These challenges are primarily due to impaired revenue sources, like sales taxes, and liquidity pressures brought by revenue expenditure mismatches, which has led to serious budgetary shortfalls and reduction in services for not only the current year but years to come. In turn, these underlying revenue impairment issues are putting a downward pressure on the credit ratings for many local governments and potentially restricting or limiting their ability to access the capital markets.

In this article, we will take a closer look at how local governments’ financial preparedness will be tested in the upcoming years.

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As service cuts, layoffs and credit rating downgrades are becoming the inevitable reality of the present and the future, the fiscal forecast for many state and local governments looks quite grim at the moment.

A recent S&P Rating Agency report stated “we expect revenue shortfalls and imbalanced budgets will lead to credit pressure through 2020 and beyond, and in many instances long after much of the rest of the economy has normalized. Falling revenues from sales and other user taxes will pressure ratings, particularly for issuers with limited revenue and/or expenditure flexibility. Uncertainty regarding the amount of federal stimulus that may be forthcoming only adds to issuers’ short-term planning pressures. We expect many issuers will use reserves to bridge gaps in revenue shortfalls. In our view, that would not necessarily exert downward pressure on ratings; we expect downgrades will be more likely for issuers who do not address issues that jeopardize structural balance over the next two to three years, and beyond.”

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That being said, here are some of the areas of concern for local governments:

• Short-term liquidity: Liquidity levels are likely to take a hit for all local and state governments and governmental entities. This means that agencies are likely to burn through their cash and short-term investment reserves to stay afloat. This will ultimately impact transportation agencies in particular, because they rely heavily on their ridership revenues, and during the pandemic more and more employers have asked their employees to work from home or have simply shut down. This means extremely low ridership for transportation agencies, and corresponding low revenues.

• Federal aid provided to local and state governments: The first round of CARES Act funding for local governments has certainly helped them offset the unexpected spending to control and mitigate the risk of COVID-19 in their communities. These funds also provided much-needed liquidity for local governments struggling with impaired sales tax and other revenues; however, federal help cannot be the answer for a long-term fiscally sustainable future for local governments.

• Shifting priorities until economic recovery: As we are seeing budget cuts to services and potential layoffs in local governments, it’s imperative that governing bodies reassess their priorities for their local jurisdictions. This means reducing expenditure and halting previously authorized capital programs until revenue streams normalize. This also underscores the importance of monitoring quarterly budget updates on revenue collections and their improvement over time.

Financial reserves are one of the key financial preparedness tools that some local and state governments deployed very early on to help mitigate the risk of future revenue uncertainties caused by a recession or a natural disaster like COVID-19.

Given the funding levels of financial reserves, they will certainly be a huge help for local governments who deployed this financial preparedness tactic well in advance in getting through the current challenges. Let’s take a quick look at the financial reserves of local governments.

To establish a financial reserve, local governments set aside funds into three designated reserves to address unforeseen emergencies or disasters, significant changes in the economic environment, and key infrastructure and capital projects. These include:

• Catastrophic reserves
• Budget stabilization reserves
• Capital and special projects reserves

The local government will often commit to maintaining these reserves at a minimum of 25% of general fund annual operating expenditures (minus one-time expenditures), equally divided between the catastrophic reserve (15%) and budget stabilization reserve (10%). This general fund reserve policy is reviewed by the board or council as part of the annual operating budget review and adoption process.

Should a catastrophic disaster or loss of a significant source of the city’s sales tax revenue occur, the required reserve level should be adequate to meet the city’s immediate financial needs. For example, in the event of natural disaster, similar to COVID-19, the catastrophic reserve would provide necessary coverage for basic operating expenses for approximately 90 days, including salary and benefits for safety and non-safety city employees, while still meeting debt service obligations. This time frame would enable the city to explore other available cash alternatives.

As more and more state and local governments come out of COVID-19 related shutdowns, economic conditions will unequivocally improve. However, this doesn’t mean that local economies will make a sharp recovery to pre-COVID levels.

It’s certain that COVID-19 related damage to the economy will definitely be felt in upcoming years for local and state government. For municipal investors, they should carefully review their future investments in municipal debt – and the revenues that back that debt – to understand the underlying exposure.

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Disclaimer: The opinions and statements expressed in this article are for informational purposes only and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned. Opinions and statements expressed reflect only the view or judgement of the author(s) at the time of publication and are subject to change without notice. Information has been derived from sources deemed to be reliable, the reliability of which is not guaranteed. Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professionals and advisers prior to making any investment decisions.