Saxony-Anhalt, Land. Annual Update. CREDIT OPINION 14 December Update. Summary Rating Rationale

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1 CREDIT OPINION Saxony-Anhalt, Land Annual Update Update Summary Rating Rationale RATINGS Saxony-Anhalt, Land Domicile Germany Long Term Rating Aa1 Type Senior Unsecured - Fgn Curr Outlook Stable Please see the ratings section at the end of this report for more information. The ratings and outlook shown reflect information as of the publication date. Contacts Harald Sperlein VP-Senior Analyst harald.sperlein@moodys.com Juliane Sarnes Associate Analyst juliane.sarnes@moodys.com The main drivers of the Land of Saxony-Anhalt's Aa1/P-1 long and short-term debt and issuer ratings are: (1) the current national financial equalisation system which provides financial support and revenue predictability; (2) its good budget discipline, despite a still-modest revenue base; and (3) its strong tax revenue development and very low funding cost, which has helped to improve budgetary results. Conversely, constraints to the rating are: (1) the Land's modest tax base with limited leeway for raising additional revenue; (2) continuing expenditure pressures that make large-scale cuts difficult; and (3) high debt levels, slightly above the German Laender sector average. The Aa1 rating also reflects our assessment of a very high likelihood that the Federal Republic of Germany (Aaa, stable) would act to prevent a default by the Land. National Peer Comparison Saxony-Anhalt is rated in line with other German Laender (regional governments), whose ratings span from Aaa to Aa1. Saxony-Anhalt's position relative to its national peers reflects debt levels comparable to the median of Aa1-rated German Laender, as well as inferior economic performances, but it has slightly better financial performances, thanks to transfers from the equalisation system. Credit Strengths Credit strengths for the Land of Saxony-Anhalt include: Strong ongoing support from the German financial equalisation system Financial surpluses, thanks to tight budgetary controls and rising tax revenues Sound debt management, with good capital markets access Credit Challenges Credit challenges for the Land of Saxony-Anhalt include: Debt burden remains very high, but steadily declining Modest tax base and limited financial flexibility Rating Outlook The outlook is stable.

2 Factors that Could Lead to an Upgrade Upward pressure on the rating could be triggered by a substantial reduction of the Land's debt burden, combined with an improvement in its financial performance. Factors that Could Lead to a Downgrade Although unlikely, a downgrade of Germany's sovereign rating would trigger downward pressure on Saxony-Anhalt's rating. A significant deterioration of Saxony-Anhalt's fiscal metrics leading to an increase in its debt levels would have the same effect. Key Indicators Exhibit 1 Saxony -Anhalt, Land of Source: Issuer, German Statistics Office, German Ministry of Finance, Moody's Investors Service Detailed Rating Considerations Saxony-Anhalt's rating combines (1) a baseline credit assessment (BCA) for the Land of aa3 and (2) a very high likelihood of extraordinary support coming from the federal government in the event that Saxony-Anhalt faced acute liquidity stress. Baseline Credit Assessment STRONG ONGOING SUPPORT FROM THE GERMAN FINANCIAL EQUALISATION SYSTEM Germany has one of the strongest equalisation systems worldwide, which combines revenue equalisation - both horizontal and vertical - and investment support from the federal government. This scheme protects all Laender against dramatic revenue shortfalls, yet places limits on their revenue flexibility through the requirement to contribute to weaker peers. The German federal constitution guarantees that Laender receive appropriate levels of funding and prescribes a very high fiscal homogeneity among Laender. Under the current revenue equalisation system, Saxony-Anhalt benefits from special financial subsidies due to its status as a financially weak Land located in former East Germany. In October 2016, after years of negotiation, the German central government and the sixteen Laender agreed to changes in the German financial equalisation system. As a result, from 2020 onward, the Laender sector will benefit financially from a larger share of total tax revenues (at the expense of the central government). This confirms the Laender s strong position within the federation. The new set of rules will govern the German financial equalisation mechanisms after 2019, when the current system phases out. Key changes include the discontinuation of horizontal equalisation among the Laender; higher equalisation payments to the Laender from the federation; and the dynamisation of a portion of these payments, resulting in annually increases in federal equalisation payments to the Laender (see also: German Laender Will Benefit from Changes to Financial Equalisation System, October 2016). As a result of these changes, we do not see any rating implication for Saxony-Anhalt's rating This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on for the most updated credit rating action information and rating history. 2

3 Another factor is the so-called "debt-brake mechanism", which was introduced to limit the structural deficit of the federal government to 0.35 per cent of gross domestic product from 2016 onwards, while after 2019 Germany's 16 regional governments are no longer allowed to run fiscal deficits. In addition to the limit, a stronger joint supervision of Bund and Laender budgets has been implemented. To comply with the debt-brake from 2020, Saxony-Anhalt benefits from some additional financial subsidies over a transition period until FINANCIAL SURPLUSES, THANKS TO TIGHT BUDGETARY CONTROLS AND RISING TAX REVENUES Saxony-Anhalt has reported a financial surplus each year since 2012 (see Exhibit 2), and the Land expects the surplus to increase gradually over the coming years. This reflects cost savings measures, tax revenue growth, but also very low debt refinancing costs. Under our baseline scenario, we expect the environment to remain positive, and that the Land will continue pursuing measures to further reduce debt levels over the coming years. In 2015, expenditure controls, rising tax revenues, and declining interest costs helped the Land to maintain a healthy gross operating surplus of 8.8% of operating revenues, slightly better than the years before. For 2016, we expect a similar or slightly lower level. We expect the 2016 financing surplus to be around the same level as the financial surplus of 4% of total revenues achieved in The Land aims to maintain and increase its financial surpluses over the coming years. We view this as realistic provided the economic environment remains solid and consolidation measures remain on the agenda. Exhibit 2 Saxony-Anhalt reports financial surpluses since 2012 Source: Issuer, German Ministry of Finance, Moody's Investors Service In the medium term, we expect that the Land will continue to tightly control spending on primary items such as personnel, goods and services, in anticipation of periods of economic uncertainty and potential declines in federal transfers. The Land is committed to using its financing surpluses to repay debt in coming years. We expect Saxony-Anhalt to comply with Germany's debt brake mechanism (i.e. structurally balanced budgets from 2020) and to deliver on its objective of reducing debt gradually in the future. The Land is well on track and significantly outperformed its initial targets. Although this is not our main scenario, the Land's financial projections could come under pressure from unexpected adverse tax revenue development or a significant increase in funding costs. 3

4 SOUND DEBT MANAGEMENT, WITH GOOD CAPITAL MARKETS ACCESS Active debt management and sound liquidity ease the burden of Saxony Anhalt's substantial debt-service requirements. Foreigncurrency risks are fully hedged, while the Land's outstanding debt has an average maturity of around 8 years. More than 80% carries a fixed interest rate, with the remainder at variable or semi-variable rates. This creates some interest-rate risk, and there is some open exposure in Saxony-Anhalt's derivatives portfolio. However, we believe the overall risk exposure is very moderate. The share of short-term debt is comparatively high, reflecting Saxony-Anhalt's commercial paper programme, a unique feature among German Laender. Consequently, debt-service ratios are very high at 58% of operating revenues in Interest expenses accounted for 5.6% of operating revenues, significantly down from more than 10% ten years ago, in line with other German Laender. SaxonyAnhalt's overall amortisation profile is relatively flat and its access to capital markets is good, based on a broad set of instruments and a sophisticated state treasury. Saxony-Anhalt's access to liquidity is underpinned by the confidence of market participants in the "solidarity system" between German Laender and the central government. To bridge its short-term needs, the Land has access to the inter-laender credit pool, through which individual Laender offer their surplus cash to each other. DEBT BURDEN REMAINS VERY HIGH, BUT STEADILY DECLINING We expect that the Land's direct debt will decline to below 200% of its operating revenue by end-2017 from 204% in The ratio is high in an international context, but is just moderately above the German Laender average (on an aggregate basis) of about 171% of operating revenues in If we include other indirect debt (i.e., mainly guarantees), Saxony-Anhalt's net direct and indirect debt (NDID) ratio rises moderately to around 224% of operating revenues. Saxony-Anhalt's indirect debt mainly consists of guarantees over subsidiary company debt, housing projects, and small and medium-sized businesses. These declined to EUR 1.9 billion in December 2015, down from EUR 2.3 billion in 2014 and EUR 2.9 billion in The reduction was mainly a result of maturing guarantees and we expect the level of outstanding guarantees to stabilise at 2015 level. The NDID ratio is above the levels of other eastern German Laender, which tend to have weaker economic fundamentals than those in western Germany. Exhibit 3 Saxony-Anahlt's debt indicators are high, but steadily declining Source: Issuer, German Statistics Office, German Ministry of Finance, Moody's Investors Service The Land did not take on any new debt in recent years. Over the medium term it plans to continue with annual debt repayments. Planned debt repayment this year is EUR100 million. This would bring direct debt as a percentage of operating revenues significantly to below 200% over several years' time. We view this as achievable if Saxony-Anhalt follows strict spending discipline. 4

5 Saxony-Anhalt's contingent liabilities are very limited compared to those of most German Laender. The Land is holding a relatively low number of participations in companies and other entities, which overall are considered selfsupporting. Saxony-Anhalt holds and provides guarantees to a regional development bank (Investitionsbank Sachsen-Anhalt; not rated) which provides services to local SMEs, supports real-estate development and lends to local government sector. As is the case for most German Laender, Saxony-Anhalt's pension obligations are largely unfunded, and this could limit its budget flexibility and negatively affect its creditworthiness in the future. However, the Land established a pension fund for newly employed civil servants and we regard this as a forward looking first step in addressing the budget impact of its unfunded liabilities. However, Saxony-Anhalt's pension obligations appear significantly lower than those of many western German Lander. MODEST TAX BASE AND LIMITED FINANCIAL FLEXIBILITY In general, Saxony-Anhalt, like other German Laender, has little flexibility to adjust revenues or expenditures in its budget. Significant government budgetary pressures persist for Saxony-Anhalt, although its budgetary discipline has improved. Saxony-Anhalt's economy is in a period of transition, but the Land's restructuring efforts are taking effect. Growth remains weaker than for western Laender. Real economic output slightly increased by 0.1% in 2015 compared with a decrease of 0.4% the previous year. Overall, GDP growth is slightly below the national rate of 1.7% in 2015 and 1.6% in 2014 (see Exhibit 4). The Land's total GDP accounts for only 2% of national GDP and Saxony-Anhalt's per capita GDP is around 70% of the German average. Exhibit 4 real GDP growth rates are mostly below German average Source: German Statistics Office, Moody's Investors Service The restructuring of the economy has had an impact on population trends, with the population dropping to 2.2 million in 2015 from 2.5 million in 2005 and 2.7 million in The pace of outward migration has slowed, although it remains potentially negative for the economy and for the budget, as both the original tax base as well as transfer payments are based on population figures. Demographic projections foresee a stabilisation of the population at current level. Saxony-Anhalt has maintained flat operating expenditure over the last few years, mainly through personnel expenditure cuts and lower debt refinancing costs. Declining federal grants however, put pressure on the Land's budget planning and execution. 5

6 Extraordinary Support Considerations The very high likelihood of extraordinary support from the Federal Government of Germany, reflects Moody's assessment of of (1) the elevated reputation risk for Germany as a whole in case of default by a Land; and (2) the Bundestreuekonzept, according to which all German Laender must express mutual solidarity in the event that one of them or the Federal Republic faces a severe budgetary crisis. Also, the debt volumes and structure of German Laender are extremely complex and an event of non-payment would be considered to have a corresponding impact on Germany as a whole. Output of the Baseline Credit Assessment Scorecard In the case of Saxony-Anhalt, the BCA matrix generates an estimated BCA of a1, close to the BCA of aa3 assigned by the rating committee. The matrix-generated BCA of a1 reflects (1) an idiosyncratic risk score of 5 (presented below) on a 1 to 9 scale, where 1 represents the strongest relative credit quality and 9 the weakest; and (2) a systemic risk score of Aaa, as reflected in the sovereign bond rating (Aaa, stable). The idiosyncratic risk scorecard and BCA matrix, which generate estimated baseline credit assessments from a set of qualitative and quantitative credit metrics, are tools used by the rating committee in assessing regional and local government credit quality. The credit metrics captured by these tools provide a good statistical gauge of stand-alone credit strength and, in general, higher ratings can be expected among issuers with the highest scorecard-estimated BCAs. Nevertheless, the scorecard-estimated BCAs do not substitute for rating committee judgments regarding individual baseline credit assessments, nor is the scorecard a matrix for automatically assigning or changing these assessments. Scorecard results have limitations in that they are backward-looking, using historical data, while the assessments are forward-looking opinions of credit strength. Concomitantly, the limited number of variables included in these tools cannot fully capture the breadth and depth of our credit analysis. 6

7 Rating Methodology and Scorecard Factors Exhibit 5 Saxony-Anhalt, Land of Source: Moody's Investors Service Ratings Exhibit 6 Category SAXONY-ANHALT, LAND Outlook Senior Unsecured Commercial Paper -Dom Curr Other Short Term -Dom Curr Moody's Rating Stable Aa1 P-1 (P)P-1 Source: Moody's Investors Service 7

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