OREANDA-NEWS. 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, which we assigned in September 2014, reflects the potential for an upgrade once the operating performance improves. Preliminary results show the 2015 operating margin increasing towards 5%, up from 1% in 2012/2013, and will strengthen further according to the 2016 budget . An upgrade to 'A-' would mean that the Basque Country would again be rated above the sovereign, as Fitch considers that the Basque Country meets the conditions for this according to our criteria, in particular, due to a stronger economic profile and large tax autonomy.

The affirmation reflects that there have been few changes since our last review in September 2015, and is based on the strong regional economic profile, with GDP per capita equivalent to 130.6% 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 2016-2017, Fitch expects the Basque Country's operating margin to gradually improve to 5%-7%, from 4.7% at end-2015, 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 2016, 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 the higher than average employment rate of 48.4% in 2015 versus 46.4% nationally. The positive momentum in the economy is underpinned by GDP growth of 1.4% yoy in 2014 (1.0% for Spain) and the positive reversal in the labour market that started in 2014, as total registered workers rose by a further 1.9% yoy in 2015, 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 EUR8.4bn-EUR8.6bn by end-2016. Direct debt will be close to a moderately high at 90%-95% of the Basque Country's current revenue at end-2018, 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 (28% of direct debt repayment over the next three years at end-2015).

RATING SENSITIVITIES
The main driver of positive rating action would be an operating margin 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.