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Standard & Poor’s

Credit Analysis of Naga City

City of Naga, Camarines Sur (Bicol Region), Republic of Philippines

Major Rating Factors

Weaknesses:

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Low-income local economy concentrated in agriculture with limited capacity todiversify

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Constrained fiscal flexibility with high dependence on central transfers and largespending on personnel expenses

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Weak intergovernmental system, exacerbated by the absence of institutionalized policies of city administration

Strengths:

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Healthy liquidity position, coupled with consistent and strong budgetary performance

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Debt burden is at present comparatively low and has been steadily declining

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Management sophistication relatively advanced by local standards

Rationale

The credit ratings on City of Naga, located in the Republic of Philippines (foreign currencyBB-/Stable/B; local currency BB+/stable/B; Philippines national scale ‘phAA+’), reflects thenarrow tax base of the city stemming from a low income and undiversified local economy,constrained financial flexibility and the weak intergovernmental system the city operates in.On the other hand, the city’s ratings are underpinned by its strong liquidity position, sound budgetary performance and a low debt level brought on by prudent fiscal management. Naga City’s economic base is comparatively less developed than international and domestic peers. Unlike the more diversified service-based economies of Metro Manila cities, Naga’seconomy is engaged predominately in agriculture. Although also a trading hub for the Bicolregion, much of the trading is linked to the agrarian sector as well. This is reflected in its taxrevenue per capita among the lowest in its peer group, and a low per capita income estimated ataround US$1,600, low by global standards. In addition, efforts to diversify the local economyhas been impeded by the city’s small population size, made worse by the outflow of skilledworkers to the wealthier national capital region. In turn, the low tax base has constrained muchof the city government’s revenue flexibility via lower than domestic average modifiablerevenue. Its overall financial flexibility is further capped by the large proportion of operatingexpenditure spent on personnel services (56% as of 2008). In mitigation, some room exists incapital spending due to Naga’s relatively more developed and well-maintained state of infrastructure by local standards (albeit still undeveloped by international standards).The weak intergovernmental system in the Philippines is a key systemic constraint on thecredit ratings of its local governments. The predictability in the system is low with the centralgovernment having a history of passing on unfunded mandates to LGUs. Central monitoringand oversight over LGUs is weak. Other than limits on borrowings and personnel expense,

Issuer Credit Rating

B+/Stable/--

Philippines National Scale Rating phA/--/--

Standard & Poor’s

there is no defined fiscal policy framework to promote fiscal discipline among LGUs. Addingto the systemic weaknesses constraining Naga’s creditworthiness, the city’s ratings are alsoaffected by the lack of institutionalized policies at its own level. However in mitigation, NagaCity’s budgetary performance has been sound despite the lack of an explicitly-stated fiscalframework. To add, in terms of transparency, Naga’s management sophistication stands outfrom domestic peers, being one of the few LGUs to have consistently received clean auditopinions.The ratings on Naga City are supported by its consistently strong budgetary performance andsolid liquidity position of its current administration. Balances after capital expendituresaveraged 15% of total revenues in 2005-2007, and free cash and liquid assets are estimated tohave reached around 83% of operating expenditures in 2008, one of the strongest liquidity positions among its peer group.Another credit strength is that the city government’s direct debt level has declined from a peak of 32% of operating revenues in 2005 to a much more sustainable level of 13% estimated for 2008. Its current net creditor position is also significantly stronger than many domestic andinternational peers in its rating category. Despite the weakened global economic conditions, weexpect Naga to maintain its overall financial profile in the near term in view of the prudentfinancial management practices that the current administration has demonstrated so far.

Liquidity

The liquidity position of Naga City is healthy, with free cash and liquid assets rapidlyincreasing since 2003. As of December 2008, the city holds around PHP303 million in freecash. After taking into account the city government’s negative working capital, weapproximate free cash and liquid assets to be sufficient to cover about 83% of 2008 operatingexpenditures, which is extremely sound compared with international peers.

Outlook

The outlook on the ratings is stable, which reflect our expectations that Naga’s budgetaryoutcomes and debt burden will not deviate significantly from current levels. A noticeableimprovement in medium-term planning and implementation of a comprehensive financial policy framework, coupled with substantial efforts to structurally broaden its tax base, couldlead to positive rating actions. Conversely, the ratings could come under pressure if persistentslippages in budgetary outcomes significantly weaken its liquidity or worsen its debt position.

Comparative Analysis

International peers

The Russian entities of Nizhny Novgorod (BB-/Stable/--) and Tver Oblast (B+/Negative/--), aswell as the Ukrainian capital city of Kyiv (CCC+/Watch Neg/--) and the Turkish city of Istanbul (BB-/Negative/--) are suitable international peers for the City of Naga. Naga’s local tax base is constrained by an extremely low-income economy in comparison to itsinternational peers. The city does not compile GDRP figures, but per capita income is believedto be somewhat similar to the Philippine national average of US$1,600. This is significantly below higher-rated peers like Istanbul with US$12,000, and even similarly-rated Tver Oblasthas per capita income almost 3 times that of Naga’s. The city’s dependent population proportion is similar to its peer group. However Naga’s Ukrainian and Russian counterpartsfaces a different set of demographic challenges with substantial segment of its dependent belonging to the elderly category while the bulk of Naga’s dependent constituents are of youngage. Assuming the Naga city government is able to stem the out-flow of skilled workers to the2

Standard & Poor’s

wealthier national capital region of Manila, in the long-run, Naga’s higher portion of young-aged residents could translate into higher growth for the local economy than international peers. However, Naga’s far smaller population size limits its ability to diversify its economic base into major national commercial center like Istanbul and Kyiv.Like some of its peers, the City of Naga has been able to partially fund aggressive capitalexpenditure programs in recent years with operating surpluses, which has helped to limit its borrowing requirements. However, the overall average level of capital expenditure relative tototal expenditure reported by Naga (18.5%) is still below that for its international peers (30%)from 2005-2007. Although its physical infrastructure is relatively well-maintained by nationalstandards, it is largely inadequate in the international context. Naga’s direct debt level has been steadily declining, unlike Istanbul’s. Coupled with a healthyand fast-rising cash position, the city’s overall debt profile is favourable and compares well tothat of Nizhny Novgorod. Likewise, Naga’s strong budgetary performance stands out amongits peer group. However, this is in part a function of the city’s weaker capacity to administer capital projects (stemming from lack of benefits of scale), and also a function of the systemic borrowing constraints faced by Philippine local governments.

Local peers

Unlike its domestic peers who are located in Metro Manila like Quezon City, Taguig andMandaluyong, who have relatively more diversified service-base economies, Naga is predominately engaged in the agrarian sector. The lack of a distinct geographic or industrialadvantage has resulted in lower property value and smaller-scale businesses operating in Naga,which in turn limits the city’s real property and business tax collection. In mitigation, its localeconomy has been relatively more insulated than Metro Manila peers in this current globaldownturn. In addition, outside the capital region, Naga’s tax base and per capita income wouldcompare more favorably than those of Iligan and Tacloban. Naga’s modifiable revenue is one of the lowest among local peers, which is a function of itscomparatively weaker own-source revenues and also higher dependence on central transfers.The city’s derived 48% of its revenues from IRA allotment in 2007, significantly higher thanits local peers’ average of 34%. On the expenditure side, the proportion spent on personnelservices is the highest in Naga which appear to further cap the city’s financial flexibility. Inmitigation, the city’s capital spending ratio has been consistently higher than the local average,and Naga’s state of infrastructure is relatively more developed and well-maintained than someof its local peers. These afford the city with some flexibility in cutting capital expenditures,hence putting its financial flexibility above those of Iligan and Tacloban, but behind that of Quezon City and Taguig who demonstrate far large share of modifiable revenues.The city’s budgetary performance is nevertheless stronger than all rated Philippines cities,despite the fact that other cities have far more revenue streams at their disposal. This reflects tosome extent the more advanced financial management practices of the Naga city governmentthan its peers. Likewise, despite its more limited resources, Naga has been able to maintainrobust liquidity coverage and a direct debt burden better than the average for its peer group.3