Spring is a busy time for states as they work on their budgets for next year. During the period from 2016 – 2018, a number of states were close to late or late in adopting budgets due to fiscal pressure and weak political consensus. This year, the state budget story has been more sedate, with budget deadlines being met; as a result, the municipal market has cheered, seeing the passage of these budgets as an indication of credit stability. We wouldn’t necessarily agree.
“Winning was easy, young man. Governing’s harder.”
— George Washington in Broadway’s ‘Hamilton’
Looking at the issue from an ESG (Environmental, Governance and Social) perspective, the budget process can be a good indicator of a municipal issuer’s quality of governance, which in turn can be highly predictive of credit risk. This is due to the reality that, in times of economic or fiscal stress, effective governance and firm political will are necessary to maintain a solid footing.
Paper vs. Practice
That said, passing a budget on paper is not necessarily an indicator of good governance, particularly where we see aggressive revenue assumptions and/or reliance on one-shot revenue items. Often, overoptimistic budgets—driven by a poor political process—have led to cuts to important programs late in the year, when aggressive assumptions are not realized. One-shot revenues, like asset sales, can be equally problematic because that revenue will not be available for recurring expenditures down the road. More broadly, the process itself—how the different branches of government work together to arrive at a budget—can be an important indicator of governance quality.
This year’s budget process in New Jersey showed signs of a weak consensus between the governor and legislative leaders—potentially signaling that future budgets and positive policy decisions could be difficult to enact. Although the current budget adds funding to high-profile concerns such as pensions and a faltering transit system, good governance goes beyond funding and requires more meaningful change in management. And while additional pension funding is a good start, it doesn’t address the underfunding enough, and the problem requires enhancing the dialogue with public unions in order to reduce pension liabilities.
In assessing the governance component of ESG, it is important to separate short-term good news, such as an on-time budget passage, from long-term fundamental issues such as structurally imbalanced budgets and pension risk. These two factors remain a concern in New Jersey and some other jurisdictions, where we remain cautious on credit quality.