Financing Austria s regional and local

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1 Financing Austria s regional and local governments (RLGs) The Republic of Austria (Aaas/AA+s/AAAs) comprises nine states (Bundesländer). States are further divided into counties and municipalities or "cities with own statute". In this report, we give an overview of the institutional framework in which Austria s regional and local governments operate, paying particular attention to the financial equalization mechanism and the states access to funding. Austria s economy is closely tied to that of other EU economies. It has one of the highest GDPs per capita in the EU. However, real GDP has grown at a slower pace in the last two years compared to previous years, and UniCredit lowered its 2014 GDP-growth forecast to 0.2% from 0.6% in December Increased uncertainty following Russian and EU sanctions and Austria s dependence on exports had a negative effect on the economy, according to S&P. However, the rating agency affirmed Austria s AA+ rating in September 2014, keeping the outlook stable. Austria s GDP per capita was EUR 37,800 in 2013 (Germany: EUR 34,790). Austrian regional and local governments are embedded in a strong institutional framework. Austrian states are responsible for important administrative functions, and they can influence federal law making. Austrian regional and local governments are part of a financial equalization mechanism that regulates the division of revenue and expenditure among the different levels of government. Around 90% of the revenues of Austrian states and municipalities come from shared federal government taxes, which ensures continuity of revenues. A significant credit strength of the Austrian states is their access to the Austrian Federal Financing Agency (Bundesfinanzierungsagentur ÖBFA). All states have legally defined and unconditional access to the agency. Despite this strong institutional framework, the credit rating of some Austrian states is below that of the sovereign. S&P downgraded five Austrian states on 13 August The rating agency lowered the credit ratings because it sees the support mechanisms for Austrian states as weaker and less predictable following the ratification of special legislation regarding the winding down of Carinthia-based bank Hypo Alpe Adria International AG. Among European regional governments, Austrian states have been a relatively small group with respect to capital markets issuance to date. The total value of outstanding bonds issued by Austrian regional and local governments (RLGs) is nearly EUR 4bn, as of November 2014, with most bonds issued in euros and a few issues in Swiss francs (Carinthia & Lower Austria). The capital-market activity of Austrian states is set to pick up momentum as the Austrian sovereign urges more states to access capital markets to refinance debt, rather than relying on the Federal Financing Agency ÖBFA. At the same time, Austrian states have committed to balancing their budgets by The governments of all Austrian states have to comply with the intra-austrian stability pact. The federal and state governments and the Austrian Association of Cities and Municipalities agreed this pact in mid CONTENTS Austria s regional and local governments 2 Austria s institutional framework 4 Financial equalization mechanism 4 National stability pact 6 Access to Federal Financing Agency 7 Effects of the HAA special law 9 Austrian states accessing capital markets 11 Rating agencies' view 13 RATINGS OF AUSTRIAN STATES State Ratings Burgenland Aaas/AAs/-- Carinthia A2s/--/-- Lower Austria Aaas/AAs/-- Salzburg --/--/-- Styria --/AAs/-- Tyrol --/AA+s/-- Upper Austria --/AA+s/-- Vienna Aaas/AAs/-- Vorarlberg --/--/-- Republic of Austria Aaas/AA+s/AAAs Related Publications Source: rating agencies, UniCredit Research - SSA: Outlook December 2014 Sector Flash RAS - Sub-sovereigns, supras and agencies: A regulatory guide Update 9 December 2014 Credit Flash Heta Asset Resolution - the new HAA 20 November 2014 Sector Flash LCR treatment of SSA issuers 15 October 2014 Credit Flash Background on Catalonia rating watch negative by Fitch 1 October 2014 Credit Flash S&P takes knife to four Austrian states 13 August 2014 Austrian guaranteed bank bonds 31 July 2014 Handbook of German States July 2014 Credit Flash Austrian SSAs: Effects of Hypo Alpe Adria law on guaranteed issuers 24 July 2014 Sector Flash German states: Solid fiscal performance & S&P comments 26 June 2014 Credit Flash HAA investors to bear full losses? 11 June 2014 Author Robert Vielhaber, Credit Analyst (UniCredit Bank) robert.vielhaber@unicredit.de Bloomberg UCCR Internet UniCredit Research page 1 See last pages for disclaimer.

2 Austria s regional and local governments Overview The Republic of Austria (Aaas/AA+s/AAAs) comprises nine states (Bundesländer). One of them, Vienna has a special status as a city state and the capital of Austria. The following is an overview of the institutional framework in which Austrian regional and local governments (RLGs) are embedded. We pay particular attention to the financial equalization mechanism, which is similar to but not the same as that of the German states. Austrian states are further divided into counties and municipalities or "cities with own statute". OVERVIEW OF AUSTRIAN STATES State Capital Ratings (Moody s/s&p/fitch) Population ( 000) Share of population (%) Area (sq. km) Burgenland Eisenstadt --/AAs/ ,962 Carinthia Klagenfurt A2s/--/ ,538 Lower Austria St. Pölten Aaas/AAs/-- 1, ,186 Salzburg Salzburg --/--/ ,156 Styria Graz --/AAs/-- 1, ,401 Tyrol Innsbruck --/AA+s/ ,640 Upper Austria Linz --/AA+s/-- 1, ,980 Vienna Vienna Aaas/AAs/-- 1, Vorarlberg Bregenz --/--/ ,601 Republic of Austria Vienna Aaas/AA+s/AAAs 8, ,879 Source: rating agencies, UniCredit Research Economic environment Modern and competitive economy Austria s economy is closely tied to that of other EU economies, especially Germany. It is characterized by a large service sector, a sound industrial sector and a small, but highly developed, agricultural sector. The largest companies in Austria s main stock index are from the financials, steel and utilities sectors (such as Erste Group, voestalpine, OMV and Verbund). Austria has shown relative resilience through the economic cycle. However, growth in 2014 will be lower than expected. UniCredit lowered its growth forecast for 2014 from 0.7% to 0.2% in December (2013: 0.2%). Foreign trade made a small contribution to growth and the momentum of the domestic economy remains muted, according to UniCredit s Austria economists. They argue that private consumer spending is rising gradually but that capital spending, despite favorable funding conditions, is not increasing given the uncertain economic setting. Growing by 0.9% and 0.2% in 2012 and 2013 respectively, real GDP has grown at a slower pace over the past two years compared to previous years. The economy should pick up only slightly from 2015 on, with GDP growing at 0.7%. GDP per capita was EUR 37,800 in 2013 (Germany: EUR 34,790), according to S&P. The unemployment rate (national definition) is forecast at 8.5% in 2014 (2013: 7.6%). AUSTRIA: ECONOMIC AND FISCAL HIGHLIGHTS f 2015f Real GDP growth (yoy) 1.9% 3.1% 0.9% 0.2% 0.2% 0.7% Inflation rate (change vs. previous year) 1.9% 3.3% 2.4% 2.0% 1.7% 1.9% GDP per capita (EUR)* 34,425 37,782 35,811 37,673 37,800 38,872 Unemployment rate (national definition) 6.9% 6.7% 7.0% 7.6% 8.5% 8.4% Budget deficit/gdp 4.50% 2.60% 2.30% 1.50% 2.80%** 1.50% General government debt/gdp 82.4% 82.1% 81.7% 81.2% 86.9%** 86.5%** f=forecast; *data & forecasts from Standard & Poor s; **figure includes support to Hypo Alpe Adria; highlighted fields indicate recent adjustments to forecasts Source: S&P, UniCredit Research UniCredit Research page 2 See last pages for disclaimer.

3 RISE IN TOTAL PUBLIC DEBT BURDEN* AUSTRIA IN COMPARISION (CHANGES FROM 1998 TO 2013) 7% 6% 5% 4% 3% 2% 1% Budget deficit (% of GDP) Total public debt (% of GDP) 85% 80% 75% 70% 65% 60% 40% 35% 30% 25% 20% 15% 10% 5% Austria Euro area Germany 30% 20% 21% 13% 11% 10% 35% 34% 27% 0% % 0% GDP (real) Employment Prices* *data restated on 30 September 2014 based on European System of Accounts (ESA 2010) Source: UniCredit s Austrian economists, Statistics Austria, Markit Economics, Eurostat, UniCredit Research HAA weighs on budget deficit Budgetary performance & debt burden The creation of a bad bank for troubled lender Hypo Alpe Adria will increase the Austrian government s debt by 4.8 percentage points by the end of In addition, Austria s deficit for 2014, at 2.8% of GDP, increases government debt by almost one percentage point. Austria s general government debt will amount to 86.9% of GDP by the end of 2014, according to UniCredit s Austria economists (2013: 81.2%). The increase in debt is a result of new debt and financial market stabilization measures (including EUR 17.8bn for the creation of the HAA wind down entity). Our economists expect slightly lower government debt as a percentage of GDP of 86.5% in This is below the euro-area average. Please note that the GDP and data for European economies was restated in September 2014 according to the European System of Accounts (ESA 2010). UniCredit Research page 3 See last pages for disclaimer.

4 Austria s institutional framework Overview The Austrian states are responsible for executing key functions such as administering education, social welfare, healthcare and housing. The financial equalization law details the rules of tax sharing and intergovernmental transfers, and it determines the way in which the Austrian sovereign, the states and the municipalities are each responsible for costs. This chapter provides details on Austria s financial equalization mechanism, it outlines Austria s national stability pact and explains the Austrian states access to the Federal Financing Agency. Financial equalization mechanism Financial equalization mechanism The financial equalization mechanism among the Austrian federal, regional and local governments is laid down in the financial equalization law (Finanzausgleichsgesetz). It regulates the division of responsibilities, revenue and expenditure of these different levels of government. Around 90% of the revenues of Austrian states come from shared taxes, which the federal government collects and distributes to the states and municipalities. The current financial equalization law originally applied to the period but was extended to The law is negotiated every four to six years. STRUCTURE OF THE FINANCIAL EQUALIZATION LAW Primary equalization Secondary equalization Tertiary equalization Regulates the degree of autonomy regarding revenue and expenditure Vertical equalization, i.e. the distribution of revenues between the central, regional and municipal levels Horizontal equalization, i.e. the distribution of revenue among the states Supplementary transfers from the central government, allowances, cost refunds (e.g. for teachers and capital expenditures for large infrastructure projects) and earmarked transfers Earmarked transfers are specific amounts to states and municipalities in support of balancing their budgets All other intra-governmental transfers (according to other federal or regional laws), e.g. transfers to organizations or public entities Source: UniCredit Research Tax sharing: central government and states Vertical equalization The majority of Austria s tax revenue is distributed between the federal government, states and municipalities, according to a fixed distribution formla. These joint taxes include tax on personal income as well as corporate tax, sales tax and financial transaction tax. Other types include taxes on tobacco, electricity, gas, coal, beer, wine, alcohol, the transfer of real estate, land value, petrol, inheritance, insurance, advertising, gambling and cars. The table below shows the distribution of joint taxes. According to these, in 2013, % of joint taxes were transferred to the central government, % of joint taxes were transferred to the states, and % were transferred to municipalities. This distribution excludes those joint taxes of which municipalities receive a higher share (gambling, advertising, real estate transfer and land value). DISTRIBUTION OF JOINT TAXES Year Federal States Municipalities % % % % % % Source: Austrian Ministry of Finance, UniCredit Research UniCredit Research page 4 See last pages for disclaimer.

5 Horizontal equalization The population of each state, combined with a fixed ratio, determines the distribution of tax revenues to each individual state. This is similar for municipalities. In this respect, financial equalization in Austria is different to the system in Germany. Here, the horizontal distribution generally follows the principle of local revenue, under which each state is entitled to the tax revenue collected in its territory. (Horizontal distribution describes the tax revenue that is allocated to the states and subsequently distributed among the states). In Austria, horizontal distribution is, to a large extent, determined by a state s population and not by the local tax revenue base. The table below shows the respective distribution levels. Given that distribution depends mainly on population, those states with a relatively high share of the national population, i.e. Vienna, Lower Austria, Upper Austria and Styria, receive a proportionally higher share of joint and shared taxes. TAX DISTRIBUTION AMONG STATES AND MUNICIPALITIES IN 2013 States Municipalities Burgenland 3.250% 1.255% Carinthia 6.881% 5.292% Lower Austria % % Salzburg 6.976% 8.252% Styria % 9.328% Tyrol 8.813% 8.939% Upper Austria % % Vienna % % Vorarlberg 4.923% 5.983% Source: Austrian Ministry of Finance, UniCredit Research 20% of total government revenues go to states and municipalities In 2013, total payments to the states amounted to EUR 21.9bn, and payments to municipalities were EUR 9.1bn. A relatively high share of the states' revenue comes from cost reimbursements by the central government. For instance, teachers' salaries and pensions are reimbursed, and capital expenditure for larger infrastructure projects are partially refunded. Total payments to the states and municipalities for 2013 amounted to roughly 20% of total government revenues (EUR 31.2bn of EUR bn). DISTRIBUTION IN 2013 (EUR MN): STATES... AND MUNICIPALITIES EUR mn share in joint taxes supplementary & earmarked transfers cost refunds 5,000 4,525 4,500 4,000 4,068 3,711 3,500 3,082 3,000 2,500 1,910 2,000 1,499 1,450 1, ,005 1, Burgenland Carinthia Lower Austria Salzburg Styria Tyrol Upper Austria Vorarlberg Vienna EUR mn 3,000 2,500 2,000 1,500 1, Burgenland share in joint taxes 573 Carinthia 1,493 1,446 Lower Austria Salzburg supplementary and earmarked transfers 634 Styria 1,167 Tyrol 799 Upper Austria 423 Vorarlberg 2,403 Vienna Source: Austrian ministry of finance, UniCredit Research Own taxes In addition to the vertical and horizontal distribution, states and municipalities levy their own taxes. In the case of municipalities, they include taxes on property, second homes and pets. There are also those taxes that are shared between states and municipalities such as taxes on fire protection insurance, tourism and toll roads. General government revenues amounted to 49% of GDP for 2013, of which 23.7% were allocated to the central government. UniCredit Research page 5 See last pages for disclaimer.

6 Recent developments: effects of HAA special legislation Summary Following the events around Hypo Alpe Adria, Austria s federal government may change the tax-sharing system in order to force the State of Carinthia to contribute to the losses of HAA. Details of these plans were not announced, but a change to the taxsharing system would make Austria s framework less predictable and less supportive. Consequently, it would mark a shift in the balance of power between the federal government and the states. S&P cited these potential changes as a reason for downgrading the credit rating of four Austrian states in August The individual share of income from tax that states and municipalities receive is determined by the population of the state or municipality. The individual share is not related to the regional tax base, as is the case with German states. The ability of Austrian states to raise taxes is limited since most taxes are set at the central level (limited exceptions include the surcharge on property tax by municipalities). The revenue of states is not linked to their responsibilities for expenditure. This may lead to moral hazard in the form of loose spending. Discussions are ongoing in Austria to give states and municipalities greater autonomy regarding taxation. To date, structural reforms and spending cuts (for example in the field of health care) have started to bear fruit. Stability pact agreed in 2012 National stability pact Austrian states have committed to balance their budgets by The governments of all Austrian states have to comply with the intra-austrian stability pact. The federal and state governments and the Austrian Association of Cities and Municipalities agreed to this pact in mid It requires the states to clarify the process of reporting, controlling and, if necessary, sanctioning. All participants must adhere to the stability pact, although intra- Austrian stability pacts do not have a good track record of success. The 2012 stability pact goes beyond implementing a reform package and a zero borrowing rule. It also implements EU rules on sustainable budget policies within Austria. The primary aim is to reduce the country s deficit and achieve a balanced budget by The strategy of the federal government for 2014 to 2018 aims for a long-ranging and stabilityoriented fiscal and economic policy. The objective is sustainable economic growth and a high level of employment. The stability pact, combined with the zero borrowing rule, aims to improve Austria s finances. It also puts into law the medium-term budget goal and puts into effect new EU budget criteria. In particular, the stability pact states that: Austrian states and municipalities accept the rules of the sovereign government regarding the zero borrowing rule States and municipalities comply with a balanced budget. This is achieved if the share of the structural deficit does not exceed 0.1% of nominal GDP Check accounts/control accounts are set up for each federal state and for the municipalities within a state. If the combined deficit of all check accounts exceeds 0.367% of nominal GDP, the states have to balance the account The overall structural deficit must not exceed 0.45% of GDP Austria s stability pact: effects on states & municipalities The national Austrian stability pact, established in 1998, originally set deficit limits for all governmental levels in light of the Maastricht criteria. Since then, the deficit targets for states have been adjusted in order to strengthen consolidation efforts and to bring the general deficit below the 3% ceiling of the Maastricht criteria. The states (including Vienna) have a maximum target deficit of 0.29% of GDP in 2014, 0.58% in 2015, and 0.19% in Meanwhile, municipalities are required to post balanced budgets. UniCredit Research page 6 See last pages for disclaimer.

7 However, an individual municipality may incur a deficit if this is counterbalanced by surpluses of other municipalities within the same state. Should a municipality not be able to balance its budget, the state is required to cover the excess spending. Additionally, the financial equalization mechanism also includes funding to cover budget shortfalls. It has to be noted that a formal bailout mechanism for states or municipalities does not exist. However, Austria s institutional framework is designed to prevent states and municipalities entering into financial difficulties. What s more, Austrian states benefit from access to the Federal Financing Agency (see next chapter). Unconditional access to Federal Financing Agency Access to Federal Financing Agency A significant credit strength of the Austrian states is their access to the Austrian Federal Financing Agency (Österreichische Bundesfinanzierungsagentur ÖBFA). All states have legally defined and unconditional access to the agency. This gives states timely access to funding, which is, in essence, provided by the Austrian sovereign. In particular, according to the Federal Law Gazette no. 763/1992 defining the responsibilities of the Austrian financial agency, "Upon request of the federal minister of finance, the Austrian Federal Financing Agency shall, on behalf of and for the account of the federation, following targets according to Sec. 2 Budget Accounting Act, Federal Law Gazette no. 213/1986 perform and enter into credit transactions for provincial states and provide such states with money from such funds, [ ]". The Austrian government has not earmarked funds for bailouts of its states. Also, no legally defined procedure exists, and such funds would not be needed due to the above-mentioned access to the Federal Financing Agency. The most supportive element for the liquidity of Austrian states is all states having [ ] unconditional access to the federal financing agency, according to S&P. The rating agency sees this as an extraordinary credit strength. ACCESS TO FEDERAL FINANCING AGENCY OVERVIEW OF THE LEGAL FRAMEWORK Federal law Section Text (English)* Federal Budget Law Bundeshaushaltsgesetz 2013 Federal Financing Law Bundesfinanzierungsgesetz 763/1992 Federal Law Gazette 213/1986 Bundeshaushaltsgesetz 24 April 1986 Section 81 Section 2 Section 1 81 (1) The finance minister may enact and finalize credit operations for states [ ] using the Federal Financing Agency. The federal minister of finance shall perform or complete credit operations [ ] for states; from these funds, the federal minister of finance then has to provide loans to the individual states. This has to be done in exercise of the relevant federal financial law or in a special federal law, paying attention to the conditions of 79 and the Austrian Federal Financing Agency. 2 (4) Upon request of the federal minister of finance, the Austrian Federal Financing Agency shall, on behalf of and for the account of the federation, following targets according to Sec. 2 Budget Accounting Act, Federal Law Gazette no. 213/1986 perform and enter into credit transactions for provincial states and provide such states with money from such funds, [ ]". 2 (1) The financial management has to fulfill the functions of the sovereign by identifying and providing the necessary funds in compliance with the principles of austerity, efficiency and effectiveness. The requirements of general economic equilibrium as well as the solidarity of the finances of the federation, the states and the communities to consider (associations of municipalities) have to be kept. *please note the English text is an unofficial summary of the original German text. Please refer to the original document for the exact wording. Source: UniCredit Research Background: Austria s Federal Financing Agency The Federal Financing Agency gives Austrian states access to funds from the sovereign. States can apply for support from the agency by way of a bureaucratic process. The financing agency is authorized by Austria s finance minister. In return, the Austrian states have an obligation to report their refinancing needs to the financing agency, according to the National Stability Pact. UniCredit Research page 7 See last pages for disclaimer.

8 The aim of this approach is to prevent the supply of too much liquidity from the government to the states and also to prevent the states spending the allocated funds recklessly. In practice, the states submit data regarding their funding requirements to the financing agency, explaining their rationale for the amounts they wish to borrow. These amounts have to be within the range of the budget deficit that is allowed, according to the National Stability Pact. The financing agency then grants the funds up to a certain limit. This process is in line with the stability pact. It is important to note that most recently the Austrian government has been encouraging Austrian states to seek funding in the capital markets. Therefore, in our view, states will turn to capital markets to refinance their outstanding debt and will consequently rely less on the financing agency (for details, see the chapter on Austrian states accessing capital markets). UniCredit Research page 8 See last pages for disclaimer.

9 Effects of the HAA special law Winding down of HAA HAA implication Rating actions Bank guarantees of Austrian states In August 2014, the Austrian government enacted a law to wind down the nationalized Hypo Alpe Adria Bank International AG (HAA). The law cancels the deficiency guarantees from the State of Carinthia on HAA s subordinated debt, which amounts to circa EUR 900mn, and the law bails in subordinated debt holders. The banking license of Hypo Alpe Adria Bank International AG was terminated on 30 October Consequently, it will continue its operations as a wind-down entity. Standard & Poor s downgraded a number of Austrian states in reaction. Consequently, five states are rated below the Austrian sovereign. S&P lowered the credit rating of Burgenland, Lower Austria, Styria and Vienna on 11 August 2014 because it sees the support mechanisms for Austrian states as weaker and less predictable following the ratification of special legislation regarding the winding down of HAA, which is based in Carinthia. Meanwhile, Moody s confirmed its credit rating for the State of Carinthia on 23 June 2014 and kept its stable outlook. We note that the views of the two rating agencies contradict each other regarding the effects of the HAA case on the Austrian states. While S&P has warned of negative consequences as a result of the special HAA law, Moody s has highlighted the special law s positive implications for the State of Carinthia. The ratings of the Austrian states fall within the range of A2 to Aaa. Deficiency guarantees for the banking sector Austrian states have issued deficiency guarantees for some of their banks amounting to EUR 40.8bn, according to budget data from the states for FY13. The amount is around EUR 6bn lower than in FY12. These guarantees include those for HAA issued by the state of Carinthia, amounting to EUR 12.9bn as of 2013 (2012: EUR 14.9bn). In addition to bank guarantees, states have also issued other guarantees, taking the total to EUR 62bn. BANK GUARANTEES IN RELATION TO STATES 2013 BUDGETS State Bank Bank guarantees (EUR mn) Total guarantees (EUR mn) State expenses FY13 (EUR mn) Bank guarantees (% of expenses) Total guarantees (% state expenses) Carinthia Hypo Alpe-Adria-Bank International 12,883 15,458 2, % 621% Vorarlberg Vorarlberger Landes- und Hypothekenbank 3,954 4,862 1, % 315% Burgenland HYPO-BANK Burgenland 2,155 2,677 1, % 238% Tyrol Hypo Tirol Bank 4,683 4,758 3, % 148% Lower Austria HYPO NOE Gruppe Bank 5,136 11,813 8,708 59% 136% City of Vienna Bank Austria 6,758 7,061 12,471 54% 57% Upper Austria Oberoesterreichische Landesbank 2,663 9,363 5,565 48% 168% Styria Landes-Hypothekenbank Steiermark 2,463 4,196 5,063 49% 83% Salzburg Salzburger Landes Hypothekenbank 55 1,830 4,429 1% 41% Total 40,749 62, % 201% *Guarantees of Austrian states for banks and state related entities according to the states budgets; state expenses according to public budgets Source: Austrian federal state budgets, UniCredit Research Definition of a deficiency guarantee Under a deficiency guarantee, creditors of a bank benefit from a direct claim that can only be called upon if the liquidity status of a bank is insufficient to pay creditors, according to a text published by the EU. The EU also states that the guarantees are not limited in duration or to a certain amount. One important question is whether the guarantee covers nominal and interest payments. The laws dealing with the deficiency guarantees generally refer to the terms all debt or all liabilities. In principle, the wording is not precise enough to clarify whether bonds nominal and interest would be covered. UniCredit Research page 9 See last pages for disclaimer.

10 If an Austrian bank has insufficient cash to either pay coupons or repay the nominal, the instrument would become immediately payable and could trigger the cross-default of the remaining outstanding instruments. For details on the deficiency guarantee, please refer to our on Austrian guaranteed bank bonds. BANK GUARANTEES OF AUSTRIAN STATES Guarantees in relation to state budgets Landeshypothekenbanken compared (total assets in EU mn) 600% 500% 400% 300% 200% Bank guarantees (% of expenses) Bank guarantees (EUR mn) 14,000 12,000 10,000 8,000 6,000 4,000 EUR mn 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2, % 0% Carinthia Vorarlberg Burgenland Tyrol Lower Austria City of Vienna Upper Austria Steiermark Salzburg 2,000 0 HYPO NOE Landesbank Hypo Vorarlberg Hypo Tirol Hypo Oberösterreich Hypo Steiermark Hypo Steiermark Hypo Salzburg Bank Burgenland Source: state budgets, company data, UniCredit Research HAA: recent developments and our view Heta Asset Resolution the new HAA In November 2014, Heta Asset Resolution (HETAR) was set up as the wind-down entity of former Austrian Bank Hypo Alpe Adria. The legal basis for the wind-down was the Hypo Act implemented by the Austrian National Council in July Consequently, Carinthia s deficiency guarantee is applicable to the senior bonds transferred to Heta Asset Resolution. The guarantee means that Carinthia would be liable for EUR 1.9bn of bonds maturing in 2015 (2016: EUR 1.7bn; 2017: EUR 3.4bn), according to Bloomberg. This compares to Carinthia s total state budget for 2013 of EUR 2.5bn, and it shows that the state would not have the means to honor its guarantees in each respective year. Note that these maturities only show publically listed bonds, excluding private placements and promissory notes. Regarding Carinthia s deficiency guarantees, there are the following possible scenarios: 1. HAA/Heta repays outstanding bonds over the coming three years; 2. HAA/Heta does not (fully) service maturing debt and investors call on the guarantees. This would likely result in the insolvency of the state; 3. The Austrian sovereign decides to void Carinthia s guarantees for senior bonds, similar to the way in which it voided the guarantees for subordinated debt, which was implemented through a special law that was enacted on 1 August 2014; 4. Alternatively, the Austrian sovereign may inject further capital into HAA/Heta in the form of state support. The state has already injected around EUR 7bn. Our view The situation around HAA/Heta is politically motivated, and therefore it is difficult to attach a likelihood to any of the above mentioned scenarios. However, a call of the deficiency guarantees for outstanding bonds, and consequently an insolvency of the state of Carinthia, is unlikely in our view. It is in the interest of the Republic of Austria to avoid the insolvency of a state, because it would have negative implications for the sovereign. Based on the ongoing uncertainties regarding the treatment of HAA/Heta s outstanding bonds (including the ones benefitting from Carinthia s deficiency guarantee), we have placed the instruments maturing after 2015 on underweight in November UniCredit Research page 10 See last pages for disclaimer.

11 Capital markets activities Lower Austria is the most frequent issuer Federal Financing Agency access Austrian states accessing capital markets Funding strategy Among European regional governments, Austrian states have been a relatively small group of issuers to date. The total value of outstanding bonds issued by Austrian regional and local governments (RLGs) is nearly EUR 4bn (see chart on next page), with most bonds issued in euros and a few in Swiss francs (Carinthia & Lower Austria). The capital-market activity of Austrian states is set to pick up momentum as the Austrian sovereign urges more states to access capital markets to refinance debt rather than relying on the Federal Financing Agency (Bundesfinanzierungsagentur ÖBFA). Lower Austria (NIEDOE; Aaas/AAs/--) is the most active of the nine Austrian states with regard to capital-market activity. Lower Austria has a total of EUR 1.7bn in bonds outstanding as of November 2014, according to data from Bloomberg. The state s most recent larger euro issue is the NIEDOE 10/2019, a EUR 145mn bond sold in October 2014 and tapped in November for EUR 210mn. The second most active Austrian state in capital markets is the state of Salzburg (SALZLD; --/--/--) with two EUR 100mn floating rate notes issued in Carinthia has five bonds outstanding, although only the KARNTN FLOAT CHF 100mn is of significant size. Beyond that, issuance of publically tradable bonds by Austrian states is limited to date. Support for Austrian states by Austria s Federal Financing Agency has been subject to discussion. Carinthia preferred to use its access to the financing agency in the past, but the state has recently relied on other sources of funding, such as private placements. In fact, Austria s financing agency aims to move from being the sole lender to being one of many sources of financing for all states. One possibility may be that the financing of states from the financing agency is reduced to a certain percentage of a state s budget. Until now, there have been no restrictions in place on the debt levels of states, their debt issuance or debt service. Also, there is no limit to the amount of guarantees that states may issue. UniCredit Research page 11 See last pages for disclaimer.

12 AUSTRIAN STATES IN THE CAPITAL MARKETS Austrian states vs. European regions Lower Austria is the largest issuer Benchmark* Other bonds Spanish regions 60 Italian regions 16 French regions 12 Austrian regions EUR bn EUR mn 1,800 1,600 1,400 1,200 1, Lower Austria KIG - Krankenanstalten State of Salzburg LIG Landesimmobilien City of Vienna State of Carinthia Lower Austria: spread performance Lower Austria: swap spread curve bp 80 NIEDOE 5% 4/ NIEDOE 5.27% 5/ NIEDOE 2.633% 6/ NIEDOE 2.125% 8/ Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 *Benchmark is a minimum issue size of minimum EUR 1bn bp NIEDOE 2.633% 6/ NIEDOE 2.605% 10/ NIEDOE 2.125% 8/ NIEDOE 0.375% 4/2021 NIEDOE 0.5% 10/ mdur Source: UniCredit Research Regulatory treatment of Austrian states & municipalities Liquidity Coverage Ratio (LCR) Solvency II Bonds issued by Austrian states and local authorities qualify as Level 1 assets under the Liquidity Coverage Ratio (LCR) regulation, in our view. Under the LCR regulation, European central governments always qualify as Level 1 assets. However, European regional governments or local authorities qualify as Level 1 assets provided that they are treated as exposure to the central government. Regional governments and local authorities may qualify for the same treatment as claims on their central governments if they have specific revenueraising powers and institutional arrangements that reduce their risk of default. This is the case for Austrian states, in our view. Moreover, regional governments and local authorities carry a 0% risk weighting under the Basel II standardized approach if they have specific revenueraising powers and institutional arrangements that reduce their risk of default. For detailed comments on the LCR treatment of SSA issuers, please refer to our Sector Flash. On 1 January 2016, the new regulatory regime for insurance companies (Solvency II) will become mandatory for insurers based in the European Union. The relevant risk categories for SSA exposure are spread risk, concentration risk, interest rate risk and sometimes also currency risk. For the spread and concentration risk, a stress factor of 0% is applied to Austrian states and municipalities. Exposure to regional governments and local authorities can be treated as exposure to the central government where there is a specific revenue-raising power of the former, and specific institutional arrangements exist, the effect of which is to reduce the risk of default. German states and municipalities as well as Austrian states and municipalities fall into this category. For detailed comments on the treatment of SSA exposure under Solvency II, please refer to our Regulatory & Accounting Briefing. UniCredit Research page 12 See last pages for disclaimer.

13 Rating agencies' view VIEW ON AUSTRIA S INSTITUTIONAL FRAMEWORK Moody s S&P Moody's evaluates the institutional framework of Austrian states as follows: The institutional framework, which encompasses legislative background and financial flexibility, reflected in the arrangements determining intergovernmental relations at all levels and jurisdictional powers and responsibilities, is mature and highly developed. The division of responsibilities between the Federal Republic and the Länder and municipalities is highly codified: any changes are implemented at a measured pace and in a transparent fashion, following discussions among the relevant interest groups. The creditworthiness of every Austrian Land benefits from the stability inherent in the federal institutional framework, which is characterized by a good degree of oversight. Despite being a federal system, the Austrian Länder have relatively limited autonomy, acting more as "executor" of the federal administration. Most law-making power is concentrated at the federal level, which gives individual states only restricted power to manage affairs in their own way. Austria operates a vertical equalization system whereby poorer Länder receive federal transfers. Extraordinary support: The high likelihood of extraordinary support from the Federal Government of Austria (Aaa, stable), reflects Moody's assessment of the vital role played by each state in the Austrian institutional framework, to the extent that the states act on behalf of the federal government for key functions (education, social welfare, healthcare/hospitals and housing). S&P provided the following assessment, which was taken from its Public Finance System Overview. The highlights include the following: "The Austrian states benefit from a mature system of intergovernmental cooperation. Austria has a very consensusbased political system, under which changes tend to be gradual. Moreover, a strong and predictable tax-sharing system is in place. The tax-sharing system underwent a major change in 2008, and it presently includes all of the substantial tax revenues. We think this change lessened the risk of states and municipalities being assigned volatile taxes, as well as the risk of federally implemented tax changes. The states are represented in federal law making, although we note that the states' influence can be limited by an overruling decision [ ]. "The tax-sharing system distributes joint tax revenues among states according to their share of the total population. Almost all of the tax revenues in Austria are joint taxes and are distributed to the federal and/or state level, according to a predefined formula. The system does not penalize any state in the equalization system because individual shares are related to states' population size and not to the regional tax base. In 2008, earmarked transfers to the states transformed into higher tax shares for the states, which, in our opinion, further increased the degree of discretion a state has in defining its expenditure policy. We note that revenues and expenditures across the states are closely matched, owing to a high share of expenditure items that are reimbursed by the federal government: Austrian states raise practically no taxes because they have only minor tax-setting capabilities. The most supportive element on the liquidity side is all states having, as we understands it, unconditional access to the Federal Financing Agency (Bundesfinanzierungsagentur ÖBFA), which S&P considers to be of extraordinary credit strength. We further understand that Austrian states could access liquidity at the federal level on a timely basis. Extraordinary support: "Although no earmarked funds are allocated for bailouts, we note these funds are not needed because states have legally defined and unconditional access to the Federal Financing Agency. According to our information, the agency removed the option for Austrian states borrowing in foreign currencies from the agency in However, we believe states' timely access to funds in EUR remains intact. We view the Austrian system as oriented toward the prevention of financial pressure on states. That said, there is no track record of direct bailouts for an Austrian state. Source: S&P, Moody s, UniCredit Research UniCredit Research page 13 See last pages for disclaimer.

14 Rating triggers S&P s rating triggers S&P cites an improved budget scenario over the base case as an upward trigger for the ratings of Lower Austria and Vienna, while the agency does not see upside potential for Burgenland or Styria. Negative triggers include higher contingent liabilities from the ownership of Hypo NOE (NIEDOE) or material financial stress at Landes-Hypothekenbank Steiermark, which could result in a large contribution of capital from the State of Styria (see table below). AUSTRIAN STATES RATING TRIGGERS (S&P AND MOODY S) State Agency Positive trigger Negative trigger City of Vienna S&P city significantly reduces debt and maintains sound liquidity position increased expenditure discipline and further savings improved budget scenario above base case city s financial management loosens control over large expenditures deterioration of budget performance looser control of budget process and weaker budget discipline weaker management of city-owned companies and participation Moody s no positive rating trigger deterioration in the creditworthiness of the sovereign issuer-specific risks that might emerge State of Lower Austria S&P notably stronger budgetary performance than base case positive effect from financial management reduction in tax-supported debt and contingent liabilities financial management deviates from strategy loss of invested funds from decline in stock prices higher contingent liabilities from ownership of Hypo NOE note: S&P sees upside & downside scenarios as highly unlikely Moody s no positive rating trigger deterioration in the creditworthiness of the sovereign issuer-specific risks that might emerge State of Carinthia S&P no rating no rating Moody s implementation of the bad bank and evidence of a positive track record progressive reduction of guaranteed debt in the next few years further uncertainty about the wind-down entity and greater-thanexpected financial support from Carinthia to address the winddown entity s future capital needs State of Burgenland S&P no realistic upside scenario pronounced deterioration in budgetary performance (increased spending) shift in budget discipline (scenario implies breach of national debt brake which S&P sees as unlikely) Moody s no rating no rating State of Upper Austria S&P positive rating action on Austria S&P caps the rating based on the long-term rating of Austria deteriorating institutional framework lower flexibility on the expenditure side higher contingent liabilities likely increase in tax-supported debt downgrade of the Austrian sovereign Moody s no rating no rating State of Tyrol S&P rating action on Austrian sovereign no realistic downside scenario Moody s no rating no rating State of Styria S&P no realistic upside scenario significant budget deterioration, leading to persistently higher deficits than S&P s base case scenario material financial stress at Landes Hypothekenbank Steiermark, resulting in large contribution of capital from the state the above would lead to rise in tax-supported debt (state has no cash holding to finance deficits) Moody s no rating no rating City of Salzburg S&P/ no rating no rating Moody s State of Vorarlberg S&P/ Moody s no rating no rating Source: Moody s, S&P, UniCredit Research UniCredit Research page 14 See last pages for disclaimer.

15 S&P s rationale S&P s rationale for the rating downgrades of four Austrian states On 11 August 2014, S&P reviewed the predictability, revenue balance and transparency of the Austrian states framework. This led to the downgrades and affected the states standalone credit profiles. Predictability: In S&P s view, the Austrian states still enjoy a mature system of intergovernmental cooperation. Austria has a consensus-based political system, under which changes tend to be gradual. The federal government renegotiates the strong and predictable tax-sharing system with the states at regular intervals. However, the discussion of a unilateral change of the tax-sharing mechanism (Carinthia) now suggests a different approach to possible interference, which, in S&P s view, leads to a lower level of predictability. Tax sharing includes all substantial taxes, which reduces the risk of the states' and municipalities' exposure to more volatile taxes and federally implemented tax changes, compared to a system under which they only benefitted from specific taxes. Usually, the changes made after each renegotiation are incremental, and the states agree on most political and legal matters through their parliamentary representatives (Bundesrat) before proposed legislation enters the approval process. Revenue and expenditure balance: Recent statements by high-ranking Austrian politicians have added to the uncertainty surrounding the federal government's stance towards supporting Austrian states. In addition, the government has temporarily blocked Carinthia's access to the federal treasury, which S&P interprets as a refusal to finance the state. In S&P s view, such an action shifts the revenue and expenditure balance in the intergovernmental system. About 90% of the states' revenue come from shared taxes, which the federal government collects and distributes to the states and municipalities according to a predefined formula. This means changes in the tax-sharing system could have a significant impact on the states' creditworthiness. That said, the federal finance minister has the power to grant all states access to funds from the federal treasury, which S&P understands is usually granted following a formal application process. This reduces the states' market and refinancing risks and underlines the supportiveness of the intergovernmental system. However, given the federal government's decision to refuse one state access to funding even if for a limited time S&P cannot rule out that this will not be repeated. Transparency and accountability: S&P still regards transparency and accountability in Austria's institutional framework as good. There is a clear distribution of tasks and responsibilities. Given that states' revenues are not linked to their expenditure responsibilities, moral hazard issues may arise (loose spending practices). In several areas, structural reforms and spending cuts, such as in health care, have started to achieve consolidation. Federal law governs the states' accounting principles, but changes are implemented only with the consent of the states. The principles are based on pure cash accounting, which, in particular, fails to address the required group consolidation and inter-period effects. The federal government is promoting a change to its recently implemented accrual accounting approach for states and municipalities, which some states have thus far not agreed to. UniCredit Research page 15 See last pages for disclaimer.

16 MAP OF THE 9 AUSTRIAN STATES Source: UniCredit Research UniCredit Research page 16 See last pages for disclaimer.

17 Disclaimer Our recommendations are based on information obtained from, or are based upon public information sources that we consider to be reliable but for the completeness and accuracy of which we assume no liability. All estimates and opinions included in the report represent the independent judgment of the analysts as of the date of the issue. We reserve the right to modify the views expressed herein at any time without notice. Moreover, we reserve the right not to update this information or to discontinue it altogether without notice. 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Key 1b: The analyzed company owns at least 2% of the capital stock of UniCredit Bank AG and/or a company affiliated with it (pursuant to relevant domestic law). Key 2: UniCredit Bank AG and/or a company affiliated with it (pursuant to relevant domestic law) belonged to a syndicate that has acquired securities or any related derivatives of the analyzed company within the twelve months preceding publication, in connection with any publicly disclosed offer of securities of the analyzed company, or in any related derivatives. Key 3: UniCredit Bank AG and/or a company affiliated (pursuant to relevant domestic law) administers the securities issued by the analyzed company on the stock exchange or on the market by quoting bid and ask prices (i.e. acts as a market maker or liquidity provider in the securities of the analyzed company or in any related derivatives). Key 4: The analyzed company and UniCredit Bank AG and/or a company affiliated (pursuant to relevant domestic law) concluded an agreement on services in connection with investment banking transactions in the last 12 months, in return for which the Bank received a consideration or promise of consideration. Key 5: The analyzed company and UniCredit Bank AG and/or a company affiliated (pursuant to relevant domestic law) have concluded an agreement on the preparation of analyses. Key 6a: Employees of UniCredit Bank AG Milan Branch and/or members of the Board of Directors of UniCredit (pursuant to relevant domestic law) are members of the Board of Directors of the Issuer. Members of the Board of Directors of the Issuer hold office in the Board of Directors of UniCredit (pursuant to relevant domestic law). Key 6b: The analyst is on the supervisory/management board of the company they cover. Key 7: UniCredit Bank AG Milan Branch and/or other Italian banks belonging to the UniCredit Group (pursuant to relevant domestic law) extended significant amounts of credit facilities to the Issuer. RECOMMENDATIONS, RATINGS AND EVALUATION METHODOLOGY Company Date Rating Currency Target price n.a. n.a. n.a. n.a. n.a. Overview of our ratings You will find the history of rating regarding recommendation changes as well as an overview of the breakdown in absolute and relative terms of our investment ratings on our website Note on the evaluation basis for interest-bearing securities: Recommendations relative to an index: For high grade names the recommendations are relative to the "iboxx EUR Benchmark" index family, for sub investment grade names the recommendations are relative to the "iboxx EUR High Yield" index family. Marketweight: We recommend having the same portfolio exposure in the name as the respective iboxx index. We expect that the average total return of the instruments of the issuer is equal to the total return of the index. Overweight: We recommend having a higher portfolio exposure in the name as the respective iboxx index. We expect that the average total return of the instruments of the issuer is greater than the total return of the index. Underweight: We recommend having a lower portfolio exposure in the name as the respective iboxx index. We expect that the average total return of the instruments of the issuer is less than the total return of the index. Outright recommendations: Hold: We recommend holding the respective instrument for investors who already have exposure. We expect that the total return of the instruments of the issuer is equal to the yield. Buy: We recommend buying the respective instrument for investors who already have exposure. We expect that the total return of the instruments of the issuer is greater than the yield. Sell: We recommend selling the respective instrument for investors who already have exposure. We expect that the total return of the instruments of the issuer is less than the yield. We employ three further categorizations for interest-bearing securities in our coverage: Restricted: A recommendation and/or financial forecast is not disclosed owing to compliance or other regulatory considerations such as a blackout period or a conflict of interest. Coverage in transition: Due to changes in the research team, the disclosure of a recommendation and/or financial information are temporarily suspended. The interest-bearing security remains in the research universe and disclosures of relevant information will be resumed in due course. UniCredit Research page 17