Significant financial challenges associated with fighting COVID-19 are straining budgets at all levels of government. State and local governments are likely to face large revenue shortfalls stemming from the economic shutdowns nationwide. These deficits have led some members of Congress to suggest bankruptcy as an option for hard-hit states. David Moore, director of municipal research, provides his perspective on the current situation and likely outcome.
States can’t escape the unexpected economic complications the COVID-19 pandemic has created. In the wake of industry shutdowns, stay-at-home mandates and stock market losses, many states face severe revenue shortfalls. Of course, the duration of the shutdowns and economic downturn will determine the severity of the overall revenue loss, but state and local governments likely will feel the effects for several months. We also expect near-term downward pressure on the credit ratings of many municipal bond (muni) issuers.
But there’s also some good news. Most states entered 2020 with strong reserves and liquidity positions thanks to improved budgetary practices during the economic expansion. In fact, 41 states increased their rainy day funds in fiscal 2019.1
The first line of defense for state and local governments during an economic downturn is tapping cash reserves they accumulated during prosperous times. On average, states’ rainy day balances recently were at record levels, or approximately 7.6% of general fund expenditures at the end of fiscal 2019. Furthermore, states collectively had $113 billion in surpluses and reserves, or approximately 13% of expenditures, at the end of fiscal 2019.2
Many states also have additional general fund reserves and excess cash balances in other accounts they could use to offset revenue shortfalls. And if that’s not enough, states could defer payments to local governments or make cuts in local aid and other state programs. Finally, states could raise revenues through tax increases, but that’s usually the last resort. Meanwhile, local governments, such as cities, counties and school districts, typically carry higher reserve levels than states, given local governments have fewer levers to pull.
While having decent cash reserves certainly will help many states meet some of these unprecedented expenses, these reserves likely will fall severely short. Based on government projections, states will face a record-breaking combined revenue shortfall of up to $650 billion by June 30, 2022.3 In mid-April, the National Governors Association asked Congress for $500 billion in relief aid—the earlier estimate of the deficit. It’s worth noting that the federal government collects approximately $1 trillion in state tax revenue annually.
California, the nation’s largest issuer of munis, entered 2020 with a healthy rainy day fund. The state held approximately $17.5 billion in general fund reserves and $47 billion in available liquidity as of the end of February 2020.4 But government officials estimate the state may experience a budget shortfall of up to $35 billion due to coronavirus-related expenses. For perspective, California had a $60 billion projected budget gap for fiscal 2010, when the state had a smaller budget and no rainy day fund.
Illinois, another notable issuer of muni debt, has minimal general fund reserves. But the state has nearly $11 billion in other cash accounts to help meet its revenue loss.5 Nevertheless, the state’s governor projects the pandemic will cause a $7.4 billion revenue shortfall through June 30, 2021.
Ultimately, it will be up to Congress to determine how much in lost state revenues the federal government will replenish. But given the important role of states in municipalities in our national economy, we expect Congress to provide significant support. The magnitude of the deficits may lead Congress to deliver aid in stages, hoping revenues will rebound as economic activity resumes.
We believe recent discussions about state bankruptcy represent the first salvo in congressional negotiations for additional pandemic-related aid. Currently, state bankruptcy isn’t allowed under Chapter 9. This federal bankruptcy law provides protection for financially strapped municipalities, not states. Allowing states to seek federal bankruptcy protection would require new legislation, which potentially could be declared unconstitutional due to the U.S. Constitution’s contracts clause. And passing such legislation would require bipartisan political support, which currently doesn’t exist. Furthermore, state governments generally reject the idea. In addition to significantly increasing a state’s borrowing costs, declaring bankruptcy would have serious implications for the state’s bondholders, pension beneficiaries, unions and other stakeholders.
And unlike a corporation, which can cease operations and liquidate assets during a bankruptcy, a state is a sovereign entity that can’t “go out of business.” Only half the states allow their local units of government to file bankruptcy. In any case of default, the debtor must prove “insolvency,” a difficult task given states have unlimited taxing power.
Combatting the virus will have serious revenue implications for many states, particularly those with long-standing, high-profile financial challenges. Accordingly, we expect to see more credit-ratings downgrades. But we don’t expect any state to default and believe the federal government ultimately will provide significant support.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
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