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+'.

KEY RATING DRIVERS
The Basque Country's ratings reflect its relatively weak but improving operating margin and high direct risk. The ratings also reflect its strong economic profile. The Positive Outlook reflects the potential for an upgrade once there is a confirmed improvement in operating performance.

Fitch expects the Basque Country operating margin to gradually improve over 2015-16 to 5%-6%, from an estimated operating margin of 3.3% at end-2014 according to preliminary results, due to an expected improvement in the economic environment, and benefiting from higher control of tax declarations. Public administrations in the Basque Country have also increased personal income tax pressure (PIT), reducing the size of deductions, principally on PIT and corporate tax, and have announced an intensification of the fight against fraud.

The singular funding system of the Basque Country means tax revenues are correlated with the economic performance, while current expenditure is quite rigid due to the scope of responsibilities (education, healthcare, social services, etc). As a result, there may be some short-term volatility in the balance between revenues and expenditure.

The Basque Country reported a positive current balance at EUR75.3m at end-2014 from the negative current balance of EUR121.3m at end-2013. The recently approved 2015 budget indicates a current balance of EUR230.7m (EUR6.1m budgeted for 2014), or 2.6% of its current revenue. This improvement partly comes from a 6% growth in transfers from the 2014 budget, mostly from value-added tax (VAT).

The affirmation also reflects the Basque Country's strong socio-economic profile, with a GDP per capita equal to 130.2% of the national average, and prudent management. Its employment rate in 2014 was 47.7%, above the national average of 45%. Its regional economy is diversified, with a solid manufacturing sector, and a smaller contribution from the construction sector than in Spain. Its wealthy economy is also demonstrated by its housing prices being 67% above national average.

There has been a large increase in direct debt since 2009 (of EUR5bn), which has left the regional government exposed to high refinancing risk (27% of direct debt repayment over the next three years at end-2014). Direct debt represented 89.8% of current revenue in 2014 and debt servicing rose to 8.5% of current revenue, from 1.2% in 2009. Fitch's base case scenario assumes direct debt to continue growing but at a modest pace, and should hover around 90%-92% of current revenue in 2016.

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

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.

KEY ASSUMPTIONS
Fitch assumes no change in the funding system or in the regional administration's level of responsibility.