OREANDA-NEWS. September 08, 2015. Fitch Ratings has affirmed the Autonomous Community of Basque Country's (Basque Country) Long-term foreign and local currency Issuer Default Ratings (IDR) at 'BBB+' with Positive Outlooks. Fitch has also affirmed the Short-term foreign currency IDR at 'F2'. The Basque Country's senior unsecured bonds' ratings have also been affirmed at 'BBB+'.

The Positive Outlook reflects the potential for an upgrade once the operating performance improves. With 2014 results in line with our expectation, an upgrade could occur once the 2016 budget has been detailed and the 2015 accounts released confirming strengthened performance. An eventual upgrade to 'A-' would mean that the Basque Country would be rated above the sovereign, as it was in the past, as Fitch considers that the Basque Country meets the conditions for this according to our criteria, with in particular, a stronger economic profile and large tax autonomy.

The affirmation reflects that there have been few changes since our last review in March 2015, and is based on the strong regional economic profile, with a GDP per capita equivalent to 130.3% of the national average in 2014. It also reflects the moderately weak operating margin and moderately high direct debt.

KEY RATING DRIVERS
Expected Improving Operating Performance
For 2015-2016, Fitch expects the Basque Country's operating margin to gradually improve to 5%-6%, from 3.25% at end-2014, based on revenue growth driven by an improving national economy. The singular funding system of the Basque Country means tax revenues are correlated with economic performance, while current expenditure is rigid due to the scope of responsibilities. As a result, there may be some short-term volatility in the balance between revenues and expenditure. Nevertheless, Fitch's expectations of improvement in fiscal performance take into account operating expenditure growth of 2%-3% in 2015, after the Basque Country lifted cost-containment policies.

Strong Regional Economic Profile
The Basque Country's economy is strong and diversified, with a solid and significant manufacturing sector (21.4% of nominal GDP) and a smaller contribution from the construction sector than at the national level. The region's strong economy is also demonstrated by a higher than average employment rate of 47.7% in 2014 versus 45% nationally. The positive momentum in the economy is underpinned by GDP growth of 1.1% yoy in 2014 (0.9% for Spain) and a positive reversal in the labour market in June 2015, as total registered workers rose 2% yoy, contributing to higher personal income tax and VAT.

Moderately High Direct Debt
The expected improvement in fiscal performance will slow direct debt growth, which Fitch estimates will reach EUR8.2m-EUR8.5bn by end-2015. Direct debt will be close to a moderately high at 100% of the Basque Country's current revenue at end-2017, from 89.7% or EUR7.7bn in 2014. There has been a EUR3.3bn increase in direct debt since 2010, which has left the regional government exposed to refinancing risk (27% of direct debt repayment over the next three years at end-2014).

RATING SENSITIVITIES
The main drivers of positive rating action would be the operating margin remaining structurally above 5% in the medium term, combined with no material change in debt stock and structure. Fitch currently considers this quite likely.

The inability to report a structural positive current balance to cover a larger part of its debt repayment could result in a downgrade to 'BBB', which is currently not Fitch's base case scenario.