OREANDA-NEWS. November 11, 2015.  Fitch Ratings has affirmed the Estonian City of Tallinn's Long-term foreign and local currency Issuer Default Ratings (IDRs) at 'A' with Stable Outlook. Fitch has also affirmed Tallinn's Short-term foreign currency IDR at 'F1'.

The affirmation reflects our unchanged view that the city's strong performance will be maintained over the medium term, providing adequate debt service.

KEY RATING DRIVERS
The 'A' ratings reflect Tallinn's sound fiscal performance, stable and moderate direct debt, high self-funding capacity of investments, a well-diversified but modest-sized local economy and a stable regulatory regime. The ratings also factor in the growing debt of the city's companies.

We expect that the city will be able to maintain a stable operating margin of around 9% over the medium term, despite structural limitations on operating revenue and ongoing pressure on operating expenditure. Effective financial and cost management helped limit growth in current spending to below that of operating revenue in 2014 and we expect this approach to continue in the medium term. We project the city's operating balance to operating revenue will reach 8.5% in 2015 after 7.4% on average in 2011-2014.

Tallinn's capital outlays are likely to average EUR70m per year for 2015-2018 or 13% of total spending, according to our estimates. Infrastructure investments are likely to dominate (roads, tram line, renovation of city's property). The city's capacity to self-fund investments is high, with capital revenue (mainly EU grants) and the current balance covering most of its capital expenditure. This should reduce Tallinn's new financing needs.

We expect the city's direct debt to stabilise at a moderate 40% of current revenue in 2015-2018 as a result of a high current balance and EU grants financing investments. In nominal terms, direct debt is expected to hover around EUR200m in 2015-2018 close to the expected end-2015 level. The sharp increase in debt to EUR240m in 2014 was due to a drawdown of a EUR22m European Investment Bank loan to secure investment finance in 2015. Additionally, Tallinn issued EUR28m bonds in December 2014 to refinance in March 2015 existing bonds, ie to lower the interest and to extend the debt maturity.

According to our projections, Tallinn's operating balance should comfortably cover debt service in 2015-2018. The debt payback ratio (debt/current balance) is forecast to improve to five years by 2018 from seven to eight years in 2011-2014, below the city's average debt maturity of nine years, which is credit positive. As a result of favourable debt refinancing in 2014-2015, the city's annual debt service declined, due to the improved maturity profile of its debt portfolio and lower interest costs. The annual debt service is expected to average EUR20m in 2016-2018, lower than the annual average in 2011-2014 (EUR23m). Interest to be paid may hover around a low 1.5x operating revenue (2011-2014: 1.7x on average).

Indirect risk is low and therefore does not exert any pressure on the city's budget. The debt of Tallinn's companies is projected to increase to EUR120m at end-2018 from about EUR90m expected at end-2015, due to debt-financed investments of the city's public sector companies, especially the transportation company renewing its fleet. The companies' debt counts towards the city's debt limits and is strictly monitored by Tallinn's administration.

As the economic centre of Estonia, Tallinn contributes about 50% of national GDP. Its service-oriented and diversified economy results in high tax revenue for the city. The city's management is actively expanding the local tax base, which together with prudent budgeting and a conservative debt policy, helps underpin its ratings.

RATING SENSITIVITIES
The ratings could be upgraded if the city's operating balance structurally strengthens to about 10% of operating revenue, accompanied by stable direct and indirect risk over the medium term.

Negative rating action could result from a sustained deterioration of the operating margin to well below 7% or a significant rise in Tallinn's direct debt, leading to the city's debt payback ratio (debt/current balance) exceeding 10 years (2014: 7 years).

KEY ASSUMPTIONS
Fitch expects the city to continue exercising operating expenditure restraint and to manage the budget prudently over the medium term.

Fitch also assumes that the city will continue to comply with all the EU regulations and procedures when implementing investments projects co-financed by the EU. Otherwise, Tallinn could face the penalty of having to return previously received EU grants.