton's pension fund. Although the canton realised CHF150m of global savings after facing the likely decline in the shortfall of revenues, the preliminary result was about CHF700m below budget, with CHF338m stemming from the operating budget and an additional CHF365m from the capital budget, as the realisation rate of the canton's investments were higher than expected.

Zurich's direct risk slightly increased by CHF285m to CHF5.349bn at end-2014. Although Zurich aims to improve its budgetary performance from 2015, the canton considers increasing debt to about CHF6bn in 2018. The canton's debt burden and debt coverage remain sound; debt servicing accounted for a moderate 7.9% of current revenue in 2014. Following a new CHF700m bond issued in 2014, the canton is exposed to floating-rate risk. However, Fitch views the impact of rate risk on the canton's interest burden as negligible. In 2015, Zurich's direct debt may increase to CHF5.62bn, following maturing debt of CHF225m and new borrowing of CHF500m.

At end-2014, Zurich had cash and cash equivalents of CHF1.5bn outstanding, sufficient to cover the 2015 debt servicing requirements of CHF360m by more than four times and can additionally resort to its two committed credit lines. This access to short-term liquidity mitigates refinancing risk.

Zurich has material contingent liabilities. Net overall risk amounted to CHF21.6bn at end-2013. Most related to guaranteed obligations of its 100%-owned Zuercher Kantonalbank (ZKB; AAA/Stable/F1+). Among other Swiss banks, ZKB is involved in inquiries by US authorities for assisting US residents in evading taxes. Fitch views the US client assets at ZKB to be limited but given uncertainties on the resolution and the sometimes arbitrary nature of the final penalty, the one-off charges for ZKB could be significant although mitigated by provisions already made. Another main guarantee obligation is the unfunded portion of its pension fund (the cover ratio stood at a strong 99.3% at end-December 2014). Recapitalisation measures implemented in 2011, which Fitch views as prudent management, should protect the canton from a future higher burden. Fitch does not include in its assessment the debt of Zurich's public sector entities since we assume their debt is entirely self-supporting.

With more than 1.4 million inhabitants, Zurich has above-average wealth levels even in the Swiss context. However, some uncertainties stem from the financial sector due to low interest rates and client activity as well as increased litigation and regulatory costs. A slowdown of Zurich's economy would negatively affect the real estate and banking sectors, two large contributors to the canton's GDP and revenue.

RATING SENSITIVITIES
Factors that could lead to a downgrade are a continuous increase of debt and corresponding weakening of debt servicing ability - with a debt payback of over 20 years - operating margin close to zero, limiting the canton's financial flexibility, or contingent risks above Fitch's expectations.

Significant changes to Swiss cantons' financial leeway or additional financial obligations, whether inner- or intra-canton, could also be rating negative. A downgrade of Switzerland ratings would also be reflected in the Canton's ratings.

KEY ASSUMPTIONS
Our base case scenario relies on the following assumptions:

- Continuing strong cantonal financial autonomy.
- Zurich's economic progress will at least be in line with Switzerland's expected growth rates.
- Expected growth of Zurich's direct risk will not be accompanied by a decline of budgetary performance and weakening of the debt coverage beyond Fitch's expectations.