OREANDA-NEWS. August 11, 2015. Fitch Rating has affirmed Austria's Long-term foreign and local currency Issuer Default Ratings (IDR) at 'AA+' with Stable Outlooks. The issue ratings on Austria's senior unsecured foreign and local currency bonds have also been affirmed at 'AA+' with Stable Outlooks. The Short-term foreign IDR has been affirmed at 'F1+ and the Country Ceiling at 'AAA'.

KEY RATING DRIVERS
Austria's IDRs and Stable Outlook reflect the following main factors:

Fitch expects the headline budget deficit to narrow only slightly in 2015 to 2.0% of GDP, from 2.4% last year, as modest revenue growth is offset by further bank support measures (budgeted at EUR1.7bn) and higher labour and pension costs. Adjusting for the economic cycle and the cost of banking sector support, Austria's structural budget deficit is projected to widen this year.

The coalition government approved a significant fiscal reform on March 2015 that will provide EUR5.2bn (1.6% of GDP) in tax relief, primarily by reducing the entry rate for income tax. The reform will be effective as of January 2016 and will be accompanied by a series of compensatory measures to boost revenue. This includes raising VAT, reducing exemptions, targeting tax fraud and streamlining administrative costs. Fitch is cautious about the effectiveness of compensatory measures and thus forecasts higher fiscal deficits in 2016-17 compared with official projections. Combined with limited budget flexibility, this will create important challenges if the authorities are to meet their debt brake rule by 2017 (which requires the structural deficit to be lower than 0.45% of GDP).

Sovereign exposure to wind down state-controlled banks remains a risk to public finances seven years after the start of the global financial crisis. Stock-flow revisions to public debt stemming from bank restructuring continue. A recent ruling by Austria's constitutional court repealed a bail-in of subordinated debt of EUR800m related to the asset resolution entity of Hypo Group Alpe Adria (HAA), which will add modestly to public debt and could lead to an upward revision of the 2014 deficit. On the upside, the Austrian government has reached a preliminary agreement with Bavaria to settle a number of costly disputes related to HAA. The country has also been the first to implement a bail-in mechanism under the EU Bank Recovery and Resolution Directive, declaring a moratorium on March 2015 on HAA liabilities. Although the goal is to limit any further costs to taxpayers, it has created a series of legal uncertainties.

Fitch maintains its forecast that general government debt (GGGD) will peak in 2015, at 87.2% of GDP, reflecting mainly the transfer of a part of Kommunalkredit Austria's liabilities (around EUR6.3bn) into KA Finanz (whose liabilities are included in GGGD). The authorities' commitment to support KA Finanz (including by providing guarantees for debt-issues), as well as uncertainty regarding the real value of HAA's assets, means that public debt levels are unlikely to fall as rapidly as the authorities expect. Fitch's baseline scenario remains broadly unchanged from the last review, with GGGD falling to only around 83% of GDP by 2018, well above the 'AA' median of 35.8%.

Fitch's BSI score for the banking sector is 'bbb', two categories below the sovereign rating and denoting "adequate" fundamentals. Slow domestic loan growth and negative developments in key Eastern European markets continue to constrain the sector's performance. The Tier 1 capital ratio was 11.6% at end-2014, the ratio of NPLs rose moderately to 3.9% at end-2014, while pressures from a stronger Swiss franc have led to only a modest deterioration in asset quality.

Economic activity in 1Q15 was weak, hindered by a contraction in investment and a relatively poor export performance. GDP growth is expected to remain below 1% for the fourth year in a row in 2015. Fitch expects a modest recovery in 2016-17, driven in part by an uptick in investment confidence. There is uncertainty about the potential effects on growth from the recent tax reform, but some positive pass-through effects on domestic consumption are likely. The country's main medium-term growth challenge is to maintain export competitiveness, especially regarding Eastern European countries, which in recent years have gained market share in Germany at the expense of Austria.

The fall in energy costs over the last eight months has helped bring down headline inflation to an average of 1% in 1H15 (from 1.5% in 2014). However, lower oil imports have had a limited effect on the external balance, as exports to key destinations such as Russia have contracted sharply this year. Continuous strong growth in tourism will help Austria maintain a comfortable current account surplus in 2015.

Austria has a stable, diversified, high value-added economy with strong political institutions and social cohesion. It also benefits from low private sector indebtedness and a high household saving rate. The unemployment rate is low, at 5.7% in April 2015, well below the EU average of 9.6%. Youth unemployment and long-term unemployment are also among the lowest in Europe, and have remained broadly stable over the past five years.

RATING SENSITIVITIES
Future developments that could individually or collectively result in negative rating action include:
-Failure to place public debt/GDP on a downward trajectory, for example due to fiscal slippage or weak nominal GDP growth.
-Further costs from the financial sector outside the range of current expectations that worsens the government debt profile.

Future developments that could individually or collectively, result in positive rating action include:
-A sustained track record of a decline in the public debt to GDP ratio from its peak to a level that provides the sovereign with greater fiscal flexibility.
-A stronger recovery of the Austrian economy and greater confidence in medium-term growth prospects.

KEY ASSUMPTIONS
The ratings and Outlooks are sensitive to a number of assumptions:

Fitch's debt dynamics do not include any government bank asset disposals as the timing and values of such operations remain uncertain.

The European Central Bank's asset purchase programme should help underpin inflation expectations, and supports our base case that in the context of an economic recovery, Austria and the eurozone will avoid prolonged deflation. Nevertheless deflation risks could re-intensify in case of adverse shocks.

In the event of a Greek exit from the eurozone, Fitch assumes this would be unlikely to trigger a systemic crisis like that seen in 2012, or another country's rapid exit. However, it would increase financial market volatility and dent economic confidence.